The scars of the global financial crisis remain, with interest rates at ultra low levels now for more than seven years.
Only when we look back at this unprecedented period will we truly understand the impact of quantitative easing and zero interest rate policy, although higher yielding assets and the growth of multi-asset income strategies have so far been clear winners.
Ultimately, to assess whether the demand for yield will continue, we have to be able to make an assessment of policymakers’ appetite to keep interest rates low. To do that, we need to have a greater understanding of inflation and growth dynamics.
In Bruce Forsyth’s hit TV show, Play Your Cards Right, contestants had to predict whether the next card would be higher or lower.
As investors, we need to predict the next move in inflation, and how central bankers will respond to that. Uncertainty about inflation is arguably the highest today since 1979. This is because different drivers of core inflation are heading in different directions.
Firstly, unemployment has fallen surprisingly fast in advanced economies in recent years. So firms’ recruitment difficulties are at elevated levels. Historically, this has led to higher wages and prices.
However, thanks to overinvestment in China, the second key driver, the excess in global manufacturing capacity, has put downward pressure on goods prices.
On top of this, commodity prices, a third key driver of inflation, have collapsed, due to a revolution in US oil production and weaker Chinese demand. The divergence between these three core inflation drivers is the highest in 36 years.
We have also had large currency swings. The dollar and the pound have been strong, while the euro and the yen have been weak over the past two years. This makes it unusually difficult for policymakers and investors to forecast inflation in the current environment.
Let us take the UK, for example. Assuming the oil price stabilises at $50 per barrel, headline inflation is expected to converge with core inflation in 2016 as the large drop in petrol prices falls out.
But it is possible there are further ‘second-round’ effects from cheaper commodity and import prices still to come. If core inflation remains subdued at around 1 per cent, then overall inflation will remain well below the Bank of England’s 2 per cent target, leaving Mark Carney in no rush to raise rates.
For those desiring income, this makes investing particularly difficult. The low yields available on investments encourage income investors to chase yields, leading portfolios to become skewed, concentrated and inefficient.
Rather than chase yields, a focus on generating the highest return within a particular risk profile will tilt their portfolio towards asset classes that can deliver income and give investors a more sustainable income stream over time.
Given the inflation uncertainty, this demand for yield is likely to continue for the foreseeable future. Investors wanting to play their cards right would be wise not to be tempted to chase yield.
