Sunday, 24 January 2016

Why a ‘safe’ yield no longer exists

Years of central bank intervention has meant investors can no longer find a ‘safe’ income and they must make sure they don’t chase yield in this environment.

In a world where yields across the broad range of global asset classes have been driven to incredibly low levels, the chase for yield has been an overwhelming recent characteristic of investment markets.

As a result, we thought it would be timely to discuss where we think there are attractive income generating opportunities and what we are currently avoiding.

In the period through to summer 2014, yields were generally falling across the bond asset classes while equities and other real assets were performing strongly with yields supported by dividend growth. Since then something has been changing: higher risk bonds have not been performing as well, with negative total returns and equities trading sideways.

Has the impact of low rates and falling government bond yields become fundamentally less supportive of asset prices and hence, credit growth and the economy? Is the cause simply falling commodity demand or even the strong dollar?

In a way it is all of the above and a consequence of this is that higher risk income producing assets have recently been delivering much less attractive returns, whether it is riskier bonds, equities with less well covered dividends or those that have been increasing leverage to deliver earnings growth or share buybacks.

Defaults on high yield bonds have now started increasing, dividend cuts are starting to come through and worries about potential defaults in certain emerging markets are starting to rise.
Clearly, there are now far fewer safe yields available and the very low yields on government bonds come with the risk of capital losses as interest rates and yields rise.

At the other end of the spectrum a continued economic slowdown will inevitably mean credit stress spreads beyond the areas where it is already being felt and the equity dividends which are being supported by debt start to be cut.

So it is more a question of “where is the attractive risk reward on a spectrum when risk is increasing everywhere?” The area for us which offers the most attractive risk/ reward in fixed income is shorter dated credit in companies which are less exposed to cyclical risk, such as those with more predictable revenue streams.

Another area which seems potentially relatively good value is bank credit where spreads remain elevated compared to pre- crisis levels, but the underlying banks are vastly better capitalised than at any time in recent history.

Less clear is yield from equities. Certain high yielding parts of the market are clearly at risk of dividend cuts: resources is a case in point but all areas with high levels of leverage or cyclicality must be more vulnerable than at any point in the most recent past, so we have actively been avoiding these.
At the same time certain lower yielding areas might also be vulnerable as global growth slows as high valuations make the pain of disappointment all the greater. Again the better risk reward appears to be in the dull middle ground. Good quality consumer defensives have relatively predictable dividend-paying capacity and as ever pharmaceuticals appear to be safer sources of income.

Finally there remains property. Clearly this industry is highly dependent on borrowing and has rents that are to a lesser or greater degree dependent on the health of the economy. In its favour, yields have not fallen anywhere near the amount that other lower risk yields have fallen.

The simple answer is to remain diversified across several income streams. As always seek professional advice where appropriate.

Monday, 11 January 2016

The investment “bright spots” in 2016

Regions, sectors and policies are more divergent than ever, how has this altered the investment landscape as we head into 2016.

The investing ‘”bright spots” globally are likely to remain in developed markets as we head into the New Year.  The consumer sector will remain the biggest driver of markets in 2016, but investors should still expect returns to remain fairly muted.

Since commodity prices began collapsing at the start of the year, consumers across commodity and oil-importing countries have enjoyed lower prices and as such have had greater incentives to spend more.

For many economies, we’re only running on one engine – consumers – but if you’re only going to have one engine then consumption is the right one to pick. I do think in all these key developed regions, at least in EU and US, there are drivers for this consumption growth.

If you look at the UK for example, there is a sweet spot we currently have where productivity, having fallen so far short in this recovery, is finally starting to pick up, but it is nowhere near where it should be if we continue the normal trend since 2008.

But it is improving and that has an interesting effect on the Bank of England because, if you look at wage growth, even compared to the US you’re seeing a lot more nominal and real wage growth in the UK then you are in the US and you’ve certainly seen more acceleration in wage growth over the last year as the economy has ticked up.

While economic improvements would usually lead to central banks raising interest rates there are several reasons why the Bank of England has not done so yet.

One of which is the exchange rate compared to the US dollar. A further reason for the lack of rate rises is that there is extra spending capacity as a result of rising economic productivity. For a large part of 2015 you can see how the unemployment rate continuing to fall has helped to boost consumer confidence.

The eurozone is showing similar traits at the moment, following the disappointment felt across markets earlier this month when Draghi announced that the ECB would extend but not expand its quantitative easing programme. While markets slumped following the news, the chief market strategist argues that expectations had simply become too high and that, if investors expect to be positively surprised, they probably won’t be.

Lending in the Eurozone region is picking up slowly, although she’d like to see an improvement on the corporate side as most of this comes from households, but there has still been an improvement in conditions nevertheless. The real concern Europe have is for the long term inflation picture, that’s why they acted, but there is a decent recovery in Europe and this is a recovery like the US and the UK which is driven by consumption.

While our outlook is overall positive, there is a multi-layered divergence in terms of policy, region and sector, and that attractive areas of the market remain in developed markets and close to consumers. I think the basic conclusion is that large parts of the world, differentiated and diverged as it is, are still doing well enough to support risk assets, but I think in a very moderate and a much more low-key way than perhaps we saw over the last few years. You should certainly keep your expectations under control as we don’t necessarily see the same kind of upside that we’ve seen in recent years. A focus on higher quality is imperative going into 2016.