Since the bull market started in 2003,
private clients have enjoyed handsome returns. Now, economic
slowdown and the mauling of major banks by the subprime crisis make
diversification of wealth through clever asset allocation an
imperative.

For the past four years, virtually all asset classes have climbed
steadily, albeit by varying degrees, on the back of a benign
macroeconomic and financial environment. During 2007, however, the
advent of an economic slowdown in North America, Japan and Western
Europe, the emergence of a credit crunch and the popping of the US
housing market bubble have caused the behaviour of asset prices to
become much more volatile, with obvious implications for portfolio
performance.

Initial reports suggest that some portfolio managers had a
particularly scorching time towards the latter part of 2007. On
average it looks as if many UK-based managers will struggle to beat
the returns for cash, despite running properly diversified
portfolios during a year in which most asset class prices ended the
year, on balance, higher than they started.

Given the problems that overhang the global economy, especially in
developed markets, future prospects over the next 12 months look
even more uncertain.

“In my 22 years in financial markets, [2008] will certainly go down
as the trickiest to date, and those 22 years include the 1987
crash, 1992 currency crisis, 1998 long-term capital management
crisis and the equity bear market,” says Paul Meader, the director
of Dawnay Day Milroy, a Guernsey-based investment manager. “Global
financial markets stand at a fork in the road. There is no ‘middle
ground’ ahead. We are trying to decide which way to head but none
of us has a very good roadmap.”

100 percent liquid

Some managers have a particularly pessimistic view of future
prospects. The managers of Personal Assets Trust, an
Edinburgh-based London-listed closed-end investment company,
decided to go 100 percent liquid due to fears about economic
prospects in the wake of the popping of the global credit and US
housing market bubbles.

Nonetheless, investment managers are nothing if not optimists, so
Personal Assets’ rather extreme action does not appear to have been
replicated elsewhere.

Even the advent of a US recession should provide money-making
opportunities. This is certainly the view of Merrill Lynch Global
Wealth Management (GWM). It advises investors to make sure they
retain cash in their portfolios to take advantage of undervalued
assets and especially equities. “Many opportunities in 2008 will
arise from picking undervalued assets that have already discounted
economic fundamentals,” says Merrill. “Vital to investing in 2008
will be retaining cash in the portfolio and keeping an open mind to
investing in asset classes that have been underperforming.”

Merrill identifies Japanese equities as undervalued but, unlike
some of its peers, is less keen on emerging markets, which could
suffer profit taking after a good run. It also likes the
pharmaceuticals sector.

Goldman Sachs, which like Merrill believes that the US will move
into recession into 2008, recommends a more defensive stance,
especially as far as equities are concerned. Investors should boost
their holdings in healthcare and consumer staples, as these areas
generally outperform during the first phase of a recession,
together with energy, utilities and telecommunications providers,
and should avoid cyclical sectors.

Risky equities

Despite the inherent riskiness of equities relative to other
assets, many strategists appear well disposed to this asset class,
irrespective of the underlying economic environment. Both Bob Doll,
the vice chairman of fund manager Blackrock, and Citi Private Bank
appear favourable towards this asset class. Doll expects equities
to maintain a bull market trajectory during 2008 and attain new
highs with large companies and growth stocks “winners again”.

“We think equities will outperform bonds in 2008,” says Citi
Private Bank. “Regionally, we favour Europe because of attractive
valuations and emerging markets due to strong future growth and
favourable liquidity conditions.”

Like Goldman Sachs and Merrill Lynch, it favours large cap stocks
over small and medium-caps, especially in the US.

Overall, however, Citi does not appear to have made any significant
changes to its model portfolios in terms of asset allocation. For
US non-taxable investors, it recommends allocations of 20.5 percent
to municipal bonds, 11 percent to “other bonds”, 21.5 percent to US
large cap equities, 10 percent to US/small and mid-cap equities,
8.5 percent to international equities, 5 percent to emerging market
equities, 13.5 percent to managed futures, 4.5 percent to private
equity and 5.5 percent to real estate.

Barclays, the UK’s biggest wealth manager, also likes equities and
suggests a moderate overweighting, relative to bonds. It points out
that price-earnings ratios are close to historic lows and equities
are cheap relative to bonds, as well as in absolute terms.
Analysts’ earnings downgrades have probably been discounted and
risk aversion appears to have increased more than actual
risk.

In terms of geographic allocation, Barclays prefers Europe and the
UK to the US and large caps to small caps. Michael Dicks, head of
research for Barclays Wealth, says: “Our analysis points to a
significant global slowdown, but not a crash. We do not have a US
recession as our central scenario – although we do put chances of a
recession at 40 percent. We are also pessimistic about the euro
area, believing that it ‘cannot go it alone’.”

Portfolio diversification

Elsewhere, Tim Price, the highly respected investment strategist of
PFP Group, a small UK wealth manager, highlights the virtues of
portfolio diversification. “In the face of what seems set to be a
particularly challenging year, there is an answer in the form of
asset class diversification, thematic stock selection over
index-tracking and a concentration on quality and simplicity versus
opaqueness and complexity,” he says.

Price believes compelling themes include a growing global water
shortage, ecology, alternative energies and agribusiness.

With one or two obvious exceptions, the outlook is not quite so
gloomy after all. So “the wealthy will get wealthier if they invest
in the right sector”, concludes Nick Tucker, Merrill GWM’s market
head for the UK and Ireland.