June 2014
During Q2 2014 global equity markets rose in each month which saw the MSCI AC World Index steadily gain 4.3% (USD) over the quarter. This was driven by rebounding emerging markets (+5.6%) as developed markets (+4.2%) lagged slightly. In common currency (i.e. USD) the domestic market underperformed its international peers as the S&P/ASX100 index gained +1.8% thanks largely to the stronger Aussie dollar which continued its broad based rally and ended the quarter at a new year-to-date high against the US dollar. In Aussie dollars the S&P/ASX100 index gained only 0.2% while trading in a very narrow range. Notwithstanding the negative currency impact as a result of the international exposures being unhedged, clients with portfolios that have exposure to international equities generally performed better than those focused purely on Australian equities.

At a sector level the defensives where generally amongst the best performing as falling bond yields helped the yield-heavy sectors such as A-Reits, Utilities, Telco’s and Banks. Meanwhile weaker iron ore prices and the stronger local currency combined to weigh on the Materials sector. While sector positioning across client portfolios does differ depending on the Australian equity option chosen, we are underweight Real estate and Banks across all options while being overweight Materials to varying degrees. As a result our sector allocations detracted from relative performance during the quarter.

Based on CBA data this sector positioning puts us at odds with the average retail investor as illustrated below. Shown are the Commsec retail holdings in each sector relative to the S&P/ASX200 sector weightings. Given the current index weightings it implies retail investors have on average nearly 40% of their equity portfolios allocated to Banks.

Purely from a risk management perspective we would caution against exposing such a significant portion of one’s portfolio to a sector where the companies are ultimately all exposed to the same broad factors, in particular the demand for credit from business and households, the related ability of borrowers to service this debt and the quality of the security (i.e. predominantly housing) provided. Based on the most recent credit data business borrowing remains subdued, personal credit growth is negative, owner-occupier home lending is growing at the slowest pace in nine months with investor housing credit growth the main bright spot enjoying high single digit annual growth. While we certainly do not expect a housing correction in Australia, banks have enjoyed earnings upgrades during the last 6 months helped by continued lower bad and doubtful debts expense and the release of impairment provisions. In the context of record low interest rates, the majority of homeowners still preferring variable rates, home price increases in the major cities over the past 12 months negatively impacting affordability and our expectation that the next interest rate move will be an increase sometime later next year, we are more cautious around continued investor led housing credit growth and further reserve releases to boost earnings. In essence we view banks as currently expensive relative to growth prospects over the next 12 months but concede that they could remain well supported near term given the attractive dividend yields, especially if bond yields stay near record lows.

Unchanged from last quarter given our expectations of relative asset class returns over the next 6 – 9 months we remain tactically overweight Australian and International equities while being underweight cash, fixed interest and real estate for clients with diversified asset allocations – 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 currently is 7% which last quarter detracted slightly from performance, primarily due to the overweight to Australian equity and underweight real estate. 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.

Turning to the Aussie dollar, we continue to view it as fundamentally overvalued and as such remain unhedged on the international exposures. In terms of our geographical exposures we increased the allocation to Asia during the quarter while decreasing the weighting to the US as the latter traded back to record highs. Despite being a beneficiary of improving global growth, the region (including both developed and emerging countries), has lagged in terms of market performance over the past year. Fears around the impact of slowing rates of growth in China meant Asian markets have not enjoyed the PE rerating like other regions, such that both absolute and relative valuations are compelling for patient investors.

The other implication of our view on the local currency is that across all Australian equity options, portfolios have substantial exposure to domestic companies with significant offshore operations that should benefit from a lower A$. Across the various options examples of companies earning at least 70% of FY13 revenue offshore include Amcor, Ansell, Brambles, Resmed and QBE.

Finally to fixed income where a drop in the yield curve (there is an inverse relationship between the price and yield) saw the UBS Composite Bond Index 0 – 5 Yr. gain +1.7%. Given that we expected to see a moderate rise in bond yields coming into the quarter we were underweight interest rate exposure with a preference for floating rate corporate credit. This view resulted in our fixed income allocations underperforming the benchmark with returns ranging between +1.3% to +1.5%. We are however persisting with the bias to floating rate corporate bonds on the expectation that yields are ultimately going higher which will lead to capital losses on fixed rate bonds.

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