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There was no reason for the Shanghai Stock Exchange to fall 4% when the US Securities and Exchange Commission announced fraud charges against Goldman Sachs but it was a sharp reminder of how skittish global markets are right now.  The Greek crisis and IMF warnings about the debt from government stimulus packages show there is still plenty of bad news to fuel uncertainty.

So what’s an investor to make of it?  

Russell Investments’ strategist Andrew Pease says that with volatility on the cards for the foreseeable future, investors have to review their asset allocations and decide if they are comfortable with their level of risk.  

Pease says that with share valuations closer to normal again after last year’s slump, and higher short term interest rates, investment choices are more complicated.

“In Australia you want to have a more balanced portfolio,” he says.  This means investors should not be underweight in shares but also need to think about fixed interest and short-term deposits.

Credit Suisse valuations of the Australian share market looking at price/earnings ratios on a trend earnings basis put the market on a p/e of 20.

Equity strategist Damien Boey says this can be sustained for a while longer if real interest yields remain low, but that is unlikely given the Reserve Bank is expected to raise rates further next month (May.)

“The valuation of the market is broadly in line where real bond yields are at the moment which means if real yields rise, even by 50 basis points, the (share) market would be a sell,” he says.

“If the market is neutral to expensive that means investors need to have more of an eye on defensive exposures compared to cyclical exposures – but we are not saying they should go all out on defensives yet.”

Boey still believes energy stocks offer value because the higher dollar has prevented them from rising in line with oil prices, and likes Woodside (WPL) and Oil Search (OSH.)  He also sees upside in the banks although we may not see it in the short term, and will be watching for Harvey Norman and David Jones to fall as interest rates rise because they could very quickly become cheap.

“Another sector that is interesting is health care because it is traditionally a very late-cycle performer, but this time has run very hard,” says Boey, who sees opportunities to buy stocks such as CSL and Cochlear (COH) on the dips.

Fixed interest not only offers a safe haven but currently some rates that outperform grossed-up equity dividends according to Antares Fixed Interest head of investment Ken Hyman.

He says there are short term deposits paying “mouth watering deposit rates” of 1.5 – 2% over the cash rate instead of the usual tiny margin on money invested for three to six months.  “The real yield – over and above the expected rate of inflation – is about as attractive as it has been for a long time,” he notes.  And Hyman says retail investors can get attractive yields without locking up their money beyond three years.

He says the corporate bond sector has become much more accessible to retail investors and super funds in the past year, when banks and corporates were locked out of overseas markets and had to offer well over the government bond rates to raise cash locally.  “The high yields have come as a response to the financial crisis but the market has really worked to attract new investors and it has awakened an interest among retail investors that wasn’t there before because margins were unattractive and it was hard to buy them.”

Both Russell’s Andrew Pease and Damien Boey of Credit Suisse warn equity investors that because Australia got through the GFC relatively unscathed the recovery will not be as strong here.

“Australian fundamentals are better than anywhere in the world but unfortunately a lot of that is priced in,” says Pease, who believes there will be better opportunities in US stocks, where firms have cut costs to the bone and are enjoying big gains in profits as revenues recover.  

Pease says that international shares are not expensive when the Australian dollar is above 90 US cents “but there is the risk that the AUD continues to go up – it is not a strategy for everyone. Typically we recommend to investors to have half their global shares hedged and half unhedged.”

He sees currencies as the most dislocated class of assets around now, with commodity currencies being very expensive and sterling and the US very cheap.

GFT Forex head of currency research Kathy Lien sees the Australian dollar rising further and says the outlook is also promising for the US dollar and sterling.  

“Australia is the only major country with a central bank that is raising interest rates at this time and based upon the tone of the monetary policy meetings, they are not ready to slow down.  The prospect of 4.75 and maybe even 5% rates has made the Australian dollar an extremely attractive currency for foreign investors seeking high yields.”

Lien says the outlook for the USD is also encouraging but not as much as the Australian dollar and there may be limited increases in the US currency until the Federal Reserve is convinced the recovery is sustainable – at which point the US dollar could rise strongly.

Australians who have not travelled abroad recently are probably unaware of how fragile confidence in global recovery is elsewhere.   With a strong possibility that shares will face a correction, it is worth investigating ways to spread risk by looking at other asset classes.

Other articles in this week’s newsletter

Time to prepare for a weaker Australian share market

18 Share Tips – 3 May 2010

Timeless Ways To Protect Yourself From Inflation

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Using Feedback To Improve Your Trading

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Australian Dollar Could Topple if the RBA Doesn’t Keep Pace

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