Asset allocation: I wouldn’t start from here!

March 6, 2015 Categories: Investment Strategy, Markets

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A local Irish man once told a visitor “If I were going there I wouldn’t start from here”.

Financial advisers these days must be tempted to give the same advice to their clients. If we were able to choose the starting point of our long-term investment decisions I think everyone would be very careful to avoid today. In this blog I will attempt to put today’s market environment in a historical perspective.

My favourite “sweet spot” is 1989. A time machine would take me amid the rubble of the Berlin wall as the wind of change sweeps through the Moskva and a famous philosopher predicts the triumph of liberal democracy and the end of history as we know it. Moving to rather more mundane matters a UK investor at the time could have reaped double digit returns by simply parking his money in a savings account. Even adjusting for inflation, which at almost 8.0% was much higher back then than in recent years, a real return well over 4% was still on the table. Needless to say that on the back of such optimism about the new world order it would have been tempting to venture into equity investments. Surely the opening up of markets previously untouched by capitalism would provide plenty of opportunities to boost companies’ profits? With the benefit of hindsight, over the 10 years between 31/12/1989 and 31/12/1999 the UK stock market handsomely outperformed cash, returning around 15% nominal per year against a background of falling inflation and interest rates. US equities did even better (nominal 20% p.a.). This exuberance at some point became irrational (to quote Alan Greenspan’s famous speech) and paved the way for the end of the party. However this was far away into the future for the enthusiastic 1989 investor.

Given the remarkable ride of the stock market over the 1990s, equity valuations had become very stretched towards the end of the “roaring 1990s”. Hence one might think 1999 was a worse time to invest than today. However back then, with inflation starting to dip under 2%, a conservative investor could have earned a real return well over 3% on rainy day savings accounts or could have locked in a respectable 5.5% nominal yield by lending to the UK Government for 10 years. At the other side of the spectrum, while the US stock market ended up barely positive for the decade, betting on emerging markets equities would have earned double digit annual returns between 31/12/1999 and 31/12/2009.

If not 1999, surely 2007 must win the ugly contest of the worst starting point in the history of financial markets. After all, troubles brewing in subprime assets were signalling that a giant real estate and credit bubble was about to burst. However, back then UK banks started to offer rates approaching 6% as customers queued in front of Northern Rock branches and feared their deposits were no longer safe. Gilt yields were still fluctuating between 4.5% and 5% and, again with the benefit of hindsight, the dramatic correction in asset prices about to come was going to offer some of the best opportunities of a lifetime for long term investors to pick up cheap assets, most notably in the corporate bond space. As we will see in my next blog, even the environment for investors in 2007 looked positively benign compared to the challenges facing them today. What this means is the current valuation environment has important implications for our asset allocation choices for the future.

10-Year UK assets returns from different starting points since 1985
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Source: Datastream using FTSE All Shares Total Return Index, UK Benchmark 10 Year Datastream Government Index
Mirko Cardinale, Head of Asset Allocation, EMEA

Mirko-Cardinale

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