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In today’s challenging markets, Michael Schoenhaut and Christina Jiang explain how a focus on sourcing the best income opportunities, while closely managing risk, can reap benefits for investors.
What does today’s market environment mean for income investors?
Income remains a challenge. Monetary policy over recent years has been driving down rates globally for asset classes such as traditional fixed income. However, this “lower for longer” dynamic has begun to shift in more recent months. While the prospect of higher rates is positive for yield-starved income investors, against this backdrop the price of fixed income and many yield-oriented equity sectors tend to suffer. This changes the challenge for income investors primarily from finding yield to managing the balance of risk, yield, and total return. In this environment, active management is more crucial than ever.
What are the most important economic themes being reflected in the portfolio at the moment?
Overall, we continue to see an improving global growth picture. The US remains the driver of global economic growth, and if we see significant policy stimulus from the new Trump administration, we believe growth will likely pick up. In Europe, the economic recovery continues, but concerns over negative interest rates and upcoming elections and referendums are on the horizon. Emerging markets had a strong run this year until the US election result. Although a more hawkish Federal Reserve (Fed) and a stronger US dollar could be headwinds for the asset class next year, we believe that the impact of these could be dampened by the improved earnings outlook for emerging markets and a pickup in growth globally. Given the expected uptick in growth and recent move in rates, global equities look increasingly attractive.
Where are you currently finding attractive opportunities?
Despite the potential for continued rising rates, fixed income remains an important allocation in both an income and multi-asset portfolio. In our search for attractive risk-adjusted yield opportunities in today’s environment, we continue to like the credit markets, specifically high yield and other opportunistic allocations such as preferred equity. With regards to high yield, we are comfortable with the credits that we own and anticipate that default rates over the next 12 months will be lower than their long-term average. We also view the risk of recession in the near term to be quite low. High yield still has a healthy spread over US Treasuries, which can absorb some of the impact of rising rates. This is particularly attractive because we are also hedging some of the duration exposure at the portfolio level by shorting five-year US Treasury futures, which allows us to access the asset class while mitigating the downside effect from rising rates. Government bonds and core fixed income offer very little protection against rising rates, which is why our fixed income exposure is much more focused on credit.
How has the portfolio’s positioning evolved in the equity space?
In the summer of 2015, we began reducing our equity exposure from near an all-time high of 46% to 32% in more recent months. At the time, we believed global growth would be low but still positive, and therefore preferred the carry of high yield and other credit assets to equities, given their reliance on stronger earnings growth. This helped the portfolio as our credit allocations outperformed equities in the first half of the year.
Following the US election and the recent rate rise, we have started to add to equities. Given stronger earnings potential with the prospect of fiscal stimulus in the US and a reflationary theme across the world, we remain positive. However, while some of our peers have focused on bond proxy sectors for equity income, we remain diversified in our equity sector allocation. This is important because while bond proxies significantly outperformed other equity sectors on the back of falling rates in the first half of the year, this has reversed in the second half. Through both of these periods, our portfolio maintained relatively steady, positive performance. Within equities, our underlying managers particularly like the financials sector given its increased earnings potential in a rising rate environment and the possibility of looser regulation.