On Tuesday, the Reserve Bank of Australia cut the cash rate by 25 basis points to a record low of 2.00%. This is another important development that supports my core asset allocation thesis of buying equity income on the ASX and buying equity growth (unhedged) in the rest of the world (ROW).

Don’t follow the market

However, the kneejerk market reaction from traders and hedge funds was to short-cover the Australian dollar and take profits in Australian yield equities, led by the cum dividend banks (37% of ASX200 Index), due to the fact the RBA seemed to abandon the “easing bias” in its release.

I think that’s a very, very premature and incorrect trading response and I want to take advantage of it in two ways. I want to get more money offshore into global growth stocks and, simultaneously, buy the dip in cum dividend major Australian banks.

What will happen next, when the trading dust settles and the reality of record low cash rates sets in, is the next leg down will start in the Australian dollar/ US dollar cross rate and the next leg up in domestic equity dividend yield compression starts, as holders of cash and cash equivalents get further punished.

The first place to start is the cum dividend banks. ANZ, NAB and WBC offer 13-month prospective dividends (i.e. current plus next two dividends) of 275c, 324c and 286c, which on last night’s closing prices translate to 13-month prospective fully franked dividend yields of 8.2%, 9.2% and 8.4%. Grossed up 13 month yields are 11.71%, 13.1% and 12% respectively versus a cash rate of 2.00%. That is more than adequate pre-tax yield compensation for taking the risk of owning bank equity.

Even if bank shares go sideways for the next 13 months, as an Australian resident taxpayer, I should collect 11.7% to 13.1% in pre-tax dividend yield, simply for holding these three banks. That is up to six times the alternative pre-tax return from cash on deposits in the very same banks. And that is only assuming bank shares go sideways. I actually think a 10% capital gain is likely from these levels too over the next 13 months.

A last opportunity?

The fact we have seen recent aggressive short-covering the Australian dollar/US dollar cross rate, and profit taking in key fully franked dividend yield equities, further increases the trading and investment opportunity. I actually think this is Australian investors’ last chance to lower Australian dollar exposure anywhere near 80 US cents.

From here, Australian interest rates will stay low for an extended period or go lower, while US interest rates are going only one direction, up. It’s just a matter of when. I see currency spreads as nothing more than interest rate differentials and GDP growth differentials. They are like an equity, where the GDP growth differential is the share price and the interest rate differential the yield. In terms of the Aussie/US dollar spread, the US will have the GDP growth advantage and the yield spread in favour of Australia is narrowing sharply.

The Australian dollar’s yield advantage to the US dollar peaked at 4.50% in 2011 and is 2.00% today. There are clearly scenarios over the next few years where that yield advantage drops to 1.00% or even parity. That would ensure the Aussie/US dollar trades in the mid 60 US cents range. That is why it is so important all Australian investors, who are interested in maintaining their wealth in global dollars, increase their US dollar exposure either directly or indirectly as I have said for three years. Currency cycles are the longest cycles of all and this one for the Australian dollar is far from played out on the downside.

The rest of the world (ROW)

For Australians, it is important to note that the earnings growth in international (ROW) equities is significantly stronger than Australian equities and this is BEFORE you take into account any potential gains from currency translation.

The table below confirms Australian equities have a yield advantage over the ROW, but a clear growth disadvantage over the next 12 month forecast period.

In terms of global diversification, it is also worth reminding ourselves of Australia’s weighting in the global equity universe.

It’s also worth noting from a liquidity perspective what percentage of global average daily equity market turnover Australia is.

Both the charts above don’t include Chinese equities because at this point in time they are not part of the MSCI World Index. That will probably change in the not-too-distant future.

Volumes trading in China are staggering. In April alone, average daily turnover in Chinese mainland equities was US$229 billion. Yes, you read that right, up from a year-to-date average of US$141 billion. In Hong Kong, average daily turnover was US$25 billion up from a year-to-date average of US$14.3 billion.

This volume spike coincided with huge upside performance from Chinese equities, with the Hang Seng +14%, H shares +18% and the Shanghai Composite +19%. Year-to-date gains are now +20%, +22% and +39% respectively.

It’s also worth noting that there were 30 A share IPO’s in April and the average performance since listing is +109%!

That’s a performance pie I feel very, very few Australian investors benefitted from in April and reminds you of the opportunities in the region.

Global growth

Finally, again on the diversification theme, it’s worth remembering ASX200 and MSCI Australia sector weights versus the rest of the world.

Australian equities represent a huge overweight in financials and materials, while a huge underweight in consumer discretionary, healthcare and information technology.

I believe we are at the infancy of a structural change in Australian asset allocation to increase the weighting of global equities. Australians will always have some home bias, due to the nuances of the Australian taxation and superannuation system, but in my view the average weightings of international equities can only go in one direction – up.

You can see this with your own eyes in the performance of Platinum (PTM), Magellan (MFG), Henderson’s (HGG) (see Roger Montgomery’s story today) and BT Financial (BTT).

As the Australian dollar falls and Australian earnings growth underperforms the world, you will see more and more money flow into global products.

ASX for income, ROW for growth. That’s how the Future Fund and family offices asset allocate and so should you.

Go Australia, Charlie

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.