Getting set for 2014

In early 2014 we now know that 2013 (2013: The year that was) was a good year for the equity part of your portfolio, but a poor one for your defensive assets. In fact the ASX 200 accumulation index (which includes both price gains and dividends) returned 19.9%.

The fall in the Australian dollar coupled with more optimism about offshore economies meant your international equity investments gained more than local ones. Here, investors in high-yielding shares including banks, and also rebounding retailers, did the best. Offshore, investors instead rotated out of high-yield and defensive stocks and many moved into small companies – causing the latter to appreciate 50% (unfortunately this didn’t happen locally). However, the weakness in the wider small caps index did not stop investors making good money in selective small caps. Indeed, my colleague Brendon Lau’s Uncapped 100 is current running 11% ahead of the wider All Ordinaries index.

Over recent months patient value company investors, both locally and overseas, were rewarded as price discounts closed. As the risk of runaway inflation and financial system collapse fell, the price of insuring that fell, hurting gold speculators.

Portfolio returns for 2013

Putting all this together, your overall portfolio return for 2013 was simply a function of how much growth assets you invested in. The following chart shows a surprisingly perfect correlation between the proportion of growth assets in Vanguard’s all-index, multi-asset Conservative, Balance, Growth and Aggressive funds and their respective returns for the calendar year. The returns from these highly diversified portfolios were the growth asset percentage mix of (or times) the 26% average return from a locally biased mix of Australian and international growth assets plus 2% (the return from depreciated bonds and low-yielding cash).

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Outlook for various assets

In Australia, and all other regions except Japan, disappointingly nearly all of the stellar equity returns last year were driven by an expansion in price/earnings ratios, not by more fundamental growth in company earnings. In other words, more optimistic, repressed investors were simply willing to pay 20-30% more for equities and their dividend streams than more cautious investors were 12 months ago. This trend can be seen in the following two charts, which also suggests:

1. share prices have been propelled upwards from historically low P/Es and aren’t cheap anymore based on this measure (left side chart);
2. shares aren’t now necessarily expensive based on long-term ratios and dividends and could easily surprise on the upside by getting more expensive;
3. Australian company earnings haven’t and aren’t forecast to grow significantly in the near term;
4. Part of the excess return from international shares was from the fall in our local currency, which isn’t a sustainable way to get rich.

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For these reasons we should expect Australian share returns to be lower in 2014, perhaps in the high single digits, not double digits. Prospects for share price growth offshore remain higher as those economies are further ahead in the cycle of recovery. Add in the chance of another 10% fall in the Australian dollar, then returns from investing offshore could double that from investing locally – say end up 20% (unhedged) versus 10% for local shares. A 10% return on the All Ordinaries index would take the index to 5,650 (up 6% from 5,327 4% yield on January 1).

Of course, if you think I can predict the finishing point of the sharemarket, please stop reading now.

With the US market increasing 50% over the last 18 months without correction, it would be highly unusual to not see sharemarkets there and elsewhere retrace their steps in the coming months. Indeed, the higher stock valuations rise the more sensitive the market becomes to bad news. So perhaps plan for the market falling back 10-20% sometime in the year, perhaps the second half of 2014, when new worries emerge. At the moment markets are being sucked forward in a vacuum of bad news, but that could change once politicians and bankers return to work and confront the magnitude of global indebtedness and other imbalances.

Taper tampering could be a significant source of market disruption. As overseas developed markets recover from the “Great Recession” the justification for printing massive amounts of money to buy bonds and keep interest rates at zero diminishes. These measures have not just been stimulating the economy but also the sharemarket, so a tapering of that should see a tapering of share price growth.

The bond market has started to anticipate a return to normal programming, which you can see in the below charts depicting the yields of 10-year benchmark Australian, US, German and Japanese government bonds. With the exception of Japan, where government bond buying continues unabated, bond yields are rising (prices falling) in most other parts of the world.

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Bond rates are a key barometer to watch in 2014.

Their substantial fall drove massive gains in bond prices and fuelled demand for now expensive high-yielding shares and other “bond substitutes” like infrastructure and commercial property. As bond yields and interest rates rise, expect this to reverse.

Importantly, large normally conservative institutional pension fund investors who couldn’t make their actuarial numbers work with US bond yields at 2%, might do so at 3% or 4%. These investors will shift large amounts of temporary money out of higher-risk shares back into safer bonds. This will create a drag on sharemarket returns as these unnatural buyers exit.

If interest rates rise quick enough, existing bond holders will have their meagre yields punished with capital loss potentially creating a total negative return. Coupled with the prospect of falling share prices, traditional balanced funds could be hit by a double negative. This possible “positive correlation” between downward share and downward bond prices puts traditional balanced portfolios at more risk than usual. This is in marked contrast to recent years when, for instance, falls in shares were cushioned by gains in bonds (2008), and when falls in bond prices were more than offset by share price gains (2013). While this is possible, I don’t see any reason at the moment to expect equity and bond returns to both be negative – if you do, then cash is a reasonable alternate to bond fund investing.

With the Australian economy looking unproductively weak, it is reasonable to expect interest rates to stay flat for longer. As local bond yields have risen to a more reasonable premium to this cash rate (see below left, 2% for example, 10-year government bonds) then perhaps bond rates need not rise further from here in a hurry. This means in 2014 investors may need to live with high-yield and term deposit rates stuck around mid 3% and bond yields of 4-6%, depending on the level of credit risk you are willing to take on (per right chart below).

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Australian residential prices increased by about 10% last year (see left chart below). While this sounds like a lot, the increase follows a few lacklustre years and even a recent negative year. Over five and 10 years, price rises in major capital cities have averaged between 4% and 5% annually, which is the expected wage-inflation-rate of increase. Fears about unemployment and already stretched levels of unaffordability seem to be so far moderating the effect of unusually low borrowing rates.

The concern about fuelling asset price bubbles is stimulating the minds of central bankers across the world. I suspect Australians will continue to borrow (as per the right chart below) and buy property with enthusiasm, but will perhaps temper their enthusiasm after May’s likely pessimistic federal budget, possible bank intervention, or as other inevitable fears arise. Perhaps we should expect bank share prices to follow this same trend. Commodity companies may have a better 2014 if prices rise in locally depreciating currency terms – though it is disappointing we have to hope for a fall in our overseas purchasing power to expect good returns from our resource companies.

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Portfolio Implications

Despite last year starting more cautiously, it was a safer year to invest in equities given the discounted price on offer then. This year you need to be more cautious and expect more modest returns as the starting price for growth assets across the board is higher.

If you tactically dialled up your exposure to shares last year, then you need to dial that back down to normal. Even if you didn’t you would have enjoyed high returns in parts of your portfolio that outperformed, making you overweight in some assets. That’s code for saying you won’t go broke taking profits in your appreciated and now pricey bank shares.

As interest rates and bond returns are likely to remain low, then taking profits and less risk isn’t going to be rewarding. So this message is about managing risk, not profiteering.

While it would be foolish to try to predict currency movements, if you think the Australian dollar will finish the year lower than it is now, then you have another reason for (staying) investing in international equities. Unfortunately those assets, with the exception of emerging markets (see Re-emerging markets), aren’t cheap either, so risks remain.

With property valuations high on global standards it is hard to recommend borrowing at fixed rates and buying more of it, however in 10 years’ time prices and rates might never have looked so cheap. 

I wonder if this year will play out in two parts – a modest continuation of the good returns from shares followed by a second-half pullback as the rubber band on asset prices is stretched too far for a lacklustre world economy and money flows back into more reasonably priced bonds.

Successful investment in 2014 might then require spotting the right time to make significant changes in your portfolio, which is not necessarily now.

Dr Douglas Turek is the Principal Advisor with family wealth advisory and money management firm Professional Wealth (www.professionalwealth.com.au). 

* This article is part of the “It's Time” series in Eureka Report focussing on new opportunities for investors in 2014. Click here to see the entire series.