This article appeared in the January 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Jon Reilly, Implemented Portfolios
If you are reading the ASX Investor Update newsletter on holiday, chances are you have more than a passing interest in investment markets, and at this time of year there is no shortage of opinion about what 2014 may hold, this note included. We live during an age in which investment information and data is available on a scale unimaginable a generation ago.
So the requirement and challenge in managing your portfolio is to be able to differentiate between what statistician Nate Silver called "The Signal and the Noise" in his book of the same name.
Below are some themes that will likely influence the asset classes in the year ahead, and in so doing hopefully provide more signal than noise.
First, let's consider the remarkable change in investor attitudes over not just the last year, but the last two or three. With spirits buoyed by another year of good returns from major equity markets, there are signs that chasing past performance is again an affliction investors struggle to avoid.
What seems forgotten is that future performance is a function of current price, and that higher current prices imply lower future returns. The inverse is also true, and what was difficult four or five years ago, in the aftermath of the financial crisis, was recognising that low prices then would eventually lead to attractive returns.
It is said investing is the only game in which people run out of the store when things go on sale, and again the inverse holds. Bloomberg reported in November that the flow of funds from investors in the United States to managed funds that invest in shares was at its highest level since 2000. At the time of writing, the S&P500 index has gained 25 per cent in 2013. Expectations that this level of return will continue will lead to disappointment for those chasing last year's winners.
To effectively manage the asset allocation in your portfolio you must be clear about your objectives - and the time frames over which you will be investing and then drawing on your capital are critical to this process. What will help you stay the course through the market cycle and achieve your objectives is defining your success criteria in terms of risk and return and your future income needs. Information and analysis that informs you about progress towards reaching your objectives is the signal to which you should be paying attention.
Two interest rate cuts during 2013 took the cash rate to 2.5 per cent, below the so-called emergency level reached in response to the financial crisis. However, rather than indicating renewed fears, this move was about our currency and the level of our interest rates compared with those in other developed economies, which remain at or close to zero. While influencing the currency may have been central to the Reserve Bank's considerations, the effect on defensive investments such as cash, bonds and term deposits is continued low returns.
The temptation in such environments is to seek more income, though that comes with increased risk. In December 2012, a one-year term bank deposit paid about 4.4 per cent and now pays about 3.6 per cent. In other fixed-interest investments, we have seen significant moves in longer-dated Australian Government Bonds - now more readily accessible after listing on the ASX in 2013. From a low of just over 3 per cent in May, rates on a 10-year bond have moved up to around 4.4 per cent, though at five years there remains about a 1 per cent better return from term deposits compared with the equivalent maturity government bond. Noteworthy is that the return premium for term deposits has almost halved over 2013, and if that trend continues, investors should consider having sovereign debt in the defensive part of their portfolio in 2014.
In most financial news is a seemingly insatiable desire to link the daily movement of a particular market with some economic data that happens to be released that same day. There are examples of announcements that affect the views of investors and where causality can be attributed, though in many more instances this sort of analysis is just noise. Before moving on to the regional discussion below, let's note that economic outcomes can vary considerably from those for equity market investors.
It often comes down to price, and specifically that in shorter time frames price and hence expected returns can be dominated by sentiment rather than fundamentals. Over longer periods, changes in sentiment or valuation factors have much less effect on expected returns. A process to assess these factors independently, which in turn informs your ongoing asset allocation, is central to effective portfolio management.
The United States provides a great example of the divergence between the economy and the sharemarket. The S&P 500 index is regularly setting new highs, and though the economy continues to recover, investors must question whether sentiment has driven the share market too far ahead of economic fundamentals. Making the situation harder for investors is that truly defensive investments currently give essentially no return in the US. This situation distorts asset-allocation decisions when investors wanting to earn something have to take on exposure to risky assets like shares and property trusts.
For now, very supportive monetary policy will continue, so the upward trend in the US share market may well continue next year and perhaps beyond. Those who have invested in US shares and have enjoyed the recent strong returns need to ensure they have a strategy to gradually lock in these gains. Corporate profits, compared with the overall economy, are at historically high levels, and the valuations being paid are fully priced, if not expensive. While talk of a bubble in US shares is premature, 2014 and beyond should see more modest return expectations.
In late 2013, China set out the policy and reform agenda for the remainder of the 10-year term of President Xi Jinping and Premier Li Kequiang. It confirms a reformist approach and encompasses wide-ranging policy measures that acknowledge past and current imbalances and future issues like demographics.
Migrant workers will get access to public services in regional cities, encouraging further urbanisation and supporting infrastructure investment. Local governments will be able to issue municipal debt for infrastructure financing, which is also expected to address the systemic corruption within Local Government Finance Vehicles. Farmers will gain rights to manage their land, which is currently leased from the government, encouraging the development of agri-business and improving rural incomes.
There will also be some long-term relaxation of the one-child policy to start addressing the ageing population. Perhaps most important was just one word - decisive. The market will play a decisive role in future resource allocation, with market-oriented reforms to State Owned Enterprises aimed at reducing monopolies and encouraging competition. The Chinese sharemarket, along with others in emerging countries, has lagged in 2013, though good underlying economic growth and compelling valuations at current prices mean these regions demand a significant place in your investment portfolio.
Germany led the way in terms of share-market returns, posting nearly 20 per cent in 2013, although low double-digit gains were recorded in the major indices in the United Kingdom, France and Italy. Valuations look reasonable in much of Europe; though imbalances remain across the region and there are still specific economic issues requiring deep reforms, not least in terms of high unemployment in the southern countries. Investors should tread carefully when considering exposure here and be prepared to stay invested for the long term before the reasonable valuation leads to good returns.
With an optimistic view on China, there is reason to be encouraged about the Australian economy and sharemarket. In contrast to the US, the ASX200 index remains well below the high set before the financial crisis, and continues to be more competitively valued than its equivalents in other developed markets. Despite a somewhat soft close to 2013, Australian shares provided close to an 11 per cent capital return and nearer 15 per cent when dividends are added.
Unusually, this rally has been led by the largest companies, particularly the largest banks. The equivalent capital return on the financial sector has been 22 per cent and more than 28 per cent with dividends, compared with annual declines for Resources and the Small Ordinaries indices. Realising some gains from the banks and deploying funds to underperforming parts of the sharemarket is worth considering in 2014.
About the author
Jon Reilly is chief investment officer of Implemented Portfolios, a leading portfolio-construction and investment-management company.
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