There are plenty of opportunities for income across both developed and emerging market equities if investors are selective, but maturity in the current credit cycle means the investment grade debt market should be avoided, according to Kames’ Vincent McEntegart.
The manager, who heads up the £315m Kames Diversified Monthly Income fund, says Europe’s fundamentals remain supportive despite political uncertainty and, given potential rate rises in the US, there will be “highly disparate” returns from equities in the region.
In contrast, he warns that credit yields aren’t compensating investors appropriately for current risk levels, while government bonds could have further to run over the short to medium term.
In the below article, the manager discusses these views and how this will impact investors’ decisions when it comes to hunting for income.
UK equities
Last year’s violent rotation from quality defensive to cyclical stocks has been well-documented, as expectations for fiscal loosening in the second half of 2016 boosted UK investors’ sentiments.
Performance of indices in 2016
Source: FE Analytics
While McEntegart (pictured) expects this trend to continue, he warns that investors should keep a close eye on any Brexit-induced uncertainties. 
“The fall in US bond yields since their December high challenges the post-Trump ‘reflation trade’. However, we continue to believe that evidence of a synchronised, cyclical acceleration and rising global inflationary pressures will give this trade further track to run,” he reasoned.
“Financials should benefit at the expense of ‘quality’ stocks, which are still relatively expensive compared to history.
“Domestic stocks pose a dilemma for 2017. We feel that some estimates (post last year’s Brexit vote) have become too bearish. However, continued uncertainty surrounding the form of Brexit and its eventual impact on the domestic economy are likely to weigh on valuations throughout the remainder of this year.”
McEntegart isn’t the only manager to believe the recent value rotation has further to run. In an article published earlier this year, Invesco Perpetual’s Nick Mustoe explained that there is still a mismatch between UK consensus numbers and the country’s improving economic data.
European equities
With upcoming elections across Europe in France, Holland and Germany, many investors are nervous on buying equities in this region.
Despite fears that alt-right parties could gain power and present a series of unknowns, McEntegart believes the region’s fundamentals remain positive and, for the selective investor, offers attractive income opportunities.
“As the market continues to digest president Trump’s every tweet for policy nuances, we should not be distracted from the fundamental backdrop,” he said. “The European economy is recovering, with the eurozone’s economic surprise peaking last month at levels not seen since early 2013.
“This has already been reflected somewhat in the bond yield-inspired rotation that we have seen towards more ‘value-oriented’ and cyclical sectors. For this to be sustained, we believe that bond yields need to continue drifting higher and earnings must deliver.”
US equities
Many investors believe US equities’ valuations appear stretched, especially given the uncertainty surrounding Trump’s future policies.
In an article published last month, Premier’s Simon Evan-Cook told FE Trustnet that he even implements an “America last” policy when it comes to positioning his portfolio, given the S&P 500 is now reaching historic highs.
Performance of index since start of FE data
Source: FE Analytics
However, McEntegart says the country still yields opportunities for equity income investors, although he warns of a wide performance gap between the best and worst performers.
“We are accustomed to a hawkish Federal Reserve being negative for the US equity market. Not so now it would seem,” he continued.
“The Federal Reserve has announced that it sees neutral real rates in the US around 1 per cent higher. However, judging by market movements in recent weeks, investors do not appear to be fully embracing this view.
“Each day a new record-high seems to be printed – perhaps over-exuberance given the uncertainty that still exists regarding Trump’s policies. As we await clarity on the Trump administration’s policies, there remains the potential for highly disparate returns over 2017 as the winners and losers begin to emerge.”
Emerging market equities
The ‘darling’ equity sector of last year has divided the opinion of many investors over recent months; while some believe fundamentals across emerging market regions are improving, others worry a strengthening dollar could exacerbate the debt burden in many of these countries.
While the potential headwind of a strong dollar shouldn’t be ignored, McEntegart believes there are still attractively valued opportunities in the sector. This is despite the fact emerging market valuations have risen from historic lows seen in 2015.
“A reasonably broad array of short-term and long-term economic indicators continue to paint a robust picture for growth and global inflationary pressures,” he said. “For example, China’s latest PPI data was the strongest in around six years, suggesting that reflationary pressures continue.
“Combined with persistent improvements in earnings expectations, we see the potential for positive returns in emerging markets. Valuations have, indeed, moved above historical averages, but they still remain supportive in an upturn phase.
“Potential headwinds are likely to be the threat of Trump-induced trade wars and the impact of a strong US dollar.”
Credit
Over in fixed income, McEntegart is more reticent when it comes to finding new opportunities. This sentiment is echoed by many, given expected inflation rises would eat into the value of coupons.
The manager says this, combined with high valuations compared to history, means now may not be the right time for investors to buy into investment-grade corporates.
“We view the current credit cycle as relatively mature, particularly for non-financial issuers. There has been a slow, but steady, migration down in credit quality within the investment grade markets in recent years as corporates look to favour shareholders with higher capital returns or engage in mergers and acquisitions,” he reasoned.
“With the cost of debt likely to remain close to historic lows for the short-to-medium term, it is difficult to see a catalyst at present that will cause this trend to reverse.
“Current valuations provide little in the way of risk premia, particularly given the recent upward trajectory in government bond yields. As such, we do not view now as an attractive entry point for investing in the broad investment grade market and prefer to look elsewhere for better opportunities in credit.”
Government bonds
When it comes to government bonds, the manager adopts a slightly more optimistic view as, despite yields rising, he believes the prospect of aggressive QE tapering is premature.
Performance of indices over 1yr
Source: FE Analytics
“The economic background continues to be more positive and less bond-friendly despite the many uncertainties that the global economy faces,” McEntegart said.
“In the US, Europe and the UK, economic growth continues to tick along and inflation keeps rising, albeit slightly exaggerated by base effects such as oil prices. Central banks have, however, yet to move.
“In the US, Federal Reserve chairman Janet Yellen has been sounding increasingly hawkish, but no action is expected until the Trump fiscal boost is quantified.
“In Europe, the ECB remains at an easing stance. Despite aggregate figures for the eurozone bloc showing inflationary pressures picking up, some countries (e.g. Italy) are still seeing deflation. Until this situation changes, we see talk of tapering as premature.”