Your asset allocation guide – March 2017
We review February conditions and recommend overweight exposure in cash and alternative assets, with underweight positions in fixed interest, property and Australian equities, while keeping neutral exposure to international equities.
Australian bank bills returned 0.13% in February as three-month bank bill yields ticked up from 1.77% to 1.78% per annum over the month.
At its March board meeting, the Reserve Bank of Australia kept interest rates on hold, as expected. The post-meeting statement from the RBA Board continued to paint a relatively more optimistic view with the RBA noting higher commodity prices, stronger global growth and better business and consumer sentiment. The RBA has made it clear that they are concerned about high levels of household debt. On balance it appears that interest rates are likely to be on-hold over the next six to twelve months.
- Retain an overweight exposure.
- Cash is preferred over government bonds for additional defensive asset exposure.
- Cash includes at-call cash and short term bank term-deposits.
- Cash holdings provide the ability to opportunistically buy other asset classes if there is risk asset sell-off.
Fixed Interest – Domestic and Global
Australian bonds returned 0.17% in February as government bond yields rose marginally in Australia helped by the stronger than expected GDP data and RBA commentary suggesting that interest rate cuts are less likely in 2017. Over the month, the two-year Australian Commonwealth Government bond yield rose from 1.80% to 1.83% per annum and the ten-year bond yield rose from 2.73% to 2.75% per annum.
Internationally, the Bloomberg Barclays Global Aggregate Bond Index (A$ hedged) returned 0.91% as bond yields fell in Germany and the United Kingdom as investors pushed back the timing of interest rate increases. In the US, 10-year Treasury bond yields fell from 2.45% per annum to 2.36% as investors dialled down expectations for major policy changes from the new Trump administration . Credit markets continued to perform well with credit spreads on investment grade and high yield bonds falling further as investors priced in lower bond default rates over the next few years.
- Remain underweight fixed income (both domestic and global).
- The sell-off in government bonds over late 2016 appears to have largely run its course and we expect bond yields to trend higher in 2017.
- Investment grade and high yield credit still offers reasonable value given low default rates.
Alternative Assets – Defensive and Growth
The HFRI Fund of Funds Composite Hedge Funds index in US Dollars returned 0.90% in February with gains recorded across all the sub-strategies. Equity long / short funds had the best performance for the month, with returns of 1.2%, taking 12-month returns to 14.5%. Marco funds also had a positive month with a return of 0.8% but returns for the past 12 months remain negative at -1.0%.
- Retain an overweight position to both defensive and growth alternative asset strategies.
- Manager selection remains more important than strategy selection.
- We expect that political uncertainty in the US and Europe should mean that market volatility and return dispersion will remain elevated in 2017 which should benefit some alternative strategies.
Unlisted Australian core property funds returned 0.3% in January 2017 and 11.0% over the past 12 months. Average distribution yields have been falling over the past six months due to higher valuations, with yields currently 5.1% per annum comprising 4.9% for office property, 4.9% for retail property and 7.0% for industrial property. Over the past one year and three years, office funds had the best performance with annual total returns of 13.8% and 13.4% respectively. Australian property securities returned 4.1% in February, and globally they returned 3.6% in hedged Australian Dollar terms.
Institutional demand for commercial real estate remains solid, particularly prime properties in major cities. Australian employment growth and retail spending are running at reasonable levels supporting the leasing market for office and retail properties which is helping to drive up valuations.
- Hold an underweight position in property as bond yields are expected to climb higher.
- No preference for A-REITs over global REITs.
- Where opportunities exist, favour direct and unlisted property over REITs.
- We prefer office and industrial over retail property.
The S&P/ASX 200 Accumulation Index returned 2.3% in February. The Australian market was dominated by reporting season. Reporting season trends appear to be mostly stock-specific than thematic, apart from the improvement in resource stock earnings. Generally bank, consumer staple and healthcare results were in line with mixed outcomes across US$ earners and domestically-focussed stocks. Excluding resource stocks, earnings per share growth for this financial year appears to be muted at ~3%, with most domestically-focused companies struggling to grow top line revenue, with cost cutting and/or acquisitions driving earnings growth.
Stocks that have surprised most positively compared to consensus expectations were AGL Energy, ANZ Banking Group, Boral, Bluescope, CIMIC Group, Coca Cola, Computershare, DownerEDI, JB Hi-Fi, Resmed, Rio Tinto, Transurban Group, Treasury Wine Estates and Woolworths. In contrast there have been noteworthy disappointments from Bendigo Bank, Blackmores, Brambles, Domino’s Pizza Enterprises, Flight Centre, Henderson Group, IOOF Holdings, James Hardie Industries, Primary Healthcare, Tabcorp Holdings, Telstra and Westfield Corp.
- Retain an underweight exposure as growth outlook is lower than other markets and valuations are above fair value.
- Avoid yield-sensitive stocks and favour opportunities in cyclical industrials and resources sectors.
Developed market international equities returned 3.2% in local currency terms and 1.5% in Australian Dollar terms. Shares in the United States once again made fresh record highs late in February with the Dow Jones Industrial Average Index rising 5.2% over the month helped by reasonably good earnings reports in the United States. Globally, healthcare stocks produced the highest returns with a gain of 6.2% in February following Donald Trump’s meeting with drug company executives in late January where he promised to ease regulations and accelerate the approval process for new medicines.
Overall valuations now appear somewhat stretched in the United States but to some extent are offset by potential tax cuts and higher revenue and earnings growth expectations. Valuations in Europe and Japan are more reasonable.
- Maintain a neutral exposure to international equities.
- Favour structural growth stocks, particularly in the innovative IT sector. Healthcare has traditionally been the least vulnerable to rising rates.
- Remain 100% unhedged as we expect a modest decline in the Australian Dollar (relative to the US Dollar) over 2017.