July 2012 Review Comments
Written by Tony Gray   
Monday, 16 July 2012 14:10

Portfolio Valuation & Comment

Despite generally conservative stances, the 2011/12 financial year was still a difficult one for portfolios, with the share market weakening from the very start of the year and closing at the lower end of the three year range.  International shares also gave up some earlier improvements.

Listed property advanced steadily and seems to have moved beyond the stigma associated with the GFC – when it was the worst performing asset class due to over-gearing.

Official interest rates declined by 1.25% percentage points since November 2011 and are reflected in lower at-call and term deposit rates.  Australian government bonds were the stand-out, with the yield on 10 year bonds falling from just over 5% to around 3%.  This resulted in capital gains for bond and fixed income funds.

The following table summarises some 12 month statistics:

Table 1

The table needs some explanation.  The changes in the All Ordinaries Index (shares), A-Reit Index (listed property) and Morgan Stanley Capital Index (international shares) show the percentage gain or loss in capital value and do not reflect income returns.

The change in the Reserve Bank cash rate and the 10 year bond rate are reported as percentage changes in the income yield.  This serves to demonstrate how extreme the fall in interest rates has been in the past 12 months and more comment on this has been made later.

In summary, listed property performed well from an income and capital growth perspective, while Australian and international shares generated negative capital returns, even when allowing for high franked income from Australian shares.  By contrast, term deposits and bond exposure generated decent returns – but are set for lower long-term returns from this point.

Cash & Fixed Interest

Money markets are pricing further interest rate falls – with the 3 year Commonwealth Government Bond rate sitting at 2.15% compared to the RBA overnight cash rate of 3.50%.  Even out to 10 years Commonwealth Government bonds are yielding only 2.77% (at all time lows for the federation)!  Put another way, if you lent money to the government today, you would receive interest of 2.77% a year for 10 years – which is a pretty miserable rate and below US 10 year rates of less than a year ago!
Whilst further falls may occur in the short-term, the medium to long-term risk is that longer bond rates rise.  When this happens, bond funds (including many fixed interest funds) will record capital losses.  For this reason we are moving out of traditional bond exposures.

There are some low cost funds that hold corporate bonds instead of government exposure, floating rate interest instead of fixed and that have shorter duration (shorter average term of debt) – that are more safely positioned than a straight bond fund.

We continue to advocate rolling term deposits for a higher than at-call yield and regular access to capital.  We also feel it is time to begin allocating surplus cash and fixed interest assets to select investments offering growth potential and higher income yields.

This is since it is our opinion that investors will not accept sub 5% interest returns and have begun chasing the high income yields available from listed shares and property.

Listed Property

Listed property trusts have advanced to the point where values are ‘ok’.  We remain cautious on retail property and have identified one trust not commonly held in portfolios – but requiring a price fall of 6% before we are prepared to accumulate.

International Shares

We continue to recommend steady accumulation of international assets (from quite low levels generally) as the Australian dollar remains high and as international shares are historically cheap.  International shares provide diversification away from the Australian economy (including interest rates) and while income returns tend to be low, capital growth can be very strong on occasion.

We generally recommend accepting the higher fees of certain boutique fund managers in preference to most low cost index exposures – although the latter are certainly worth considering as part of a portfolio.

‘Other’ Assets

The gold price has been gradually weakening and at US$1,570 per ounce is down from the 2011 peak of ~US$1,860.  We are undecided on this asset class – as the price has tended to move with markets, despite all of the ructions in Europe and rising sovereign risk.

As such, whilst gold is a potential hedge against a falling $A and sovereign defaults, we are reluctant to buy while the trend is negative.  There may be some scope to re-introduce some gold equity exposure – as stocks are already priced for a lower gold price – but we expect any exposure will be minimal overall.

The Australian dollar appears too high and has been supported by buying of Australian government bonds.  With foreign ownership of bonds already in the vicinity of 85% and the issuance of new bonds expected to decline, we do not see this as providing lasting support to the currency.  On trade weighted terms we expect the $A to US$ to be trading below parity.  We are comfortable retaining some USD in portfolios as a hedge.

Australian Shares

As noted earlier, we believe a move into income yielding equities is underway.  If we do see interest rates fall through to 2013, then we believe investors will pay up for relatively high share dividend yields – even without any earnings or dividend growth.

In fact, the difference between the 10 year government bond yield (2.77%) and the yield on Australian shares (5% plus franking benefits) is historically extreme and in theory portfolios should be weighted very heavily to equities and at low levels to fixed interest.  While we’re not prepared to make that sort of change just yet, we do feel the risks of NOT buying for portfolios underweight shares (relative to written investment strategy ranges) is rapidly rising.

Ask yourself this question – ‘if interest rates do fall as money markets predict, and at-call monies are yielding under 3% and term deposits yielding perhaps 4%, then are shares still likely to be yielding 7%?’.  I have included the value of franking credits to come up with the 7% yield on Australian shares.  I feel the answer is ‘no’ shares will likely be higher.

We have already seen this behaviour overseas.  Consider for example that the US market is trading at ~15% off 2007 market peaks, whereas in Australia we are more than 40% off 2007 market peaks!  In the US at-call money doesn’t collect any interest and the greater than 3% dividend yields from US blue chip stocks looks attractive by comparison.  If US stocks were still trading 40% below 2007 peaks then the yield would be ~4.5% compared to US 10 year bond yields currently sitting at 1.47%!

Despite the weakness apparent when considering the All Ordinaries Index or S&P/ASX 200 Index, there have not been bargains to be had at the blue chip level!  This is since large index stocks such as BHP, RIO and Fortescue have dragged the index lower, whereas the income yielding stocks we would like to buy have not fallen.  While tempted to consider BHP and RIO for portfolios, high cost producers will go out of business if we do see key commodities fall back – such as $80 per tonne for iron ore vs $130 presently.

Energy stocks have fallen sharply.  We see significant capital risks for the likes of Santos and the weakening oil price counts against buying.  We also hold concerns about shale gas in China becoming a major energy source – as has occurred in the US.  Even the prospect of this could significantly dampen export energy prices and energy stocks.

In terms of banking, we are comfortable accepting high franked dividend returns, even without any growth in earnings expected.  This sector is vulnerable to recession but unless or until we see unemployment rising meaningfully we are happy with reasonable allocations.  The banks are replacing wholesale funding with local deposits at a steady rate and the Australian economy is gradually deleveraging.

Some industrial stocks have disappointed, especially Toll Holdings.  There is the risk of further downgrades and while we feel the company will generate a decent return through a full economic cycle, we suspect more weakness to come first.  This stock may be a candidate for switching into other exposures.

There remain a collection of decent businesses at decent prices to accumulate, although many may already be in portfolios.  We do see some emerging opportunities in smaller companies – with the risk more to do with share price movement than business fundamentals.

Conclusion

There may be some financial planning issues to consider early in this new financial year to reflect the lower contributions cap (maximum $25,000 concessional contribution) or rollover strategies, but the main focus in the short-term is review of portfolio positioning and that current investment strategies remain appropriate.

The potential for a re-rating higher of Australian shares exists in the short to medium term due to interest rate falls.  Few commentators are calling it this way, with the focus almost exclusively on European, Chinese and US risks.  The reporting season is about to get underway and we will then have up-to-date information on how well companies are coping.

Best wishes,

A.W. (Tony) Gray BCom, LLB, Dip FP, GDipAppFin, CFP, FFin
Principal, TG Financial

Please treat the above comments as General Advice, with no action to occur until we have considered with reference to your financial position, needs and goals.
Last Updated on Monday, 16 July 2012 14:34
 

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