The key issue for income investors in 2017 is how far the emerging reflationary theme of higher inflation can run.
In recent weeks we have seen markets dramatically move to re-price the 'lower for longer' scenario, with fixed income, dividend-paying equities and REITs selling off. Assets dependent on central bank policy will be vulnerable over the next 12 months.
Income investors should also be cautious in welcoming the return of inflation from a portfolio perspective. Many favourite income sources of recent years will now face significant volatility, amongst them dividend-paying equities.
WHERE TO LOOK FOR INCOME OPPORTUNITIES?
To help overcome the issues of inflation and central bank dependence, income investors should look to those assets which have not benefited so much from policies like quantitative easing.
This includes asset classes like Asian investment grade bonds, infrastructure and loans.
Asian investment grade bonds offer an attractive yield compared to US and eurozone markets, and the shorter duration of the market makes it less sensitive to rising interest rates.
Infrastructure and loans are also shielded from central bank policy by virtue of the flexibility of their income payments.
Infrastructure yields are often linked to inflation while loans are floating rate instruments, meaning their yields rise and fall in line with central bank rates.
EMERGING MARKET DEBT ALSO IMPORTANT IN 2017
Emerging market (EM) assets also have an important role to play in the year ahead.
The yields on local currency EM debt yields have not fallen as far from pre-crisis highs, so if we do see some degree of normalisation in developed market yields, this process should be less extreme for EMs.
While the trend is for rising inflation in developed markets, the high real yields available in EMs should allow domestic central banks to cut interest rates and thereby provide a boost to the capital value of EM debt.
The ideal scenario for income investors would be one of gradually rising rates over the coming year, allowing them to earn a higher level of income but also providing time to adjust. Yet investors should position for a range of outcomes, rather than what they want or hope will happen.
We are potentially seeing a regime change in markets - in itself likely to lead to higher volatility - with a great deal of accompanying political uncertainty.
Amidst a more volatile outlook, investors should remain alert to opportunities, following a strategy of buying on weakness and selling into rallies. This should help to build downside protection into a portfolio, while locking in gains - a vital strategy in the year ahead.
Eugene Philalithis is portfolio manager of the Fidelity Multi Asset Income Fund.
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