In this month’s Asset Allocation review, we review July 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 0.17% in July as three-month bank bill yields fell from 1.96 to 1.86% per annum as markets moved to price in a higher chance of an August rate cut following the release of the June quarter CPI figures.

At the August RBA Board meeting, official interest rates were cut from 1.75% to 1.50% per annum. The Board concluded that the “prospects for sustainable growth in the economy, with inflation returning to target over time, would be improved by easing monetary policy”. More recently, the RBA updated its forecasts, which indicate that it expects inflation to remain below its target for the next few years, raising the prospect that interest rates may be cut further.

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 sell-off.

Fixed Interest – Domestic and Global

Australian bonds gained 0.74% July after government bond yields in Australia fell to record lows driven by greater prospects that the RBA would cut interest rates.  In July the 10-year Australian Commonwealth Government bond yield fell from 2.01% to 1.90% per annum and the two year bond yield fell from 1.60% to 1.54%.

Internationally, the Barclays Global Aggregate Bond Index (A$ hedged) returned 0.7% as bond yields were mixed in the major economies.  Yields fell 19 basis points in the UK as the market factored in additional monetary policy easing by the Bank of England.  In Germany and Japan, where long term bond yields are negative, yields rose slightly.  In credit markets, the hunt for yield resumed which resulted in investors chasing high yield and investment grade corporate bonds with credit margins contracting during July, after the post Brexit sell-off in June.

We suggest:

• Remain underweight fixed income (both domestic and global).
• With record low bond yields post Brexit, developed world government bonds are very expensive and offer poor absolute value and in some cases negative yields.
• Corporate credit 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 1.3% in July in a volatile month for most asset classes. Event-driven funds posted the strongest gains in July boosted by funds that specialise in distressed companies.  Equity long/short funds also participated in the post-Brexit equity market recovery with value-based strategies outperforming growth strategies.  Hedge funds focussed on macroeconomics and momentum trading posted small positive returns with systematic strategies outperforming discretionary.

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

Returns from unlisted Australian core property funds were 12.7% in the 12 months to the end of June 2016. Average distribution yields range from 5.0% for retail property, 5.5% for offices and 7.3% for industrial property – down on the yields in May as properties were upwardly revalued. REIT prices were stronger with Australian property securities gaining 5.4% in July and global REITs returned 4.9% in hedged Australian Dollar terms.

Demand for commercial real estate is expected to remain high especially demand for prime properties in major cities and strong flows from institutional and high net worth capital which is helping to keep prices firm. Globally, listed real estate is trading at a small premium to historical valuations, when measured against net asset values, but remain at higher dividend yields than fixed income alternatives.  Modest growth in employment and retail sales is also supportive for office, industrial and retail leasing markets.

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 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 (the Index) rose 6.29% with the Materials, Consumer Discretionary and Consumer Staples sectors leading the way. The month began poorly until the release of the US non-farm payroll numbers which precipitated a rally that continued for the balance of the month. Global yields continued to fall and the Australian Dollar rallied on the back of strong gains in iron ore and gold. As such, the Australian equity market outperformed most other developed markets in both local currency and US dollar terms.

While the rally in the Index was broad-based, there was notable underperformance in the Energy sector as the oil price topped out at $50 per barrel and fell away on supply side concerns. Stocks such as Santos (STO
-5.4%), Origin Energy (ORG -4.3%) and Woodside (WPL -1.2%) were among the worst performers in the Index. Defensive sectors such as Telecoms and REITs rallied but underperformed the Index with Telstra adding only 3.8% for the month. High-growth stocks such as BlueScope Steel (BSL +32.7%), Sirtex Medical (SRX +23.1%) and Blackmores (BKL +19.6%) attracted interest as did offshore earners like Aristocrat (ALL +15.5%), ResMed (RMD +10.8%) and Domino’s Pizza (DMP +10.4%).

The fall in global yields has supported world equity markets without the added support of earnings growth. While the markets are benefiting from relative asset class valuation tailwinds, reporting season in both the US and Australia will determine whether the current lofty valuations are justified. Guidance for 2017 earnings will be crucial for current market levels to be maintained.

We suggest:

• Retain an underweight exposure.
• Growth outlook is lower than other markets and valuations are slightly above about fair value.
• Prefer quality small and mid-sized companies with structural growth but beware about high valuations for many of these companies.
• Risks are currently skewed to the downside.

International Equities

Global equities returned 4.1% in July in local currency terms with Germany the best performing developed market with a gain of 6.8% for the month.  Equity markets were buoyed by reasonably good earnings reports in the US and Europe and investor expectations for more monetary and/or fiscal stimulus in the UK, Japan and Europe.  IT shares were the strongest performing sector helped by good results from Facebook, Google and Apple.  Energy shares were the worst performing sector as the oil price fell 14%.

Price-to-earnings ratio valuations in developed markets have returned to the 15-18 times range, with European and Japanese shares at lower multiples than the US.  Emerging market shares are trading on around 12.5 times forward earnings.

We suggest:

• Maintain a neutral exposure to international equities.
• International equities currently offer greater opportunities to invest in companies with structural growth or cheaper valuations than Australia.
• Regionally we favour US and Asian stocks.
• Remain 100% unhedged as we expect a decline in the Australian Dollar (relative to the US Dollar) over the rest of 2016 towards the US$0.70 level.