National Australia Bank's wealth management arm suggests clients should move to equities, show hedge funds some love and back away from bonds as the "great rotation" gathers pace.

National Australia Bank’s wealth management arm advises investors to put money in equities, dabble in hedge funds and back away from bonds as the “great rotation” from fixed income to stocks gathers momentum.

Following the fears caused by the budget wrangles known as the US “fiscal cliff”, equity markets rose strongly last month. Based on current trends, bonds could deliver no returns or even lose money over this calendar year, NAB Private Wealth said in Private View February , its most recent investment strategy paper.

In terms of equities, developed market shares returned 5.4 per cent, with Japanese stocks standing out thanks to returns of over 7 per cent last month. The firm said global equities are better value than Australian equities, for which earnings are forecast to remain flat this financial year. Meanwhile, emerging market equities rose by a more modest 1.3 per cent, with Chinese stocks gaining 4 per cent.

The bank advises investors to stay overweight on equities and favour high-quality, cash-generating, though not necessarily defensive, companies. In its report it added that themes of IT and media, developing country consumers and healthcare requirements have not yet run their course. For emerging markets, it said exposure should ideally equate to 10-15 per cent of total international equity weighting.

For the first time in years, bond markets are unlikely to be the best place for new investment, the firm said. It said investors should maintain underweight exposure to developed market global and government bonds, citing no preference between Australian and global bonds. It added that investors should consider a move from investment grade to high yield or bank loans.

The banks said that while cash was the worst performing asset class in 2012 and is unlikely to provide favourable returns after tax and inflation, it is a preferred asset relative to longer term fixed rate government bonds.

Alternatives

Hedge funds posted returns of 2 per cent during January, the strongest gain since December 2010. In light of this, NAB continues to believe that hedge fund strategies provide an attractive source of diversification and, in some instances, optionality in an environment where “economic growth rates are likely to remain muted in the developed world, bond yields continue to hover near all-time lows and equities are generally considered to be fair value.”

However, the bank added it is important for investors to remain realistic about return expectations in that while hedge funds may protect capital in significant market declines, this does not necessarily translate to positive absolute returns in all market environments.

Meanwhile, the property sector on the whole has seen preferable economic conditions and capital flows, according to NAB. It said buyers are still interested in quality core assets, particularly as cash yields trend lower. However, tenant demand and rental growth look subdued in the short to medium term with weak business conditions impacting employment growth and retail spending, affecting demand for commercial and residential real estate. The bank’s advice is to remain neutral and choose Australian listed over international listed property.

The asset allocation recommendations reflect NAB Private Wealth’s views on the relative attractiveness of the asset class over a one to three year holding period.