The September quarter saw global equity markets resume their march higher following the losses in May and June on talk from the Fed of “tapering”. The MSCI World Index (USD) gained 7.7% over the quarter despite its largest constituent – the US at around 53% – lagging as the S&P500 gained 4.7%. The stand-out region was the euro zone with the Euro Stoxx 50 up 11.2%. The Australian market did not disappoint with the ASX200 accumulation index rallying 10.2%, its best quarter in four years.

At the sector level there was a near perfect reversal of fortunes from the June quarter as the equity market’s charge higher was led by the cyclicals, with the traditional defensive sectors lagging. The best performing sectors included Materials (+14.7%) and Consumer discretionary (+13.2%) while A-Reits (-1.1%) and Consumer staples (+2.9%) lagged the broader market.

For the AUD it was a tale of two halves as the local currency initially continued its slide lower, trading as low as 88.5 cents against the USD before rallying strongly to end the quarter up 2% at 93.2 cents. The stronger local currency is a negative for the international positions as these are unhedged.

Over the quarter global bond yields continued higher (negative for bond prices), though pressure on bond yields did ease after the US Fed decided against “tapering”. With the RBA having cut the cash rate to a record low 2.50% and Australian long bond yields rising due to developments overseas, at the end of the quarter the difference between the 10-Yr bond yield and the cash rate stood near the highest level since April 2010. As the cash rate has continued lower, investor sentiment towards deposits as the wisest place to invest has been declining too.

Turning to portfolio positioning, this remains broadly unchanged from the June quarter.  With both global and domestic equity market valuations around fair value, further gains will need to be driven by earnings growth and not multiple expansions.  We view the defensive / yield plays as generally expensive.   Many cyclical stocks are also trading in-line with the broader market, but given our expectation of continuing improvement in global growth, we see the potential for further earnings recovery to mid-cycle levels as greater than the market consensus currently expects.  Accordingly the “Blend” and “Growth” Australian equity models are currently tilted towards the Industrial and Materials sectors.  In the “Income” model, portfolios are more defensively positioned given the focus on dividend income, but we do have a tilt towards Consumer discretionary where investors are being rewarded with solid yields while waiting for an improvement in the retail environment.

Within fixed income we still prefer investment grade corporate to sovereign bonds due to the following which should be supportive of credit over the next 12 months:

• very solid company balance sheets with net leverage well below the 10 year average;
• high interest cover by historic standards, currently at decade highs;
• reduced refinancing risk with median short term debt as a % of total debt at the lowest level since 2004; and
• limited supply.

While we have been underweight fixed rate bonds in client portfolios for the better part of two years, if yields continue to rise we will reconsider this stance and look to add additional interest rate exposure.  With long term rates more likely to be driven by international developments whereas shorter term rates should be supported by an accommodative RBA, any addition of fixed rate bonds will initially be shorter maturity.

Despite 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.

Turning to the A$, we continue to view it as fundamentally overvalued against the USD. Medium term the local currency adjustment lower is expected to be driven by inter-alia:

• a lower interest rate spread as rates in the US start increasing as economic growth picks up, while rates in Australia are kept lower for longer to help the domestic economy adjust to the mining boom slowdown; and
• a normalisation of foreign ownership of Australian bonds.  With international investors seeking high yielding AAA rated bonds during periods of market stress, foreign ownership of Australian bonds surged as high as 80% of the total outstanding.  As global sovereign credit risk fears ease, foreigners will start reducing their holdings putting pressure on the A$.

With this view of a weaker A$ we remain unhedged on the international exposures. Should the currency however weaken as expected we will look to progressively add currency protection as the A$ depreciates. While the level at which hedging starts will depend on prevailing market conditions at the time and the cause of the weakness, it will likely only start at levels below the recent low of 88.5 cents. The other implication of this view 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.

In conclusion, our base case remains largely unchanged from last quarter.  Equity valuations on an absolute basis are probably around fair value, with earnings for cyclical companies expected to rebound more strongly than market consensus expects as the global economy continues to recover.  From a relative valuation perspective equities remain more attractive than cash and fixed income, but the easy gains have been made and we will need to see earnings growth going forward.  The A$ remains overvalued so we persevere with the unhedged international exposures and allocation to domestic companies with significant offshore revenues.

Finally, within fixed income we still prefer floating rate corporate credit, but as sovereign bond yields continue to rise we will look to increase the allocation to fixed rate bonds, starting with shorter maturity bonds.

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