What lies ahead for income investors?
For those that invest with the aim of generating an income, the last year provided a unique set of challenges.
After years of declining yields on government debt, bond investors suffered some heavy capital losses after Donald Trump’s surprise election victory led to concerns his fiscal plans could result in extra bond issuance and higher inflation. Over the fourth quarter of 2016, investors in 10-year Treasuries suffered losses of nearly 7%.
There is increasing talk about a move towards fiscal policy to help stimulate the economy.
Similar concerns have spread to the UK bond market. There is increasing talk about a move towards fiscal policy to help stimulate the economy, and a reduced focus on monetary policy. Although UK interest rates will probably be kept on hold in the coming year, concerns about rising government spending have contributed to a sell-off due to worries about higher issuance.
Inflation – the scourge of bond markets due to the fixed nature of bond coupon payments – is also on the rise. UK inflation recently picked up sharply to 1.6%, its highest reading since July 2014. The effects of sterling’s recent decline suggest inflation will breach 2% shortly.
Meanwhile, commercial property, which had been the asset class of choice for the previous three years, came off the boil as valuations continued to climb and investors became nervous about life after Brexit. Offering an initial yield of 5.3% as at the end of 2016, the payouts from commercial property compare favourably to bonds. However, uncertainty and investor nervousness seem likely to cast a cloud over the property market in 2017.
What the last year has provided was a useful reminder that no one, be they pollsters or investors, can predict the future, or indeed the effects of such events on markets. The falls in bonds and property markets caught many investors on the hop. To time markets and to bet successfully on their direction on a consistent basis is nigh on impossible.
For the majority of investors, a better approach is to reinvest in a diversified portfolio of shares, bonds, property, and alternative investments. The advantage of this approach is that it smooths out the peaks and troughs, leading to far more consistent returns.
This approach could also help protect investors from bouts of market volatility, which seem likely to prevail in coming months. Brexit negotiations, elections in Europe and Trump's first months in office will be closely followed and influence investor sentiment day-in, day-out.
Meanwhile, the pace of US rate rises seems likely to escalate as the economy continues its long-awaited recovery following the global financial crisis, bringing inflationary pressures.
Equities should have another reasonable year, despite hitting new highs in 2016. As sterling weakness continues, many FTSE 100 companies are benefiting from the rise in the value of all their non-sterling revenues.
Looking globally, there are some encouraging trends for equity income investors. Managements across the world are increasingly realising that dividends, and the discipline to pay them, tells investors something about the quality of the company. Hence in Europe and in the United States companies are paying more attention to investors’ dividend requirements. And even in Japan, not previously thought of as a happy hunting ground for income investors, dividends are now seen as part of the evidence that companies are more focused on their shareholders.
In contrast, the outlook for other mainstream asset classes (bonds and commercial property) is far from inspiring, making equities the least-worst major asset class.
Despite the recent sell-off, we think developed market bonds offer little value. However, other forms of debt are more attractive and offer the potential to produce returns similar to equity markets, but with lower volatility. This includes high yield bonds, emerging market bonds and corporate loans.
Some of the most interesting opportunities will come from niche asset classes, which many investors may not have previously considered. Examples include renewable infrastructure, social infrastructure, peer-to-peer lending, insurance-linked securities and aircraft leasing. These asset classes are capable of providing secure sources of income, which are often uncorrelated to mainstream investments, such as equities and bonds. As such, they also provide excellent sources of diversification and can help smooth investment returns. While not all will flourish, I predict we will see much increased interest in these ‘alternative’ assets during the coming year.
My predictions for 2017 may turn out to be wide of the mark and – as ever – we should be prepared for the unexpected. But by sticking to our principles and investing in high-quality assets within well-diversified portfolios, it should be possible to continue generating for investors, whatever 2017 has to throw at us.
Mike Brooks
Head of Diversified Multi-Asset Strategies, Aberdeen AM
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