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Risks to income stocks

Bank of England governor Mark Carney's statement that the risks to inflation "lie slightly to the downside" have led traders and economists to believe that rates won't rise for several months. The Bank "is unlikely to raise Bank Rate before 2017", says Danny Gabay at Fathom Consulting.

This could be good for income stocks because economists believe that low interest rates have led to a 'reach for yield': a desperation for income has caused investors to buy higher-yielding assets. This phenomenon isn't confined to equities or to retail investors: Silvia Pepino at the Bank of England points out that insurance companies have shifted into higher-yielding lower-quality bonds in recent years.

To some extent, this is a feature of monetary policy, not a bug. The Bank will keep interest rates low because it wants to support economic activity. And one way in which low interest rates do this is by encouraging investors to buy riskier assets, which reduces companies' borrowing costs thus encouraging them to borrow and spend.

With rates likely to stay low, this reach for yield should continue to support higher-yielding stocks.

History tells us this is likely. Since 1990 there has been a statistically significant negative correlation between the level of three-month interest rates and the performance of the FTSE 350 high-yield index relative to the low-yield index. Below-average interest rates tend to lead to above-average outperformance by higher-yielding shares. It's not just in the UK that this is the case. New research by Hao Jiang of Michigan State University and Zheng Sun of the University of California at Irvine shows that much the same is true in the US.

All this is especially good news because there is another reason to expect higher-yielding stocks to do well. Quite simply, it's the right time of year for them. High-yielding sectors such as miners tend to outperform during the winter, and high-yielders generally usually beat the market in the first four months of the new year.

Sadly, however, there's a big caveat to all this. It's that while UK rates might not rise for some time, US rates probably will: markets are now betting on the Fed raising rates next month. This poses two threats to UK higher-yielders.

One comes from contagion. If US high-yielders suffer as US rates rise, their UK counterparts might also do so: UK and US stocks are highly correlated.

Secondly, higher US rates might reduce capital inflows into emerging markets: the World Bank's chief economist Kaushik Basu has warned that a rise might trigger "panic and turmoil". And a fall in emerging markets would hit a big category of UK high-yielders, namely miners: these have for a long time been very highly correlated with emerging markets.

These risks should in principle be small: the Fed has for years been saying that rates will rise only very slowly. But they might argue for UK investors to prefer defensive high yielders such as utilities to cyclical ones. Doing so, however, comes at a cost. While holding defensives might partially protect one from the adverse effects of any US rate rise they would also deprive us of the benefits of UK equities normally doing better in the winter than summer.

Personally, my solution to this dilemma is to simply have a market-weighted exposure to higher yielders: this is what a tracker fund gives me. Sometimes, there are simple second-best solutions to tricky problems.