Newton's Simon Nichols looks at the advantages the sector offers in uncertain economic times
The search for yield, which has effectively been manufactured by global monetary authorities’ cutting of cash interest rates to zero (or near zero), has forced risk-averse investors into more risky asset classes in pursuit of some element of return on their investments.
For many investors this has encouraged a move into bonds, and those investors have been well rewarded as recent returns from both sovereign and corporate issues have been strong.
The yield available on government bonds has fallen significantly as the prospects for US economic growth appear to have deteriorated and worries about a ‘double-dip’ recession have gathered pace.
Something’s got to give: The search for yield
Many commentators have readily compared the outlook for the US economy to the recent experiences of Japan, with the resultant conclusion that ‘risk-free’ government bonds represent excellent value.
Although nominal yields look low, the real (inflation-adjusted) yield on government bonds is still rather generous in the sort of world such commentators foresee, in which deflation is rife and growth is non-existent.
It is not difficult to construct this argument given the required ‘deleveraging’ of the developed-world consumer and the austerity measures being put in place by overstretched governments. A deflationary scenario, in which government bonds would be likely to continue to perform well, is certainly a downside risk for other asset classes.
However, monetary authorities have shown an unprecedented commitment to ensure that such a situation does not come to fruition. Given the levels at which yields currently stand, the term ‘risk-free’ could well prove to be a misnomer when attached to sovereign debt.
Markets took great confidence from the coalition government’s first budget in the UK, and from the new chancellor’s hope to eliminate the deficit over the course of a parliament. However, in a world where growth is absent, the mathematics of deficit reduction no longer work.
Should the funding cost of countries with the prevailing public sector finances of the UK (and US) really be so low? What will be the effect on inflation of the inevitable acceleration of quantitative easing in those countries?
What will be the knock-on effect on emerging economies if they are unable to stir domestic demand? There is no simple answer to these questions, but those ‘risk-free’ investors should prepare for heightened volatility as investors look for one.
Spreads on corporate debt have clearly narrowed from the distressed levels at which they stood two years ago and corporates have also benefitted from the declining yields on government bonds.
Companies are now able to borrow at very low absolute interest rates in an historical context, and mergers and acquisitions activity has already started to pick up as those who have access to liquidity seek opportunities for growth.
It is unlikely, however, that the debt-fuelled transactions of the past will make a quick return in this financial environment. Given the tepid rate of recovery, interest rates are likely to be held at very low levels for some time and, in the absence of further shocks to the financial system, corporate bonds should offer reasonable, if not stellar, returns to investors.
With the uncertainties that exist in financial markets at the moment, one of the advantages of investing in the Cautious Managed sector is the 60% upper limit that is imposed on equity holdings; there is no minimum threshold however.
There has been much comment recently about the diverse nature of the Cautious Managed sector and whether investors really appreciate the underlying exposures to which investment in the sector gives rise. Latest figures highlight such divergences; the range of holdings in the sector in UK equities was 0% to 53% for example.
Similarly, the range of holdings in overseas bonds was 0% to 48%. While this is perfectly permissible within the sector limitations, it highlights the performance divergence which may occur between different funds within the sector.
We believe volatility is likely to continue to remain at elevated levels in the period ahead. Market sentiment may change very quickly, especially given the scope for policymakers at present to have a disproportionate effect on market sentiment.
It would seem sensible, therefore, to have a portfolio which has elements of both fixed-income and equity securities to provide protection in most market conditions. Of course, in the future there will come a time when uncertainty recedes and the results of the experiments that are currently taking place with fiscal and monetary policy become a little clearer.
For now, the asset allocation of the Newton Cautious Managed fund remains positively skew towards equities. Valuation plays a key part in this decision and it is noteworthy that the dividend yields on some good-quality companies stand at levels significantly above the same companies’ corporate bond yields.
In an environment in which there is some element of global economic growth, dividend yields should prove sustainable and, in most cases, have the potential to grow. The relative valuation case for equities appears clear, therefore, given all but the most pessimistic of economic outcomes.
A well-chosen cautious managed fund should therefore remain a popular choice for those investors who agree the outlook is finely balanced and require a degree of asset diversification from their investments.
Simon Nichols is manager of the Newton Cautious Managed fund
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