The non-price-sensitive central banks may have provided investors with a conveniently greater fool to sell their sovereign debt to, but this is unlikely to be a sustainable dynamic. Today’s low growth has come together with all-time high valuations in rates and credit while showing stubbornly positive correlations to equities, arguably diminishing fixed income’s ability to diversify a portfolio effectively.
The themes of expensiveness and inconsistent correlations personify the low growth environment in many ways and cause difficulties for investors. Crucially, investors must search for alternatives to what fixed income used to provide.
In some regions, cash can still be a useful preserver of capital, but it provides either very low or even negative yields – a situation exemplified by Europe’s -0.4 per cent central deposit rate. Investors can still find good pockets of yield and fundamental opportunities further down the credit spectrum, in particular in the emerging markets and mortgage-backed securities, with the latter enjoying government guarantees to some extent. However, money managers need to be aware that they are taking credit and potentially currency risks in these sectors of the market, and should use active management to compensate for their lack of direct expertise in the area. By taking on credit risk selectively and blending it with cash, it is still possible to generate strong total returns including an income component without jeopardising capital protection and diversification.
In the current period of low growth, a vicious cycle has formed as investors increase their focus on reliable income, pressuring yields down and perpetuating the difficulty of hunting for said income. Some investors have taken to bond-proxy equities for a source of income, driving their valuations to all-time highs and implicitly assigning them bond-like characteristics. This is particularly evident in the US Staples sector and it presents a serious risk to portfolios.
Equities should never be regarded as income generators in the same way as fixed income. They are further down the capital structure, and dividends are subject to far more volatility than coupon payments, plus there is no guarantee that the outlay maintains its value throughout.
Furthermore, the volatility profile is more significant and income generating stocks will not adequately diversify the portfolio from other equity investments – a role that fixed income has traditionally fulfilled. As the cost of debt has fallen so low and consequently capital allocation has been so poor, it is true that equity yield is more attractive than bond yield, but we believe this is an aberration that is causing bubbles in equity markets and should be avoided in a low growth environment.
Despite these bubbles, we believe that there is still some genuine growth to be found in equities. The pie does not necessarily need to be growing in order for the best businesses to take market share and provide strong returns for equity investors.
