Investors in Australian equities have had a good year in 2012, bolstered by strong performance by defensive stocks, but increased volatility may be on the horizon, says State Street.
According to State Street Global Advisors' (SSgAs) Australian Equities: 2012 into 2013 report, 2012 saw "strong pockets of performance in the perceived 'defensive' and high dividend paying stocks, with obvious weak performance in the 'growth' oriented and cyclical industries such as small caps, materials and energy."
Speaking to Investor Weekly, SSgA head of active Australian equities Olivia Engel said she expects defensive stocks to "continue on this run," a prediction she says is based on her department's assessment of valuations. More broadly, Engel said it was likely equities as a whole would continue to perform well in 2013.
Coinciding with this appetite for seemingly defensive assets is the lowest level of volatility in the market since 2007 - before the inception of the global financial crisis (GFC). According to the report, 2012 started with implied volatility in Australia at around 23 per cent and finished around 12 per cent.
"The lower volatility you get with defensive stocks is very attractive to investors who are required to remain invested in equities, but are concerned about a range of issues affecting the macroeconomic climate," Engel said.
"Investors need certainty, so they will continue to seek pockets of return that are more certain than others, this is a major reason the defensive sector has done well - a trend that has increased over a number of years now," she added.
Considering the historically low level of market volatility seen in 2012, Engel suggests a spike is likely. "We've rarely seen volatility lower than this," she said. "The weight of likelihood is that volatility will rise rather than fall." In other words, what goes down must go up.
The report lists a number of potential global catalysts for volatility in Australian markets, including "the unresolved Eurozone debt crisis, fiscal challenges associated with the US debt ceiling, and uncertainty over China's economic growth rate."
For those who have become accustomed to the calm, Engel offers a warning: "Caution is advised." She says that regardless of volatility levels - or perhaps because of them - diversification and getting the right balance of "risk and cushioning" has never been more important.
At the same time, investors should brace themselves for stagnant - if not decreased - dividends per share (DPS) in 2013. The increase of payout ratios from 60 to 68 per cent in 2012 made a similar occurrence in 2013 unlikely, the report indicates. Unless there is an uptick in earnings per share (EPS), there is unlikely to be an increase in DPS, Engel said.
Putting its money where its mouth is, SSgA's Australian Managed Volatility Alpha Fund - which focuses investment on low volatility stocks - performed well in 2012, the report indicates, recording a portfolio turnover of 79 per cent.
Despite a potential spike in volatility, the fund will continue to focus on defensive stocks in 2013.
"The strategy positioning continues to focus on the lowest volatility segment of the market, namely on low volatility stocks. It's an active strategy designed to weather the period when defensive companies might become super expensive," Engel explains.
"Our current positioning is reflected in the more defensive part of the market, including staples, healthcare, utilities, telcos and some property trusts but also some companies in metals and mining and financials, so as to ensure diversification," she adds. "It's a benchmark unaware strategy."
