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With interest rates expected to rise in the US this year and eventually in the UK, we continue to believe equities offer the most attractive long-term returns.

As inflation picks up across the developed world, US interest rates are widely expected to rise further in 2017 – although there is still plenty of uncertainty about the speed and timing. The US Federal Reserve (Fed) increased its benchmark rate at the end of 2016 and average projections from Fed officials have pencilled in two further quarter-point hikes for the year ahead and the possibility of a third. However, Fed chair Janet Yellen has admitted the bank is operating under a “cloud of uncertainty” until it knows more about President Donald Trump’s economic direction of travel.

Meanwhile, Bank of England (BoE) Governor Mark Carney has said rates could move in either direction in 2017 owing to uncertainty surrounding Brexit. While the bank recently lifted its UK economic growth forecast for 2017 to 2%, having predicted 1.4% as recently as November, it doesn’t see this fuelling higher inflation than it previously forecast over the next two years. This economic optimism appears to be largely due to strong consumer spending, fuelled by an increase in borrowing.

Financial markets have previously been rattled by speculation of tighter monetary policy, and some investors may fear another ’taper tantrum, the name given to the market’s adverse reaction to suggestions by the Fed in 2013 that it could begin to ‘taper’ its bond-buying stimulus programme. Money started pouring out of the bond markets and yields increased dramatically.

CLEAR SIGNPOSTS

This time around central banks are clearly signposting their moves so that they don’t come as a surprise. However, there is a risk that rates could rise faster than expected if inflationary pressures prove to be stronger than anticipated. This could weigh heavily on investor sentiment, particularly for bonds.

Still, we see this as unlikely and don’t see inflation making a sustained rise beyond the 2% target set by both the Fed and BoE. Moderate price rises are welcome news for a global economy that has already started the year in relatively good health. Low but rising inflation should allow central banks to leave rates low or only raise them gradually – market-friendly monetary policies that can help sustain steady economic growth.

These conditions should spur a revival in company profits, setting the scene for a recovery in capital spending (even without tax cuts in the US) and prompting further stock market gains. We believe equities remain the best placed among the major asset classes to provide the potential for relatively attractive long-term returns.

Compared with government bonds, the higher dividend yields available from equities should continue to support demand in what is likely to remain a low-yield environment. Meanwhile, healthy economic conditions should also continue to support higher-yielding corporate bond markets and commercial property, asset classes that we also prefer over low-yielding government bonds.
 

DIVIDEND YIELDS OUTSTRIPPING INCOME FROM BONDS

Dividend yield outstripping income from bonds

INVESTING THROUGH UNCERTAINTY

Although interest rate rises normally spell losses for government bonds, they are starting from a record low base in this cycle. In the 10 years before the financial crisis, for example, UK rates hovered around 5%. We don’t believe they will increase by enough to cause a substantial sell-off in government bonds. However, we have maintained an underweight allocation to government bonds for some time owing to their unattractive long-term return potential.

One of our core investment principles is to have sensibly diversified portfolios, with different sources of potential returns that are not closely correlated with each other. We currently see alternative investment strategies as source of diversification away from equity risk (i.e. with the tendency to move in the opposite direction when equities are falling) that has better long-term return potential than government bonds.  In recent months, we’ve been increasing exposure to alternative investment strategies that seek to generate positive returns through most market conditions.

One of our investment principles is to exercise patience by not overreacting to short-term market movements and staying focused on capturing long-term opportunities

Political uncertainty remains a key risk, and market conditions are likely to remain volatile as the Brexit process unfolds and President Trump’s economic policies become clearer. For example, equities suffered a short-term correction after Trump signed an executive order imposing a temporary immigration ban into the US. Similarly, sterling has been affected by comments from Prime Minister Theresa May about the terms of leaving the EU.

Another of our investment principles is to exercise patience by not overreacting to short-term market movements and staying focused on capturing long-term opportunities. We believe central banks will also exercise caution by increasing rates only gradually, providing their economies with supportive conditions for further growth.

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