After a solid start to the quarter, global equity markets sold off sharply in September which saw the MSCI AC World Index down -2.2%.  Losses across Emerging Markets (-3.4%) exceeded those of Developed Markets (-2.0%) with the latter benefitting from a more resilient US market where the S&P500 index gained +1.1%.  In common currency (i.e. USD) the domestic Australian market underperformed significantly with the S&P/ASX300 index down -7.8% thanks largely to the weaker Aussie dollar which suffered its largest monthly decline against the USD since May 2013 in September.   The currency weakness was broad with the RBA’s trade-weighted index falling -4.3%. In local currency the S&P/ASX300 index decline was -0.6%.   (Note: all performances are quoted on a total return basis and for the quarter unless stated otherwise)

Domestically the weakest major industry group was Banks (-4.5%) as investors priced in the risk of higher capital requirements and possible credit controls aimed at cooling the housing market. The Materials sector (-2.8%) also lagged the broader market, though probably less than expected given the weakness in commodity prices.  The standout sector was Health Care (+9.4%) followed by Telecommunications (+5.5%).  While sector positioning across client portfolios differ depending on the Australian equity option chosen, we are very underweight Banks across all options (preferring Diversified Financials and Insurance) while being overweight Materials to varying degrees.

Following the August reporting season FY14 EPS growth for the market overall was largely as forecast with expectations for FY15 & FY16 also little changed despite the tough operating environment for domestic facing businesses in particular. Top-line revenue growth remains subdued, with earnings growth aided by lower-than-forecast net interest and tax expenses. The main surprise was strong operating cashflow helped by tight ongoing cost control and strict working capital management – the sustainability of this will be key going forward. Capital expenditure also continued to drop resulting in a strong increase in ‘free to invest’ cashflow and strong dividend growth.

Despite being tactically overweight growth assets across all diversified asset allocation models (i.e. Growth/ Balanced/ Moderate/ Conservative), given the strong start to the quarter from Australian equities in particular, the impact from tactical asset allocation ranged from flat for the Conservative & Moderate models to -0.13% for both the Balanced & Growth models.  I want to reiterate that any deviations from the long term strategic asset allocation benchmarks that clients have agreed to are limited to a maximum cumulative 10% overweight to growth assets (i.e. Australian & International equities and listed property) in terms of our investment restrictions.

The positive currency impact as a result of the international equity exposures being unhedged resulted in clients with portfolios that have an allocation to this asset class generally performing better than those focused purely on Australian equities.

Looking ahead, especially considering the pull back in shares over the past month, investors are obviously questioning whether this is the start of a deeper and more protracted bear market or simply a to be expected short term correction?

In our view it’s a correction given:

• equity valuations are reasonable as highlighted in the chart below (provided earnings hold up);
• while uneven and below the long term trend, global economic growth remains sufficient to support single digit company earnings growth;
• dividend yields remain attractive in a low interest rate environment;
• despite Fed tapering and the focus on monetary policy tightening in the US, the ECB maintains an easing bias as does the BOJ. With subdued global inflation the monetary policy environment will remain supportive;
• strong company balance sheets support the potential for capital management; and
• in Australia specifically, investors remain overweight cash despite deposit rates having decreased substantially over the past 18 months. Any reallocation back into equities to nearer pre-GFC levels will be supportive of the equity market.

Source: Morgan Stanley Research

Turning to the Aussie dollar, we expect the local currency will continue to drift lower over 2015, especially against the USD as Australian-US interest rate spreads narrow as the US normalises rates.   The persistence of zero rates (and QE) in Europe and Japan could however support on-going “carry trade” capital inflows into the AUD and help limit any weakness against the currencies of these regions.   With the expectation of a weaker AUD we remain overweight (and unhedged) international equities with a preference for Asia.

Finally to fixed income and Australian listed property where the outlook for the latter is expected to be tied to the direction of bond yields and investor appetite for ‘yield stocks’.   The RBA is expected to hold rates steady until at least 1Q15 while longer bond yields will rise from current historic lows driven by higher long bond yields in the US as confidence in the economy there grows.   Any further credit spread contraction is also expected to be fairly limited with spreads back to post-GFC lows. We thus expect muted returns from fixed income generally and longer dated fixed rate bonds in particular.  As such we maintain our tactical underweight position in fixed income with a preference for floating rate corporate credit.   As regards listed property, despite the sectors more defensive earnings holding up relatively well we also remain slightly underweight given the expected rise in bond yields coupled with price-to-book values slightly above the 20-year average.

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