Standard Life Investments

Through the Lens

Central banks and asset prices: a multi-asset viewpoint

  • We expect a shift in US monetary and fiscal policy that could negatively impact yield-seeking investors
  • Multi-asset portfolios with flexible mandates can still find income opportunities
  • We highlight investments in bond, real estate and currency markets

Central banks have never had a greater role in determining asset prices as in the years since the financial crisis,but this is set to change in 2017.

A shift in policy is underway. US government spending is expected to increase, while US interest rates are forecast to rise. This shift has already boosted the US dollar but further gains are expected. It has also pushed up government bond yields around the world. Amid still low interest rates, what opportunities are available for beleaguered yield-seeking investors? And which assets offer protection against this potential turn in the tide for yields?

After five years of gains, valuations are rich for many assets offering a reliable stream of income and downside risks have increased. Multi-asset managers will need to cast their nets widely across geographies and asset classes. With this in mind, we consider income opportunities in high yield corporate bonds, real estate and currency markets.

High yield corporate bonds performed strongly in 2016 but still offer attractive yields. The US market dominates the asset class and should be supported by the revival in the domestic growth outlook. We see scope for further compression in yields relative to government bonds, but this is likely to be measured in basis points rather than percentage points. However, the odds of a recession have diminished and this means default risk is lower. The near doubling of the oil price from its lows (below U$30 in January 2016) has reduced the main source of financial market stress last year, the shale oil sector. A key risk is that this optimistic view of the US economy is a consensus call, but few investors were positioned for the election of Donald Trump and this should allow recent trends in markets to run further.

Global real estate investment trusts (REITs) are also attractive in what remains a low-yield environment. Inflation is expected to increase this year and REITs offer inflation protection for long-term investors in the form of rising rental income. Valuations are not cheap, making them vulnerable if sentiment turns. However, we expect commercial property prices to rise in most global markets. The recovery to date has been driven by interest rates and has not led to a significant increase in physical supply. The notable exception is the UK market, where prices have already moved aggressively higher. Meanwhile, demand is vulnerable because of the possibility of major banks relocating staff to Continental Europe after the UK’s vote to leave the EU.

Currency markets offer a different route to generate income. India is now the seventh largest economy in the world (by GDP), making it less vulnerable to the ‘mood swings’ of the developed world. In addition to its high growth rate and moderating inflation, India should benefit from Prime Minister Modi’s ongoing policy reform, which includes fiscal deficit reduction, plus energy, infrastructure labour and land law reform. This should attract foreign direct investment and support the value of the Indian rupee.

This positive picture contrasts markedly with the outlook for the Swiss economy and currency. The Swiss economy is heavily reliant on exports. Amid widespread concern in recent years over declining global growth, the franc has been in strong demand – to the extent that most Swiss government bonds now offer negative returns. The franc’s strength is now damaging the global competitiveness of Swiss exports, forcing policymakers to look at ways to weaken it. We see upside for the Indian rupee relative to the Swiss franc. But this is an income play too. The interest-rate differential between the Indian and Swiss currencies is currently around 7.5%, providing another source of return.

The era of central banks across the world driving interest rates ever lower - and the prices of assets that most obviously benefit from this trend ever higher - appears to us to have reached its limits. Investors with income requirements will need to be more selective. A multi-asset approach provides the broadest universe from which to find income-generating opportunities.