Artemis’ de Tusch-Lec: The income ‘carry trade’ – the beginning of the end?

Leaviss Jim M&G 480

In June, government bonds, corporate bonds and equities all produced negative returns. The culprit? The idea that QE might not last as long as the market had hoped.

The US Fed is currently buying Treasuries and mortgage-backed securities to the value of $85 billion a month. The prospect that those purchases might be wound down – or ‘tapered’ – is a troubling one. It presents us with a radically different reality with significant implications for asset allocation.

At the same time, however, it is a sign of a strong(er) recovery in the US economy that the Fed is talking about normalising monetary policy. The Fed has made it clear that it will only taper when the economy is strong enough to handle it.

Furthermore, inflation continues to come in below expectation – so talk of tapering is emphatically not being driven by any threat of inflation. The Fed wants us to embrace tapering as a positive thing. The market, however, is not convinced, hence the sharp falls in so many asset classes.

The worry is that when (if?) the taper happens, everything that has been thriving on cheap money or benefitted from the hunt for yield will be less in demand. Carry trades will be carried out…

The challenge this poses to classic equity-income stocks is particularly acute. These low-volatility, yield-producing assets have been prime beneficiaries of what has been termed a carry trade but which might more accurately be described as a hunt for yield. So when Fed Chairman Ben Bernanke talked up the prospect a QE taper it wasn’t a surprise that income stocks gave back some of their earlier performance.

Are we, then, at the end of the road for income stocks as a carry trade? Perhaps not. I do think the fears over QE tapering have been overdone. It shouldn’t have come as a surprise that interest rates will need to move higher at some point. And the Fed hasn’t stopped the music. They have simply turned the volume down. In June, however, everyone stopped dancing at once.

How to respond? Some episodes of volatility always seemed likely to accompany the winding down of QE. So investors should avoid any temptation to overreact. This is not to say they should fold their arms and do nothing. Things are changing – for the better in many cases. So, in response to those changes, I made some changes to my portfolio.

Since the start of last year, the fund I run – the Artemis Global Income fund – has had a bias towards value yield. That has served it well, particularly in Europe.

But I recently reduced its value yield exposure and moved towards cyclical stocks with good dividend-growth prospects. The reason? Economic surveys in developed markets are generally improving. Despite continued worries about the global economy, European industrial production figures point to an improving trend consistent with a return to modest growth.

In essence, I’ve added to US and Asian growth stories and reduced holdings in telecoms, utilities and REITs.

I haven’t, however, abandoned bond-proxy holdings, such as REITs, entirely. And I wouldn’t be surprised if, having capitulated somewhat, valuations here start to look attractive again.

We seem likely to remain in a low interest-rate environment for years to come. Equities are not expensive in absolute terms – and certainly not when compared to other asset classes. So I am positive on the prospects for income-generating equities going forward. Fund flows could also be supportive. Most flows over past five years have been into corporate and government bonds.

With equity allocations still low and cash holdings high, there is a reason to think flows into cheap(ish) equities will be supportive – particularly given that the global economy is, on balance, getting better rather than worse.

Jacob de Tusch-Lec is manager of the Artemis Global Income fund