Recent comments from Bank of England governor Mark Carney suggest the market is applying too low a probability to interest rates rising in the near future.
And with the most recent data showing UK inflation accelerated more quickly than anticipated in June, the likelihood of an interest rate rise before the end of the year – earlier than initial expectations of the first half of next year – is even greater.
Investors have been enjoying a long run of market rises recently and volatility has been remarkably low. In light of this, however, and as investors adjust their interest rate expectations, we feel pressure is mounting and the probability of a market correction is rising.
So we have been reducing our allocation to fixed income assets (particularly long-duration government bonds), whose valuations are looking increasingly less attractive, and are beginning to rotate instead into cash. This should mitigate the effect of a rise in interest rates, which could erode the value of fixed income investments, and let us benefit from any rise in deposit rates.
For some time we have been pursuing an equity income theme. Last year’s equity rally was just the latest in a series of strong years for markets, which has resulted in full valuations in many areas of the market. This is particularly pertinent in the mid-cap space, which saw the greatest rises as investors pursued high growth opportunities.
On a relative basis, valuations of large- and small-cap stocks are looking most attractive and we are increasing our allocations here in an effort to reduce relative valuation risk. However, we are aware that return prospects across markets are lower this year and consequently dividend-paying stocks are most attractive as the additional income should help maintain total returns.
In addition, as well as providing income, companies that pay dividends tend to be more disciplined in their management of cash and allocation of capital, and consequently have held up relatively well amid the recent equity market volatility.
Another asset class in which we have increased our exposure recently is property; the increase in UK property prices has been well documented. Returns for commercial property exceeded expectations in 2013 with a total return of close to 11 per cent and property managers are talking of similar, if not greater, returns in 2014.
Alongside the potential for capital appreciation, property offers attractive opportunities for income – particularly with interest rates low and bond yields still depressed. Yield comes primarily from rental income and there are increasing signs of rental growth. Over half the total 11 per cent return for the IPD All Property Index in 2013 was from income. Another important advantage of property exposure is the opportunity it offers for some diversification when held in a portfolio.
But it is important to be aware that property is relatively illiquid compared with equities and bonds and therefore investors need to make sure they manage the risks when allocating to it.
Caspar Rock is chief investment officer at Architas