Australia Strategy: Asset Allocation Update – Q3 2022

About the author:

Author name:

By Andrew Tang

Job title:

Analyst - Equity Strategy

Date posted:

04 July 2022, 9:00 AM

Sectors Covered:

Equity Strategy and Quant

• A great deal has changed since our last update - an energy shock, sharp interest rate hikes and a weaker global macro outlook. We have reduced our portfolio risk-taking as a result and brace for market volatility ahead.
• Tactically we favour domestic equities and real assets, with a clear bias toward quality. Short-term opportunistic risk hedges (currency, gold) are another option to navigate the uncertainty.
• We retain a preference for inflation protection with escalating prices unlikely to unwind given the supply-chain challenges and higher energy costs. We believe non-traditional return streams (alternatives) including unlisted real assets and commodities, have the potential to add value and diversification.

The unease in financial markets

As inflation rates surge to multi-decade highs, central banks have started what we expect to be the most aggressive cycle of interest rate increases since the late 1980s/early 1990s. The spectre of significantly higher interest rates has sent shockwaves through global markets as investor concerns grow that efforts to rein in inflation will end in recession.

Recession is not a foregone conclusion, but monetary policy tightening is upon us. Investors are thus advised to keep duration short on equity and fixed income.

We think the rises in global government bond yields and falls in equity prices have further to run. Government bond yields have typically peaked shortly before the end of central bank tightening cycles and we expect most major central banks to continue hiking rates over the next 12 months.

We think the increase in government bond yields, as well as the threat of slowing global economic growth, will keep risk assets such as equities under pressure. This environment may see some continued widening in credit spreads. We suspect markets will start to turn a corner later this year as tightening cycles near terminal levels.

Maintaining a home bias

Tactically we prefer a portfolio closer to home with economic conditions holding up and inflation concerns less acute than global peers. In our view strong employment conditions will provide an offset against a backdrop of falling house prices and weaker consumption. However, we remove our overweight to Australian equities this quarter acknowledging the near-term risks.

While we do see ongoing risk to core assets equity and fixed income, we see an allocation to alternative assets as a way to diversify portfolio risk. Due to the low correlation of returns against equity and bond indices, alternative funds have the potential to offer diversification benefits in a multi-asset portfolio of long-only funds in traditional assets.

For more conservative portfolios, alternatives can play a valuable role in increasing the prospective return, without adding to equity market risks. See our full publication for preferred exposures. We list our preferred exposures on page 3.

Key changes to our asset allocation settings

We cut risk exposure this quarter moving to underweight global equities. Despite the recent pullback, valuations in the US remain elevated and higher energy costs in Europe will constrain growth. We cut Australian equities back to neutral.

The resilient earnings outlook assisted by higher commodity prices, in our view, will see Australia outperform global peers, but Australia is not immune to the inflationary backdrop. We overweight cash as we see the risk of heightened volatility over the next few months.

Figure 1: Morgans recommended asset allocation settings

Source: : Morgans Financial, Company

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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.