July 2013 Review Comments
Written by Tony Gray   
Friday, 12 July 2013 09:15

Portfolio Valuation & Comment

The new financial year commenced with some of the largest daily moves in the index for the year – both positive and negative.  In the last week market sentiment has gradually improved as local economic news worsened and the US Federal Reserve governor reassured investors that QE was not about to finish after all!

There are several broad moves that have a bearing on investment portfolios and that are guiding our thinking.  I have attempted to explain my take on what is going on below.

Rising unemployment, weaker job ads, low business confidence and falling investment intentions now make a cut in the Reserve Bank of Australia’s overnight cash rate more likely.  This is being greeted positively by markets – as lower interest rates improve the relative value/attractiveness of other assets.

Perversely, long-term investment decisions rely on calculating the value of future cash-flows and are priced off longer dated debt – such as 10 year government bonds (not the RBA overnight cash rate).  The yield for bonds has been rising in Australia and around the world as investors realise that QE is going to end.  Knowing that the music is slowing down, bond investors are reacting now as there is only one end-game:

As QE ends, either in a US Federal Reserve ‘controlled’ manner or in a disorderly fashion, then long bond yields in the US will rise.  As everyone realises this will be occurring at some point, with potentially large losses for bond investors, it makes sense to take some action now (i.e. sell bonds, lowering their price and lifting yields).  As the yield is still low and the interest rate risk is high, it is rational to keep selling as rates rise. 


As US interest bond yields rise, other debt market yields will also rise.  This is bad news for Europe, which is in recession and needs interest rates to stay low.  For emerging market debt and Australia, the modestly higher yields on offer are no longer attractive enough to offset the exchange rate risk – as bond investors usually do not hedge currency exposure as costs are too high.  As money flows to the US, exchange rate losses occur for investors holding bonds and stocks in Australia – so they sell.

One well regarded international manager expects US 10 year bond yields to rise to 4.5% to 5.5% (from 2.7% in late June) over the next 2 to 3 years.  If this was to occur then yields in Australia would be 6% to 7% plus (from 4% at the end of June).

If bond yields are destined to trend higher over time (with fluctuation along the way), then this impacts on how we position portfolios.

Cash & Fixed Interest

Now is not the time to lock in longer dated term deposits or hold long duration bond investments.  At-call money, short dated deposits and floating rate notes (limited pool of ‘good’ notes available) are recommended.  There will be stresses as rates rise, so now is not the time to be adventurous with higher yielding/higher risk debt assets.

Property

Rising bond yields will result in higher refinancing costs for listed and unlisted property – the opposite of recent years.  Property trust unit prices may decline as interest rates rise – as has occurred since May.  We have not added to this sector for some time and for portfolios with larger allocations some selling occurred in May.

We will continue to monitor individual assets, since if markets over-react in selling there will be some low geared assets worth adding.

Australian Shares

Normally shares adjust lower initially as interest rates rise and then push ahead as the focus shifts to earnings growth – as rising interest rates are usually associated with a stronger economy.

This time around bond yields are rising from QE’s artificially low levels, at the same time that our economy is in fact weakening.  This could be a one-two hit to sentiment and share prices!

We are not finding many obvious buy opportunities – with the reasonable expected total return from stocks significantly lower than that available as recently as October 2012.  We are seeing a large number of stocks that have fallen dramatically in price – but few of these are quality companies.

China’s economy continues to slow and with it sentiment towards Australia and mining/mining service companies.  On the plus side, this is resulting in a falling $A – and while some sharp bounces will happen (as futures traders cover short positions), this will cushion the impact of falling metal prices.

With mining and service company exposures in portfolios extremely low, there is some scope to add a handful of assets in coming months – if we see capitulation in share values.

Australian companies with international earnings are in demand as investors realise how few really large listed companies we have left to choose from.  This does result in premiums paid for stocks that leave international investors scratching their heads.

We are still to think through the full repercussions of a major rise in long bond yields in Australia over the next 2 to 3 years.

International Shares

Emerging markets exposure has not paid off lately, as international investors fled those markets as interest rates rose (i.e. bond prices fell).  We’re happy to stick with exposure as stock values are sound.

International shares remain cheaper than Australian shares, with the usual problem of paying a lower, less tax effective yield.  However, the challenges facing the Australian economy and investors is such that the total return potential from international shares is higher and the risk of holding an Australian only portfolio is higher.

We feel a mix of active managers, with some lower cost exchange traded funds is the best way forward.  An example of an exchange traded fund (ETF) exposure is iShares S&P Global 100 (IOO) ETF.  The internal cost of this is a mere 0.4% p.a. and it holds 111 of the largest freely traded global companies (e.g. Exxon, Johnson & Johnson, Nestle, Samsung).  The price to earnings multiple is just over 12 times, but the dividend yield (after 15% US withholding tax) is 2.7%.  Total return potential exceeds 10% p.a. in our opinion – especially if the $A trends lower over the next few years.

Summary

Despite all of the explanations and thoughts above, what we look for most of all are individual assets that add value to portfolios, without adding too much risk.  We will continue to look for individual opportunities.

If you have any concerns or queries about your portfolio, please contact me to discuss.

Best wishes,

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

Please treat the above comments as General Advice or general information, with no action to occur until we have considered with reference to your financial position, needs and goals.

 

Portfolio Management


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