Asset allocation looks at the question of how much of one’s savings one should invest in different asset classes. There are four main asset classes (cash; bonds; equities; property) and a growing band coming under the name of ‘other’ (includes metals, oil, agricultural products and hedge funds).
At times, the decision about which asset you hold can be more important than which particular equity, bond or property that you hold. The last year has been such a period and indeed, has been a challenging one for asset allocation. The returns which the different asset classes have generated over the last year have been quite different.
As most people are aware, the last year has seen housing markets decline in many of the developed economies. What has happened in Ireland would be typical of what has happened in the UK, the US and some other developed economies. This has had implications for banks in these countries, but from an asset allocation perspective, it has had a material impact on economies.
At the start of 2007, people would have expected the Irish economy to grow by 5.6 per cent in 2007 and three per cent in 2008; the Eurozone by 2.1 per cent in 2007 and 2.3 per cent in 2008 and the US by 2.4 per cent in 2007 and three per cent in 2008.
The out-turn is now looking somewhat different. Ireland grew by six per cent in 2007 but is now expected to decline by over two per cent in 2008; the Eurozone grew by 2.1 per cent in 2007 and should expand by 1.4 per cent in ’08 and the US expanded two per cent in 2007 and will probably register growth of 1.4 per cent in 2008.
As a result, profits for 2008 will turn out materially lower than would have been expected at the start of 2007. In the Eurozone, the forecast for profits in 2008 are now 11 per cent below January 2007 expectations; in the US it is 25 per cent lower and in Ireland, it is down 20 per cent. Hence the falls we have seen in equity markets. Profit growth is an important determinant of equity returns and profit growth is sensitive to economic growth (see graph 1).
But profit growth is not the only determinant. Equities are also affected by valuation, which we call the PE (price/earnings ratio). It is merely the index level divided by the level of earnings.
As mentioned above, equities were under pressure due to declining profit growth over the last year. But they got no help from valuation, either. Indeed, the declines in markets were greater that the decline in expected profits. Hence the valuation of equities also declined during the period.
h4. Interest rates
The valuation does not always stay constant but is dependent on what has happened to interest rates and in particular, longer-term interest rates. We find these in the bond market, by looking at the ten-year interest rate or yield. This has increased slightly over the last year from four per cent to 4.2 per cent and thus would imply a lower valuation for equities than 12 months ago.
This would be regarded as a somewhat unusual outcome for the bond market. When recession looms, bond prices usually go up (which is the same as bond yields going down). Investors like the certainty of Government bonds, when the economic environment is very uncertain. Normally when recession approaches, inflation starts falling – and bonds like falling inflation.
h4. Inflation expectations
Bonds have fixed money (or nominal) payments and a set nominal redemption value. Thus, the lower the rate of inflation in the future, the higher the ‘real’ value of the bond payments. If people believe that inflation is going to fall, then they will pay a higher price for bonds today.
But over the last year, things have not worked as normal. As economies have slowed, we have not seen inflation subside – in fact, it has gone the opposite way and has been accelerating over the last year. As a result, we have seen bonds record a slight loss over the last year. The reason we have seen inflation accelerate is the large move we have seen in commodities: oil; metals and foodstuffs. Consequently, inflation expectations have risen slightly over the last year (see graph2).
h4. Rising interest
The second factor that has held back bond markets is interest rates. In the past, during those times when economies have slowed, central banks have responded by cutting interest rates. But this time around in Europe, interest rates have actually gone up. This feeds into the interest rate in the bond market (called the yield). If rates are rising, there is pressure for bond yields to rise (which means bond prices fall). If you can earn four per cent in an overnight deposit, there is little incentive to hold a ten-year bond on a yield of four per cent. If the ECB then increases rates, the probability is that bond yields will rise also. Over the last year, the ECB has moved interest rates up 0.25 per cent and thus the increase in bond yields over the same period (see graph 3).
It has been a challenging year for asset allocation. The divergence in the performance of the different assets has been high and almost all assets types are down in value. The next 12 months will be equally challenging. Just as one tries to foresee the start of economic difficulties, one also has to try and see when these difficulties end. When will inflation subside and allow central banks to cut interest rates, as weakness in economies suggests they should? When will economies stabilise and at what level of growth will they level off?
* Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers. He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
* Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.
* This publication has been approved by Goodbody Stockbrokers. The information has been taken from sources we believe to be reliable, we do not guarantee their accuracy or completeness and any such information may be incomplete or condensed. All opinions and estimates constitute best judgement at the time of the publication and are subject to change without notice. The information, tools and material presented in this article are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities.
About Gary Culliton
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