The June 2013 quarter was a tale of two halves with central bank monetary policy dominating financial market movements during the quarter.  Large scale asset purchases by the Bank of Japan helped the Q1 rally to continue early in Q2, but both equity and bond markets then lost ground as the US Fed signalled that its QE program could be scaled back sooner than anticipated, and the People’s Bank of China appeared to take a tougher stance on rampant credit growth in the shadow banking sector.

Following the swings and roundabouts the MSCI World (USD) index finished Q2 down -0.1% while the local ASX300 index lost -3.6% (-2.8% accumulation). Yet again the worst performing sector was Materials (-11.6% accumulation) as investors sought relative safety in the defensive sectors, the best performing being Telcos (+6.2%), Health Care (+3.9%) and Real Estate (+3.3%).

Our currency suffered its steepest quarterly fall against the USD since December 2008 as it tumbled below parity to close the quarter at 0-91 cents. On a trade weighted basis the AUD lost over 10%.  Global bond yields moved dramatically higher and credit spreads widened (both negative for bond prices), as markets adjusted to the Fed’s signalling of a conditional exit path from its accommodative policy settings.  Despite this, Australian fixed income managed to eke out a small gain with the UBS Composite Bond index gaining 0.4%.

There is no doubt that central banks have gone to great lengths to stimulate economic recovery as the graph below – which shows the increase in central bank balance sheets as a % of GDP – illustrates:

Concerns around changing policy conditions are thus understandable.  It should not be forgotten though that a “tapered” withdrawal still implies further balance sheet expansion – albeit at a slower pace.  Secondly, the backdrop in which the Fed is comfortable tapering its current QE program is one of an expanding US economy – particularly the corporate sector – which should be supportive of company earnings growth and hence share market gains. Having spent so much reputational capital on their stimulus policies, it is unlikely that central bankers will risk removing the stimulus prematurely.

We however expect that due to the changing policy environment, the PE multiple expansion which helped drive equity markets higher until recently, is coming to an end.  This is despite both global and domestic valuations being relatively undemanding at around 13x estimated earnings for next year. Any further equity market gains will have to be driven by earnings growth.

So given the domestic earnings growth has disappointed over recent years, what is the outlook for the year ahead?

Our view expressed last quarter – that earnings appear to have bottomed – remains unchanged despite a patchy economy and questions around whether the non-mining sector can offset the clear slowdown that is occurring in the mining sector.  Financial conditions in Australia have eased significantly during the last quarter which will help de-risk the economy looking to next year and beyond.  Looking to FY13/14, earnings will be supported inter alia by cost savings programs and the weaker A$.

While the precise impact of the fall in the A$ – which we have been saying was fundamentally overvalued – is difficult to predict, on balance it should be good for overall earnings.  All else being equal, companies in the resource sector should clearly benefit from a weaker currency.  While the latest uncertainty around Chinese growth will obviously not help resource stocks, following the continued share price weakness despite the lower A$, valuations of the major miners and energy companies are attractive, especially with the rising A$ fully franked dividend yields on offer.

For the broader industrials sector, the impact is less certain since companies with offshore earnings will benefit while those with significant imported input costs could be worse off.  Then there are companies whose locally produced products compete for sales with imported goods.  Estimating the sales volume increase for these domestic producers is difficult, but it should be positive.  So even for the industrial sector we believe the impact on earnings will be positive, though less so than for the resource sector.  Ultimately the extent of the benefits does of course depend how much the AUD depreciates.

Even after the recent backup in global bond yields the relative valuation appeal of equities versus bonds and cash remains attractive.  Accordingly, from a tactical asset allocation standpoint, across the more conservative diversified portfolios we remain broadly overweight Australian equities and fixed income while being underweight cash.  Across the more balanced diversified portfolios we remain overweight both Australian and International equities while being underweight cash and fixed income.

Within fixed income we still prefer investment grade corporate to sovereign bonds as very solid balance sheets combined with limited supply should be supportive of corporate credit over the next 12 months. With our medium term view being that rates will rise even further from current levels, the majority of our exposure is to floating rate debt.  QE tapering by the Fed and bond redemptions by offshore investors as the A$ weakens could be a near term negatives, though we expect the impact to be less severe for bonds with short maturities as the RBA maintains its easing bias.

With the A$ at current levels, the extent of fundamental overvaluation is obviously less than before.  Despite the recent depreciation our offshore exposures remain unhedged as most of the key drivers for the A$ are still working to the downside.  This is however being closely monitored and we will look to progressively add currency protection if the A$ continues to depreciate.

In conclusion, our base case for the second half of 2013 remains largely unchanged from last quarter.  Equities are unlikely to benefit from PE expansion but the financial conditions in the domestic economy are much better than a year ago.  Global liquidity will remain accommodative as central banks avoid the risk of killing any recovery too early.  A greater focus on economic fundamentals could lead to increased short term volatility, but investors should continue to find better opportunities for portfolio growth from equities as opposed to the fixed income market.

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