The biggest risk facing income investors is faster than expected rate hikes from the US Federal Reserve, according to Fidelity’s Eugene Philalithis, who says investors need to keep a close eye on rising inflation. 
The overwhelmingly consensual view is that investors face a prolonged era of low growth and low inflation, as the global economy – with its over-capacity and still high debt levels – continues to nurse a severe hangover from the global financial crisis.
However, with falling commodity prices and slowing economic growth in China, many warn that central banks – who are fast running out of tools following a prolonged period of ultra-low interest rates and quantitative easing – will be unable to stave off the threat of a deflationary spiral.
This, in part, explains the rally in developed government bonds since the start of the year.
Performance of indices in 2016
Source: FE Analytics
As such, it came as little surprise that Janet Yellen, chair of the US Federal Reserve (Fed), opted against another interest rate hike during the FOMC’s March meeting – even though four were previously expected for 2016.
However, while equity markets have reacted very positively to the news Philalithis – co-manager for the Fidelity Multi Asset range – says that though the market has been focused on the threat of deflation, core inflation has ticked up markedly.
He says that, if it continues to remain unchecked, the outcome could be very damaging to investors in traditional income producing assets.
“Given market volatility, it was always unlikely that the Fed would hike in March. However, this statement was more dovish than expected with the committee’s expectations of rate rises in 2016 being lowered,” Philalithis (pictured) said.
“In some ways this is good news for income investors, with a more gradual pace of tightening allowing for greater scope for the income from bonds to offset bond repricing from higher interest rates.”
“However, the risk is that the Fed is forced to raise rates faster than anticipated in order to head off raising inflation. This has picked up in recent months with core PCE [Personal Consumption Expenditure] inflation – the Fed’s preferred measure – already above its expectation for the end of the year.”
There are many who disagree that a period of aggressive policy tightening is on the cards, especially as deflationary pressures from China continue to persist in a world which is still highly-leveraged.
This is shown by the changing attitudes among investors towards fixed income. According to the latest Valuations Index from the CFA Society of the UK (CFA UK), Q1 2016 saw a significant drop in the proportion of investors who view government bonds as being overpriced (from 79 per cent in Q4 2015 to 67 per cent) and a similar sharp fall in those who regard corporate bonds as overvalued (from 73 per cent to 58 per cent – which is the lowest figure in three years).
This is despite the fact the likes 10 year gilts now yield 1.4 per cent – after falling almost continuously from 2.2 per cent in June last year (as measured by the FTSE Actuaries UK Conventional GR Yield 10 Years index).
10-year gilt yields since June 2015
Source: FE Analytics
“These changes in perception around value in both the bond and equity markets are significant,” Will Goodhart, chief executive at CFA UK, said.
“Both follow periods in which those markets have recovered much of the value that they held towards the end of last year. While most respondents continue to be concerned that bond valuations are pricing in too long a period of low interest rates, a growing number of respondents appear now to believe that we may be entering a sustained period of close to zero or falling real interest rates.”
However, there are others who believe investors may be playing down the threat of inflation. These include Craig Erlam, senior market analyst at OANDA.
“Yellen’s downplaying of the rise in inflation, which in January reached 1.7 per cent, just shy of the Fed’s 2 per cent target and the highest since July 2014, perhaps came as the biggest shock,” Erlam said.
“Yellen has previously been keen to avoid overshooting the central bank’s target and warned of inflation rising faster than markets expect and now she appears intent on doing the opposite, instead warning of the negative impact of the global economy on the US.”
“She even indicated that further stimulus is possible if necessary which is odd for someone who insisted on three months ago that it is suitable for the tightening cycle to begin. Whatever the reason for her remarks, I’m sure there will be few that will disagree with the need for rate increases to be gradual, certainly more so than the four hikes the Fed indicated in December.”
He added: “That said, I wonder how much the global economy and financial markets are now influencing the Fed compared to what it has previously, given that both appear to be creeping increasingly into its messaging.”
To protect his portfolios against higher than expected inflation and the negative impact that would have on traditional income-producing assets (which would almost certainly fall in value in such an event), Philalithis – who has comfortably beaten his peer group composite since he began running funds in February 2010 and has outperformed in each of the last four calendar years – is maintaining a high weighting to index-linked bonds.
Performance of Philalithis versus peer group composite
Source: FE Analytics
He added: “Exposure to floating rate loans help to protect a portfolio from higher interest rates, and this continues to be our favourite asset class going forward.”
Investors can of course find funds which would limit overall portfolio volatility or even benefit from rising inflation (such as funds that have high weightings to index-linked bonds) and FE Trustnet will take a closer look at the options available if such an outcome were to happen in an article later this week.
