The rules of the game

The rules of the game
Tuesday 10th April 2007


Equities have had a volatile start to 2007, but how has the market changed over the past century and what’s the outlook going forward? Pauline McCallion finds out

The ABN AMRO Global Investment Returns Yearbook (GIRY) is published annually in partnership with the London Business School, and examines the total returns since 1900 for stocks, bonds, cash and foreign exchange in 17 major markets covering North America, Asia, Europe and Africa.

We have picked out the most interesting results in terms of stocks and bonds and combined them with expert commentary below, in an effort to provide a clear picture of historical global market performance and an idea of what could happen throughout the world’s markets in the coming months and even years.

Socially responsible investment (SRI) has begun to take root in the investment world, but there is evidence to suggest that it may not have totally sunk in just yet: advocates of the cause will no doubt be irritated to see that tobacco generated the best returns of all sectors between mid-March 2000 and the end of 2006, according to ABN AMRO, which found that an investment in this sector would now be worth 17 times more than an equivalent amount in IT hardware - the worst performer - in terms of the world index. When looking at the UK index, this jumps to 137 times more.

Real estate was one of the five best sectors worldwide, while mining was in the top five for both the world and the UK (as was tobacco). Poor performers were media (which was in the bottom five both for the UK and globally), software and computer services, and both fixed-line and mobile telecoms.

Property

Property was not just a successful equity sector in 2006, according to Ed Walker, portfolio manager for the JPMorgan Overseas Investment Trust; it also made its mark as an asset class. ‘Property was an asset class with six years’ growth behind it and it continued to do well; particularly in Asia, but also across the globe â“ even in Japan, which didn’t do so well in general,’ he explains.

Commenting on UK property in particular, Julian Chillingworth, chief investment officer at Rathbones, says, ‘The Bank of England is keen to get the price of residential property to stabilise, which is one reason why interest rates might stay higher for longer. Except for certain areas, we see property as overvalued. A lot of people are banking quite heavily on continued capital appreciation, rather than on income generation.’

Others differ slightly in their assessment, predicting that commercial property will continue to perform in 2007 â“ but at a reduced rate to the stellar performance seen in recent years. One such person is Cardales’ chief executive Robert Court. He says, ‘According to the International Property Databank (IPD), UK commercial property returned an impressive 18.6 per cent in the three years to the end of January 2007. This is not sustainable. Average total returns over the years 2006-2010 will settle back to between eight and ten per cent; but this is still attractive because of the comparatively low risk profile of UK commercial property.’

Court also maintains that UK commercial property has several advantages over commercial property in many other parts of the world. ‘Leases tend to be longer. For instance, the average retail lease here is about 13 years; in Singapore it would be nearer to two years,’ he explains. ‘Lease terms also tend to favour landlords, rent reviews are commonly “upward-only reviews”, and everything is extremely transparent.’

Bond returns

Over the long term, Danish bonds had the best real returns, at three per cent on an annualised basis since 1900. This is in comparison to a world average of 1.6 per cent, with US and UK bonds at 1.3 per cent and 1.9 per cent respectively.

Corporate bonds were well placed to weather recent storms in the equity market (see box below), according to F&C Strategic Bond Fund manager Fatima Luis. ‘The recent events in China primarily highlighted the huge rally we have seen in risk assets globally, and the need for a correction as most credit markets were over-leveraged,’ Luis says. ‘For bond investors, the real issues are, for example, the low-end consumer in the US, who is starting to feel stretched, and the flow of private equity deals that are seeing companies taken out with little or no injection of equity, but with balance sheets loaded down with debt. The bond markets are starting to mirror the concerns in these areas despite the fundamental backdrop for credit, which is still largely positive.’

Equities – past, present and future

The ABN AMRO report also analyses the long-term record of stocks between 1900 and 2006.

The best-performing equity markets over the long term with regards to real returns were Sweden and Australia (7.9 per cent and 7.8 per cent); the world average was 5.8 per cent and Belgium came last out of 17 with a 2.6 per cent annualised real return for stocks and shares.

Equity performance around the world was, however, punctuated by volatility between 1900 and 2006. Less risky markets included the UK (19.9 per cent standard deviation) and the US (20.1 per cent), while the more volatile end of the spectrum included Germany (32.4 per cent) and Japan (29.9 per cent). The argument for international diversification was bolstered by the GIRY portfolio, which had a standard deviation of 17.2 per cent.

Going forward, AXA Investment Management highlights Europe as an attractive region in which to invest. Thanks largely to the recent rise in equity risk premiums, it says many regions have moved towards their long-term average historical level: Europe, for example, is currently at one standard deviation above its average. However, the US is not so attractive, running closer to one standard deviation below its historical average, according to AXA.

US economic woes

The USA’s current problems with sub-prime lending and a generally slowing economy are no secret, prompting various industry commentators to issue warnings to investors. For example, Peter Bickley, chief economist at Tilney, has the following to say about the short-term prospects across the pond: ‘I think the US will get worse before it gets better. We have got more to come in terms of a slowdown in the housing market, and we are expecting a further downturn in consumer demand. But inflation will stay low.’

Bickley estimates that US GDP growth for the year will be between zero and two per cent, ‘with a high degree of uncertainty’.

‘I think things could be improving by the end of the year because the negative downdrafts will begin to dissipate then. But now is not the time to increase exposure to US equities. The profit outlook in 2007 is very poor and that is not fully reflected in the marketplace yet,’ he adds.

Although ABN AMRO didn’t include any of last year’s emerging market success stories, there are plenty of people ready to extol the virtues of countries like China and India. However, in March of this year JPMorgan tipped Russia as likely to outshine its BRIC (Brazil, Russia, India, China) counterparts in 2007 after the Government announced a US$185 billion spending programme on infrastructure. ‘Russia stands out among its peers in the BRIC markets,’ says Oleg Biryulyov, co-manager of JPM Russian Securities. ‘Not only does it have a big advantage in terms of its huge natural resources sector, it also benefits from access to high levels of investment capital and a large skilled workforce.’

‘These factors look set to drive Russia’s rapid economic development, with many commentators expecting the Russian economy to be among the world’s top ten largest economies within the next 12 months.’

Catalyst for change

Going forward, the big issue in terms of world markets has obviously been the recent correction kicked off by events in China and America (see "The Market Correction - what happened?" below). Although the timing caught many in the market by surprise, a correction had been predicted by some. For example, in December 2006 F&C circulated a note from Ted Scott, manager of the F&C UK Growth & Income Fund, in which he warned about the ‘hangover after the party’. He predicted a significant mid-cycle correction for UK equity markets, in line with the US market.

‘The US dollar has weakened, and if the consensus view that the interest rate cycle in the US has peaked is correct, any fall in interest rates could see the dollar weaken further,’ Scott explained at the time. ‘This could also destabilise equity markets if it proved to be a sharp sell-off, as it would reflect a lack of confidence in the US economy.’

Chillingworth regards the sell-off in China as a catalyst for people to assess the risk in their portfolio. ‘We feel the whole de-risking process has further to go. Once people have come to terms with what has happened, they will continue to reassess the risk in their portfolios and will probably decide that some of their holdings are too high-risk. It is not a disaster, but it is a setback â“ people are coming to terms with the fact that growth might slow.’

The outlook for private investor interest in equities remains positive going forward, according to Chillingworth. He concludes, ‘Once people have had this reassessment of their assets it will not be a surprise to see some downside, but they will look at equities more and probably feel that the outlook is generally good going forward.’

He singles out ‘interesting’ areas such as retail, aerospace and utilities. ‘Utilities are not cheap but certain areas like power generation will remain in vogue. People are going to be building power stations and there will be demand for electricity, especially with places like California experiencing ‘brown-outs’; so this should be a good sector to look at. National Grid is not expensive and definitely worth looking at.’

The recent market correction seems to have been closer to a spring-clean of the equity market than a sign of the end of the bull run. ABN AMRO’s report shows that equities have been performing well and from a global perspective the market looks set to continue to provide competitive returns for investors in 2007.


The Market Correction – what happened?

Stock markets across the globe saw major falls on 27 February 2007 after events in China and the US spooked investors.

Equity markets from Asia to Europe and the US experienced sharp pullbacks from the highs recorded by many indices throughout 2006 and early 2007. The activity was mostly down to Government intervention in the Chinese market and US economy troubles due to worries over sub-prime lending and recession fears.

Kully Samra of stockbroker Charles Schwab explained to whatinvestment.co.uk at the time that the appetite for risk in Asian markets had got ahead of itself, resulting in a nine per cent drop in the stock market overnight. Comments by former US Federal Reserve chairman Alan Greenspan about a possible recession in the US were also taken out of context, according to Samra, which added to investor worries. ‘What he was saying was that the economy was benign and stable but that there had been a build-up of force, resulting in the potential for a recession,’ he said. ‘We have had a long bull run of four years in equities: this correction will clear the decks.’