Asset allocation
Comparing apples to oranges: bond yields vs equity dividend yields
A common chart that shows the extreme differentiation between bond yields and equity dividend yields is being used to support current equity valuations. However, we are cautious on this traditional valuation benchmark as bond yields are, in our view, reflecting risk aversion rather than fundamental valuations.
In most countries with high credit-ratings, government bond yields are negative – especially if inflation is subtracted to calculate the “real” yield. However, over time real bond yields should roughly align to the annual rate of real GDP growth, which is currently positive and running at around 1-2% p.a. in the major developed economies.
So what is currently supporting equity valuations, outside the traditional price-to-earnings ratio? The proposition that companies can grow earnings at 3-5% p.a., in line with nominal GDP growth, and payout a dividend yield of 4-5% per annum, in aggregate, from free cash flows, does not seem to be a stretch to us.
In summary, we would encourage investors to step away from the short-term volatility of the market and focus on the underlying potential of each company. Over time, this approach should see valuations and capital appreciation take care of themselves.
Australian Equities
The S&P/ASX 200 Accumulation Index lost 1.8% in February. The market was impacted by a large 9.1% decline in the banks, which was partly offset by a rise of 9% in resources while other sectors were mixed.
We remain positive on sectors such as diversified financials, healthcare and utilities. We are also positive on selected industrial and consumer discretionary stocks. Overall, equity valuations are a little higher than average, partly due to another cut to growth forecasts. However, there is a large dispersion with cyclical sectors and banks relatively cheap while miners, defensive earners and higher growth stocks are relatively expensive.
We suggest:
- Remain underweight.
- Valuations are fair value but attractive, sustainable growth opportunities are expensive.
International Equities
Global equities lost 1.5%, in local currency terms, led by declines in Japan and Europe. Shares in the US were flat and rose slightly in the United Kingdom. Emerging markets finished marginally higher with Brazil rising 5.9%, China falling 1.8% and India 7.5%.
Price-to-earnings ratio valuations in developed markets have now returned to the 15-16 times range, which is more attractive given the earnings outlook and bond yields. We prefer Europe, where valuations are lower than the US, and also Asia and Japan for better growth.
We suggest:
- Maintain a neutral (unhedged currency) exposure to international shares.
- Overweight Europe and Asia.
Fixed Income
Australian bonds gained 1.0% in February as investors continued to swap into safe-haven bonds which pushed up prices. The 10-year bond yield fell from 2.67% to 2.39% and the three-year bond yield fell from 1.91% to 1.74% as investors worried about economic growth.
Internationally, the Barclays Global Aggregate Bond Index (A$ hedged) returned 0.9% as bond yields fell by 20-30 basis points in the major bond markets. Credit spreads were relatively unchanged: sub-investment grade bond index spreads remained at around 775 basis points over US Treasury bonds.
We suggest:
- Remain underweight with an equal split between Australian and international (hedged) bonds.
- Corporate credit offers reasonable value given low default rates.
Cash
Australian bank bills returned 0.19% in February as three-month bank bill yields remained steady at 2.29% p.a.
At the March, the RBA had a more dovish stance in its post-meeting statement that reflected financial market volatility. However, following the RBA meeting, Australia’s fourth quarter 2015 GDP showed that the economy grew at a strong 3.4% annualised rate in the second half of 2015, which is above long- term trend growth rates and the RBA’s forecasts.
We suggest:
- Hold a neutral position.
- No preference for term deposits over at-call cash.
Alternatives
Hedge funds lost 0.3% in February in another volatile month for most asset classes. Funds that trade macro and trend-following strategies outperformed with a gain of 0.3% over the month. At the other end of the return spectrum, equity long/short funds lost 1.1% with poor performance across all regions and styles.
We suggest:
- Retain an overweight position.
- Manager selection remains more important than strategy selection.
- Liquid alternative investments such as hedge funds remain favoured for incremental risk exposures.
Property
Returns from unlisted Australian core property funds were 12.6% in the 12 months to the end of January 2016. Average distribution yields were 5.4% for retail property, 6.0% for offices and 7.4% for industrial property. REIT prices outperformed other equities with Australian property securities gaining 2.9% and global REITs rising 0.1% in local currency terms.
Sentiment and capital flows are still favourable, with the lower interest rates pushing property yields and capitalisation rates lower, particularly in CBD A-grade office buildings. The corporate leasing market is more challenging with new supply, high vacancies and high lease incentives in many markets.
We suggest:
- Remain neutral
- Reduce weighting to Australia and increase international exposure.
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