The landscape for income investing has changed radically from the pre-pandemic era of low interest rates and quantitative easing. For the first time in years, the interest available on cash deposits is tempting. However, parking money in ultra-defensive options comes with its own risks and offers no opportunity for capital growth.
Not that long ago, investors would have bitten your hand off for the deposit rates available today.
More than 15 years of ultra-low interest rates have understandably set expectations. Investors can get today’s 5 per cent yield virtually risk free. For those of us accustomed to receiving next to nothing for our money, it looks appealing.
But there’s a snag: rates are higher because inflation is now higher. Real cash yields - deposit rates minus the rate of inflation - are still low and 5 per cent may not be as tempting as it first appears.
Dormant inflation in the decade before the pandemic means this is the first time since the financial crisis that investors have had to think about the difference between real and nominal rates of return.
While real yields on cash will be higher if inflation continues to fall, that would also create pressure to cut policy rates. And looking longer term, deglobalisation, demographics, and decarbonisation are also expected to keep inflation sticky. For savers in developed economies, where life expectancy has grown dramatically and income may need to be sustained during a retirement lasting decades, capital growth is vital. Without it, inflation will eat away at real values over extended periods.
Two big advantages of multi asset income strategies
Anyone investing over a time horizon longer than a few years needs to find assets that will deliver a positive real return, not just a positive nominal return. Multi asset income strategies tend to offer higher yields than cash and have two big structural advantages - the potential for capital growth and the benefits of flexibility and diversification.
A mix of core income-yielding assets - typically high- quality bonds, high yield, and selective emerging market bonds - is the relatively stable bedrock of a multi asset income fund. Given their recent cheapening these assets may provide the potential for gains in asset value as well as attractive coupons. There is also a place for dividend- oriented equities, where earnings growth should boost both the dividend and the share price over time.
If rates do fall in the months and quarters ahead, then the outlook for yielding assets should be good - prices of these assets should rise as interest rates fall. In addition, the rush of money into the safer end of the fixed income spectrum over the past few years, in particular money market funds, is likely to reverse as interest rates fall. These flows are likely to be primarily directed at other yielding assets, further supporting prices.
Why diversification is not what it used to be
Of course, it’s not just attractive yields that have driven investors to cash over the past four years. It carries zero risk at a time when both bond and equity markets have seemed in flux.
Conditions inevitably change, as do yields on different assets. Diversifying the sources of income within a portfolio can help smooth out performance over time. Dynamic allocation - changing the blend of assets as conditions evolve - is likely to become even more valuable in future as the era of ultra-low rates fades and cycles become shorter.
But even diversification is not what it used to be. When yields were at rock bottom before the pandemic, assets’ idiosyncratic risks were pushed aside so long as they promised an income. The lesson of the last few years is that this less discerning approach to diversification has come at a cost.
In future, not only will the role of each asset need to be considered now that yield is plentiful, but also how they all fit together to form a portfolio. Correlations have become less predictable recently, which requires a more selective approach to achieving diversification. This process is likely to lead to more focused portfolios with fewer assets but a greater emphasis on the role each one plays.
Currencies are another example of how we expect income investing will change. Greater divergence in monetary policy across regions will lead to higher foreign exchange volatility, meaning the currency mix of assets in a portfolio will demand closer scrutiny and the proactive management of currency risk will be a more useful tool to deliver objectives like downside protection or diversification than in the past. As an example, the US dollar proved an effective diversification asset at the start of the year because it was negatively correlated with both bonds and equities during a period when the correlation between the latter two was high.
Investors can’t stay in cash
The abrupt change in macroeconomic regime has made cash a tempting option for income investors and it is undeniable that there have been periods when holding cash would have been preferable to holding other assets. But market conditions never stand still. The outlook for cash is already less favourable than it was in 2023 and while it might be a good place to hide from time to time, it is not a good place to stay.
The US$4 trillion question
In the four years following the onset of the pandemic the amount of cash held in US money market funds rose by US$4tn, more than doubling from US$3tn in 2020 to US$7tn. Sterling and euro cash accounts have also surged and there is the equivalent of more than US$10tn residing in developed world cash savings accounts.
The new era of higher inflation and higher interest creates powerful incentives to unwind those recently built-up cash positions and put that money to work. Investors have already begun moving some of those funds and where they end up will have a significant influence on markets.
The growth play of the past decade may be fading but capital growth should still be an important component of any income approach. Investments need protecting from inflation. A sensible portfolio should include core income-yielding assets, typically high-quality bonds, but also assets that provide both an income and the potential to appreciate in price. Often these are dividend-paying equities in sectors where earnings growth will boost share prices over time.
Outlook for equities
It is often said that bull markets climb a wall of worry. When markets are high and rising, there will always be fears that enough is enough and a collapse is around the corner.
We believe that a lot of people are worried; nonetheless, we believe we are in a bull market. There are good reasons for stock markets to be content. We have gone from concerns about rising interest rates damaging the growth outlook to a situation where upside and downside interest rate risks are much more balanced. Market positioning implies rates will fall at some point in the next few months. And if they don’t, it will be because growth has held up, which would support a market rally.
Looking at the income universe, dividend equities have never underperformed the broad market to this degree (except in China), despite dividend distributions hitting an all-time high.
“Growth” plays remain in favour so people are buying technology stocks. That leaves the boring, stable stuff that people would have owned historically at this stage in the cycle looking quite cheap, both on an absolute and relative basis.
We think the asset management industry is underweight the stocks rally. At best people are neutral to slightly long but I don’t see any exuberance. Meanwhile, profits are at record highs and earnings revisions within the market are going up. That is what is supposed to happen at this stage in the cycle and it makes me positive about equities for the months ahead.
Outlook for bonds
Following the pandemic, politicians have realised that sending money to people is easy, popular, and no longer the taboo it once was. There should therefore be a greater level of risk premium in bond markets. But if you look for risk premia, you don’t find much of it.
For now, stickier inflation will undermine the nominal value of bonds at a time when spreads are already so tight that there’s little reward for the risks involved. You can make the case that government bonds are at fair value - 10-year bonds are trading roughly in line with nominal GDP. But why take the risk of lending to a corporate for a tiny spread?
Duration is important. At some stage the curve will steepen and cease to be inverted. That encourages me to stay at the short end, because at some stage two-year money will be cheaper than 10-year money and there is a return available there.
