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Equities and property are still best bets despite tight spread of returns Back  
Investment returns in equities, bonds, commodities and property have been uncommonly close over the past year. Eugene Kiernan looks at the reasons behind these performances and explains why equities and property are still the safest bets.
The interesting thing about asset allocation, typically a key driver of investment portfolio returns, over the past 12 months, has been the closeness of returns across the various asset classes. For the 12 months global equities will deliver up to nine per cent, while Eurozone bonds are punching in numbers around the eight per cent mark. Property will also be pushing over 10 per cent as far as Irish investors are concerned. The closeness of these returns is exceptional. The gap between the best and worst performing broad asset category in the year just gone was around three per cent. The average gap over the last eight years has been 30 per cent! The one place not to be in 2004 was in cash. Record low levels of interest rates meant that the biggest risk for investors was in not actually taking risk and being invested.

The big drivers of stock markets are always corporate profits and interest rates. On the profits front, the past 12 months have been especially favourable as for most of the year profit outcomes comfortably exceeded what analysts had been expecting. Companies continued to bear down on costs, which, combined with improved operating leverage meant margins pushed higher in most developed markets. There has been a substantial improvement in company balance sheets as debt is being paid down as free cash flow picks up. This has played to the benefit of equity investors through improved dividends, share buy backs and some pick up in acquisition activity. Eurozone has been a good example of this.

By any measure, the Eurozone economy over the past 12 months qualifies as the definitive doldrums economy, yet against this background, companies have delivered positive surprises on the profits front.

It was more interesting to drill deeper within equities as an asset class to generate returns. In local currency terms, the high-octane markets of the Pacific Rim (including Australia) and Latin America were the best performers. There were good numbers from some of the European markets. Irish equities were very solid, even excluding the stellar performance of Elan. The US stock market delivered good returns in local currency, but this was lost in translation for Eurozone investors as the US dollar weakened.

Where do stock markets go from here? We can still see better company profits in 2005, albeit not at the same pace as in 2004. We would see for example Eurozone companies able to grow profits in excess of 10 per cent for the year as a whole. This is the key determinant of what we can expect from equities. We don’t feel that interest rates or valuations will provide significant tail winds. Interest rates, already low, are set to remain low and in the comfort zone, but aren’t set to fall from here. Equity market valuation is neither set to be a driver or hindrance as levels are typically where they should be given the interest rate and bond yield environment. We believe equities will be fine in 2005 but investor expectations need to be realistic - equity bull markets simply don’t start from here.

Property proved a good choice for asset allocators in the last twelve months. Total return from Irish commercial property in 2004 will be in the 10-12 per cent range. All sectors - retail, office and industrial - produced positive numbers with retail continuing to be the hot spot, as it has over the last three years. Rock bottom interest rates are driving this asset class. The positive aspect on property is also being supported by a severe scarcity of good quality standing investment on the market. In the office sector the vacancy rate is falling slowly but there is some speculative development resuming. The economic outlook here is still benign for commercial property. Growth will hover around the five per cent mark for the next 18 months or so. Our property outlook for the next two to three years would be for average returns in the seven to nine per cent range per annum.

Government bonds were probably the surprise asset class of 2004. The consensus view at the start of the year was that bonds had little to offer, that yields would drift up as we moved into a more expansionary phase of the global business cycle and the onset of a new cycle in interest rates. As it turned out bonds were a good place to be.

Central banks were generally lethargic on the interest rate front as inflation risks failed to materialise. The monthly drip feed of weak job numbers in the US did little to bolster faith in the robustness of the economy. A near absent Eurozone economy was also supportive of government bonds as the risk of rate increases here dissolved. Coupled with this bond friendly economic environment, we had continuing demand for fixed income exposure from pension funds looking to ring fence and match liabilities. It was this confluence of structural demand and a loss of momentum in some of the principal economies that drove bond prices higher. We still believe that it’s not the appropriate time of the cycle to be moving into bonds. Interest rates have bottomed and inflation has also probably seen its lows. Buying into 10-year yields at around 3.5 per cent doesn’t make investment sense. Given the current economic picture, the risk may be low, but so we believe is the opportunity.

Are there other choices for asset allocators beyond the traditional? Latterly some portfolios have looked to commodities as a possible area to put money to work. Certainly the last 12 months have been explosive in terms of returns. Energy, copper, aluminium- practically all commodity types have been strong. There is almost a one-word explanation for this – China. Growth in the Chinese economy and in Chinese demand for practically everything has been soaring. Despite attempts in 2004 to slow it down, the economy has been growing at a run rate of just under 10 per cent. This has fuelled a bull run in many commodity prices. One useful way of gauging this is the Goldman Sachs Commodity index or the CRB index, both a fair representation of how general commodity funds have done. Over the past 12 months we’ve seen a rise of around 12 per cent in commodities in general with some weakness in the softer commodities more than offset by the surge in metals and energy. While the very strong price moves are clearly welcome, for many asset allocators the true benefit of commodities may lie more in the ability to allow the portfolio a more balanced inventory of assets, ultimately lowering the overall volatility. Domestically there is little direct exposure to commodities. Many funds, such as pension funds, may need to revise their rules and guidelines as many existing trust deeds would dis-allow exposure to commodities.

Asset allocation across the broad categories didn’t repay aggressive moves in 2004. It was more important to be nimble and tactical rather than strategic. Looking forward we would feel that equities and property are still the assets of choice for investors. Liability reasons may be the main determinant of allocation to fixed income. Commodities are still far out on the horizon as far as many Irish funds are concerned and it is important that investors don’t extrapolate the commodity returns of the last 18 months into long term planning.

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