1999 is a very significant year for European-based pension funds, nowhere more so than in Ireland. In a world of important events, the first phase of monetary union from January this year is the single most significant factor in asset allocation for Irish pension funds since the lifting of exchange controls in 1989.
The removal of currency risk fully opens a door for Irish investors into Euro-land that was only partially open previously. Given the illiquidity and stock-specific nature of the domestic equity market there has naturally been significant switching from domestic assets into Euro-zone assets. Twelve months ago the average weighting in domestic assets was over 36%. Today it stands at just 28%. And the process is continuing. Exposure to the surging Irish economy (GDP growth last year was over 10%!) is highly desirable but is countered by the relative risk (liquidity, stock specific etc) of the domestic equity market and the prospects of opportunities in Europe as a whole – with no currency risk. Thus today for our own portfolios, Irish assets represent some two thirds of our overall euro exposure, and although this is likely to decline, the pace will be metered by relative attractiveness.
As regards euro assets in general, we have moved to an overweight position against our benchmark. We believe that the second half of the year will see a much stronger euro economy and despite European Central Bank statements of a tightening bias, there is little inflationary pressure on interest rates. This stronger growth, together with what we believe is a long-term positive picture for equity markets in terms of underlying demand from pension funds and individuals is supportive of an overweight stance. The fact that growth will be more plentiful in the next few years is also supportive of our “value” approach at stock selection level. And indeed 1999 has proven a better year for value investors.
Our other principal overweight position in the portfolio is in the Pacific rim where we believe that the turn-around in some key economies is on a much sounder basis than much of the growth we experienced in the 1993–95 period. Equity markets have had a very good run so far this year, but we believe that the underlying domestic liquidity conditions are still very favourable for investors. Recent results from the banking system point to a clear bottoming in default risk and there are signs of better local property markets. We do see, however, that developments in China will continue to influence short-term moves in asset markets and currencies.
We have moved to an underweight in the US. The principal concern here is valuation. Deterioration in the bond market has put an already stretched market under further pressure. Profits growth, while good, may no longer surprise so much on the upside given more recent trends in productivity and labour costs. The funds flow picture, long a stalwart of the market, is also less clear currently with net outflows becoming more frequent. Appropriate action by the Federal reserve and the continuation of the low inflation/low interest rate environment will ultimately be supportive for US equities but much of this is already in current prices.
We are underweight fixed interest. There is, we believe, no longer a strategic argument for being long bonds. We are past the best in the current interest rate cycle. We are past the best as regards inflation. The outlook for inflation is, we believe, very subdued but it simply doesn’t get much better than this. There is scope for some further fall in inflation rates in the UK, for example, but generally we see inflation picking up marginally from today’s levels. The best prospects for capital returns from bond markets are behind us. There will be trading opportunities and bonds may well become oversold in the current climate but these are tactical opportunities in what will at best be a neutral overall bond position. Our bond exposure is both Euro-zone bonds and major international markets such as the UK and US.
One significant exposure of our funds over the past few years and an area where we remain overweight today is property. Domestic property has had a true bull run in the past four to five years, reflecting the unique combination of an exuberant economy and falling interest rates as they converged to euro levels. This offered a fantastic opportunity for pension funds to achieve superior returns. Our property weighting moved to 10% during this period and while we feel there is still upside we have scaled back our position to its current 6%.
World economic growth is picking up and our portfolios are positioned, we believe, to benefit from this both geographically and in terms of asset class.
Eugene Kiernan is head of asset allocation at Irish Life Investment Managers in Dublin