I have been bullish on Australian equities for the past 18 months, principally because of supportive interest rates, okay company valuations and improving corporate profits. But as we enter the seasonally weak May trading period, extra caution is needed.
Don’t get me wrong: I still see shares trending higher this year and next. Any correction or significant pullback is a buying opportunity. That said, Australian equities have had a good run and are vulnerable to a larger sell-off.
The S&P/ASX 200 index has returned 18.6% (including dividends) over one year. That momentum will be hard to maintain in the next few months given geopolitical tensions with North Korea, lower commodity prices and a patchy local economy.
After a stunning rally in the fourth-quarter 2016, iron-ore prices have fallen and brokers are starting to downgrade resource company earnings forecasts.
I nominated Fortescue Metals Group as one of five stocks to sell for the Switzer Super Report in late 2016, suggesting investors cash in on iron-ore euphoria. Fortescue, $6.12 at the time of my report, rallied to $7.27, before hitting $5.09 this week.
Bank stocks, too, face greater challenges as fears of a property downturn intensify. Such fears are overdone (except for some inner-city apartment markets) but enough to create a bigger headwind for bank lending volumes, earnings and dividend growth, and share prices.
With resources and banks under pressure – two sectors that dominate this market by capitalisation – the ASX 200 could struggle to maintain recent growth. The investment adage, “sell in May and go away” looks particularly apt this year.
But every problem is an opportunity. Investors should look for ways to profit from a market pullback or patch of seasonal weakness to maintain portfolio returns. Exchange-traded funds (ETFs) that benefit from “risk off” scenarios are an option.
ETFs are mostly promoted as a portfolio tool to gain “long” exposure to markets, sectors or themes (and benefit from a positive view). They can also be used tactically to profit from short-term weakness in asset markets as risk aversion grows.
To recap, ETFs aim to replicate the price and yield of an underlying index or strategy. A rush of ETFs being quoted on ASX in the past two years has vastly boosted the choices available. Assets under management in ETFs are growing quickly, albeit off a low base.
Here are four ETFs to consider in a scenario where market volatility spikes, global equities sell off and investor risk aversion rises.
1. BetaShares Australian Equities Bear Hedge Fund (ASX Code: BEAR)
This ETF is a simple way to gain “short” exposure to Australian equities and profit from a view that our share market will fall.
The Bear fund is designed to go up when the S&P/ASX 200 Accumulation Index goes down, and vice versa. BetaShares says a 1% fall on the Australian sharemarket will deliver a 0.9% to 1.1% increase in the value of Bear. The ETF has fallen in the past 12 months as the Australian sharemarket rallied.
Unlike short-selling strategies, investors are not borrowing shares with Bear. Unlike margin loans, there are no margin calls and investors cannot lose more than their initial investment.
The ASX-quoted Bear fund looks a lot simpler than options or contract-for-difference strategies for most investors.
Investors who use Bear during bouts of Australian equity market weakness over the next few months could maintain returns – or use Bear as a tool to hedge portfolios and add some “insurance” should the market fall.
Chart 1: BEAR
Source: ASX
2. BetaShares US Equities Strong Bear Hedge Fund – currency hedged (BBUS)
I usually avoid geared ETFs or borrowing to buy shares in general. There’s too much gearing within most companies as it is, without adding another layer of debt through a margin loan, instalment warrant or geared product.
US equity trading strategies are an exception, simply because those markets have rallied too far and look overvalued. The forward Price Earnings (PE) level on the US S&P 500 index is near levels not seen since the dot.com bubble in the late ‘90s.
The bulls argue rising corporate profits will help lower the aggregate PE and perhaps they will be right as the upcoming US reporting season unfolds. With profit margins under pressure, I can’t see US earnings rising enough to justify the market’s nose bleeding PE.
BBUS enables investors to profit from a negative view on US shares and magnify that view through the ETF’s internal gearing. BetaShares also has a geared version of the Bear ETF, but the non-geared version is sufficient for Australian shares.
BBUS is designed to rise 2% to 2.75% on any given day for every 1% fall in the US sharemarket (as measured by the S&P 500 Total Return index). As such, BBUS can be used to short the US equity market or hedge portfolios against a fall in US equities – a reasonable strategy for those with an overweight position in US equities after the rally.
US equities look ripe for a correction as the Trump effect on markets fades, the reality of a chaotic administration sets in and US interest rates rise this year.
Like Bear, BBUS has fallen in the past 12 months as equities have rallied – a trend that is poised to reverse in the next few months.
Chart 2: BBUS
Source: ASX
I emphasise that this strategy suits experienced investors and that geared ETFs magnify gains and losses. Do not attempt this strategy if you are unfamiliar with geared trading techniques or have lower risk tolerance.
3. ETFS Metal Securities Australia Ltd (Gold)
Gold bullion invariably rises during periods of risk aversion as investors return to the metal for its safe-haven qualities. That trend was evident again this month as tensions over North Korea’s nuclear ambitions drove the US-dollar gold price higher.
The ETFS Metal Securities Australia ETF, one of the market’s most popular ETFs, is a simple way to gain exposure to gold bullion via the ASX. The ETF rises when the gold price rises (assuming constant currencies). The ETF is unhedged for currency movements, so changes in the Australian dollar affect returns.
I favour unhedged gold ETFs (hedged versions are also available) because of a view that the Australian dollar will fall (see below). A rising gold price and easing Australian dollar are good news for local investors seeking to profit from interest in gold during higher market volatility.
Regardless of short-term commodity movements, most investors should have a small allocation of gold in the portfolio (no more than 1% to 5%, depending on market conditions and investor needs). As they say, “hold gold in your portfolio and hope it is the worst-performing investment”, for that usually means other assets are rising.
Chart 3: Gold
Source: ASX
4. ANZ ETFS Physical US Dollar ETF (ZUSD)
Commentators have long complained about Australia’s stubbornly overvalued currency. Record-low interest rates, lower commodity prices and risk aversion theoretically should have driven our currency lower, relative to the Greenback, by now.
Our dollar rallied from about 71US cents in late 2016 to 77.7 US cents in mid-March, underpinned by gains in commodities, such as iron ore, and the global equity rally. It briefly fell below 75 US cents this month and looks to be losing a little momentum.
The ANZ ETF Physical US dollar ETF provides exposure to a rising US dollar (before fees) relative to the Australian dollar. Further US interest-rate rises this year should support a higher Greenback, despite President Trump’s comments that the dollar is too strong.
Ultimately, market fundamentals, not White House rhetoric, prevail in currency markets. Higher US rates suggest an upward bias in the Greenback this year.
Our currency, range-bound between US72 cents and US78 cents, should eventually resume its downward trend as interest-rate differentials between the US and Australia narrow (they hike rates, we stay on hold), and as the iron-ore price falls.
Do not expect sharp falls in our currency. A gradual easing towards US70 cents later this year is likelier, but even that will provide handy gains for investors in a returns-challenged market.
Chart 4: ZUSD
Source: ASX
Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at April 19, 2017.
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.