“My dear” said the Queen, “here we must run as fast as we can, just to stay in place. And if you wish to go anywhere you must run twice as fast as that.” This sentiment from Lewis Carroll’s immortal ‘Alice in Wonderland’ surely rings true for many investors today.
Faced with 10-year gilt yields of just 1.25%, base rates of just 0.25%, and 2Q17 GDP growth of just 0.3%, many funds’ income and return targets – still often anchored in the mid to upper single digits – appear an almost impossible dream. Of course there are always equities, but UK growth is slowing, the economic and policy outlook as rather uncertain, and valuations are not especially cheap. So what is an investor to do?
We’re often told investing is a marathon not a sprint, but in the spirit of the Red Queen’s words to Alice, it sometimes feels like investing today is a marathon run at the pace of a sprint.
It’s really not all bad news though. While it is the case that UK growth slowed in the second quarter, growth around the world continues at a reasonable pace. True, the excitement of the initial acceleration of growth that started in mid-2016 might have passed. Nevertheless it has settled into a pattern of broad-based, trend-like global growth which creates a supportive backdrop for asset markets. The biggest problem is not so much an absence of growth, but more that we’ve been in a gradual expansion phase for so long that we’ve already banked a lot of market returns. As central banks around the world step away from “emergency policy,” bond yields are set to rise – creating a challenge for bond owners; meanwhile full valuations create a headwind for stock owners.
Simply put, whether you’re optimistic or more cautious about the economy there are few obvious choices for building a strong portfolio with blockbuster returns. For the optimists, our long term UK equity return expectations of 6% are consistent with prevailing levels of global growth but are far from “thumping” – especially in real terms. For the pessimists, 10-year Gilt yields would need to dip back to their post-Brexit lows of just over 0.5% to generate a capital return above 6% – but what such a move in yields would imply about the state of the broader economy would be grave indeed.
To square the circle we should instead ask what we’re expecting each part of our portfolio to do for us, and more than look at whether that’s reasonable given the prevailing outlook and valuations. Traditionally, investors split their portfolios across bonds and stocks, expecting the bond portion to provide a stable income and some safety, and expecting the stock portion to provide some growth even if the ride was a little wilder. But neither the income available to bonds today – well under 2% yield on 30 year gilts at a time when inflation is running at 2.6% – nor the level of economic growth available to boost equity earnings, are high enough to meet many investor’s return objectives. But what if we look at things the other way round?
Income from bonds might be compromised, and indeed dominated by the negative price impact as yields rise, but what if we trade them for capital gain? Using the bond part of a portfolio to find relative value positions across yield curves and between regions can generate capital gains even as yields rise – especially at a time when global central banks are scaling back their bond purchase programmes. Meanwhile, equity markets provide surprisingly resilient cashflow returns if we consider the combination of buybacks and dividends. UK Stocks are roughly fairly valued on a Price/Earnings basis but on a cash return basis are quite attractive. UK equities provide a combined dividend and buyback yield in excess of 4%: around 4 times what a 10-year gilt is offering. Over the next 10-15 years we expect around two-thirds of equity returns to come from dividends and buybacks as corporates jostle to return excess cash to shareholders and maintain return-on-equity.
It may seem unconventional to consider boosting capital gains from fixed income, and boosting income from equities but as the last eight years of central bank policies may imply, these are unconventional times. And if the Queen in Alice’s adventure could believe in six unbelievable things before breakfast, surely trying just the one isn’t such a stretch?
John Bilton is global head of Multi-Asset Solutions at JP Morgan Asset Management