Your asset allocation guide – July 2014

Even though equity prices are high compared to historical levels, we believe equity valuations are not excessive, so equities are still attractive compared to other asset classes. We provide insights on our favoured asset classes and how best to position your portfolio.

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In recent months, a growing number of commentators have warned that the current market environment looks eerily similar to 2007 – before the Global Financial Crisis (GFC) – with some saying equity prices are due for a large correction.

With the US S&P 500 index reaching new highs, record issuance of high yield bonds and low volatility in equity prices, such comments do have some credibility. However, if we were to move out of equities, what asset class should we move into?

Every asset class looks expensive compared to historical levels – bonds are expensive, credit margins are relatively narrow, property in many markets appears expensive and cash returns next to nothing. However, when we look at equities relative to bonds, and factor in earnings growth forecasts, valuations don’t look too stretched.

According to Bloomberg, the US S&P 500 Index has a forecast dividend yield of 2% and earnings growth in 2015 of 12%, implying a total return of around 14% before any currency impact and earnings multiple changes. These returns aren’t bad compared with 10-year US Treasury bond yields of 2.5% per annum. For Australia’s S&P/ASX 200 Index, the dividend yield is 5% but growth is lower at 8%, so the total return is around 13%.  Europe’s STOXX 600 Index has an expected yield of 3.7% and earnings growth of 14% in 2015, for a total return of close to 18%.

So, for investors with a medium to longer term time horizon, equities are still an attractive asset class even if interest rates and equity volatility normalise over the medium term.  And for investors worried about an equity market crash, low volatility makes option protection strategies cheap by historical standards.

Our asset allocation summary:

  •  Cash: Although cash is still a preferred defensive asset, particularly relative to government bonds, we suggest a slightly underweight position. We suggest term deposits out to two years are preferred over at call cash.
  • Fixed income: Preferred over cash and alternatives at present. Suggest an equal split between Australian and (hedged) international bonds. Tactical income, absolute return fixed income strategies, floating rate corporate securities and short duration fixed income preferred over benchmark aware bond strategies.
  • Australian equities: Remain underweight. Valuations are somewhat stretched and growth is lower than in other markets meaning opportunities in the Australian market are hard to find.
  • Property: Hold a neutral allocation to commercial property. Demand for core property is robust and rental growth fundamentals should improve. At current pricing, local and international property appears fair value.
  • International equities: Maintain overweight allocation as growth outlook is more attractive than in Australia. Prefer US equities over European given economic growth profile. Emerging markets are relatively cheap so maintain exposure either directly or indirectly.
  • Alternatives:Maintain a neutral allocation until opportunities emerge. We believe that alternative sources of risk and skilled active management represent important diversifiers for the future. Alternatives as part of an overall strategy of building allocations to assets with low/moderate correlation to equities.

For further analysis, download the full report: