The opportunities for effective diversifiers

The expectation was that bond yields would rise, but supportive central bank policies coupled with concerns about the strength of the global recovery – with tensions in the Middle East and Ukraine –have pushed bond prices higher. This climate has made it more challenging for multi-asset investors to find effective diversifiers, but a few bright spots remain in equities and commercial property.

The good news is that we are seeing the recovery beginning to take hold. The UK economy is expected to grow by 3.1 per cent in 2014, the highest since 2007, while unemployment has fallen faster than predicted, sitting at a six-year low of 6.2 per cent.

All of this is happening against a background of a modest inflation rate of 1.5 per cent, which has helped to create a dream scenario for financial markets. Similarly, the US economy appears to be returning to health and China is still growing at a fast rate.

Even so, we continue to face headwinds. The European currency crisis might be fading, but the economic recovery that we have observed in the past year now appears under threat. Economic growth in the second quarter was flat owing to weakness in France and Germany, and more recently the OECD cut its growth expectations for 2014 to 0.8 per cent.

Meanwhile, industrial output has also come under pressure and eurozone’s inflation rate fell to a five-year low of 0.3 per cent in August, raising the spectre of deflation. This negative environment is likely to take its toll on the UK, where an already large trade deficit remains. Overall, Europe has been damaged by weak growth, the slow pace of structural reform, economic sanctions on Russia and the ongoing tensions in Ukraine.

Equities continue to be attractive, but few can ignore just how far markets have come since they bottomed out in 2009. In the US, the S&P 500 has broken through the 2,000 point barrier, reflecting improvements to the underlying economy. But this also means that equity valuations are at high levels relative to equity markets elsewhere in the world and therefore they appear unattractive.

UK equity valuations, by contrast, appear more modest and, therefore, more favourable. Markets have clearly provided plenty of growth over recent years, but the FTSE 100 still offers a dividend yield of 3.5-4 per cent that exceeds 10-year UK gilts by one percentage point.

Proving even more challenging for ­multi-asset investors have been bond markets. At the beginning of the year, the expectation was for government bond yields to rise as the economic recovery progressed and risk appetite increased. Instead, bond prices have risen this year.

Yields on 10-year UK gilts have traded in a range of 2.3-2.8 per cent in the past three months and therefore offer only moderate value for security and yield. Similarly, the European bond market has been driven higher in response to geopolitical tensions in Ukraine and anticipation of further easing by the ECB. The yield on 10-year German bunds fell to 0.88 per cent in late August but have since risen above 1.0 per cent.

Away from the challenges of equities and bonds, commercial property appears to be one of the strongest investment opportunities. This is underpinned by rising rental incomes and the prospect of achieving a yield that is significantly higher than bond markets. Concerns remain about the future of high street properties and the retail sector, so it is essential to focus on properties in good locations and long-term tenancy agreements.

David Marchant is chief investment officer of Canada Life and managing director of Canada Life Asset Management