With the large fall in the Australian Dollar over the past month, due to declining commodity prices, a stronger US Dollar and rising equity market volatility, we’re reminded that currencies are good “shock absorbers” in financial markets and the economy.

So, the Reserve Bank of Australia continues to try talking down the Australian Dollar to help rebalance our economy away from mining investment to manufacturing, tourism and sectors which benefit from a lower exchange rate.

In financial markets, falling equity prices often go hand in hand with currency declines, particularly in economies such as Australia where foreign investors can rapidly sell local securities and repatriate funds back into US Dollars or Japanese Yen. This was seen in September when global equities were down 1% in local currency terms, but on an un-hedged basis, the MSCI World ex-Australia index actually rose 4.3% (as the Australian Dollar fell 6.3% against the US Dollar). This is why we’ve favoured an unhedged exposure to international equities: to see positive returns from currency gains when shares sell off, but also because we think the Australian Dollar was fundamentally overvalued and likely to decline.

By contrast, for lower risk focused portfolios, it makes sense to hedge foreign currency exposure associated with international bonds and property investments. Not only do these portfolios have a low exposure to equity market movements but income payments and capital values of bonds and property are more stable and predictable and therefore more easily hedged.

Our asset allocation summary:

• Cash: Hold a slight overweight position until better opportunities emerge. We suggest term deposits out to two years are preferred over at call cash.

• Fixed income: We suggest an overweight position, and an equal split between Australian and (hedged) international bonds.

• Australian equities:Remain underweight. Valuations have pulled back but growth outlook remains lower than other markets. Favour selected industrials (i.e. 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 maintain exposure either directly or indirectly through the emerging markets earnings of global companies.

• Alternatives: Maintain a neutral allocation until opportunities emerge. Alternatives represent important diversifiers and as 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 and rental growth fundamentals should improve. At current pricing, Australian and international property appears fair value.

For further analysis, download the full report.

• Your asset allocation guide – October 2014 (PDF, 359KB)