Private Wealth View November 2015

Cash 
The Reserve Bank of Australia (“RBA”) kept interest rates on hold during October and November. Economists now believe the RBA has greater scope to lower interest rates given the major banks have increased variable interest rates to cover the cost of higher capital requirements. The RBA had previously been reluctant to cut again given long held concerns regarding an overheating residential property market.

Whilst the RBA appears content with the current level of interest rates, the bias towards lower levels in the future remains. RBA Governor Stevens recently stated that if interest rates were to change in the near term, the direction would almost certainly be lower.

Recent economic data released in Australia provided no compelling reason for the RBA to act prior to the end of the year.  Recent inflation data was softer than expected, indicating slack in the Australian economy. However, the release of employment data for October indicated economic strength. Australia’s official unemployment rate dropped to 5.9% as employment surged, beating economists’ expectations by a wide margin.

The RBA is  likely to maintain its “wait and see” approach given the contradictory messages being sent by the economy. It will continue to monitor the implications of higher mortgage rates on consumers,  incoming economic data and developments in China. The RBA does want a weaker Australian dollar (“$A”), however it seems content to let this occur via United States dollar (“$US”) strength rather than engineering an immediate fall via an interest rate cut.

Term Deposit rates remain largely unchanged since our last update. The highest term deposit rates currently available are 2.85% across 3 months, 2.8% across 6 months and 2.85% for 12 months.

Fixed Interest 
Demand for “safe haven” government bonds continued during September and October as uncertainty remained over China and the timing of United States (“US”) interest rate hikes. Australian and global bond yields fell and prices rose as investors sought safety by rotating away from equities into the sector.

Recent moves in fixed interest markets highlight the diversification potential during times of uncertainty in global share markets.  The Australian fixed interest index¹ has increased by a total of 0.55% during September and October, whilst the global index² has risen  1.24% over the same period.

November has seen a modest reversal in the “safe haven” theme. Investors have become more comfortable with the ongoing economic transition in China and the continued strength of the US economy despite the prospect of rising interest rates. The increase in confidence has seen investors rotate back into equity markets at the expense of their fixed interest holdings.

The yield on the sector continues to be attractive in a low interest rate environment. Australian fixed interest is currently providing a yield of 4 – 4.5%, whilst international fixed interest is yielding 5 – 5.5%. Like all asset classes, diversification across both domestic and international markets is important.

We will discuss the outlook for the sector and our current investment strategy in the final part of our “Fixed Income Focus” later in this update.

Australian Equities 
The Australian market³ finished -2.96% lower in September, led by Energy and Resource companies. Energy recovered in October, supporting a 4.37% rebound in the market, however the major resource companies remained under pressure due to falling commodity prices.

The market has attracted buying interest in November, with investors pushing up banking stocks and other high dividend paying companies. Resource stocks have found little support as commodity prices continued to weaken.

The persistent weakness in commodity prices appears driven by institutions such as Hedge Funds  seeking to profit from falling prices rather than a fundamental lack of demand by end users. Demand should not be plunging if China is still growing and the US is in the process of an economic upswing. Commodities are also priced in $US, meaning their value falls whenever the $US dollar strengthens. This has been the case over the last twelve months.

In a period of falling commodity prices it is prudent to limit exposure to leading companies with diversified operations, low cost production and low debt levels. Leading diversified miners such as BHP Billiton (“BHP”), Rio Tinto and S32 are good examples. Whilst these companies can withstand a period of lower commodity prices, they are still responding with large scale cost cutting.

These measures will create leaner more profitable businesses when the eventual upswing in commodity prices occurs. BHP has also signalled that its balance sheet is more important than maintaining its dividend, which makes sense given the cyclical nature of its earnings and overall business.

From a valuation perspective the November bounce leaves our market⁴ trading on a Price Earnings (“PE”) Ratio of around 15.6x (see chart below). Whilst this is above the long term monthly average of 14.4x, there are a number of factors which are likely to provide support to the market going into the end of the year.
SP/ASX 200 Price Earnings ratio vs long term average

Source: JP Morgan

The sell off in banking stocks looks to have run its course for now. Whilst concerns remain around earnings and dividend growth, recent employment data suggests that there is no imminent sign of bad debts increasing.  The banks have also successfully raised interest rates to cover the initial costs of higher capital requirements.

The continued fall in the $A also makes many of our listed companies potential takeover targets. Many foreign investors see the strategic long term value in Australian companies which is often unappreciated by local analysts.

Dividend yields can also provide an indication of “value” in the market. Dividend yields on the 20 largest stocks have reached levels not seen since the Global Financial Crisis. Data from Morningstar shows the average gross yield (including franking credits) is 7% , compared to a peak of 7.5% during the Crisis.

Whilst a stock or index should not be purchased purely on dividend yield alone (given dividends can be cut if earnings drop) it is another useful indicator to determine what value is on offer from a historical perspective.

Australian equities have notably underperformed international equities during the course of the year. We will discuss some of the fundamental reasons for this underperformance in the next section.

International Equities
Investors often question whether it is necessary to invest outside of Australia.  Australian investors traditionally have a strong “home country” bias, referring to the tendency by an individual to invest more in local shares because they are more familiar with the companies they are investing in.

There remains a strong case for the average investor to increase their weighting to international equities. The Australian share market represents only 2 – 3% of the global investment opportunities. Investing internationally increases diversification  and also provides the opportunity to benefit from a fall in the $A.

International equities⁵ have outperformed Australian equities materially over the last six months. International equities have increased by 7.50% during this period,  while Australian equities have fallen by -7.30%. There are two main reasons for the large performance gap: a falling  $A and a rally in sectors globally which do not feature heavily in our market, such as technology stocks.

Technology stocks only make up 0.8% of our market⁶, meaning Australia has lagged during the recent rally in global share markets. Our market provides a large exposure to banks and resources companies, two sectors which have recently struggled. The big four banks and BHP make up over 34% of the our market, meaning any movement in these key stocks will largely determine the direction of the overall market.
The international equity index⁷ is far less concentrated. The top 10 holdings only represent around 8% of the total index, with the technology, industrial and financial sectors well represented. The table below provides a summary of the top ten holdings in each index, confirming  the concentrated nature of our market.

Top 10 Index Weights at 30 September 2015

The fall in the $A against the $US has also materially contributed to the return received by international investors. The move in the currency has provided around half of the outperformance delivered by  international equities over the last six months.  Over the longer term we  expect the $A to continue its fall against $US as US interest rates move higher.

In conclusion, an allocation to international equities increases diversification by providing exposure to world leading companies in industries which are difficult to access domestically. Further sources of return and diversification are also possible when the $A falls against the $US.

<sup>1. Bloomberg Ausbond Composite 0 YR Index AUD
2. BarCap Global Aggregate TR Index (AUD Hedged)
3. SP/ASX 200 Index
4. SP/ASX 200 Index
5. MSCI All Country World Index
6. SP/ASX 200 Index
7. MSCI World Index</sup>

Reporting date 31 Oct 2015

Source: Bloomberg

In the final part of our Fixed Income Focus we will summarise our current investment strategy and explain how it is implemented via our approved managed funds. Our preference is to use managed funds to invest in fixed income because they provide cost effective access to a wide range of securities and markets. It is extremely difficult for an investor to achieve diversification outside a fund because most markets cannot be directly accessed.

A managed fund must satisfy numerous criteria prior to being approved by our Investment Committee. Some of the things we consider are:

• the quality of the personnel
• performance track record
• the level of fees charged.
• a superior research rating from an external research consultant.

The fund’s investment approach must also align with our current investment strategy. A summary of the key aspects of this strategy are outlined below.

Preservation of capital
Fixed interest is held for defensive reasons. It should generate a reasonable return without exposing an investor’s capital to excessive risk. The temptation in a low interest rate environment is to invest in a fixed interest managed fund which is delivering an unusually high return. The investment manager is usually generating these returns by investing in higher risk securities. This strategy usually results in the investor losing more capital than the additional income which originally attracted them to the investment.

In the current environment our preference is to allocate to investment managers who implement conservative investment strategies. They would prefer to retain funds in cash rather than invest in securities which carry a higher risk of capital loss, even if this means lower returns in the short to medium term.

Quality focus 
Investing in securities with a higher credit rating lowers the chance of capital loss. A credit rating agency assists an investor to determine which securities satisfy this criteria. The table below summarises the rating scale provide by the two of major rating agencies. The highest rating a security can achieve is AAA. The investment managers in our portfolio remain focused on the highest quality areas of the market, holding securities with an average credit rating of A to AA.

Liquidity
Liquidity means you are able to sell an investment at a price which reflects the underlying value of the investment. Liquidity is very important when a portfolio is required to fund pension payments or other liabilities. Higher risk securities generally have less liquidity. For example, there have been instances in the listed hybrid market where no trades have occurred for an extended period of time. We favour investment managers who pay strict attention to portfolio liquidity as part of their investment process.

Diversification
Diversification is a key part of any portfolio. In the fixed income sector diversification is achieved by investing across a wide range of securities both domestically and overseas. For example, one of our investment managers invests in over 500 different securities. Whilst this may seem like a high number it is necessary given the global fixed income market is significantly larger than the global equity market.

Based on the above investment strategy our fixed interest portfolios remain focused on government bonds, semi-government bonds, high quality corporates and cash like investments. We are avoiding any material exposure to sectors which are contradictory to this strategy, including hybrid securities, high yield bonds and emerging market debt.

This concludes our focus on the fixed income sector. In the next edition of Private Wealth View we will focus on a new topic relevant to your investment portfolio.