Time to re-balance investments

As people return from their summer holidays feeling relaxed and refreshed, they should be motivated to contact their financial advisers to talk about their investment portfolio and arrange any portfolio adjustments necessary for the year ahead.

Whilst many advisers have a program in place to remind them to do so, it is often up to the investor to follow through and make the decision to contact their adviser.

It is a good time to review asset allocation, especially in light of the market volatility we have seen recently, and the changes expected in 2015. Such a review enables investors to take into account what has happened in markets and the economy since this time last year, and what is likely to occur as a result.

Changing environment

The current climate is a pivotal time for our economy, which investors should recognise when considering their portfolio.

Australia is undergoing significant changes, including in its relationships with other countries and economies — for example, free trade agreements with China, Japan and South Korea, and potentially with India — as well as the monumental shift in domestic manufacturing and production, particularly mining.

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The impact of these changes has started, and will continue for some time, so investors need to take them into account sooner rather than later.

For the last 20 years, most investors have relied on a combination of three mainstays for their portfolio construction — Australian equit-ies, residential property and term deposits.

These mainstays have served investors extremely well in the past. But the easy gains they provided are gone, and it's time to start thinking of other opportunities.

End of economic expansion

Australia has experienced 24 years of economic expansion. This has only been surpassed twice before in world history — by Japan as part of its post-World War II reconstruction, which saw 30 years of economic expansion; and by Norway, which experienced 26 years of growth thanks to North Sea oil.

Ours has been driven by, firstly, micro-economic reform in the 1980s and secondly, the commodities boom which drove a rapid increase in demand, but it is not sustainable. We are well and truly out of the mining investment phase, and into mining production, which is having a significant impact on our economy.

For example, changes in employment requirements vary enormously according to what is driving the economy. To build a large mine requires huge investment, not least in personnel — it takes around 35,000 to 40,000 people to build a mine. But once that mine is up and running, it only needs around 500 people to keep it going.

Such changes also have a direct knock-on impact on standard of living. At the moment our standard of living is declining in Australia — not enough to push us below average on a global scale, but enough to affect the Australian dollar, and ultimately wages and interest rates.

There is also an impact on our terms of trade - how much we earn for what we produce and export (notably iron ore), compared to the costs of what we import (such as oil). Over the last few years, iron ore prices have gone up dramatically, which led to a boom in our terms of trade. Australia has experienced similar trading booms in the past — in the late 1920s and after World War II — but these were based on wool exports. None of them lasted more than five years, but the current iron ore-driven boom is now in its fourteenth year, according to an Australian Government Productivity Commission Report.

However, one reason to be concerned at the moment is that unlike wool, which is a renewable resource, what we get out of the ground - such as coal and iron ore — is not. Once we've dug it up and sent it overseas, it is gone for good. So the current boom is living on borrowed time, and is very unlikely to happen again. Indeed, by any measure we are on the cusp of a correction in our terms of trade.

As shown in this chart much of the increase in our national income (gross national income per capita) from 2003 came from increases in the prices received for our commodity exports, while our economic growth rate (gross domestic product per capita) slowed.

Almost all Australians benefited from the boom. Incomes went up and up — Australian incomes, and our standard of living, are in the top 10 world-wide (see the Credit Suisse 2013 Global Wealth Report). Incomes have never been higher, but income growth is already slowing, data from the Australian Bureau of Statisics shows.

And Australian housing is up there with some of the most expensive in the world — ranking the sixth most expensive after Belgium, Norway, Canada, New Zealand and France.

I believe that house prices are around 35 to 40 per cent overvalued. Never before has so much of our wealth been tied up in housing. And things are stretched pretty tightly in many household budgets. It's pretty clear that house prices are not going to rise further over the medium to long term — valuations for residential property are about as good as they are going to get.

While I don't think that house prices will collapse, there is an affordability issue which will increase over the next year or two and should unemployment increase across the board then a downturn in house prices is inevitable.

Interest rate impact

Interest rates are currently extremely low — indeed the cost of servicing a home loan has never been lower — but this is likely to change in the coming year.

Put all this together and it paints a sober picture for household budgets and investments. People will be less able to borrow so that retail lending will slow down dramatically.

Another impact on banks will be likely action by the Reserve Bank of Australia (RBA). Both the US and UK central banks have said that they will start raising interest rates in 2015. With the RBA still keen to drive the Australian dollar lower, it is only a question of time before they take advantage of the breathing space provided by the rising interest rates overseas, and start to increase interest rates here also.

And while bank shares won't slump, and will still offer attractive franking credit benefits, investors aren't going to get the capital growth and dividend yield that they are used to. Bank profits will decline and growth and dividend yield will come under pressure.

All this means that investors need to start thinking outside the "three trick pony" portfolio of Australian shares, residential property and term deposits.

While term deposit rates will go up if the RBA raises the official cash rate, they are unlikely to go up as much as they have done in the past, because banks will be lending less. Therefore in comparative terms, the return to investors won't be as strong as it has been during the last seven or eight years.

There are significant flow-on effects on investors' portfolios from the shifting economy, such as changing terms of trade, flattening of the housing market, and a likely increase in interest rates.

Investors who don't recognise these signals and the likely impact on their portfolio are likely to have a bad year in 2015.

For example, as bank shares and residential property are based on the housing market, investing in both these asset classes doesn't offer any diversity in a portfolio and investors need to get advice on how to protect their capital and income.

Investors don't need to panic, dump their entire portfolio and sit on cash, but they do need to consider how to strengthen their portfolio. This doesn't have to be done all at once, but they can't afford to stand still.

For example, if they like property they should consider commercial property rather than residential. This in itself offers diversity — office, retail, industrial and healthcare, for example.

For those who like equities, it's time to think about investing offshore if they haven't already. While currency movement adds to risk, it doesn't outweigh the risk of not investing in overseas markets.

Equity investors looking for alternatives to banks and resources should consider the goods and services that we use every day. One example is telecommunications. Mobile phones and the internet are ubiquitous and most of us would struggle to get through the day without using one or the other — more likely both - on a regular basis.

But telecoms are under-represented on the Australian share-market. Telstra is our largest company, followed by Spark New Zealand (formerly Telecom New Zealand) and iiNet Limited. Compare this to Asia, where the telecommunications sector is bigger than the entire Australian share-market, and investors can start to get a feel for what they are missing out on if they refuse to look offshore.

So there's a bit of thinking for investors to do. I've only touched on some of the issues here and all investors are encouraged to talk to their advisers urgently.

David Bryant is chief executive officer and chief investment officer at Australian Unity Investments.