Who dares wins

Don't expect last year's bumper equity returns to signal a return to the boom years. The facts don't lie. Investors still face the considerable triple challenge of government indebtedness, the withdrawal of quantitative easing and an aging workforce, which will keep growth and interest rates low for some considerable time yet.

Last year also showed that sudden and unexpected events, such as natural disasters and geopolitical flare-ups, occur more frequently than many assume - one important reason why you shouldn't give up the safety of bonds, although specialist advice is needed.

Against this backdrop, the implications for investment returns aren't great. Investors face lower returns from risk assets such as equities while yields from 'safe-haven' government bonds remain depressed, albeit they have recovered from last year's low level of 1.6 per cent to closer to 3 per cent (benchmark ten-year US Treasury bonds). In such an environment, investors can't rely on inertia and assume that markets will just keep going up. Active advice and expert investment management are essential.

However, these challenges shouldn't mask the fact that there are opportunities to generate returns in 2014. But where should you look?

Equity valuations challenging

We still expect equities to outperform bonds and cash, but after the strong gains of 2013 equity valuations are a lot more challenging than they were a year ago. In particular, US shares look fully valued. Europe remains our favourite equity market, but the strong rally and growing divergence highlight a need to choose carefully. We currently favour Germany, European exporters (which should benefit from a weakening euro) and value equities.

Economic reforms in China should support lower but better quality growth, which should create longer-term opportunities in Chinese equity markets. China's resurgence also increases the attractions of its north Asian neighbours.

Lower for longer

We remain firmly in the camp of interest rates staying lower for longer, which will continue to drive demand for higher-yielding equities. Income-paying shares have historically delivered higher returns when real interest rates are negative (i.e. rates are below inflation), but careful stock-picking is crucial.

We look for companies with a track record of growing their dividends and the ability to continue doing so. We search for sectors where dividend yields are historically above average, and where dividend cover (the number of times dividends can be paid out of earnings - the lower the number, the greater the risk that dividends won't be paid) is above average. We also look for the potential for dividends to grow.

This analysis favours the luxury/consumer goods, healthcare and energy sectors.

In fixed income, investors may need to move up the ladder of credit risk to achieve above-inflation yields. We believe that European investment-grade corporate bonds can offer protection against the risk of rising interest rates at a reasonable price.

Investors looking to diversify their portfolios by assembling asset classes that don't move up and down in tandem may also want to consider commercial property and possibly alternative investments.

UK commercial property has a low correlation to equity markets. It offers attractive yields relative to government bonds (we estimate net yields this year will be close to their long-term average of 8 per cent) and has the potential for capital gains amid broad-based recovery in the economy.

We believe that the best value for individual properties is either paying up for longer leases (for investors seeking relative security) or buying discounted properties that are unoccupied or have leases close to expiry, and taking the view that this will change as the economic recovery gathers pace.

Passion for portfolios

Since the financial crisis, volatile markets and low interest rates increasingly make the case for considering alternative investments. Some asset classes, such as classic cars, Chinese porcelain, classic watches and fine wine have risen in price much more than share markets in recent years.

As assets that can be difficult to buy and sell, alternative investments are best held by investors who have a genuine passion for them. Financial returns should be regarded as a secondary benefit. With many alternative assets being unique and requiring specialist knowledge and finance, expert advice is more important than ever - and this is true in general in a year when returns will be harder to come by.

Mike Anderson is a managing director for the wealth manager professionals client group at Coutts

Coutts writes a regular blog for Private Client Adviser

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