For those who invest with the aim of generating income, 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 that 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%.
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 from 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 of the end of 2016, the payouts from commercial property compare favorably 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 declines in bonds and property markets caught many investors by surprise. To time markets, and to bet successfully on their direction on a consistent basis, is nearly impossible.
A better approach may be to invest in a diversified portfolio of equities, bonds, property and alternative investments. The advantage of this approach is that it can smooth 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 and day out.
Meanwhile, the pace of U.S. 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 realizing that dividends, and the discipline to pay them, tell investors something about the quality of the company. Hence in Europe and in the U.S., 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 could 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.
*Brexit is an abbreviation for "British exit," which refers to the June 23, 2016, referendum whereby British citizens voted to exit the European Union.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks may be enhanced in emerging markets countries.