By Steve Merlicek, Chief Investment Officer
The uncomfortable reality is that global bond yields have further to rise, credit spreads have little room to narrow, and equity markets are trading at fairly full valuations along a variety of different metrics. However, we still think risk will be rewarded and well-structured portfolios can achieve realistic investment goals. It does however, sharpen our focus on managing downside risks, searching for additional return opportunities across and within asset classes, and dynamically managing portfolios over the year to achieve desired outcomes.
The headwinds for fixed income investments are likely to continue as government bond yields trend slowly higher. In an uncertain world, the role of fixed income as a diversifier to equities should not be underestimated, but the challenge will be to seek out pockets of return while actively managing interest rate exposure.
We believe better value can be found in Australia, where ten year government bonds are trading at 4.08 per cent as at 31 March 2014, and where growth rates are beginning to lag northern hemisphere counterparts for the first time in a decade. Weaker economic growth would be a positive for Australian bonds. On the other hand, foreign holdings of Australian debt rose to record highs through the years of global crisis. As Australia’s ‘safe haven’ status fades, there is some risk of a rush for the exits.
Investment grade corporate bonds are not exactly expensive, but they are definitely not cheap. Current spreads versus treasuries are unlikely to tighten much, but they do provide more than adequate protection against the relatively low risk of default that’s currently the case in this sector of the bond market. That means we like investment grade corporate bonds as a short duration alternative to government bonds. High yield corporate bonds also do not have much scope for capital appreciation. But their yields are high enough to make them attractive – even relative to equities. Again, the default cycle is expected to be very sanguine in 2014, and their relatively short duration is beneficial in a rising rate environment.
Equity markets are near the top of their valuation ranges. The rotation from bonds into equities could easily gather pace. It could also abruptly reverse if fears about growth being too strong or weak take hold. We haven’t seen a ten per cent correction in the US equity market for more than two years. It would be surprising if markets didn’t pull-back at some time during the rest of the year.
Australia looks expensive in a global context with its valuation difficult to justify either by its sector composition or its economic prospects. The Australian market is trading at a P/E of 15.5, above its long term average of 14.0, but its dominant sectors, finance and resources would ordinarily be considered low-multiple sectors. That said, a forecast dividend yield of around 4.5 per cent before franking, could attract fund flows from domestic cash and bond funds. We are circumspect but not overtly negative.
The challenge for investors in the coming low return world is to achieve their required rate of return at a level of risk they can tolerate. The best way to do this, in our opinion, is through the use of actively managed, globally diversified, multi-asset strategies. ‘Set and forget’ won’t cut it anymore, and a more dynamic approach to asset allocation is required.