Liquidity concerns

It has been seven years since the Bank of England last raised interest rates and five very long ones where the official policy rate has been sitting at the record low of 0.5 per cent. That all may change next year. The economy is in decent shape heading into 2015. Employment is rising strongly and consumer confidence is back to pre-recession highs while there are signs that business investment is increasing. The very closely watched Purchasing Managers’ Indices for manufacturing and services offered more encouragement last week and suggest that the final quarter of growth will be another good one. But - and it is a big one - one or two rate hikes from the Bank of England will solve the income problem.

Income seekers have been pushed further along the credit spectrum and into a wider pool of yielding assets which has provided some income relief. Some may be hoping that rate hikes will mean higher yields on traditional ‘safe’ income assets such as longer-dated government bonds. However, yields will still be at very low levels for some time and there are reasons to believe that yields on longer-dated gilts may be capped by things such as demand from pension schemes that continue to follow a path of portfolio de-risking.

The high-yield bond market in the US and Europe is another alternative which still looks attractive. Granted the high yield is perhaps more fittingly called just yield these days but while the yield on offer is not as high as the past compared to the meagre yield on government bonds it should not be overlooked, especially when viewed against very low default rates of the companies issuing the debt. However, there is increasing speculation about potential liquidity constraints in some parts of the fixed income market. With many investors all holding the same assets what happens when rates do rise and we all rush for the exit at the same time? For that reason, equities may be a preferred source of yield.

As at 3 December, the yield on the 10-year gilt was just below 2 per cent. But does this 2 per cent compensate me for the risk of capital loss should interest rates rise? I would argue that it does not. Equity markets will not be impacted in the same way as bond markets. There will be volatility in the markets around the first rate hike. This is to be expected: if we are faced with the first rate hike in six years, of course markets will be nervous about the impact. But rising rates are a reflection of a healthier economy and a return to a more normal monetary environment - nothing more sinister. This should mean a better environment for equity markets as revenues increase and earnings rise.

The chart breaks down the MSCI All Country World Index, a benchmark index which includes companies in developed and emerging equity markets, by region for companies that pay a dividend of at least 2 per cent. Of the 2,400 companies in the index, approximately half meet this criterion meaning that there are plenty of opportunities to find a higher yield in equity markets than on government bonds right now.

What is also fairly evident from the chart is that investors who are looking for income need to cast the net pretty wide and fish in both the emerging and developed market ponds. Asia, Western Europe and North America have the largest number of companies to choose from, partly due to their bigger weight in the MSCI ACWI. But these are also the regions that traditionally have companies that return more cash to shareholders. So equities can provide the income but what are you paying for it?

In the US, the strong market run now means that equities are no longer considered cheap, but not yet expensive, but the pessimism that has grown towards Europe and emerging economies over the year means that there may be more attractively priced opportunities in those markets.

Kerry Craig is global market strategist of JP Morgan Asset Management