The past few years have posed some important questions for income-seeking investors.
Yields have risen significantly in response to the scale and pace of monetary policy tightening. Cash and other lower-risk asset classes now offer tempting levels of income for the first time in recent history.
Given growth looks fragile in certain places, such as Europe and the UK, it’s easy to see why investors who need income are mulling over their allocations to cash and other defensive assets.
There is no doubt investors who prioritise defensiveness will do fine in cash in the short term. Indeed, given the heightened chance of a recession and the attractive yields, holding some cash in portfolios is prudent.
However, the desire for yield must be balanced with the need for growth in order to counteract inflation, as well as the flexibility and diversification required to generate steady income through time. Cash might be a good place to hide but it is not a good place to stay.
There are several reasons we believe a multi-asset approach still makes sense for income-seeking investors. First, yields across asset classes change over time. While this seems obvious, it’s easy to forget natural income generated by individual asset classes can fluctuate significantly across cycles due to factors that can be hard to predict (in recent years, notably, the economically motivated activity of central banks).
Relying on a single asset class for income is therefore a risky strategy, and particularly so for investors with longer time horizons (for example, those taking regular income through retirement).
Indeed, current yields on cash and other low-risk assets may provide a false sense of security when it comes to generating income over multiple market cycles. Yield curves are highly inverted today. For investors in short-dated money market instruments, it is worth bearing in mind these instruments constantly mature and need to be reinvested, potentially at much lower yields than can be achieved today.
A portfolio based only on present yields without the flexibility to move across asset classes is unlikely to deliver stable income over the long term.
Another problem with relying purely on cash and low-risk assets for income is that they cannot provide growth to tackle inflation, meaning the total value of a portfolio (and the income generated from it) will fall in real terms over time.
While multi-asset income approaches vary significantly – ranging from those focused on delivering capital preservation to those which offer higher potential for total return – investing through a mix of asset classes can provide an element of long-term growth.
Higher dividend paying equities are often used to boost capital growth in an income portfolio but there are pockets of the fixed income market, such as emerging market local currency debt and certain bank debt, that offer both higher income than the risk-free rate and capital appreciation potential.
Multi-asset approaches can take advantage of the differences in asset class behaviour in the context of inflation. For example, in an inflationary environment, asset classes like equities (and specific sectors like energy, Reits and financials) may play an important role in a wider income-seeking portfolio.
We believe we are entering a period of structurally higher inflation, which will force investors to think carefully about the long-term growth of capital as well as the income it generates. Alongside higher-risk exposures in traditional asset classes, multi-asset strategies with the flexibility to invest in alternatives can take advantage of the specific characteristics of areas such as renewables and infrastructure, which have cashflows linked to inflation.
Finally, we believe diversification remains as important as ever. The coming years are likely to require a highly flexible approach, balancing the need for inflation protection and capital growth alongside evolving yield levels.
Cash and other low-risk assets currently offer decent levels of yield so it is understandable that some income-seeking investors may decide to allocate more here, but multi-asset strategies can also take advantage of this, while at the same time providing opportunities for growth to combat inflation.
We retain a cautious bias over the medium term but prefer to implement this view tactically given there are pockets of the market where growth is robust and sentiment strong.
We prefer high quality dividend equities, which we believe can outperform as a style, especially on a risk adjusted basis. We have a preference for Asia equities, including those from China and Japan, and for UK large-cap equities.
We are cautious on high yield credit generally due to the heightened risk of recession. We prefer global hybrids and high-grade structured credit. Finally, we are trading government bonds tactically as markets move in a wide range.
George Efstathopoulos is multi-asset portfolio manager at Fidelity International
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