While developed markets equities appear expensive relative to average long-run price-to-earnings ratios and, given relatively subdued earnings growth, many investors argue that they aren’t expensive when compared to current bond yields. Academic theory suggests that risky assets such as equities should return, on average, about five to six percentage points more than “risk free” long term government bonds. This is based on long term studies comparing equity returns with bond returns.

With the 10-year Commonwealth Government bond in Australia yielding 2.66% per annum (at the end of April), theoretically equities should return about 7.5-9.0% per annum, on average, over the next few years. This return doesn’t appear too demanding when looking at current equity valuations. At current prices, the local share market is providing a dividend yield of 4.5% per annum, another 1.5% per annum in franking credits (so a grossed-up yield of 6.0% per annum) and, if we assume that companies can grow earnings per share at about 3% per annum then we can easily get to 8-9% per annum in long run average equity returns, all else being equal.

Of course, if bond yields return to more “normal” levels – typically the rate of GDP growth plus inflation – so about 6% per annum, then equity returns need to rise through higher dividend yields (potentially involving lower share prices) or earnings need to grow more rapidly. For these reasons, asset allocators and investors need to understand the path of interest rate normalisation undertaken by central banks to avoid a situation, such as in 1994, when bond yields rose rapidly causing both bond and equity prices to fall in unison.

Overall, there are no compelling reasons to change our asset allocations this month.

Our asset allocation summary:

• Cash: Hold an overweight position in cash to be able to take advantage of new opportunities when they arise, for example, a selloff in equities. We suggest shorter maturity term deposits over at call cash.

• Fixed income: We suggest an overweight position in fixed income until we identify opportunities in alternative investments to shift capital into. Developed world government bonds are very expensive and offer poor absolute value, so prefer products with limited interest rate risk. We suggest an equal split between Australian and (hedged) international bonds. Tactical income, absolute return fixed income strategies and short duration fixed income are all preferred over benchmark aware bond strategies.

• Australian equities:Remain underweight. Growth outlook is lower than other markets and valuations are above fair value. Favour selected industrials such as financials, healthcare and utilities. Hold positions in quality smaller companies but do not add.

• International equities: Given higher valuations in developed market shares, hold a neutral weighting. Maintain unhedged currency exposure for now. Emerging markets are cheaper than developed markets so maintain exposure and favour Asia over other regions.

• Alternatives: Maintain a neutral allocation until opportunities emerge. Alternatives represent an important part of an overall strategy of building allocations to assets with a low/moderate correlation to equities.

• Property: Hold a neutral allocation to commercial property. At current pricing, Australian and international property appears fair value. Favour international property securities over Australian.

For further analysis, download the full report (PDF, 360KB)