Clarity amid Caution

We think recent share market declines reflect sentiment more than fundamental change.  Equities seem neither cheap nor expensive, with expected modest global growth likely to reward patient investors.  European and Japanese equities (shares) are more attractively priced than the US and they’re also likely to benefit from structural reforms, easier money and depreciating currency.  Australian shares are generally fairly valued with a relatively high tax-advantaged yield and solid earnings growth in some areas.

However, the defensive part of a portfolio offers unpalatable choices.  Interest bearing returns are the lowest ever at 2-3% p.a.  Longer dated bonds involve significant capital risk if rates rise beyond current market expectations.  Inflation-linked hybrids are a little better but can involve stock market risk, as they’re often really preference shares.  Gradually rising US interest rates and a possible surprise from rising inflation may create headwinds for bonds and property.

The defensive portion of your portfolio is unlikely to add to overall return.  Instead its role is now simply preservation of capital – still a worthy outcome.  So, let’s first summarise our view of the investment climate around the world, which may point to sources of financial caution.

Continued episodes of high volatility can be expected amid uncertainty about slowing China, falling commodity prices and rising US interest rates and US$.  This creates weak manufacturing, trade and capital spending.  But offsetting this, the service industries are growing strongly in the US, China and Europe.  This is due to better employment, low interest rates and energy costs, which makes consumption the key to global growth.

The slowdown in China should not be surprising but there, retail sales outstrip industrial sales in the gradual shift from infrastructure to consumer-led growth.  High debt and over-capacity is weighing upon industrial activity, putting Chinese manufacturing in deep decline.  Meanwhile, strong ongoing retail sales growth from China’s hugely emerging middle class reduces the risk of overall recession there.  Further stimulus is likely… while their structural reforms take effect.  So, China’s transition to consumer-led growth gives consumer goods and service providers great opportunities – can Australia be nimble enough?  We need to be… and India lies in the wings.

The biggest commodity boom in history created massive oversupply, exacerbated by reducing demand.  Low energy pricing should boost demand and reduce non-OPEC supply, thus helping to offset the re-entry of Iranian oil for a better balanced market later this year.  But with supply still rising, prices could fall further.  So, it may take longer for metals and bulk markets to return to equilibrium.

In the US, consumption ‘trumps’ industry.  A higher US dollar drags on manufacturing and lower oil prices shrink company profits.  But US consumption is 70% of their economy, so this external slowdown is of less concern.  Improving employment and wages, with low interest rates and energy costs should help consumer spending and hence their growth.

European growth responds to stimulus, a weak Euro and lower energy costs – triggering mild growth.  Meanwhile, Japan’s aging population and declining workforce suppresses its growth (by 2050, 45% will be over 60).  But structural reform should boost Japan’s long term growth profile.

For Australia, conditions are becoming unbalanced.  Our lower A$ is boosting tourism, exports and our confidence – business confidence is better and housing is a key to short term growth.  Hence, we expect 2% interest rates to remain until 2017.

How will you position your portfolio to prosper in the years ahead?  If hindsight proves a lucid analysis, it may suggest – overweight in European and Japanese equities, underweight to the US and especially Australian bonds, with a neutral outlook for the ASX and interest rate sensitive real estate securities.

Investors will have been tempted in recent years by low yielding deposits to overweight in high yield bank and other stocks for income.  But last year, banks shares lost 15-20%, taking the shine off their ~9% gross yield which itself may prove unsustainable.  So, capital preservation is worth keeping front of mind.

So, what returns should one expect from here?  For the next 5 years, lower returns might be expected – 2.8% from cash, bonds at 2.1% (i.e. a capital loss), Australian shares 9%, international shares 7%, listed property (AREITs) 6.7% and inflation at about 2.5%.  This suggests an average of about 5.9% p.a. for a ‘balanced’ portfolio and 6.6% p.a. for ‘growth’.  Unfortunately, experience shows many investors under-achieve the average, mostly by leaving the market at a bad time and mis-timing their return.  Are you benefiting from a professional partner?