February 10, 2015

Your asset allocation guide – February 2015

2014 was another strong year for international shares, with only part of the gains for Australian investors attributed to a weaker AUD. However, with the prospect of Australian interest rates falling further, investors’ future income from currency hedging is unlikely to be as high.

2014 was another strong year for international shares which delivered a 15% return in Australian Dollar terms (assuming no currency hedging).

Although part of the return from international shares was driven by the decline in the Australian Dollar (which fell 8.5% against the US Dollar in 2014­), overall currency gains were less than this. This was because the Australian Dollar rose about 4% against the Yen and Euro, reducing gains from currency to about 4-5%.

Given further falls in the Australian Dollar so far this year to US$0.77 – 78 (and economist estimations of fair value at US$0.75), our expectation of further currency depreciation is much lower than previously.

However, whether we shift our recommendation to fully or partially hedge international equities exposure remains an open question. In the past, there were significant income benefits from hedging against changes in the exchange rate. This is because short-term interest rates in Australia were much higher than other major markets. Going forward, the outlook is for a second cut in Australian official interest rates while US interest rates “normalise” back up to pre-financial crisis levels. This means income from currency hedging is unlikely to be as great. The other fact to consider is the portfolio diversification benefits an investor receives by remaining unhedged. Our currency tends to fall at times when investors are reducing risk (that is, selling shares or commodities) so currency can act as a good investment “shock absorber”.

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 term deposits out to two years are preferred over at call cash.
  • Fixed income: We suggest an overweight position. 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, floating rate corporate securities and short duration fixed income are all preferred over benchmark aware bond strategies.
  • Australian equities:Remain underweight. Growth outlook remains lower than other markets. Favour selected industrials (that is, offshore earners).
  • International equities: Given higher valuations in developed market shares, hold a neutral weighting. Maintain unhedged currency exposure. Emerging markets are relatively cheap so direct or indirect exposure is recommended.
  • 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. Demand for core property is robust as larger investors seek to buy real assets with attractive rental yields. At current pricing, Australian and international property appears fair value.

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