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From the experts - Global

Richard Dunbar

Hunting high and low

Richard Dunbar, senior investment strategist – investment solutions at Aberdeen Asset Management, considers where income-seekers should be looking in order to generate positive returns in the current environment

December’s rate cut by the European Central Bank sent interest rates in the single-currency region further into negative territory and followed similar moves by the Swiss National Bank and Sweden’s Rijksbank. January then saw the Bank of Japan take the surprise decision to join them in adopting negative interest rates.

In comparison, the form of Japan’s negative rate regime is relatively diluted– the measures enacted by Japan’s central bank effectively charge financial institutions to hold their funds with the central bank. The policy has, however, resulted in bond yields falling even further. It has also, contrary to many expectations – including, I suspect, those of officials at the Bank of Japan – resulted in an appreciation of the yen.

"The cry of the gold bears that ‘it is impossible to value, as it has no yield’ is a facet shared by a growing proportion of the investment universe."

Yields on 10-year Japanese government bonds recently fell below zero for the first time and the total amount of global government bonds trading with negative yields now stands at a record $5.5 trillion (£3.9 trillion). Central bankers are certainly making the investment strategy of ‘stuffing cash under the mattress’ increasingly appealing.

So for investors seeking any kind of positive return on their money, the environment is becoming ever more challenging. Where should they look to generate positive returns in this kind of environment? It is worth bearing in mind the reason for this decline in yields – in many cases it follows an attempt to avoid deflation, recession and, in some cases, financial collapse via the use of quantitative easing. The efficacy of this policy is, however, increasingly being questioned by investors.

So we are clearly entering territory where the unthinkable has become the possible or even probable. If deflation takes hold, then it is likely that expectations of economic growth will recede as shoppers defer purchases in anticipation of goods becoming cheaper, allowing price declines to become entrenched.

This was Japan’s experience until recently and one that Abenomics has been trying to alter. In this environment, one might be more circumspect on the outlook for corporate profits and it is unlikely to be an environment that will be good for equities. The challenging sales figures that we are seeing from many companies currently reporting might support this assertion.

Government bonds may perform well in the short term, as inflation expectations fall – but low or negative yields leave them vulnerable to any ‘normalisation’ of policy in the future (however unlikely that this might seem at the moment).

When markets are volatile, investors are scared of putting their money to work. Holding cash may seem sensible as long as banks do not pass on negative interest rates to depositors. It is possible that gold could experience a rise in popularity, as investors lose confidence in the value of fiat money, despite the fact the precious metal is normally perceived to perform better in a rising inflation environment. It is certainly an unusual situation that the cry of the gold bears that ‘it is impossible to value, as it has no yield’ is a facet shared by a growing proportion of the investment universe.

Overall, sensible investors should, as ever, try to diversify across as many parts of the market as possible and to allocate risk carefully. As multi-asset investors, we look to add value within asset classes, but it is asset allocation that is the key determinant of returns. By investing in asset classes that enhance diversification, it is possible to smooth overall returns and prevent the erosion of capital.

But, while diversification is a good thing, one needs to be careful into what one diversifies. Diversifying into poor-quality assets is the first step along the road to penury. So we still need to ‘do our homework’, know our assets and have a strong view as to what they are worth.

Over the past year, holdings in so-called ‘alternative’ assets such as infrastructure, commercial property, insurance-linked securities and asset-backed securities have fared comparatively well – providing both positive returns and diversification. We will continue the hunt for other such opportunities. In today’s uncertain world this seems a sensible strategy.

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