Equity markets delivered ahead of expected returns across most global equity bourses in 2012. The volatile returns from one quarter to the next were not a pleasant investor experience, but the approximate 16% total accumulation return for the ASX200 year-to-date will be a positive driver for superannuation wealth effects. Given most mandates remain overweight their cash benchmark, there is the prospect of a switch from cash to equities if a more stable performance compared with the past few years develops. Given the extreme event and tail risks priced in earlier this year (and in previous years) the current landscape appears to be more of tactical money waiting on the sidelines to redeploy on any market correction (circa 10%).

Chart 5: Australian equity valuations. Recent multiple expansion is anticipated to continue in 2013.

Chart 5 shows the one-year forward consensus multiple. Despite the recent multiple expansion, valuations remain discounted compared with historical results. For equities in general, there is good value for both domestic and global equities, particularly the quality (‘perpetual’) dividend paying global stocks, and domestic defensive dividend themes.

Going through the check list of standard equity valuations, they all remain compelling on a medium-term perspective: the one-year forward multiple, trailing multiple, Earning Yield vs Bond Yield, tighter credit spreads, negative ‘real’ yields and Price to Book for financials globally all build the solid case that there is value. The higher volatility heading into the fiscal cliff debate was anticipated. The recent correction is an opportunity to accumulate quality exposure on a medium term view.

Chart 6 shows the ASX200 dividend yield with and without franking and the Australian Reserve Bank of Australia (RBA) cash rate. Given the very high weighting to cash in superannuation, reflecting a cautious investor, a lower rate environment (cash and bonds) will continue to be a positive driver for equities in 2013. Lower cash rates drive investors towards higher risk assets to search for a higher return. In all cycles, lower rates drive more risk seeking behaviour, that is what lower funding costs aim to do – drive equity and property prices higher.

Chart 6: Australian Dividend Yield vs Cash Rate. The dividend yield becomes more compelling in a lower cash and bond yield environment. It will drive more risk seeking behaviour for investors who are overweight cash. The franking is just a bonus. 

The ASX200’s heading to 4,950

It is important to reflect that equities as an asset class have delivered more that the average annual expected return this year and with a higher component in dividend return versus our global peers. The expectation for 2013 year-end for the ASX200 is 4,950 (UBS WM). The target is a little under 10% from current levels, which is effectively the average expected return for equities as an asset class. The 4,750 target remains for 30 June 2013. The franking credit will remain an important contributor for local investors in 2013 and is just a bonus. The risks to the 2013 year-end target will be cash and bond rates, the Australian dollar level and the impact of the slower mining sector capex cycle. Lower cash and bond rates would need to follow with an Aussie dollar closer to parity to achieve constructive earnings growth in the year ahead.

Chart 7 is a timely reminder that equities deliver over the long term, but are a volatile asset class. The chart shows the annual performance of the All Ordinaries Accumulation Index over the past fifty five years. Reinvesting the dividend has a powerful impact to your total return over your life cycle.

Chart 7: Australian Equity Market Performance over the long run.

As we look towards the next year, the global growth outlook looks modest. Europe is the clear challenge and will continue to detract from global growth until the second half of 2013. The US recovery cycle looks promising. The short-term fiscal challenges remain and the data remains mixed. That is why there is such accommodative monetary policy. Once there is some sign of fiscal progress, corporate America can then begin to plan going forward and help drive activity towards a more trend rate of growth.

The emerging economies, particularly China, will continue to be the driver of global growth. The uneven nature of global growth between the developed and emerging economies will persist for some years to come.

Our core view is for event risks to be lower in 2013 compared with 2012, particularly versus the tail risks in the June quarter this year with regard to Europe. Market volatility is simply a normal part of the market, excessive market volatility is not. Therefore investors need to reflect on the appropriate risk budget allocation to achieve their specific outcomes.

Your asset allocation will be your core driver of total return. It needs to reflect your risk appetite (can you sleep at night?), expected returns (growth versus income), what stage of the life cycle you’re in (income certainty required for ageing demographic) as well as other personal circumstances. A lower rate environment (cash and bonds) will ultimately help drive more allocation away from cash (overweight position for most Australians) towards equities in 2013.

Next week: Keep an eye out for George’s predictions for interest rates and the Aussie dollar.

George Boubouras is the Head of Investment Strategy and Consulting, UBS Wealth Management. 

Important information: 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. Anyone should consider the appropriateness of the information in regards to their circumstances.