Why chasing high yields can lead to danger

The big question was and still is what effect the result will have on both fiscal and monetary policy. This is further exacerbated by a sudden change of prime minister and a new resident at the Treasury responsible for managing an orderly and considered exit from the EU.

We should be under no illusions that the outcome of the vote on June 23 is anywhere near being clear: the political shenanigans involved will run for some time to come and the outcome is far from clear.

Unfortunately, it is this uncertainty that equity markets are most troubled by, and the manifestation of this uncertainty comes in the form of volatility and whipsaw shape graphs of stock prices.

Brexit threw the UK financial world into turmoil: markets fell quickly as a contagion panic ran like wildfire and the UK pound nose-dived about 10 per cent, and the result was at one time a 31-year low value against the dollar.  

Understandably many investors and savers alike have been forced to re-think their strategies when looking for income. Capital growth or capital preservation and stability? Or both? 

An obvious  consequence of the UK investor heading for more safe homes for their capital has been that gilt yields declined. What is more,  yields on UK credit have slid back. To make matters worse, the global ratings of the UK economy have been downgraded from previous triple-A category.

The reason given by the ratings agencies was twofold. First, that the economic GDP projections for the UK were likely to be less than previously thought. Second, the political upheaval would inevitably create further uncertainty and negativity.

 As we move through the final quarter of the year, those comments by the ratings bodies look particularly telling.

Traditionally in times of great political upheaval and market turbulence, investors have attempted to adopt a defensive position by favouring bonds, gold, infrastructure, healthcare and consumer staples.

The problems they face taking this approach are very challenging. First, the interest rate environment has not changed as many people have been consistently calling; the Bank of England has remained steadfast and maintained this record period of below average base rate.

The knock-on effect for savers is of course that their deposit capital is effectively yielding in negative territory when compared with inflation on the cost of living. Although it is still very benign, inflation is still with us. Since the Brexit vote and the slump in currency value of the pound, it is not going to take long for the increased costs of importing raw materials and food to start to bite and provide some inflationary pressure.

So what does the  future look like for investors and savers who are increasingly under pressure to squeeze out yield – particularly so in the case of an ageing population who need to maintain income levels.

There is a real danger for these people and it comes in the form of investment risk. In the heady days of 5 per cent interest rates, it was a no brainer for many people to avoid the shocks and scared of the equity market and simply stuff their cash into deposit-based vehicle and simply let the interest generated provide some income, albeit with a potential tax liability on some of it.

The brave new world of the post-Brexit vote in 2016 has thrown up a real conundrum for these investors. While all the news was bad and fear was everywhere, the UK market and others elsewhere around the globe have recovered from the initial shock and for the most part bounced back and indeed made some upside gains.

What I suspect will happen is that those people who have adhered to a cautious view on their investments will inevitably have their attention drawn towards equity investing to achieve their goals, while not necessarily fully grasping the risk therein.

The value and levels of the UK equity have been further challenged recently, with the circus masquerading as the US Presidential elections, but interestingly enough have by and large ridden the tide of misinformation and rhetoric and shaken off the Trump Pence factor and continued with business as usual.

How this will impact on the make-up of investors’ portfolios and the balance between bonds and equities is really tough to call, but I suspect that the ongoing depressed levels of interest rates on both sides of the Atlantic will push more people into the active strategy funds and reduce over-reliance on fixed-interest. 

Nick McBreen is an independent financial adviser at Worldwide Financial Planning

Key points

Many investors and savers alike have been forced to re-think their strategies when looking for income.

Savers’ deposit capital is effectively yielding in negative territory. 

There is a real danger for investment risk.