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Working harder for income in a changing world
The late cycle acceleration in economic activity has brought with it negative consequences in the form of rising inflation, tightening of monetary policy and a spike in financial market volatility
Leon Goldfeld 22 Mar 2018
 Leon Goldfeld is a portfolio manager, multi asset solutions for J.P. Morgan Asset Management
Leon Goldfeld is a portfolio manager, multi asset solutions for J.P. Morgan Asset Management

THE global economy has entered a late cycle period. This brings with it a change not only in the economic environment but also in the behaviour of financial markets and the type of challenges that income investors face.

After a prolonged period of sub-par global growth since the 2009 financial crisis, we are finally in a more normal growth environment that has resulted in a broad uplift in activity across the world economy. However, this late cycle acceleration in economic activity has brought with it negative consequences in the form of rising inflation, tightening of monetary policy and a spike in financial market volatility. The challenge for investors is further compounded by seemingly expensive valuations across major equities and fixed income markets.

For income-focused investors this brings a new mix of threats and opportunities. The key concern is the increased possibility of capital loss in fixed income investment. Rising rate environments have often resulted in capital losses on a mark-to-market basis, as bond prices fall when interest rates rise. But this challenge certainly does not need to mean the end of successful income investment.

Rather than relying only on a few sources of income, which is unlikely to work at this stage of the cycle, investors need to take a multi-dimensional approach. The key is to diversify across asset class types – not strictly fixed income instruments but also other assets such as equities, listed property, preferred securities and credit that offer a breadth of income opportunities.

It is also important to spread the exposure geographically. Not all markets are in late stage and there are many different valuation opportunities. Emerging markets are not as far along in their economic cycle and face less inflation risk. They are also considerably cheaper than many developed market investments. European equities and fixed income are also more attractive than both US and Japanese markets.

Diversification also needs to take place by style of investment and the quality of underlying investment. A pure stretch for yield is a poor approach in the late cycle. There needs to be a judicious assessment of quality. Investments offering a higher yield but with poor underlying fundamentals can suffer substantial losses. Deep fundamental research and analysis is imperative at this stage of the cycle, as a rising tide will no longer lift all boats. As the tide is going out, it will be skill and aptitude that will win out. Successful multi-asset investors will be differentiated by a concerted focus on risk management, insightful research and the ability to tap into a broad investment opportunity set.

The late cycle environment favours broad exposure to equities over traditional fixed income. As income investors, equities with the ability to grow their income stream are particularly in focus. Dividend yielding equities with the potential to provide capital appreciation as well as grow their dividend stream through time look attractive. European equities also offer a diversified stock selection opportunity and an opportunity to capture attractive dividend yields. We’re trimming our exposure to global equities slightly where more capital is being returned via buybacks rather than dividends. The outlook for emerging market equities is constructive and they increasingly merit more of a place in balanced portfolios. It’s important globally across equities to seek out investments that offer value and the potential for compelling income.

The ability to be flexible, tactical and nimble in finding income has been very important in the low yield environment. An interesting example of a non-core source of income, as part of a broadly diversified portfolio, has been US non-agency mortgages, which provide a compelling and less correlated income stream to a broader portfolio. Another attractive asset class is preferred equities, which sit in the middle of the capital structure between equities and bonds. They pay a dividend and are typically issued by US banking institutions.

High yield debt is looking slightly less compelling as value in the asset class has been somewhat eroded, but it remains a relatively attractive source of income. At these valuations, investors are likely to get their coupons but not much in terms of capital gains.

How multi-asset income investors manage interest rate risk in the year ahead will be pivotal, considering the significant central bank transition underway from easing to tightening.

We expect the fair value range of US 10-year yields to rise toward 2.5%-3.15% by the end of 2018, as the Fed funds rate is hiked towards 2.00-2.25%; this would imply a modest flattening from current levels, but not the fully flat or inverted curve that some fear. For bond yields to move more aggressively we’d need either a positive growth shock, a hawkish policy surprise, or an inflation surprise – none of which are very likely. As a result, yields should continue to merely grind higher through the year.

With interest rates on a gradual but inevitably rising path, having the flexibility to scour the world for yield across different income sources is more crucial than ever. In order to continue to find income, investors will need a greater emphasis on truly global diversification with constant attention to risk-adjusted returns.


Leon Goldfeld is a portfolio manager, multi asset solutions for J.P. Morgan Asset Management

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