Overview
Not that long ago, investors would have bitten your hand off for the deposit rates available at the start of 2024.
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.
It’s not an equation that’s easily solved. While real yields on cash will be higher if inflation continues to fall, that means policy rates are likely to fall too. Deglobalisation, demographics, and decarbonisation are also expected to keep inflation sticky in the years ahead. 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.
Back to reality
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 the recent cheapening they 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 ends 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 will be primarily directed at other yielding assets, further supporting prices.
Fewer eggs, fewer baskets?
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 those outcomes over time. Dynamic allocation, mixing the blend of assets, 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 each fits 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 clearer focus on the role they play.
Currencies are another example of how we expect income investing will change. Greater dispersion in monetary policy between 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. At the moment, for example, the correlation between bonds and equities is higher than it has been for some time, and the US dollar is proving an effective diversification asset because it is negatively correlated with both.
New world
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.
