These are confusing, unprecedented times for investors. The key direction-setter for interest rates, the US Federal Treasury, remains split on the timing of its first hike in many years, Chinese data in recent days has disappointed again and Europe continues to have negative interest rates.
Figure 1. Government bond yields
Source: Mauldin Economics, Thomson Reuters
At home, Australian labour force data has been better than expected — unemployment actually dropped from 6.2 per cent to 6.1 per cent — but then again our stockmarket is not cheap.
Banks and resource stocks continue to swap leadership in our flat, excessively concentrated sharemarket. This situation compares with the wealth of diversification and superior growth opportunities to be found in offshore equity markets. What’s more, it is a reminder to SMSF investors to consider increasing their allocations to global equities, but today let’s focus on the ASX.
Overall, portfolios should be fairly well invested to benefit from the market rally we expect, but how to get there is a delicate matter given the range of possible scenarios investors need to weigh up. Apart from stock-specific factors, everything depends on central bank behaviour and intentions — and in Australia’s case how these interact with commodity prices, currency and confidence.
What will happen next on the market?
Here are four scenarios:
Scenario 1: Iron ore keeps falling but the Australian dollar stays elevated because US economic data disappoint and the premium of Australian government bond yields to US yields widens, attracting more foreign capital to Australia and supporting our currency. The RBA is forced to cut rates to engineer a depreciation in the Australian dollar. In this scenario “yield stocks” such as the banks and Telstra should continue to outperform as income investors flee fixed interest for higher-yielding equities.
Scenario 2: The Australian dollar depreciates into the mid-US60s (from around 78c today), outweighing the effects on resource stock earnings of falling commodity prices. The Australian dollar value of US dollar mining earnings rises and resource stocks rally. BHP Billiton goes to $36 (from about $29 today).
Scenario 3: The eurozone and Japan continue massive monetary stimulus programs, creating more strong flows of liquidity into eurozone and Japanese equities, which rally further.
Scenario 4: The improvement in the Australian unemployment rate is temporary as overall growth remains weak and the economy cannot create enough new jobs. Eventually the Australian dollar depreciates.
What does this mean for the investor?
All of these, and other scenarios, could happen in this unprecedented, unpredictable investing environment.
- The first response is not to have too much cash, which is dead money given equity markets should continue to be supported by central bank stimulus and real cash yields are nil or negative.
- The second is to be sufficiently diversified to benefit from the most likely scenarios. Despite gloom about iron ore there is a case for having a small weighting to BHP. Aim for a spread of stocks but concentrated bets in a core group.
- The third is to use the “buy-write” options strategy, which is ideal in a fully valued market likely to become more expensive due to central bank liquidity. Buy-write investing increases portfolio yield by selling call options over fully valued equities and can be gained via specialised exchange-traded funds.
- The fourth is to get more invested by taking a “relative value” approach, which is to prefer stocks with more value support than others. The market is headed higher but the stocks with the least risk are the undervalued ones and the best stocks have yield support or US dollar exposure. We like CSL, Flight Centre, Origin Energy and Telstra.
This multifaceted strategy should preserve capital, deliver the right amount of leverage for the conservative investor, and provide income greater than term deposit yields.
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