Despite New Labour's patter of domestic economic success, it is a questionable risk to place all your bets on the UK stock market
If you had all your eggs in one basket, should you be worried? What if that becomes a basket case? British private clients seem blissfully unaware of the risks they run by doing so. That is why I believe it is right to run a scare story. Even if my fears prove exaggerated, it is always prudent to diversify one's risks, and profitable to do so if there are better investment opportunities abroad.
During the general election our Chancellor crowed about Britain's economic success. Since the troubles of the European project, our Prime Minister has been lecturing the European Union about the virtues of the Anglo-Saxon model. As host of the G8 Summit meeting, he now has a global stage for New Labour spin.
Time and again markets show that pride comes before a fall. What could possibly go righter? Little in my view, that makes it an excellent opportunity to diversify internationally.
Before considering the investment merits of this case, it is necessary to dispel the crucial misconception that many investors already believe that they have diversified internationally.
At the simplest level, many believe that when they invest in a managed fund, they invest globally, because the provider's publicity machine boasts about their global team. Legally that is correct, because a proportion of the funds are invested abroad, but how big is that proportion?
Many might assume that if the UK accounts for approximately 7% of global GDP and 8% of global stock market capitalisation, that 90% or more of a managed fund is invested abroad.
That is generally not so, unless it is an offshore fund marketed internationally. Typically 5%-10% might be in cash, all of which is usually held in the home currency. Often a similar amount is held in commercial property, but whether it is invested in shopping centres, offices or industrial units, these are also mainly in the UK. Around a quarter is nowadays held in bonds of various varieties - corporate, long-dated or index-linked, but here again the vast majority is denominated in stirling, even if some corporate issuers are foreign.
Thus it is only funds invested in equities that take international diversification seriously. Even then half the portfolio is usually invested in British companies. To be fair, the proportion of foreign shares is being steadily increased by most managers, but that is a global trend.
To be fair also, the British stock market is the most international of all, not only because of export sales, but more importantly because Britian is home to an exceptionally large proportion of multi-national companies. That is due to our imperial heritage, and good fortune on being on the winning side of the last World War.
However, there are three reasons why the case for even 50% held in domestic companies was destroyed.
• Even since the Chancellor raided £5bn of tax credits from pension funds, the fiscal advantage of holding UK shares disappeared for most institutional investors other than investment trusts.
• Since the launch of the euro, the investment funds of our continental neighbours have been redeployed from the home market to the euro- zone.
• The international diversification of UK companies is heavily concentrated. Four sectors account for half the market's capitalisation and these are essentially multi-national companies - oil, mining, pharmaceuticals and banks. Key growth sectors, such as technology are under-represented.
Similarly, unless they were former colonies, many rapidly growing emerging markets are often also under-represented.
Thus, even if half the managed funds are invested in internationally-diversified equities, if only half of those are foreign companies, only a quarter of these funds are invested outside the UK. Even if there are additional liquid assets, these are usually represented by bank accounts and life assurance policies, and both of those are again typically invested in stirling-denominated deposits or fixed interest instruments.
The lack of diversification becomes worse when property is taken into consideration. The main residence is normally the largest single asset and that must be in the UK. If there is a holiday home, it might be somewhere in the sun, but given the problems of travelling time overseas, it is more likely to be intensively used if it lies within a couple of hours drive from home. For a continental European, that could be another country, but not for a Briton.
Residential property has been the fastest growing part of private client portfolios. Some invest in holiday flats or villas in ski-resorts or on the Mediterranean, but by far the largest part is two room flats and terraced houses rented out to young professionals, hopefully.
A comprehensive wealth check would also place a capitalised value on the income stream from the breadwinner's job. Valuing that presents certain practical difficulties in estimating lifetime earnings and selecting the appropriate discount rate given the equity risk premium of many careers. Nevertheless practical problems do not devalue its theoretical importance (see table).
Thus, even before accounting for the discounted stream of his or her UK salary, the typical UK millionaire has an estimated 85% of their assets invested at home. Clearly that does not trouble the majority of Britons with short memories. However Jews have a very different memory. Generation after generation, they have had to flee from one country or another with little other than their natural resourcefulness and any cash they had managed to hide abroad. For Englishmen who believe that could never happen to them, it is worth reminding that this can indeed happen and did to those who emigrated to Rhodesia or South Africa.
It happened to all of us here in the 1960s when exchange controls were introduced and we were only allowed to take £50 each on holiday abroad.
UK investors may be lulled into a false sense of security because the last three decades happen to have been a good time to invest in general and in the UK in particular.
Disinflation made this a good time in general. Global bond and stock markets benefited from a once-in-a-lifetime adjustment to low inflation. Globally inflation fell from a peak of 14% in 1974 to a low of 1.3% in 2004. As a result the yield on long-term US Treasury bonds halved from 8% to 4% and the P/E ratio of the S&P 500 index trebled from 8 to 24, after declining from much higher levels during the Millennium bubble.
The swing of the political pendulum made this an especially good time for UK investors. After the big swing from far left socialism in 1974 to extreme Thatcherism in 1979, the pendulum only swung modestly back leftwards under the New Labour government since 1997.
As a result, over the same period British inflation fell even further - from 17% to 3% - so generating even bigger re-rating in both bond and stock markets. The yield on British government bonds fell from 15% to 4%, trebling the price of War Loan and other undated bonds and the PE ratio on the FTSE All Share Index soared five-fold from 3.5 to 18.9 .
To capture the overall asset allocation effects, I have constructed a set of indices for all assets in each of the major investing regions. The six classes are cash, commercial real estate, domestic and foreign bonds plus domestic and foreign shares. As custom varies so widely around, both the fairest and simplest approach is equal weighting (see chart below).
Overall, when measuring in a common currency, UK investors have done about twice as well as their peers in the rest of the world. That is shown in the chart of UK versus World Performance (below). In relative terms, UK performance is at an all time high, so there has not been a better time to switch than now.
Fundamentally, the dangers are growing. The Chancellor won the recent election for Labour by borrowing demand from the future. Consumer spending has been boosted by unsustainable capital gains on housing, by raiding the corporate sector through the pension fund system and from foreigners via the current account. Meanwhile the productive private sector is facing ever-higher burdens as resources are being diverted to an increasingly unproductive public sector.
The last time that happened it led to the stirling crisis of 1976. While something so extreme seems unlikely now, the conditions for a repeat of Black Wednesday in 1992 are in place. Thanks to consumer borrowing, the current account deficit as a proportion of GDP is at its worst since the 1992 crisis, as shown in the long-term chart of the exchange rate.
Once again, stirling is shadowing the DM bloc, now formally united as the euro. The medium-term currency chart shows a similar configuration of beguiling calm up to the election. Like the movement of tectonic plates, that made the subsequent movement all the more dramatic when it finally happened in August 1992. Four months later stirling crashed.
If history repeats itself, investors have approximately two months to find greener pastures overseas.
Many investors, especially those with UK connections, are unaware how tied in their overall net worth is with UK stock market performance.
Now is an excellent time to be diversifying out of UK equities.
UK investors are being lulled into a false sense of security by recent good performance.
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