Diversify to profit in uncertain times

Although the global economy appeared to slow in the second half of last year, growth is forecast to pick up somewhat this year and then to lift again in 2017. To counter market uncertainties, investors should hold diversified portfolios, Conrad Burge writes.

This global forecast comes with the International Monetary Fund's (IMF's) 19 January rider that "unless the key transitions in the world economy are successfully navigated, global growth could be derailed".

Furthermore, "downside risks, which are particularly prominent for developing economies include (the potential for) a sharper than expected slowdown in China, tighter global financing conditions as the US exits from extraordinarily accommodative monetary policy... and an escalation of ongoing geopolitical tensions".

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The balance of probabilities though still points towards a generally positive outlook, reflecting, above all, the strongly expansionary policies being implemented in most key jurisdictions.

In particular, expansionary monetary policy remains very much in place and, in the case of the US, may already have done its job (mostly), with the Fed beginning what is likely to be a slow process of "normalising" or raising interest rates back towards historically "normal" (or average) levels.

The introduction of large-scale quantitative easing (QE) in the Eurozone from March last year and its more recent escalation points to the potential for growth to accelerate mildly in the Euro zone; with positive flow-on effects to trade partners, including commodity-exporting nations.

There is no doubt that the European Central Bank will maintain its QE program for as long as it is needed to achieve its goal of inflation of close to two per cent (its current forecast is for inflation to reach only 0.1 per cent this year, but 1.3 per cent in 2017, and 1.6 per cent in 2018) and its goal of sustainably higher growth for the region.

The same applies to Japan, where the Bank of Japan continues to pursue its target of a core inflation rate of two per cent.

Overall, this coordinated global monetary policy stimulus could be expected to underpin an upward trend in stock markets for some time to come, although the start of a process of monetary tightening in the US has already led to increased market volatility.

Apart from expansionary monetary policy (and less contractionary fiscal policy), the developed world has also been the beneficiary of falling commodity prices.

In particular, the large decline in the price of oil that has occurred over the past year and a half could "provide a stronger boost to demand in oil importers", IMF said on 29 January, albeit at the expense of oil-exporting economies.

By end-February, oil prices had dropped to levels last seen in 2004 and despite moving up a little in early March, oil revenues for the Organisation of the Petroleum Exporting Countries (OPEC) cartel of oil producers as a whole had dropped from around US$1.2 trillion in 2012 to a likely US$500 billion in 2016 (at a Brent oil price of around US$40 per barrel).

This would represent a large transfer of wealth to oil-importing countries, notably including China and India.

But oil (down by over 60 per cent over the two years to early March) is not the only commodity that has experienced hefty price declines.

Other US dollar price drops over this period (in round numbers) included iron ore down around 50 per cent, nickel 40 per cent, coal 35 per cent, copper 30 per cent, and aluminium 10 per cent.

Such price declines for commodity inputs could be expected to assist global economic growth (except for some commodity-exporting economies, including Russia, the Middle East, and parts of Latin America).

In turn, stronger growth could be expected to underpin key stock markets.

On the other hand, some commodity prices have rallied well above their recent lows (with iron ore up over 30 per cent from 1 January to 10 March and oil and gold also up solidly), pointing to a strengthening Chinese economy in particular (with Chinese oil usage up by 600,000 barrels per day in the last year).

In fundamental valuation terms and assuming ongoing earnings growth, most share markets appear to be fairly valued, especially given the low-interest rate environment that continues to prevail.

In contrast, most bond markets appear expensive, with bond yields (interest rates) at historically low levels.

Most major sovereign bond markets were on a downward trend in 2015, with yields rising in response to an improving outlook for global growth and, in the case of the US, less expansionary monetary policy than before (QE was ended late in 2014, putting an end to new purchases of asset-backed securities, one of the aims of which had been to keep sovereign bond yields low).

In valuation terms, as at end-February, the MSCI World Shares index was trading at around 13.1 times forward (12 months ahead) earnings, below its long-term average price to earnings (PE) ratio of around 15.

International fixed interest

Sovereign bond yields in most major markets began to move down in late December, soon after the Fed began to tighten policy.

However, yields began to rise again after other central banks embarked on expansionary programs earlier this year. Bonds still appear to be over-valued.

Australian fixed interest

The domestic fixed interest sector has been moving in line with international trends.

Despite slow domestic growth, the sector still appears expensive. Domestic bonds appear to be over-valued.

Inflation-indexed fixed interest (CPI Bonds)

Inflation-linked bonds could out-perform if inflation rises over time. This sector could be a defence if growth lifts and interest rates rise.

Australian shares

The domestic share market was relatively weak in 2015, although after dividends it actually rose slightly for the year. Up to 11 March this year, the market was virtually flat, although for a change the resources sector was strong.

The outlook for this sector depends on the movement of commodity prices (especially our two biggest exports, iron ore, and coal), which mostly depend on the growth outlook for China, which accounts for almost 50 per cent of all world metal imports and around half of global coal consumption.

Overall, the stock market appears fairly priced, especially given a historically high average yield.

International shares

Global share markets were mixed in 2015, with the US flat but some markets up strongly, including Japan, China, and Germany. This year though began with most markets going into reverse due to investor concerns about the impact of slower growth in China, along with the Fed tightening. However, more expansionary monetary programs in Europe, China, and Japan have since been able to soothe most major markets.

Share markets mostly appeared to be fairly valued by mid-March, especially compared with other liquid investment opportunities, such as bonds and cash. The Chinese market also appeared to be better valued than last year.

Listed property trusts

The listed property sector is now more conservatively geared and better cashed up (after large capital raising) than it was prior to the global financial crisis. The sector has become less attractive than it was but still has a reasonable dividend yield and a fair PE ratio.

So, in the current climate, one could allocate as follows over the next three to six months:

International fixed interest: underweight;

Australian fixed interest: underweight;

Inflation-indexed fixed interest (CPI Bonds): neutral;

Australian shares: neutral to overweight;

International shares: neutral to overweight;

Listed property trusts: neutral; and

Cash: overweight.

Market sentiment could change quickly, following leads from worldwide fiscal, monetary or geo-political activity. To counter market uncertainties, investors should hold diversified portfolios.

Portfolio asset allocation decisions and short-term market time are also often best left to experienced investment professionals who exercise these decisions on a professional basis with the benefit of all available information.

Conrad Burge is investment manager at Fiducian Investments Management Services.




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