2015 has been a challenging year for asset prices; however, following the widening of credit spreads, large swings in government bond yields and the recent equity sell-off, many income sources are offering attractive yields again.
Demand for income is still strong The demand for income remains global and structural, driven by low interest rates and by an ageing global population.
Despite this ongoing demand, the environment has been challenging for income strategies. First, the appreciation of the dollar is impacting liquidity and some interest rate sensitive assets. Second, the normalisation of real rates happened as inflation expectations dropped both in the US and Europe. Real yields are the discount rates of financial asset prices. If they increase, growth needs to be strong enough to offset this negative effect.
So what should we expect going forward? Investors will have to adapt to a fast changing environment as valuation may not be a sufficient guarantee of a successful investment strategy.
Regional divergences are more apparent Global economic cycles are diverging across regions and are expected to continue to do so in 2016. Recent divergences have been mostly driven by exchange rates and central banks’ guidance. As such, we favour regional asset classes in Europe and Japan, which are both supported by loose monetary policies. Europe is now accelerating thanks to a weaker euro.
Elsewhere, there are some signs of slowdown in the US manufacturing sectors whilst emerging economies remain under the stress of a strong dollar and decelerating Chinese growth. The Federal Reserve (Fed) is expected to raise its key rates. However, regardless of the timing of the first hike, this cycle is unique and the Fed may lack room for manoeuvre in the future and could reverse its course of action if imbalances grow. Typically, tighter monetary policy tends to generate lower expected returns and this requires investors not only to focus on total return but also on strategies which are dynamically managed.
For this reason, we expect volatility to normalise higher. Asset prices will be more dependent on the realisation of growth to deliver future returns, whilst fair-to-expensive long-term valuation levels may cap equity price appreciation.
High dividend stocks and high yield bonds look attractive In this context, high dividend stocks could offer some defensive characteristics with more regular and robust cash flows. They have been underperforming for more than two years versus a standard global equity universe and now offer an attractive entry point.
We are also finding some value in high yielding bonds, although security selection matters. It is our preferred fixed income asset class given the attractive yield and high implied default rate.
Regarding emerging market assets, we are cautious despite attractive valuation because of a strong dollar and a low growth environment.
To conclude, central banks and real rates will remain key drivers in 2016. The first rate hike by the Fed in the coming months is not likely to be followed by an aggressive tightening cycle because of the dollar appreciation impacting US exports and of weak Chinese growth. Government bonds are therefore unlikely to run out of control but are unlikely to offer attractive returns. This could benefit actively managed income strategies.
Past performance is not a guide to future performance.
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