4 minute read
Although the hunt for income remains intense, it is still possible to find good opportunities, says Nick Samouilhan.
The search for income shows no sign of letting up as equities continue to climb in price and bond yields remain at low levels, while other natural income-generating assets also face challenges. At the same time, the uncertain outlook for interest rates globally complicates the decision of whether to invest in bonds, equities or other assets such as property for income. Against this backdrop, Nick Samouilhan discusses where he sees opportunities and challenges.
How would you describe the current environment for income?
There are two factors that anyone investing for income currently must consider. Income remains hard to find if you are focused on any single asset class. The price of equities has risen to high levels in key developed markets such as the US and UK, while dividend yields remain at relatively low levels globally.
Figure 1: Dividends yield on the MSCI World index in US dollar terms, 2012-17
Source: Thomson Reuters Datastream, March 2017
Meanwhile, treasury bond yields have increased in the US on the expectation the Trump administration will boost growth and inflation, but remain at low levels in historical terms. Yields available in other government bond markets, such as UK gilts and German bunds, are significantly lower than treasuries and near to their historical lows.
Figure 2: Percentage yields on 10-year German bunds, US treasuries, UK gilts, 2012-17
Source: Thomson Reuters Datastream, March 2017
It’s a similar story in the corporate bond market, with spreads for both investment grade and high yield bonds at relatively low levels. Real estate investment trusts (REITs), through providing a steady and visible cash flow, tend to have the same risks as bonds at times. Selling call options is another way of generating income, although that is proving challenging at present given low levels of implied volatility; a measure of the expected volatility of a stock and a key factor in determining the price of an option.
Figure 3: US and European volatility indices, 2012-2017
Source: Bloomberg, 17 February 2017. VIX = Chicago Board Options Exchange (CBOE) Volatility Index, VSTOXX = EURO STOXX 50 Volatility Index
The second factor is the uncertain outlook for inflation and interest rates. This makes it difficult to determine whether to invest in equities or bonds or whether you should be investing in bond proxies or growth stocks. The uncertainty surrounding the path of interest rates in the US also affects investors seeking income on a cross-currency basis. If you are investing in emerging market debt, for example, you cannot be sure where the dollar will be in a year’s time given the uncertainty surrounding US monetary policy. Much depends on unknown variables such as whether Trump will be able to press ahead with his tax and spending plans and the path of inflation in the US.
It is possible the Trump administration will struggle to implement the mooted border adjustment tax. That could reduce the scope to cut taxes and/or boost spending in specific areas, potentially resulting in weaker-than-expected inflation and monetary tightening. Such an outcome would lessen support for the dollar, so benefiting investors in emerging market debt.
Given the challenging backdrop, where do you see opportunities for income investors?
Emerging markets look interesting both in terms of equities and debt, on a selective basis. They came under pressure last year following Trump’s November electoral triumph due to fears of increased protectionism. Both South African and Indonesian government bonds are examples where yields appear attractive given the risk profile.
As well as an attractive income, the bonds also provide opportunities for capital growth. In the case of Indonesia, the economy is improving following the implementation of a number of reforms. Indonesia’s recent budget contained realistic revenue targets and derived additional credibility from the fact the current finance minister, Mulyani Indrawati, held the same position during the global financial crisis. She has a reputation for delivering on her goals. Although foreign investors, who own around 35 per cent of the Indonesian government bond market, sold holdings following Trump’s win, they have begun to re-enter the market in 2017.
The improving economy should boost bond prices, including those denominated in the local currency. The rupiah could appreciate to 10,000 to the US dollar over the next three years from over 13,0001 currently if the government fulfils its reform agenda, growth picks up and the central bank starts to cut rates.
The threats to this view include a collapse in commodity prices; a depreciation of the Chinese renminbi, which could damage the competitiveness of Indonesia exports; or an aggressive tightening of monetary policy in the US. The high level of foreign ownership could result in a sharp sell-off were sentiment to deteriorate.
There are also opportunities in emerging market equities. Take South Africa. Although the country continues to encounter political turbulence, it is home to some well-run companies that generate high, sustainable and growing returns; exercise good capital discipline; pay attractive dividend yields and trade at cheap valuations. The standard of corporate governance also stands out relative to other major emerging markets.
Are there any opportunities elsewhere in equity markets?
Stocks that pay consistent dividends on the back of transparent and predictable income streams, such as utilities, REITs, consumer staples and telecoms, have delivered strong returns in an environment of ultra-low interest rates. These bond proxies performed well up until 10-year US treasuries dipped to lows in the middle of 2016. The subsequent rise in treasury yields prompted some convergence between the two sectors.
Donald Trump’s victory in the November 2016 US presidential election sparked a sharp divergence again, with growth stocks moving sharply higher and bond proxies selling off in the expectation his policies would boost growth and inflation. But given the uncertainty on Trump’s ability to press ahead with his fiscal plans, bond proxies could once again be an attractive option.
Figure 4: The performance of bond proxies relative to the S&P 500, 2016
Source: Bloomberg, March 2017
Are there any opportunities in currencies?
We believe the Chinese currency will depreciate steadily against the US dollar. China still partly controls the foreign exchange rate of the yuan, but is seeking to gradually relinquish that control so that the International Monetary Fund recognises the country's currency in its elite reserve club, the Special Drawing Rights basket. China believes reserve currency status would give the economy more credibility on the international stage.
As part of this process, the authorities have widened the “bands” within which the currency can trade against other currencies. In practice, this means that while the currency floats freely on the market, within these bands the authorities are intervening to ensure stability. However, as the bounce in the renminbi in January revealed, China’s central bank is also prepared to engineer an appreciation of the currency against the US dollar.
The main risks involve the possibility that China’s central bank could intervene to manage the currency aggressively, and establish a tighter fixing regime or a hard peg to the US dollar.
Can you find decent income in the corporate bond market?
Credit spreads in both the investment grade and high-yield markets continue to narrow. The spread differential between corporate bonds and treasuries has fallen to its lowest level since 2014; around 150 basis points, according to Bloomberg data, compared to 230 basis points in February 2016. The potential for further gains is limited. So again, it is difficult to generate healthy levels of income simply by focussing on corporate bonds.
While at a macro level we are seeing changes in interest rates and inflation, the situation facing income-seeking investors hasn’t materially changed. The key is to have access to a diverse range of income-paying assets rather than rely on a single source.
Figure 5: US Corporate bond spreads, 2012-17, (US BBB/Baa Corporate bonds percentage difference over 10-year treasuries
Source: Bloomberg, February 2017
1 Bloomberg, 17 February 2017
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 20 March 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.