Your asset allocation guide: October 2016

We review September 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.

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In this month’s Asset Allocation review, we review September 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.

Cash

Australian bank bills returned 0.14% in September as three-month bank bill yields remained unchanged at 1.74% per annum following the RBA’s August rate cut.

At the October RBA Board meeting, official interest rates were left unchanged, as widely expected, and the post-meeting statement did not contain any indication as to the timing or direction of the RBA’s next move. At his first speech as RBA Governor, Dr Lowe, indicated that the RBA is relatively relaxed with allowing inflation to remain below its 2-3% target range for a period of time suggesting that the RBA would not necessarily be concerned about a low inflation reading for the September quarter, which is released later in October.

We suggest:

  • 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 lost 0.22% in September after government bond yields rose marginally in September. The two-year Australian Commonwealth Government bond yield rose from 1.45% to 1.55% per annum and the ten-year bond yield rose from 1.89% to 1.97%.

Internationally, the Barclays Global Aggregate Bond Index (A$ hedged) returned just 0.07% as bond yields rose in the United States and United Kingdom but fell marginally in Germany and Japan. In the US, 10-year Treasury bond yields finished four basis points higher at a yield of 1.61% after trading as high as 1.74% intra-month before the September Fed meeting where officials elected to keep interest rates on hold. Credit markets were subdued, like equity markets, with little change in credit spreads during the month.

We suggest:

  • Remain underweight fixed income (both domestic and global).
  • Developed world government bonds are very expensive and offer poor absolute value unless the world falls back into recession, which is unlikely.
  • 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 0.45% in September and 2.4% for the quarter. Equity long/short funds produced the strongest returns over the month with growth-based strategies outperforming market-neutral and value-based strategies. Hedge funds focussed on macroeconomics and momentum trading generated small losses for the month while event-driven and relative value strategies posted average returns of around 0.5% in September.

We suggest:

  • Retain an overweight position to both defensive and growth alternative asset strategies.
  • Manager selection remains more important than strategy selection.
  • Liquid alternative asset strategies such as hedge funds remain favoured for incremental risk exposures in times when traditional asset classes appear expensive.

Property

Unlisted Australian core property funds returned 11.5% in the 12 months to the end of September 2016. Average distribution yields range from 5.0% for retail property, 5.1% for offices and 7.2% for industrial property – with the upward revaluation of office properties pushing yields down from 5.5% in July. REIT prices were weaker in September as the sell-off in yield-sensitive stocks continued. In September, Australian property securities lost 4.3% and global real estate securities lost 1.3%.

Institutional demand for commercial real estate remains strong, particularly prime properties in major cities. In Australia, offshore demand for higher-yielding Australian assets is supporting property valuations. Modest growth in employment and retail sales is also supportive for office, industrial and retail leasing markets. However, listed real estate securities are vulnerable to higher interest rates in the United States and a general rotation away from “bond proxy” stocks.

We suggest:

  • Hold an underweight position in property.
  • Global and Australian REITs have become expensive on the back of record low bond yields and strong price performance over the past few years.
  • No preference for A- REITs over global REITs.
  • Where opportunities exist, favour direct and unlisted property over REITs.

Australian Equities

The S&P/ASX 200 Accumulation Index increased by 0.5% as the market started to sense the possibility of earnings growth in 2017. As with last month, the best performing sectors were materials (predominantly resource stocks), consumer staples and financials (ex-REITS). These were mirrored by underperforming interest rate sensitive sectors such as REITs, tele-communications and utilities.

Best performing stocks included South32 (S32, +25.5%), Northern Star Resources (NST, +15.1%), Challenger (CGF, +10.7%), and BHP Billiton (BHP, +9.5%). TPG Telecom (TPM, -29.3%), Santos (STO, -18.7%), and Vocus Communications (VOC, -19.0%) were the most significant underperformers.

In spite of the lack of movement in global bond yields, there has been a significant rotation away from high-yielding stocks. We believe that we have seen the ultimate low in bond yields and see no reason to chase yield over cyclically-biased companies. We remain positive on resource stocks and are looking for potential opportunities in the energy and mining services sectors.

We suggest:

  • Retain an underweight exposure.
  • Growth outlook is lower than other markets and valuations are slightly above about fair value.
  • Avoid yield-sensitive stocks and favour opportunities in resources and cyclical sectors.

International Equities

Global equities returned 0.2% in September in local currency terms. Asia ex-Japan was the best performing region again with a gain of 1.7% for the month. Energy shares were the best performing sector, helped by an 8% rise in crude oil prices. In early September equity markets sold off after comments from a US Federal Reserve official suggested that interest rates could be increased at the September Fed meeting. However, markets recovered later in the month after the Fed’s Open Market Committee elected to keep interest rates unchanged.

In an absolute sense Price-Earnings ratios are full, but compared with returns from bonds or cash valuations do not seem excessive. Moderate economic growth should be sufficient to support mid-to-high single digit earnings growth for the key US and European indices in 2017. 2016 earnings growth is estimated at just 0.8% for the US and 1.8% for Europe, but improved energy and commodity prices should boost earnings in 2017. Bottom up consensus estimates are for 13.3% growth in both the US and Europe in 2017.

We suggest:

  • Maintain a neutral exposure to international equities.
  • Favour structural growth stocks, particularly in the innovative IT sector. Health care has traditionally been the least vulnerable to rising rates.
  • Remain 100% unhedged as we expect a decline in the Australian Dollar (relative to the US Dollar) over the rest of 2016 and 2017.