It’s clear that the company profit-reporting season wasn’t as bad as feared. Companies under promised and over delivered – an old strategy that continues to work.

CommSec has assessed the results of the 138 companies that reported interim earnings (the six months to December 2012) and the 29 companies reporting annual results for 2012. Almost 86 per cent of interim reporting companies reported a profit – the best result since the 2009/10 financial year.

Excluding heavyweight companies (BHP Billiton, Commonwealth Bank and Telstra) aggregate profits were up 17 per cent on a year ago. More companies lifted interim dividends than those that cut or maintained dividends.

To read the report, click here.

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Australian equities attractive in the long term

Australia’s strong economic position post the financial crisis has generated positive returns for investors during the past 12 months however, headwinds in 2013 will mean lower returns for investors with too much home bias, according to BlackRock’s Global Chief Investment Strategist, Russ Koesterich.

Visiting Sydney and Melbourne this week, from San Francisco, Mr Koesterich said Australia’s exceptionally low debt burden, budget that is close-to-balanced, profitable corporate sector and sustainable superannuation system made it an attractive long term play.

In the short term, Mr Koesterich said four factors may adversely affect Australian equities, increasing the need for investors to ensure their portfolios are not disproportionately home-biased.

Australia is not as cheap as it was six months ago. Australian equities are trading for nearly 2x book value. While this represents a discount to US stocks, Australia is now trading at a premium to most developed markets.

Growth remains soft. Australia has been hurt by falling commodity prices, particularly for iron ore. This drop in prices has had a negative impact on Australia’s terms of trade and has undermined the country’s business investment and household income.

Australia has become a two-speed economy. Australian monetary policy has become complicated by the fact that the country’s mining sector is growing at a very different rate than the rest of the economy. After an aggressive round of rate cuts, the Reserve Bank of Australia is taking a pause to determine if its recent policy easing will be sufficient to ensure a pickup in the non-mining sector.

Australia has an over indebted consumer. One factor holding back the non-mining portion of the economy: too much consumer debt. Australian consumers are in the process of repairing their balance sheets, much like US consumers. As this process unfolds, consumption will remain soft.

Mr Koesterich said: “For investors focused on the longer term, Australia has many factors in its favour. Australia suffers from fewer long-term economic imbalances than the United States, Europe and Japan. In addition, thanks to its large banking sector, Australia offers the second highest dividend yield among developed countries. In light of the country’s benign inflation outlook and attractive budget situation, Australia still has more monetary and fiscal policy flexibility than many other developed markets.”

“However, with Australia now trading at a premium to most developed markets, I am currently recommending maintaining a benchmark weight to the Australian market and encouraging investors to add international investments to their portfolios to avoid home bias,” he said.

Home bias is the tendency of many investors to allocate larger proportions of their portfolio toward securities in their home country, forgoing the benefits of a well-diversified global portfolio. Notwithstanding the franking credit benefits for local investors, an investor’s perceived familiarity with “local” companies or investments leads to over-confidence in the ability to invest in those companies compared with unfamiliar foreign companies or countries.

Mr Koesterich said: “We are already seeing some Australian investors expanding into international equities to diversify their portfolios. Witness the recent strong flows into Australian-listed ETFs that invest in international equities. Australian investors should consider taking advantage of the relative strength of the Australian dollar by investing in overseas assets. Global equities look increasingly attractive as a source of income.”

Mr Koesterich’s comments formed part of his latest outlook on a group of countries he refers to as ‘CASSH’ – Canada, Australia, Singapore, Switzerland and Hong Kong.

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Despite an encouraging valuation level for the broader market, the team believes in a targeted approach given the uncertainty that exists locally and globally. 

Outlining the key themes to emerge in Australian equities over the period the Goldman Sachs Asset Management Australian Equities team has identified an excessive focus on ‘yield at any price’ as a cause for concern, which has potential to unwind. While overall results largely reinforced the team’s sector ratings, a significant change was to exit most holdings in the REIT sector. 

“The number of companies who missed expectations, was broadly in line with the long-term historical average, with the bad news having been broadly factored in,” said Dion Hershan, Head of Australian Equities at Goldman Sachs Asset Management. “Despite this the reality is that there are a number of cross currents buffeting the Australian economy and we believe that a targeted approach is required to identify value.” 

The Goldman Sachs Asset Management team consists of 10 analysts, eight of which are sector specialists. It manages $2.8 billion on behalf of Australian institutional and individual investors. The team adopts a long-term, active, research-driven approach to managing domestic equities which includes more than a thousand meetings with Australian companies per annum. 

“There are a number of themes playing out in the market at the moment,” Hershan said. “On the positive side interest rates are falling, balance sheets have largely been strengthened, although a few weak outliers persist, and sectors exposed to higher growth regions have been resilient.” 

“On the negative side most companies are experiencing cost pressure, low productivity and the impact of a strong Australian dollar. Miners in particular are facing rising input costs, and lower commodity prices with a negative flow on effect for investment in new projects. Perhaps unsurprisingly companies are also being reticent about providing guidance which we think is a function of lower levels of confidence in uncertain markets.” 

“As a result of this uncertainty, many investors have become pre-occupied with yield and so-called ‘safe haven’ stocks,” said Hershan, “We have a strong view that ‘yield at any price’ is a flawed concept, and without valuation support, an unwind is likely. Over the long term we prefer to focus on the total return of an investment, with capital growth being critical in addition to yield.” 

“We believe that there is value to be found at the moment but you have to be extremely selective to find it. You can’t rely upon an economic recovery or normalization across the board, at least in the short-term. We are focused on identifying companies we believe can thrive irrespective of the operating environment, whether that be through organic growth, quality of the management team, or through control of the cost base and productivity gains.” 

“From an overall sector perspective the results season largely reinforced our key positions. We remain underweight metals and mining, insurance and telecoms. By contrast to our position on resources we are overweight energy. That’s a reflection of our view on energy prices and the level of confidence we have on some of these LNG projects progressing to market and delivering against return targets. We are also overweight transport where we see opportunities for increased productivity and efficiency, and banks which we think remain stable and resilient and which offer strong total returns.” 

On the team’s position on REITs Hershan added; “We were an early re-entrant back into REITs in 2009 with a view that balance sheet issues had been addressed, the underlying properties were performing well and the steep discount to asset backing was unsustainable. The valuation opportunity has largely played out and headwinds are emerging for property fundamentals with regard to rental growth and vacancies, given the broader economic environment. With the risk/reward now unfavourable we have moved to a significant underweight position.”

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Mark Arnold, Hyperion’s Chief Investment Officer, believes these companies now have a strong long-term return advantage because they can grow revenues, profits and dividends at attractive rates.

“Access to cheap debt in the decades prior to the GFC resulted in an explosion in the earnings growth rates of mediocre companies.  Both businesses and consumers were encouraged to gear up and increase spending on consumption and investment, and strong earnings and dividend growth over multi-year periods appeared to be the norm. 

“Businesses with strong fundamentals didn’t stand out, because even the most average companies were achieving strong short-term earning growth.”

Arnold suggests subdued investor confidence has resulted in deleveraging across the market, and with global investment markets remaining depressed and the local housing market soft, gearing levels are unlikely to rise substantially in the near future. 

“GDP and profit growth are likely to be below the levels experienced over the past 50 years,” he said.

“Now is the time that we are starting to see the better quality companies shine.”

Arnold said that the situation was unlikely to change in the immediate future, as Governments, households and investors continue to repay debt, build cash buffers and reduce exposure to risk and growth assets. 

“Capital light businesses with long-term organic growth options should outperform in a subdued economic environment,” he said.

Arnold concluded by saying, “The Hyperion Australian Growth Companies Fund has low levels of gearing, strong sustainable competitive advantages and attractive organic growth options. They are unlikely to need to raise significant equity capital through time and thus should not suffer material dilution to their long-term EPS growth rates arising from additional shares being issued. 

“We have always focused on companies with sustainable and attractive long-term earnings growth profiles and this has been the core driver of our alpha generation since inception in 1996. Since 1996, our portfolio has averaged 10% per annum growth in earning per share, which compares with around 6% for the market as a whole over the same period.  This differential in earnings per share growth represents a core component of our long-term alpha generation.”

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Rates on cash are higher in Australia than in many OECD countries and it has looked like a safe haven from equity volatility. But is having all your eggs in one basket really a risk-off strategy?

Most definitely not, says leading global investment manager, Threadneedle Investments (Threadneedle).

Head of Australia for Threadneedle, David Chinnery, said:

“In fact, global equities have rarely looked more attractive as part of a diversified portfolio. Yields are competitive relative to cash, and valuation models suggest that stocks are cheap. Now is the time to consider re-allocating out of cash and into global equities. Gradually building up exposure to global equities now could provide significant opportunities for investors in the future. This is particularly true in an environment where most analysts predict that interest rates are still coming down, which can only mean diminishing returns from cash going forward.”

Mr Chinnery went on to say the key to good portfolio management lies not in chasing sentiment and specific asset classes, but rather having a long-term investment view by focusing on allocating regularly and sensibly between competing asset classes.

“We all know that the news out of Europe has been dire, and that the US and China both have their problems as well. But every cloud has a silver lining, and economic conditions have produced a number of portfolio drivers that point to global equities as a great upside play”, he said.

Threadneedle’s Head of Global Equities, William Davies, said:

“Debt is cheap, and for well-managed, strong companies this means a lower cost of capital and a lower hurdle rate for new investments.”

Mr Davies backed this up with examples of thematic areas driving stock selection from Threadneedle’s portfolio of investments:

• Emerging consumers: Long-term growth, new areas of expenditure, opportunities for global brands. For example, Swatch.Shift in supply of and demand for gas: Asian demand for energy increasing, new areas of gas supply being developed eg Brazil, LNG technology enables development of global market, shale gas transforms US domestic gas industry. Beneficiaries include BG Group (British Gas), LyondellBasell and Dresser Rand.
• Innovation driving growth: Secular growth in low growth world, market share winners driven by new product innovation (e.g. smartphone adoption boosts e-commerce and online advertising). Beneficiaries include Apple and Ebay.

“The important point is that investors needn’t limit themselves to the Australian market in an effort to minimise risk.  Global equities selected by an experienced investment manager should be considered as a key element of any diversified portfolio. It’s worth remembering we invest in companies not economies or countries. Despite the challenging economic backdrop, there are strong companies with competitive franchises to be found and diligent stock-pickers will reap the rewards,” Mr Davies said.

19 July 2012

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Mr Taylor says “the first is a crisis of confidence associated with the possible breakup of the European Union and the Euro as a currency. From an investment perspective the key issue is that whatever happens it would be a temporary dislocation. It is creating a crisis in confidence rather than creating any real and permanent negative impact on the global economy.

“For Australia, the impacts from this crisis of confidence would primarily be focused on the dislocation of European and global debt markets. 

“This could potentially impact Australian corporates with higher debt levels as well as Australian banks seeking wholesale funding.

“However, currently Australian corporates have very low debt levels and Australian banks have been reducing their dependence on wholesale funding due to the very strong growth in domestic term deposits and low levels of system credit growth. 

“The negative impact from such a crisis of confidence would likely be very short-term in nature and if anything would create a short-term buying opportunity,” suggests Mr Taylor, who is also Portfolio Manager of the Fidelity Australian Equities Fund.

“The second aspect is the global sovereign debt crisis, which includes the debt issues of many European countries as well as the debt of many developed countries around the world, including the United States. 

“Debt levels of many developed markets are too high and need to be brought down to more manageable levels over a prolonged period. This is a real issue and not just a crisis of confidence and will likely negatively impact global economic growth over a prolonged period. Due to the global sovereign debt crisis we are likely to experience a low growth world for at least the next several years. 

“Australia as a country is very well positioned for this low growth world. The Australian Federal Government has very low debt levels and is projected to move back into a slight budget surplus as early as next year. Australian interest rates are also high by global standards giving the monetary authorities, the Reserve Bank of Australia, ample ammunition to further stimulate the domestic economy should the global economy continue to falter.

“While we may be in a lower growth world for a prolonged period we do not believe that all regions, countries, sectors and companies are low growth. In fact we believe that there are some strong pockets of growth within this lower growth world. If a company can achieve growth in a low growth world we believe that it will be increasingly bid up by the market as a rare asset.

“Similarly, if a company has a high and sustainable dividend yield in a low growth world it will also be bid up by the market as a rare asset.”

Mr Taylor notes “at the moment valuations are very compressed as capital markets are very sceptical, believing that as we are in a low growth world all regions, countries, sectors and companies will be low growth. 
 
“This is the ideal environment for individual stock selection. Markets are currently not differentiating between good and bad companies or high and low growth companies.

“The Fidelity Australia Equities Fund is investing in high quality companies with strong balance sheets and either good growth prospects or a high and sustainable dividend yield. We believe that these companies will continue to out-perform as they prove their growth and the sustainability of their dividends. Many of the top 10 positions in the fund have both a high sustainable dividend yield and good growth prospects,” he adds.

As for the outlook for Europe, Mr Taylor notes “the key concern is that if Greece does leave the European Union will the exit be orderly or disorderly? If it does exit, will the market’s focus then move to whether Portugal, Spain, Italy or Ireland will be next to leave?

“To ensure Greece stays in the eurozone requires a political decision, rather than an economic decision.  The key issue creating the specific crisis within the eurozone is that it is a monetary union, but is not a fiscal union. The establishment of a fiscal union would allow subsidies to flow throughout the area from strong to weak states.” 

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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Lonsec’s Head of Equity Research, Bill Keenan, commented, “While Australia has low direct exposure to Europe, it will still be indirectly impacted by financial markets in terms of the cost of wholesale bank funding (still about 40% of the banks’ funding), currency fluctuations and global investor sentiment.”

“In addition, a European recession could indirectly affect Australia via its impact on China.”

“While the European situation remains very uncertain and hard to predict, there are a number of reasons to expect the downside to be limited this time around.”

Lonsec believes there are a number of reasons for this, including:

1. Market lower – the Australian sharemarket has retreated from the 4,500 level rather than the 5,000 level as in April 2010 and 2011, and accordingly, dividend yields are higher and PE ratios considerably lower.
2. Yield curve lower – the RBA has cut the cash rate by 100bp since late 2011 and another 100bp in cuts is expected in the short term. The yield curve from cash to 10 year bonds is falling quite rapidly, which is supportive of economic growth and equity valuations.
3. AUD lower – the AUD has weakened 8% this year, which is taking some of the pressure off Australian exporters and manufacturers.
4. China easing policy – China is progressively easing monetary and fiscal policy to support growth, which is still expected to be around 8%. Back in 2011, it was tightening monetary policy to combat inflation.
5. US economy robust – US retail sales and manufacturing have been solid, while the housing market is showing signs of bottoming out. The US also has a new-found supply of cheap energy in shale gas, which will prove to be important over the medium term. On the negative side, new payrolls have been weakening again in recent months and the US budget deficit is due to be reigned in after the US election in November 2012.

“European issues are complicated and will take time to resolve,” said Keenan.

“However, we remain positive on the medium to long term outlook for the US, Asia and Australia.”

“Given the local market is already low and company balance sheets are strong, we don’t see any reason to be overly negative towards Australian equities.”

Lonsec expects the market to rebound, but it is likely that the rate easing cycle will need to play out fully before the market starts to recover in the second half of the year.

“Stocks with good dividend yield and fairly secure earnings are likely to outperform in the short term,” said Keenan.

“Investors should also target high beta resource and cyclical stocks on market weakness, taking a long term view that global growth will recover, led by Asia.”

Lonsec believes the next positive catalysts for the sharemarket will be:

1. RBA rate cuts
2. Lower AUD
3. China stimulus
4. EU progress
5. Change in Federal Government.

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“Lonsec has had a target of 5,000 for the All Ordinaries Index by the end of calendar year 2012,” said Keenan.

“I believe yesterday’s rate cut by the RBA will fuel this.” “History shows that a period of successive rate cuts nearly always leads to a strong rally in Australian equities.”

There are a number of reasons for this according to Keenan.

“The two most important reasons are firstly, a lower cash rate (and yield curve) lowers the return from cash, term deposits and bonds.”

“Secondly, the cost of debt is reduced which improves the disposable income of households and increases the return on equity of companies.”

In turn, economic growth recovers as consumption and business investment improve and a softer currency (usually) boosts exports. The Australian share market rallies as company profits improve and investors switch out of low yielding cash, term deposits and debt and into equities. Lonsec believes this easing cycle will end at 3.50% and therefore expects cash and deposits to come down by 75 basis points or more (from today) and loan rates to reduce by around 60 basis points.

“When you combine lower interest rates in the Australian economy with an improving global growth outlook, particularly in the US and Asia but also Germany, and Liberal/National governments transitioning back to each State and most probably federally by 2013, the economic and earnings outlook is suddenly a lot more brighter,” said Keenan.

Lonsec stock picks

Income stocks

• Commonwealth Bank (CBA) – best positioned and the most profitable major bank in the Australian market with the most advanced technology platform. Credit growth, superannuation flows and investment returns will recover over the medium term. Buy for yield (6.2% fully-franked) and long-term growth.
• Woolworths (WOW) – defensive with growth, given earnings are 90% food, liquor and petrol; home improvement provides a new growth driver. Has retreated to a good yield (4.7% fully-franked) and cheap valuation (FY13 PER 13.7x). Retail conditions should improve as interest rates come down.

Growth stocks

• Origin Energy (ORG) – has a leading vertically-integrated position in the Australian energy market. ORG’s LNG joint-venture (APLNG) is heavily de-risked after Sinopec (China) agreed to take most of the LNG and 25% equity in the project, but the market is paying very little for it. ORG has plenty of growth levers.
• Computershare (CPU) – the blockbuster BNY Mellon acquisition positions CPU as the dominant share registry company in North America (70% of the S&P500 covered), and indeed globally. CPU should generate double-digit earnings growth over the next few years from acquisitions and an up-tick in the cycle.

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So when eventually the strong contribution of growth coming from the mining sector starts to fade there are other sectors of the market that will start to do better. That’s a key positive for our market; a lot of flexibility and ammunition should we need a bit of policy response.

Valuations are also very reasonable right now. The market rarely gets to levels this cheap and almost always when you’re buying at levels like this you get a positive return, certainly on a multi-year view.

Will the Australian dollar remain strong and how will this affect our economy?
We’ve got a real tug of war going on right now with the Australian dollar. On purchasing power parity models, fair value for the dollar is around 70 cents, so it is trading far above its fundamental value. But on the other hand, one of the reasons that the Aussie dollar is strong is because the major central banks around the world are injecting huge sums of liquidity and debasing their own currencies and that’s keeping ours strong, because people want to be able to invest into a stronger fiscal situation. This is a real tension, which of those is going to prevail and over what timeframe.

Supporting the Australian dollar is also the mining boom. The Reserve Bank doesn’t want inflation so it wants to keep a lid on the household and the domestic side of the economy.  It does that by higher interest rates, higher interest rates support the dollar and this is really putting a dampener on manufacturing, retail and tourism related sectors.

This becomes a problem if it lasts for long enough that you get structural changes and you start to lose that side of business, because then if you do get weakness on the mining side, the other sectors can no longer rebound to offset that slowing.

If China’s growth slows, will our economy still be able to grow?
It’s really natural for us to spend a lot of time thinking about China’s economy and the growth rate because of the very direct linkage we can see. We sell an extraordinary volume of iron ore and coal to our northern neighbour. But it’s important to realise that what’s more important for our economy is a stronger for longer scenario. China needs a sustainable growth rate and a mid-teens growth rate is not sustainable for any economy, for any sustained length of time. China’s growth slowing to a 7.5% and 8% rate, it probably means that that growth trajectory for China is sustainable for longer, which should allow our exports to China to continue unimpeded. Personally, I welcome a bit of a moderation in China’s growth. I think that puts our export business on a more sustainable footing. 

Will it just be dividends and little capital growth for investors?
Over the last couple of years investors have received almost all of their return from the equity market in the form of dividends. Of course that means that the actual share prices have gone nowhere and in some years gone backwards. What does that mean looking forward?  Well, the great thing about buying into cheap markets is you can buy in to stocks with high dividend yields. So in a lower growth world, all asset classes are struggling to deliver strong returns and actually equities look pretty good now. 

The dividends that you can get in Australia in the market overall are about 6% and there are some quality companies that will yield 7% or more, sustainably. This is great because it means you can buy into those stocks, you can get that return year in year out and then actually you’ve got an upside option that markets do rerate upside at some point in the future.

What do you like at the moment and why?
This is a challenging environment for investing as the market seems to be lurching between risk-on and risk-off phases. So there’s always a temptation to chase each of those and that kind of trading mentality is not good for long-term investment returns.

We have a preference for companies that are running their own race and that can do well regardless of what the macro environment is doing. In the resources space we have a preference for Oil Search and for Iluka. These are companies that have the returns coming out of their current businesses to be able to self-fund their growth into the future. They have secure supply demand fundamentals that will support them.

In retailing, there is a lot of concerns about consumer discretionary retailing and the headwinds they’re facing. We like Wesfarmers because it can run its own race by reducing its costs and increasing sales per square metre and closing the gap with Woolworths a bit.

In terms of stocks offering a high yield we’re very comfortable with Commonwealth Bank and ANZ Bank.  Yes, credit growth rates are slowing but these businesses still generate high levels of cash that can be returned as dividends, and we also like Sydney Airport, a great business that’s gone through a simplification process and now offering a terrific yield and access to a really great asset.
This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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The basic argument is that compared to other major countries Australian pension funds have a higher share allocation and a lower bond allocation and that this leaves members exposed should shares plunge. And after shares have underperformed bonds in recent years such concerns resonate. There are several aspects to this debate. Why is the share allocation relatively high? Is now a good time to be thinking about switching into bonds? Is the real issue the underdeveloped corporate bond market?

Share allocations – super versus total wealth
Roughly speaking the Australian superannuation system has about 50% invested in equities and 18% in bonds. The share allocation is higher than that of other major countries and the bond allocation is lower as can be seen in the following table.

While the share allocation in super may be relatively high, this does not appear to be the case if Australian households’ total wealth is looked at. Thanks to a huge allocation to housing, Australians tend to have a much higher allocation to non-financial assets compared to other countries and a relatively low exposure to shares outside of superannuation. As such the total allocation of Australian households to shares as a proportion of total household wealth is not out of line with households in other countries, being above the UK, Japan and Germany but below the US and Canada.

Shares in super
There are several reasons why Australian superannuation funds may have a higher allocation to shares. The first thing to note is over long periods shares provide higher returns than bonds and cash. This can be seen in the next chart which shows that since 1900 Australian shares have returned 11.9% pa compared to 6% pa from bonds.

Similarly the next chart shows that over most rolling ten year periods shares provide higher returns than bonds, and when every so often they don’t the share return usually rebounds.

Second, Australian shares have tended to do better than most over the long term, so the higher allocation to shares which has been biased to Australian shares may have served Australians’ well (notwithstanding poor recent years).

Third, dividend imputation provides a tax boost to the return on Australian shares equal to around 1.5% pa. In a world of relatively low returns where a diversified mix of assets is expected to return around 8% pa, this is quite significant.

Fourth, the government bond market is relatively small thanks to years of budget surpluses and asset sales which have led to a relatively low level of public debt. On average, countries in the OECD have a stock of government bonds equal to around 100% of GDP to invest in. By contrast, in Australia gross public debt is just 24% of GDP which means there is not a lot of public debt to invest in.

Fifth, Australia’s corporate bond market is relatively small as corporates have traditionally relied more on either the share market or banks for funding. And in recent years they have found it easier to issue debt overseas. In fact, this is a key issue because if there were a more developed corporate bond market it would provide a higher return alternative to government bonds with less risk than shares.

Sixth, reflecting its high immigration level and fertility rate, Australia has a relatively younger population compared to Japan and many European countries so as a result a greater proportion of pension fund members can afford to take the longer term horizon necessary for investing in shares. As such it stands to reason that the share allocation might be higher in a country like Australia, than in Germany or Japan.

Finally, and perhaps partly reflecting this, the “default” superannuation system has tended to focus on funds with a 70% allocation to growth assets (including shares & property) and a 30% allocation to defensive assets (mainly bonds and cash). Some superannuation funds adopt a “life stages” approach where the proportion of shares declines with a member’s age. However, many members may not be in a system that offers this so unless they receive advice they may not adjust their growth allocation as they get older.

What is appropriate?
There is no easy answer as to what is the appropriate allocation to shares and bonds. It is essentially a function of age (the younger the member the higher the share allocation), wealth (the wealthier the investor the easier it is for an investor to accept short term volatility so a higher share allocation may be appropriate) and risk tolerance.

There is a case for superannuation funds to invest more in alternatives such as property, infrastructure, private equity and distressed assets to provide some diversification away from a reliance on shares, though it should be recognised that such assets are usually less liquid and more expensive to manage limiting any asset allocation to them.

There is also a strong argument that a better way to manage superannuation funds, particularly for older members with less wealth, may be with a particular return (or outcome) objective over time rather than to manage to a particular benchmark allocation to shares, bonds and other assets.

For these reasons, along with My Super reforms, the ageing population and hopefully the growth of the local corporate bond market it is likely that over time the share allocation in the Australian superannuation system may decline a bit.

Not the best timing
The trouble is that now is not a good time to undertake a structural reweighting from shares towards bonds. Shares have already had several tough years resulting in very poor returns. And at the same time bond yields have plunged to record lows in the US and generational lows in Australia and elsewhere, making it very hard for the strong bond returns of recent years to be repeated. The next chart shows the gap between the grossed up for franking credits dividend yield on Australian shares (ie the annual cash flow investors receive from shares) relative to the 10 year bond yield. The dividend yield has risen relative to the bond yield, with the latter pushing down to levels not seen since the early 1950s.

Putting the period through the GFC aside, the gap between the two has blown out to levels not seen since the 1950s when the post war share boom was getting underway.

With shares offering a 2% or so yield pick up over bonds, they only require modest capital growth to deliver a total return sufficient to cover the extra risk of owning them. At the same time the generational lows in bond yields are at risk of reversing resulting in capital losses for investors in bonds.

Corporate bonds offer a higher yield than government bonds, but their yield advantage over shares has receded. For example, since 1997 A rated Australian corporate debt has yielded an average 1.4% pa more than shares, but yields are now in line. See the next chart.

While average share market returns are likely to remain constrained in the years ahead, relatively low bond yields are likely to mean that shares will provide a relatively better return on a 5 to ten year horizon. So now may not be the best time to undertake a structural shift away from shares to bonds in superannuation funds.

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