March 2014

During Q1 2014 global equity markets continued to grind higher with the MSCI AC World Index generating a total return of 1.2% (USD) and reaching a new all-time record high in March. This was driven by developed markets (+1.4%) as emerging markets (-0.5%) faced continuing pressure. The local market once again outperformed its international peers with the S&P ASX 200 Accumulation index gaining 2.1%. In USD the performance was even better (+6.0%) as the A$ rallied.

At a sector level gains were led by the higher-yielding sectors with Financials and Utilities amongst the best performing. Detracting from performance were the Consumer Staples and Materials sectors as illustrated below:

As noted, the A$ enjoyed a resurgence and ended the quarter above 92 cents against the USD after having traded below 87 cents in January. The strength was broad based with the trade-weighted index up 3.0% as better-than-expected domestic data and a lack of verbal intervention (i.e. talking the currency down) from the RBA helped the recovery.

The US Fed announced a reduction of asset purchases by $10bn in each month of the quarter, with ‘tapering’ effectively beginning in February and by April bond purchases are down to $55bn. This falling support from the Fed was however largely overlooked due to capital outflows from emerging markets into perceived safe havens like US Treasuries. As a result bond yields both domestically and abroad were fairly stable with the UBS Composite Bond index gaining 1.4%.

Given our expectations of relative asset class returns over the next 6 – 9 months our portfolio positioning remains unchanged from last quarter. For clients with diversified asset allocations we are tactically overweight Australian and International equities while being underweight cash, fixed interest and property. The exact combination of over/under weights depends on the specific asset allocation model selected – the maximum overweight to growth assets across all asset allocation models is 7%. As some may be aware, to avoid significant deviations from the long term strategic asset allocation benchmarks that clients have agreed to, we are limited to a maximum cumulative 10% overweight to growth assets (i.e. Australian & International equities and property) in terms of our investment restrictions. Should you require further details please contact your adviser.

While some investors are concerned that in an environment where economic growth remains sluggish valuations are full, we see global growth as trending up led by a recovery in developed market (DM) economies, with the US most advanced in its recovery. Emerging market (EM) growth did came under pressure through mid-2013 from the lift in real bond yields and capital outflows, but recent economic data suggest conditions are stabilising and we believe they can successfully transition their “broken” growth models. Given this more constructive view on EM economies we are reviewing our international exposures, especially given the biggest valuation gap between DM’s and EM’s since early 2000’s as illustrated below:

Domestically recent data suggests that the economy is successfully making the transition from mining investment-led growth to a more broad-based domestic/consumer-led economic growth. The February reporting season also shows that earning per share growth (EPSg) is making an increasingly meaningful contribution to returns, with the improved outlook for EPSg supporting the expanded price to earnings (PE) ratios. Valuation differentials between cheap and expensive stocks are however widening which provides potentially attractive opportunities for active stock picking.

Turning to the A$, we have been somewhat surprised at the extent of the recent rebound but continue to view it as fundamentally overvalued. With this view we remain unhedged on the international exposures. The other implication is that portfolios have substantial exposure to domestic companies that benefit from a weaker A$ due to significant offshore operations, reduced import competition and/or USD denominated revenue.

Finally to fixed income where we expect to see a moderate rise in long-term bond yields, which translates to capital losses for those securities with long duration, such as long-dated government bonds. As such we maintain a bias to corporate bonds that have been outperforming government bonds and are expected to continue doing so.

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