Commonwealth Private QUARTERLY INVESTMENT STRATEGY Q3 … · Australian Equities – Are we really...

Quarterly Investment Strategy Q3 2014 4 July 2014 Page 1 of 19

Commonwealth Private

QUARTERLY INVESTMENT STRATEGY Q3 2014Halcyon days, but watch for the winds of change.



ContentsSummary 03

July - September 2014 Outlook 04

Commonwealth Private Central case and House View – April 2014 05

Summary of Asset Allocation Themes 06

July - September 2014 Outlook by Region 07

Australian Equities – Are we really decoupling from Asia as mining fades? 10

International Equities – Continue building unhedged positions 13

Fixed Income – Take some profits and stay safe at the front of the curve 14

Sovereigns – watch for the unwind 14

Corporate credit – tighter still 15

Property and Alternatives 15

Property 15

Alternative assets 17

Asset class performance as at 30th June 2014 18


Important Note: This document is produced by the Investment and Advisory Services team of Commonwealth Private Limited ABN 30 125 238 039 AFSL 314018 (“Commonwealth Private”), a wholly owned, but non-guaranteed subsidiary of The Commonwealth Bank of Australia ABN 48 123 123 124 AFSL/Australian Credit Licence 234945 (“CBA”), and is for distribution within Australia only to Commonwealth Private clients. This document does not contain any analyst research and has not been generated by the CBA Group’s Research divisions. This document is based on information available at the time of publishing, information which we believe is correct and any opinions, conclusions or forecasts are reasonably held or made as at the time of its compilation, but no warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither Commonwealth Private nor any of its related entities accept liability to any person for loss or damage arising from the use of the information herein. This document has been prepared without taking into account your objectives, financial situation or needs, so before acting on the information herein, you should consider its appropriateness, having regard to your objectives, financial situation and needs and, if necessary, seek advice from a Commonwealth Private Wealth Manager before making any investment decision.

About the author

Dermot Ryan is the Investment Strategist in Commonwealth Private’s Investment and Advisory Services team and has been with the Commonwealth Bank group since 2006.

Dermot develops Commonwealth Private’s investment strategy by analysing the risks and opportunities in global investment markets.

The Investment and Advisory Services Team

The IAS team is a team of experts in investments, advice, strategy and operations that supports Commonwealth Private’s Private Wealth Managers. The team researches investment markets and produces a range of publications to help clients deepen their understanding of investing. The team also constructs portfolios of direct equities and specialist managed funds to help our clients manage and grow their wealth. All portfolio changes and product recommendations are assessed and approved by the Commonwealth Private Investment Committee.

For more information, call 1300 362 081 or visit commbank.com.au/commonwealthprivate

http://commbank.com.au/commonwealthprivate



Still water may seem serene, but can also be deep and dangerous. Investing looks easy these days as every asset class grinds steadily upwards. Markets are calm and trending in the right direction. It appears as if we’ve cracked a code for steady returns with ultra-low interest rates. Life and markets rarely remain this banal and stationary. This optimistic stage of the cycle is often characterised by complacent trades that are easy to make, but more risky than they might seem. While one can easily get caught up in the momentum, it’s wise to keep an even higher quality filter and remain disciplined before the winds of change blow.

Despite this sanguine backdrop, there are some disquieting trends: moderating growth in China, a lacklustre European recovery and muted improvements in corporate profits. Low rates have made all assets appear attractive and made investors feel that there is no alternative but to go up the risk curve. But we need to view valuations through the looking glass of rising rates as markets move to price them in as monetary policy rises up from around zero.

The beauty about this time in the cycle is that you can ride the momentum wave. With the valuations re-rate more or less complete, narrower momentum should see equity indices move more in line with earnings growth. As this process evolves, we expect market leadership within sectors to switch from yield and quality focused plays to those companies and sectors with operational leverage to higher earnings. While it is quiet on the water, it is prudent not to take too much risk and be more patient than usual, but be ready to act as interesting opportunities arise.

Summary

Momentum drives prices higher

3000

4000

5000

6000

Jun 09

Dec 09 Jun 10

Dec 10 Jun 11

Dec 11 Jun 12

Dec 12 Jun 13

Dec 13

ASX 200

200d MA

50d MA

Source: Bloomberg

Above is a simple moving average technical chart. Momentum traders would take comfort that the short term trend (black line) has stayed above the longer-term trend (yellow line) suggesting that momentum still has legs even after a two year rally.

Down trend

Up trend

Key strategy recommendations

• Australian Equities – Show me the profits!: Australia is moving through a tricky transition from our mining boom. Although there are encouraging signs in the economy, this reporting season is unlikely to produce more than mid-single digit earnings growth.

• International Equities – the Atlantic recovery grinds higher: Job and economic conditions continue to improve around the Atlantic as a new induced cycle emerges. While valuations aren’t as appealing as they were, global profits are in a recovery cycle. Asian and Emerging Market valuations are cheap on growth concerns.

• Fixed Income – Reduce exposures and be more defensive: Expected returns in Fixed Income are likely to remain contained in the 3-6% range in line with running yields albeit with a standard deviation of 3-4%. This means negative annual returns are a higher probability now than earlier in the cycle.

• Alternatives – Build positions to diversify risk: These assets can provide diversification in what could be a trickier year for markets.

• Cash – Overweight: Rates are unattractive, but running higher cash levels is prudent at this point in the cycle and gives you flexibility.

• Be patient and buy quality – Be patient and measured with your investments in this bullish market. Quality won’t perform as well in this climate but will be better for you over the cycle.

• Tidy up portfolios – Many lower quality stocks and investments have been running hot. Now is a good time to tidy up portfolios and sell poor quality or subscale positions that you might have within your portfolio.

• Don’t reach too hard for yield – After six years of ultra-low rates many of the assets traditionally used to obtain yield have been bid up. Don’t target high yields at this stage of the cycle as you may well find yourself risking capital to get that higher yield.

Implementation Strategy



The wind is currently very much in the sails of the market as momentum pushes the rally almost past its second year. Interestingly right now all assets are going up at the same time: sovereign bonds, domestic equities, global equities, credit and property. This is quite unusual and hasn’t happened since the weeks that ran into the taper tantrum and sell off we saw about this time last year. The chart on the right shows a simple moving average chart that would comfort momentum traders as the 50 day moving average is well above the 200 day moving average line. So while valuations are around their highs of the last cycle, momentum is pushing the market even higher. The only caution is that this can reverse quickly if growth and corporate profitability don’t build.

Many valuations across asset classes are near the highs of the last cycle. While it is not yet the time to be a contrarian and start selling down positions in growth assets, it is a very important time to keep your quality filter on its highest setting. Clients who have participated fully in this strong rally should rebalance their portfolios by taking profits in areas which have disproportionately benefited from two years of strong price momentum. The situation for clients arriving today with fresh cash or who haven’t yet invested

money in the market is trickier. Returns from here will likely be lower and more aligned to earnings growth. Investors can still avail of the benefit of an A$ that is still high relative to history and offshore equities which are trading at a discount to our local market. Clients in this situation should gain a foothold in the market with a reasonable stake of their planned positions and then work with their Private Wealth Manager to get the remainder set in subsequent reviews or at times when there is less calm and either valuations or profit growth are more attractive.

We retain a growth stance in our Central Case portfolio, with an overweight position in International Equities that still have a reasonable valuation edge especially if the A$ falls from here. In domestic equities, gross yields of about 5.5% are reasonable but spread your portfolio positions as the mining boom fades. Given the large rally, low interest rates, and low volatility it is very important to be measured and calm in your implementation of additional capital. In Fixed Income continue to take profits and sell down Emerging Market Debt positions completely. We will stay underweight as the curve resets higher and look to get set again at better yields.

July-September 2014 Outlook

• US scales back stimulus further as the economy grows

• UK improves and moves towards rate rises

• Interventions in Chinese property and credit markets

Positioning:

Continue trimming Fixed Income, build cash levels, but keep adding equity exposure with an offshore bias.

• The time has come to start cashing in on positions particularly in Fixed Income where valuations rely on ultra low rates and sustained stimulus.

• Equities are still relatively more attractive, valuations are such that corporates will need to demonstrate profit growth in the upcoming reporting season.

Changes this quarter:

Ride the momentum but clean up and rebalance your portfolio.

• While Mr. Market is in good spirits it’s a good time to clean up those lower quality and subscale positions in your portfolio, rebalance too after this long rally.

• After 5 profitable years it is now time to sell down and move completely out of Emerging Market debt and other lower quality Fixed Income in your portfolio.

Outlook:

Volatility is very low but may resurface as major central banks pull back support and a global recovery emerges.

• Favour assets with operational leverage and shift away from assets whose values rely on ultra-low interest rates to justify their valuations.

• Macro issues can re-appear if growth falters due to high levels of debt, but central banks are orchestrating a recovery.

Key Themes for Q3 2014

ASX 200 market forecasts

31 Dec 2014 target of 5,750 | 30 June 2015 target of 5,850 | Plus dividends



Commonwealth Private Central Case and House View - April 2014

Strategic asset allocation (SAA) is the average for the allocation to that asset class through the cycle. Dynamic asset allocation (DAA) is our current allocation based on the current outlook for risk and return in each asset class, which we assess through three lenses: fundamental - whether the economic drivers for the asset class are strong or weak; valuation - whether asset are expensive (pricing in little risk or high

growth) or cheap (pricing in high risk or low growth); and sentiment - whether price trends, investment flows and commentary is positive or negative on the asset class. DAA also incorporates the relative risks and rewards of different asset classes on a medium term (1 to 3 year) time horizon. The values shown here are for our Balanced asset allocation profile and may not precisely represent your individual portfolio.

Core Asset Class Sub sector House View Fundamental Valuation Sentiment Over the cycle (SAA) Current (DAA)

Australian Equities Australian Shares - Large cap Neutral 22.5% 22.5%

Smaller companies Neutral 2.5% 2.5%

25.0% 25.0%

International Equities FX Hedging level 20%

Developed Markets Over 16.0% 20.0%

Emerging Markets Over 4.0% 5.0%

20.0% 25.0%

Property Global REITs (Hedged) Over 1.9% 3.4%

Australian REITs Neutral 1.9% 1.5%

Australian Direct Property Under 3.8% 2.6%

7.5% 7.5%

Fixed Income Australian Government Bonds Under 5.5% 2.9%

Global Government Bond Very under 5.5% 0.7%

Investment Grade Credit Over 9.0% 12.6%

High Yield and EM Debt Very under 2.5% 0.3%

22.5% 15.5%

Alternatives Real Alternatives Neutral 7.5% 5.0%

Absolute Return Growth Neutral 5.0% 6.0%

Absolute Return Defensive Neutral 2.5% 4.0%

15.0% 15.0%

Cash Cash Over 10.0% 12.0%

10.0% 12.0%

Growth vs Defensive Growth assets Over 65.0% 68.5%

Defensive assets Under 35.0% 31.5%

Scale

Very positive

Positive

Neutral

Negative

Very negative

Overweight

Above your strategic weight at this point in the cycle.

Neutral

In line with your strategic weight at this point in the cycle.

Underweight

Below your strategic weight at this point in the cycle.

Exposure to this asset class should be:

Legend



Asset Class Forecasts Strategies

Australian Equities

• Our 31 December 2014 ASX 200 forecast is 5,750

• Our 30 June 2015 ASX 200 forecast is 5,850

• Earnings will grow in the mid-single digits and have the potential to pick up later in the year if A$ turns lower and rate stimulus and economic activity push the economy forward

• Keep range-bound friendly portfolios with a core of high quality stocks which have sustainable dividend yields

• Buy companies with a high proportion of offshore earnings

• Rebalance your portfolio after a lopsided rally which over-bought yield plays

International Equities

• We expect the US recovery to continue and broaden to Western Europe

• Cheaper areas of global equities such as Europe can continue to re-rate

• EM equities continue to suffer divergent fortunes but pick up as the path of stimulus withdrawal becomes clearer

• Use the high A$ as an opportunity to add breadth to your portfolio

• We prefer developed markets and have a large position which is 80% unhedged

• Consider an EM position as valuations are looking attractive, albeit with some risk. Build positions once earnings have stabilised

Currency • Persistent US growth brings a strong dollar and markets will anticipate higher rates

• The A$ has started to move higher again despite fading traditional indicators

• Low hedging of 20% will benefit your portfolio as the A$ weakens again over time

• Hold stocks in your portfolio that have strong businesses and gain as the A$ subsides

Fixed IncomeSovereigns

• Monetary policy should stay ultra-loose but 2015 is the year where markets will begin the process of stimulus removal and higher rates

• As a result sovereigns will come under pressure

• Sell EM debt and put proceeds in cash

• Keep trimming back other FI positions

• Try to delay buying fresh FI positions as curves set higher

Fixed IncomeCredit

• Spreads can grind tighter for now as inflows combine with low issuance to grind spreads in

• We expect lower quality credits to do well in the near-term but position in higher quality credits for a better through the cycle experience

• Total credit returns will be low in 2014 but yields will increase as the recovery develops

• Proactively trim any oversized hybrid security positions in your portfolio

• Continue to move allocations up the quality curve towards better rated (floating) names

• For new money, try to be patient and get set at lower valuations as curves and volatility pushes spreads wider

Cash • Term deposit rates can continue to fall, as banks have strong capital positions and are still paying well above the RBA cash rate

• Keep some powder dry with an overweight cash positions which gives you flexibility to react in any market dislocations

Alternatives • Alternatives will provide another source of growth and diversification for portfolios outside of equities, which is valuable in this lower return environment

• Trend following strategies like managed futures can benefit as bond valuations moderate

• Reduce your overweight in Fixed Income and Cash to start building an allocation to Alternatives which should improve risk-adjusted portfolio returns

• Managed futures strategies should provide hedging if bonds continue to sell off

Property • Property valuers in the unlisted space are behind the curve and will be forced to catch-up

• Lower quality property will start to outperform from here, don’t get tempted to move down the curve

• Favour adding to unlisted allocations as valuations are marked up

• Favour developers who are using other people’s money to fund their balance sheet like GMG and WFD

Summary of Asset Allocation Themes



Atlantic recovery continues and the key indicators show healing.

The Atlantic recovery is intact and economic healing is continuing. Global Purchasing Managers Intentions (PMIs) are at their highest level since Feb ‘11 which is a good sign for growth and production intentions. Unemployment rates continue to fall around the region and GDP levels are moving back towards their pre-GFC watermarks despite one of the slowest recoveries on record. Beside this major share indices are regularly hitting new all-time highs, with low volatility that we haven’t seen since before the crisis.

Tightening financial conditions could happen sooner than the market anticipated.

Financial conditions tightening could bring the winds of change. All three main central banks are currently easing policy. But the alignment of policies won’t last forever. In time, central banks will cross the Rubicon of tighter policy. This could well be the catalyst for a change in regime. The US Fed is reducing its rate of bond purchases and the probability of a small lift in UK and US rates next year is building. The biggest risk in our view is that markets get wrong footed by rising rate expectations. There have been a few comments to that effect recently from the Bank of England head Mark Carney and Fed board member Bill Bullard who both signalled that the benchmark interest rate might start to rise earlier than anticipated. Managing the exit strategy will be a knife-edge game and will no doubt have a few more plot twists.

Developed economies are now stepping up, but need to show acceleration in growth and profits.

The global recovery has entered a new phase where now developed countries are moving forward, while the level of growth in Emerging Markets declines from elevated levels. There are many similarities to 2006 conditions where investors were clamouring for returns and driving valuations ever higher. In this climate quality will likely underperform. We think that underperforming in this point of the cycle is not a bad thing as the additional risk of buying lower quality investments may boost short term return but sacrifice the integrity of investors’ portfolios.

Markets delivered another very strong year of returns in FY14.

We’re coming off another strong year of returns for investors in a balanced portfolio recording a second year of low-teens positive returns. This has been driven by strong equity returns, particularly global equities which marginally outperformed their domestic counterparts again by roughly 2% in the last financial year. Other asset generally recorded positive returns across all asset classes although at lower levels.

Developed markets heal with time

UK US EU AU

Unemployment rate 6.9% 6.6% 11.8% 5.9%

Inflation 1.7% 1.4% 0.6% 2.9%

GDP growth 2014 3.0% 2.2% 1.1% 3.1%

Source: CommBank and Bloomberg

July-September 2014 Outlook by Region

GDP growth continues – GDP quarterly growth%

Mar 10

Mar 11

Mar 12

Mar 04

Mar 05

Mar 06

Mar 07

Mar 08

Mar 09

Mar 13

Mar 14

-6

-4

-2

0

2

4

6

8

10

12World

BRICS

Australia

Source: Bloomberg

Offshore unemployment falls – Unemployment rates %

0

2

4

6

8

10

12

14 USEU

Jun2004

Sep Dec Mar Jun Sep Mar Jun2014

UK ChinaAustralia

Source: Bloomberg



are building for 2015 and onwards should the government not stem potentially big losses in the property/credit system. While news flow has been quieter, property markets in China continue to deteriorate. Price changes are negative on a month-on-month basis and are showing consistent falls across their largest 70 cities. This could have knock on effects in demand for Australia’s commodities, but also for the credit system in China. Things are still unfolding and the financial world is watching.

Domestically we are building growth outside of our mining economy, but sentiment seems fragile.

Domestically, we are navigating the mining slowdown sufficiently well to date. A leverage and construction trend has sprung up around the housing market. The boost of fresh interest rate cuts seems to be wearing off and is not being helped by a stubbornly strong A$. The stark reaction to the recent budget suggests that households are still fragile. This rebalance may well be tested if iron ore and coal price falls continue and force mining closures and more capex cuts.

Europe is still in a low gear, ECB rate cuts will help but the credit channel still isn’t working.

Europe is on a slow but consistent recovery trajectory. Policymakers are doing the right things: restructuring the system, dropping rates and easing their austerity drive. Europe’s economy is showing signs of improvement, but inflation has dipped again and deflation is gripping countries like Spain. That said, the ECB has been forced to react to weakening European data by cutting its main interest rates (refinancing rate from 0.25% to 0.15%; overnight cash rate to -0.1%) This should encourage bank lending but it will take time for this to happen. The ECB has also announced a small but targeted assistance package to promote lending to the small and medium enterprise space. The credit channel in this space was up to now just not working and is vital to remedy in order to orchestrate a solid recovery in the region.

China is transitioning to a lower growth model and their property market represents a downside risk.

The twin issues of an unstable property market and easing indicators suggest China is transitioning to a new lower level of growth that will be less focused exporting and building/resource intensive sectors. We think China can still grow somewhere near 7% in 2014 but risks

Chinese property in downtrend – China House price YoY%

Nov 06

Oct 07

Sep 08

Aug 09

Jul 10

Jun 11

May 12

Apr 13

Mar 14

Chinese property in downtrend

-10

-5

0

5

10

15

20

25Tier 1 Tier 2 Tier 3

Source: Bloomberg

Chinese indicators point lower – Chine lending, property and growth YoY%

Sep 06

Sep08

Sep 10

Sep 12

Chinese indicators point lower

Social lending (LHS)

Floor space sold (LHS)

GDP growth

-40

-20

0

20

40

60

80

0

2

4

6

8

12

10

14

Source: Bloomberg

A$ rise makes rebalance tougher – Cross rates

A$ rise makes rebalance tougher

Jun

09

Jun

10

Jun

11

Jun

12

Jun

13

Jun

14

40

60

80

100

120

140

160

US$Yen

EuroBG Pound

A$ Trade Weighted

Source: Bloomberg

Volatility is at post-crisis lows – Volatility indices

Aug 08

Feb09

Aug 09

Feb 10

Aug 10

Feb 11

Aug 11

Feb 12

Aug 12

Feb 13

Aug 13

Feb 14

0

10

20

30

40

50

60

70

0

50

100

150

200

250VIX ASX 200 VIX MOVE

Source: Bloomberg



The bottom line

Economic and profit growth need to continue to justify market optimism.

Global growth and corporate earnings need to continue to build with a broadening recovery. We are entering the second phase of the recovery where central banks implement their exit strategy, short-term rates rise and asset dynamics shift in response. As this happens the market will turn to focus on higher rates and this could cause setbacks for some pricey assets. Clients need to buy growth assets with operational leverage cheaply when they can.

Continue trimming Fixed Income, in favour of growth assets with operational leverage.

From a portfolio point of view we are close to the point in which investors need to begin thinking about how long they want to ride this momentum. The easier money has been made and markets are still comfortably numb with ongoing stimulus injections. This time has come in Fixed Income: take some profits on yield focused areas of your portfolio. Equities will have lower returns due to their starting valuations, but can push higher on momentum in the short-term and their earnings capacity longer term.

All assets trending up – Asset class return indices, 100 = Jan 14

All assets trending up

Jan

14

Feb

14

Mar

14

Apr

14

May

14

Jun

14

Bank billsGlobal property

BondsGlobal Equities

Australian Equities

95

100

105

110

115

120

Source: Bloomberg



Fundamentals Valuation Sentiment

Fundamentals are reasonable for domestic equities with good balance sheets and building revenue and profit growth

Valuations are about fair value. Dividends (5.5% gross) are still well above term deposits and are showing some growth

Domestic confidence is improving albeit it was fragile after the budget, IPOs and M&A building, but not yet euphoric

Domestic market posts another strong year, with all sectors up on this time last year.

The domestic rally has continued and the market is now up almost 18% again last financial year. Interestingly the rally carried across all sectors. Earnings picked up for the first time in two years in February, but we are not expecting much more than mid-single digit profit rises in August. While the economy is rebalancing, the effects of interest rate drops are fading in the economy since we reached a record low rate of 2.5% in August.

Can Australia and Asia decouple?

One of the interesting things market valuations are inferring is that Australia is decoupling from Asia, our key export market. Funnily enough if you look at simple Price/Earnings ratios Australian valuations are behaving more like the US that our regional neighbours. So it begs the question whether the market is too negative on Asia or is it just positive on our outlook with a weaker mining contribution?

Australian equities – Are we really decoupling from Asia as mining fades?

Index and Sector Aggregates

12 months Forward

EPS Gr. P/E Yield

S&P/ASX 100 2.8 14.6 4.5

S&P/ASX 200 3.0 14.8 4.4

Small Caps 6.5 16.9 4.0

Financials ex Property 10.9 13.3 5.4

Property 3.9 15.0 5.4

Industrials ex Financial 9.9 17.1 4.2

Industrials 9.7 15.2 4.8

Resources -8.4 14.0 3.6

Source: CommBank Equities

Mining is under pressure and iron ore and coal are added to the injury list.

On the mining side, conditions are deteriorating and you should trim positions in advance of downgrades. Previously resilient iron ore prices have been weak this year, trading down 25% to around US$90/t. Australia is a very low cost producer so in aggregate we are lifting supply, driving ~25% y/y growth in Port Headland exports. Demand risks too are growing as China’s steel production has been falling through May and weak property construction indicators point to growing downside risks. A strong exchange rate and a widening of low grade discounts further punish emerging producers.

Are we more Asian or American? – Historic Price/Earnings ratios

Are we more Asian or American?

0

20

40

60

80ASX 200

MSCI ASIA

S&P 500

Jun

07

Jun

08

Jun

09

Jun

10

Jun

11

Jun

12

Jun

13

Jun

14

Source: Bloomberg

Resources have muted rally – Total return indices, rebased to Jul 12

Resources have a muted rally

Jul 1

2

Sep

12

Nov

12

Jan

13

Mar

13

May

13

Jul 1

3

Sep

13

Nov

13

Jan

14

Mar

14

May

14

MarketBanks

ResourcesIndustrials

80

90

100

110

120

130

140

150

160

170

Source: Bloomberg



Non-mining economy picking up, although consumer confidence remains weak.

Consumer downgrades and intriguing M&A.

We have noticed that the pick-up in domestic conditions has faded somewhat and almost every listed retailer has downgraded their profit guidance as we move towards reporting season in August. Consumer Sentiment continues to remain weak and took a large hit after what was a tough budget. The domestic PMI also continues its downward trajectory. All suggest a fragile household still struggling to get confident. Despite this corporate activity has pick up in the sector with South African Woolworths bidding for David Jones. Premier Brand’s Solomon Lew must be a good poker player because he extracted maximum benefit on his side holding of Country Road, a company in which SA Woolworths owned 88%. In a daring move he quickly accumulated a 10% blocking stake in David Jones in order to flush out a bid for his minority holding in Country Road. You have to have deep pockets to even try such an audacious move, but we will tip our hat to this successful manoeuvring as long as he gets around the “collateral benefits” rule.

Rates at record lows have given a big boost to asset quality at banks which is the main driver of earnings.

Over the quarter the Big Four banks all reported and look to be on track to grow earnings by high-single digits this year. Conditions could not be more benign for the sector at the moment with rates at all-time lows, mortgage growth roaring back and an orderly decline in mining to date. Asset quality has been the main source of upgrades for two years as low rate have seen low levels of losses on loans. The fact that business lending is not picking up is also a little incongruous as ultimately it is business spending that drives jobs and the economy rather than investors buying houses. The interest rate driven parts of the market such as banking continue to benefit from falling costs of debt and improving asset quality which is boosting earnings. However after rallying 50% including dividends they are beginning to represent a concentration risk for the index.

Sectors with earnings stability are attractive at the moment, although some infrastructure can be quite cyclical.

Sectors that offer greater earnings certainty like infrastructure are in high demand. Transurban, along with two pension fund partners, bought a 70km stretch of motorway in Queensland for $7bn. Spark bought 30% of Duet, but we are still happy to add to this position in advance of the privatisation of public electricity generation assets in NSW. The strange overlap between high multiples in this sectors and the declining mining outlook can be seen with the Port of Newcastle sale. It was sold in a deal worth $1.75 billion, representing 27-times annual earnings at almost exactly the time when there is no longer any ships queuing to get port access and about 40% of NSW thermal coal mines are operating at a loss. Overall the government is the winner from these disposals and much of the proceeds will fund new infrastructure development nationally.

Muted confidence despite rate cuts – Consumer confidence

Muted confidence despite rate cuts

-40

-30

-20

-10

0

10

20

30

6

26

46

66

86

106

126

146

Jun

04

Jun

05

Jun

06

Jun

07

Jun

08

Jun

09

Jun

10

Jun

11

Jun

12

Jun

13

Westpac index (left) NAB index (right)

Source: Bloomberg

Port of Newcastle - a timely sale – Australian Thermal Coal indicators

0

5

10

15

20

25

30

0

20

40

60

80

100

120

140

160

180

200

Port of Newcastle -a timely sale

Dec

06

Dec

07

Dec

08

Dec

09

Dec

10

Dec

11

Dec

12

Dec

13

Coal price US$ LHS (left)Ships queued at Newcastle Port (right)

Source: Bloomberg

Iron ore plays under pressure – Iron Ore fundamentals

Source: Bloomberg

Iron ore plays under pressure

Dec

11

Mar

12

Jun

12

Sep

12

Dec

12

Mar

13

Jun

13

Mar

14

Jun

14

Sep

13

Dec

13

Bbg iron and steel index (left) Iron ore price (right)

0

50

100

150

200

250

0

20

40

60

80

100

120

140

160

180



Overall we are happy with the portfolio positioning and are looking to broaden our portfolio exposures as the year unfolds.

Despite the recent rise in the currency, we continue to maintain our conviction in a lower medium term AUD closer to 80c, driven by a US economy marching higher while a decade long Australian investment boom comes to an end. This makes foreign revenue earnings stocks more attractive.

The Commonwealth Private Core Equity Portfolio is positioned with exposures to both resilient earnings at home and the recovery offshore. Watch as the falling A$ and lower rates kick in to support earnings and push profits upwards again. We feel we have the right mix of companies that have stable earnings and can handle a local economy transitioning from mining to domestic and export-led growth.

Core Equity Portfolio by sector

Core Equity Portfolio by sector

9.0%Energy

16.2%Matrials

8.4%Industrials

8.2%Healthcare

32.2%Financials

6.5%Property

2.0% IT

4.5%Telecom

3.0%Utilities

10.0%Cons Staples

(0.0% Cons Disk)

Source: CommBank Equities

Core Equity Portfolio vs. ASX 200

Core equity portfolio vs ASX 200

Underweight (% points) Overweight

-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4

Financials

Cons Disc

Property

Telcom

Materials

IT

Utilities

Industrials

Cons Staples

Energy

Healthcare

Source: CommBank, July 2014 CEP



Despite the well heralded recovery, US and global growth for the year may well only come in slightly above last year and are still growing below potential. Fiscal and deleveraging drags are waning across the developed economies, while financial conditions more broadly are improving. At the same time, global monetary policy remains near the easiest it has been in the history of modern central banking.

Valuations are now above long term averages, but earnings are growing at about twice our local rate.

This has taken Price/Earnings (P/E) valuations to just above their long-term averages. The next leg up for equities will have to be driven by capital expenditure and stronger corporate revenue and earnings growth. Forward earnings growth is still quite attractive relative to our domestic market with US and European consensus earnings estimated to grow by 10%, relative to our 6% despite being on about the same multiples. This is due to the fact that offshore developed markets are at the start of a cycle after almost six tough years.

EMs have challenges but attractive valuations and may be a trade to increase when flows stabilise.

EM equities are amongst the few cheap growth assets currently and if investors can be patient they will be rewarded as the cycle turns. Valuations appear to have bounced off the resistance line that we highlighted earlier in the year. Energy related economies should fare well. Although those that export hard commodities may well be watching developments in China as anxiously as we are.


The global economy is growing at trend. Cash flows and balance sheets are strong

Valuations are reasonable as long as earnings can grow, EM starting to look very attractive

Sentiment has improved on the whole, but nervousness remains on EM indices

Unhedged global equities have continued to deliver as global indices hit new records.

International equities continue their good run returning just over 20% for the financial year on a hedged and unhedged basis. Unhedged returns have been notably stronger over the past two years.

Europe and EM look cheap

Index CY 15 P/E Div. Yld. P/B

MSCI World 14.4x 2.5% 2.2

MSCI EM 10.3x 2.7% 1.5

ASX 200 14.4x 4.5% 2.0

S&P 500 14.9x 2.0% 2.6

Euro Stoxx 13.0x 3.5% 1.5

FTSE 100 13.0x 3.7% 1.9

Shanghai 7x 3.7% 1.1

Source: Bloomberg

Much heralded recovery is still a long drawn out affair.

International Equities – Continue building unhedged positions

Strong returns in local currency – Equity total return indices, 100 = Jun 12

Strong returns in local currency

Jun

12

Aug

12

Oct

12

Dec

12

Feb

13

Apr

13

Oct

13

Dec

13

Feb

14

Apr

14

Jun

13

Jun

14

Aug

13

USWorld

EMEurope

Australia

80

90

100

110

120

130

140

150

160

Source: Bloomberg

EM starting to pickup – Price/Book Ratios

EM starting to pick up

Jun

04

Jun

05

Jun

06

Jun

07

Jun

08

Jun

09

Jun

10

Jun

11

Jun

12

Jun

13

Jun

14

0.5

1.0

1.5

2.0

2.5

3.0

3.5 MSCI Word MSCI EM EM Resistance

Source: Bloomberg



Keep building to your target allocation in this asset class.

Given the valuation buffer, high A$ and better position in the cycle it has the opportunity to be a more profitable growth asset exposure than Australian Equities right now, so keep allocating to this asset class. While businesses and balance sheets are in great shape don’t expect as large a payoff in the short-term as starting valuations are now closer to fair depending on the pace of earnings growth. While earnings growth is well above our domestic market, offshore analysts are still cutting back their expectations, suggesting a strong profit outbreak is still some time away.

Earnings revisions still negative – Citi earnings revisions

Earnings revisions still negative

GlobalDM EMAsia

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

Jun

04

Jun

05

Jun

06

Jun

07

Jun

08

Jun

09

Jun

10

Jun

11

Jun

12

Jun

13

Jun

14

Source: Bloomberg

Sovereigns - watch for the unwind


Sovereign balance sheets globally have just surpassed their previous post WWII record of 120% of GDP

Long yields don’t even cover 3% inflation. OECD bonds remain over bid. Yields are just too tight

Bonds have started to sell off, but remain at high valuations. Inflation not an imminent problem

Sovereign bonds have surprised us and rallied throughout 2014.

Fixed Income – Take some profits and stay safe at the front of the curve

Two years rise, but long yields fall – Atlantic Short vs long bond yields %

Two years rise, but long yeilds fall

GlobalDM EMAsia

May 12 Nov 12 May 13 Nov 13 May 140.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Source: Bloomberg

Domestic rates suppressed – Rates %

Domestic rates suppressed

RBA cash rate Aust 10y

Jun 09 Jun 10 Jun 11 Jun 12 Jun 13 Jun 140

1

2

3

4

5

6

7

Source: CommBank and Bloomberg

One of the things that has surprised us year to date has been the rally in sovereign bonds, despite rate expectations beginning to pick up. 2015 is a year where global interest rates should start to rise, bringing tighter financial conditions which should lead to higher yields (which would see lower prices for some Fixed Income instruments). The prospect of higher rates domestically are apparent too and clients should favour floating rate securities for any new purchases. Clients should work with their Private Wealth Manager to right size their positions in this asset class and trim back areas of it after a strong five years of returns.

Rising rate expectations should push yield higher.



Corporate credit - tighter still


Ultra-low rates have suppressed the credit cycle but loose issuance will see it rise again in years to come

Spreads are too tight across the board. EM debt is most at risk as investors retreat and US rates and US$ rise

Sentiment has been too strong for these asset classes at these yields and reversals are likely

Don’t be tempted to risk your capital in order to reach for an extra 1-2% yield this late in the cycle.

In this yield desert, the oases are on the edge of the system. But they may quickly become a mirage as these are the places in the market that are less liquid and peripheral assets offer an additional premium. Remember to treat Fixed Income as the defensive side to your portfolio and don’t get tempted into lower quality areas. These include areas of structured credit, CoCo bonds, leveraged loans and most forms of “high yield” Fixed Income.

Our managers are positioning defensively at the front end of the curve which will limit downside in a sell-off.

Investment grade to lighten further – Basis points over swap

Investment grade to lighten further

Avge Sprd

Long termAvg Sprd

0

50

10020

02

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

150

200

250

300

350

400

450

500

550

600

Source: CommBank

Property


REITs continue to enjoy very low interest rates. Yields are tightening, but vacancies and supply are rising

REIT valuations are contracting as rate expectations rise, bringing the sector to about fair value

Inflows are strong and the development cycle is in full swing. M&A starting to happen

Property transaction prices are running hot, despite weak leasing conditions.

Property transactions and financials are reasonably strong at the moment buoyed by the very low interest rate environment which suits this capital hungry sector. But local leasing conditions are the weakest since the early 1990s with vacancies high and concessions (where landlords give a rent-free starting period or free refurbishment to keep the headline rent of the building higher than it

As the cycle matures investors pile into the riskiest part of the asset class in search of elusive yield, instead of being patient and focusing on preserving their capital while receiving a modest yield. At this point in the cycle for Fixed Income don’t reach too hard for yield as that extra one to two percent of carry could cost you capital if the trend reverses. We are positioned defensively on the front of the curve within the managed funds we use in this space.

Property and Alternatives

might otherwise be) at levels equivalent to 25-30% of annual rents. Sector returns are currently running in line with income as earnings and net tangible assets are growing in low single digits. The cost of debt financing across the A-REIT sector has fallen to around 5% as debt continues to be issued cheaply and at longer tenors. Prices are moving up despite soft fundamentals. This could be worrying if demand conditions continue to deteriorate, but it’s not unique to this asset class in today’s environment.

A-REITs are moving with earnings and benefiting from lower costs of debt.

The listed A-REIT sector actually has gone through a de-rating since this time last year and is now trading only at a slight Net Asset Value (“NAV”) premium suggesting that the sector is now marginally overvalued. Dividends, covered by operational cash flow, are about 6% and current gearing has remained steady at around 30% despite the temptations of ultra-low interest rates and increasing mergers and acquisitions in the sector.



G-REITs have performed well and have fully recovered from their bump around May last year.

For Global-REITs we believe the valuation levels remain reasonable today compared with capital market alternatives like bonds and some parts of the equity market. Property stocks currently offer a decent yield which is 1-2% higher than equities in each given region. The sector was under pressure as the market marked it down to lower multiples after last May’s taper event as markets extrapolated the negative effect of rising interest rates on the sector. Since then markets have settled down and property companies are focussing on development options to drive earnings growth. This is normally exactly when property firms get into trouble by taking too much debt on their balance sheets. But in this cycle a unique thing has happened, pension funds are stepping in to fund these developments because they are desperate for yield. Local examples of this are Goodman and Westfield who are boosting their returns and reducing their risk with other people’s money. A beautiful combination that we are very happy to exploit on the stock side.

We are starting to see some late cycle behaviour but the sector looks well placed in our low-interest rate world.

Overall we are seeing some mid-late cycle activity coming to play in property markets but not enough for us to worry at this point. Overall the listed and unlisted domestic market is set to gain from higher valuations and transaction prices despite the subdued fundamentals. Clients should work with their Private Wealth Manager to right size their positions and get the right allocations in an asset class that can still do well in this low interest rate world.

Capitalisation rates continue to tighten, driven by cheap offshore money forcing valuers to mark prices upwards.

Cap rates have continued to tighten across Office, Retail and Industrial subsectors as asset prices have risen faster than rents. Valuations for unlisted property assets are rising but look to be behind the curve as professional property valuers seem to be reluctant to mark up valuations in the absence of improving tenancy conditions. We think the trend for high valuations/lower cap rates will continue as transactions at higher valuations without simultaneous rental growth will force these valuers to mark cap rates tighter (i.e. higher valuations). The flow of transactions, often funded with cheap offshore money, is underpinning these moves to higher valuations as liquidity overspills from expensive offshore markets with even lower costs of capital.

A-REITs have solid financials

50

25

75

100

125

150

175

200

225

250

275

300

A-REITs have solid financials

-20

-15

-10

-5

0

5

10

15

20

May

03

Apr

04

Mar

05

Feb

06

Jan

07

Dec

07

Nov

08

Oct

09

Sep

10

Aug

11

Jul 1

2

Jun

13

May

14

Dividend Yield Payout ratio (RHS) FCF Yield (right)

Source: CommBank

G-REITs continue to power on

G-REITs continue to power on

A-REIT G-REIT

80

100

120

140

160

180

200

Jan

09

Jul 0

9

Jan

10

Jul 1

0

Jan

11

Jul 1

1

Jan

12

Jul 1

2

Jan

13

Jul 1

3

Jan

14

Source: CommBank

Unlisted sector returns all up – Annualised inlisted returns % by sector

Source: CommBank

Unlisted sector returns all up

Jun 04

Jun 05

Jun 06

Jun 07

Jun 08

Jun 09

Jun 10

Jun 11

Jun 12

Jun 13

Australian O�ce

Australian Retail

Australian Industrial

-15

-10

-5

0

5

10

15

20

25



Alternative assets

Liquidity Leverage Systematic risk

Is abundant at this time, however trading volumes have dropped due to Basel 3 regulations

Leverage is building, borrowers should be wary of potential rate hikes

Markets seem a touch complacent after such a long smooth rally

Infrastructure investments continue to be a strong performer in this part of our portfolio. In a world with lower returns they have a very attractive appeal due to the steady and inflation linked nature of their businesses. Inflation has been surprising to the downside since the GFC (as you can see on the opposite chart). But if it does pick up you will be able to capture it in your infrastructure earnings as many of their contracts are inflation linked.

Alternatives are a good source of diversification and while they rarely keep up with equities when they are on a bull run such as the last year they can provide valuable downside protection in pullbacks.

Leverage is building in the system – Margin loans and fear

0

5

10

15

20

25

30

35

40

Leverage is building in the system

Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Dec 13

US Margin Loans CS Fear index

US Cash in Margine loans (right)

0

50000

100000

150000

200000

250000

300000

350000

400000

450000

500000

Source: CommBank

Index Asset Class Bloomberg Ticker Current Value Fin YTD 1 mth YTD 3 mth YTD 6 mth YTD 1 yr (%pa) 3 yr (%pa) 5 yr (%pa)

Australian Equity Australian shares

S&P/ASX Acc 200 Australian Equity ASA51 Index 46,769 19.42% 1.77% 3.31% 5.97% 15.30% 13.19% 16.59%

S&P/ASX Acc Small Ordinaries Australian Equity - Small Cap ASA38 Index 5,476 16.25% 4.34% 3.19% 1.70% 7.19% -2.20% 5.93%

Citigroup Value Australia Australian Equity - Value STVBCAUL Index 1,127 18.89% 1.77% 3.51% 6.44% 15.70% 16.85% 19.86%

Citigroup Growth Australia Australian Equity - Growth STGBCAUL Index 742 20.00% 1.97% 3.00% 5.59% 14.68% 6.98% 12.21%

International Equities International Shares

MSCI World (USD) International Equity ex-Aust MXWO Index 1,736 21.10% 0.51% 5.57% 5.51% 15.86% 10.49% 17.14%

MSCI World Small Cap (USD) MSCI hedged in AUD MSDUWXA Index 705 21.95% 1.41% 4.30% 5.35% 21.95% 15.10% 33.51%

MSCI Emerging Markets (USD) International Equity - Emerging Markets GDUEEGF Index 2,101 15.88% 1.45% 5.84% 10.17% 15.07% 0.48% 13.57%

S&P500 International Equity - United States SPX Index 1,968 22.49% 1.62% 7.48% 8.16% 17.10% 16.44% 23.67%

Nikkei 225 International Equity - Japan NKY Index 15,164 10.87% 0.44% 9.01% -4.70% 4.53% 17.40% 13.51%

FTSE 100 International Equity - UK UKX Index 6,690 7.64% -1.29% 1.62% -0.99% 2.22% 4.42% 11.84%

Hang Seng International Equity - Hong Kong HSI Index 23,233 11.68% -0.37% 0.84% 1.51% 9.19% 1.99% 6.93%

Shanghai Composite (China) International Equity - China SHCOMP Index 2,047 3.42% -1.15% -3.97% 1.86% 0.37% -8.93% -6.71%

Fixed-Income and Currencies Fixed-Income

RBA Cash Rate Income - Cash RBACTRD Index 2.50% 2.75% 2.50% 2.50% 2.50% 2.75% 4.75% 3.00%

Bank Bill Swap 3 Month Rate Income - Short Duration BBSW 3M Index 2.64% 2.82% 2.71% 2.71% 2.64% 2.76% 4.95% 3.12%

UBS Australian Bank Bill Index Income - Short Duration AUBI Index 8,073 2.79% 0.23% 0.67% 1.32% 2.68% 3.65% 4.22%

UBS Australian Composite Bond All Index Fixed Interest - Bonds ACMPALL Index 7,997 6.71% 1.64% 3.10% 5.08% 6.44% 7.34% 7.67%

BarCap Bond Composite Global Index Fixed Interest - Diversified BNDGLB Index 382 5.61% 0.73% 1.36% 3.52% 5.65% 2.85% 4.96%

BarCap Global High Yield Fixed Interest - High Yield LG30TRUH Index 390 12.56% 0.39% 2.59% 5.41% 11.48% 10.93% 18.87%

Aus Dollar/Euro Currencies AUDEUR Curncy $0.690 -1.77% -0.61% 1.20% 4.05% -0.32% -3.34% 3.76%

Aus Dollar/Yen Currencies AUDJPY Curncy $0.952 4.81% -0.77% -0.82% 2.05% 5.72% 3.58% 4.71%

Aus Dollar/ US Dollar Currencies AUDUSD Curncy $0.939 2.70% -0.11% -0.35% 3.59% 3.65% -4.85% 3.32%

Aus Dollar/ GB Pound Currencies AUDGBP Curncy $0.549 -9.46% -0.96% -2.64% -0.70% -9.13% -7.24% 2.41%

Property Property

S&P/ASX Acc Property Trusts Property - Listed Domestic ASA6PROP index 30,895 13.44% 4.96% 9.85% 12.59% 13.77% 19.80% 21.52%

FTSE Global REIT Index (USD) Property - Listed Global UNGL Index 2,226 10.38% 1.18% 6.13% 9.58% 6.57% 6.33% 19.06%

Mercer Unlisted Property Post Tax Asset Weighted Property - Unlisted Domestic MAUPPOTX Index 6,269 8.83% 1.40% 2.42% 4.48% 8.83% 9.34% 9.28%

UBS Real Estate ex-Aust (AUD) Property - Listed Global UREIUNOA Index 1,506 12.49% 1.78% 7.47% 10.31% 7.49% 16.82% 22.77%

Alternatives and Commodities Other Alternatives

UBS Global Diversified Global Infrastructure (H) UINFWAHT Index 4,807 26.55% 1.07% 9.39% 11.58% 21.09% 27.25% 32.50%

CS Tremont Hedge Fund Hedge Funds HEDGNAV Index 542 7.81% 0.00% 0.92% 1.86% 7.81% 5.14% 8.80%

CBOE SPX Volatility S&P500 Volatility VIX Index 12 17 13 13 13 14 20 26

GSCI Industrial Metals (USD) Commodities - Industrial Metals SPGCINTR Index 1,417 7.86% 7.07% 6.12% 4.26% 4.85% -9.48% 4.18%

GSCI Agriculture (USD) Commodities - Agriculture SPGCAGTR Index 568 -15.66% -11.26% -18.93% -5.55% -16.10% -9.98% 0.64%

GSCI Energy (USD) Commodities - Energy SPGCENTR Index 1,139 8.90% -4.73% -1.46% 6.39% 1.07% -0.14% 6.96%

Gold Spot (USD) Values Commodities - Gold GOLDS Comdty 1,339 1234.57 1276.89 1327.99 1253.22 1285.7 1582.38 920.3

Source data: Bloomberg. Please note: These returns have been calculated by the investment and Advisory Services using discrete compounding assumptions. Discrete compounding assumes all the returns over a given period are earned at a single point in time, specifically the end of the time period. Discrete compounding differs from continuous compounding. Under continuous time assumptions, returns are earned incrementally over the time period to reach the final performance number. Past performance is not a reliable indicator for future performance.

Asset class performance as at 30th June 2014





CPB1102 280714

For more information, call 1300 362 081 or visit commbank.com.au/commonwealthprivate

http://commbank.com.au/commonwealthprivate

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