Most charities remain under constant pressure to grow and protect income alongside the value of capital assets. Ensuring that the real value of income and capital are protected enables an organisation to do more and helps to safeguard their future. With other sources of funding under increased threat, income from investment portfolios is playing a more prominent role in many operational charities for whom a regular cashflow is vital.

But it is our old enemy inflation that we must keep a constant eye on, both to ensure that invested capital maintains its real value, and that the level of income maintains its real power to benefit society. In the UK, inflation as measured by the retail prices index (RPI) stood at 3.3 per cent by the end of September 2018. While the key pressures have been more transient, driven by cyclical factors (such as food, travel and fuel price inflation), this is a more demanding target when compared to the average RPI rate of 2.8 per cent over the past 20 years.

It is interesting to note that in the ten years to the end of September 2018, every £1,000 held in the average UK instant access savings account would have grown to just £1,017, whereas RPI inflation has led to charities needing £1,298 to do the same amount of good as £1,000 would have achieved in 2008. The magnitude of this inflation gap remains underappreciated, but should certainly focus minds.

Safer assets such as cash deposits, UK and other western government bonds are offering negative real returns; in effect, if you buy a ten-year UK government bond, or gilt, you are paying the government for the privilege of you lending them money! So, where are the opportunities to access a high and growing income while maintaining a diversified portfolio?

Equities

Equity (company share) markets expose investors to greater capital volatility, and there is understandable unease during this present bout of heightened market volatility. However, it is important to appreciate that not all equities are expensive at the same time; for income-focused investors, plenty of opportunities exist to recycle profits from shares that have performed strongly into shares offering a higher income on more compelling valuations. Short-term bouts of volatility allow active managers to identify long-term value at an individual company level; and a little bit of extra inflation in the economy often proves beneficial, particularly for certain sectors such as banks and insurance.

There has been a strong and consistent trend of investors reducing their exposure to the UK in favour of more overseas exposure, most markedly since the Brexit vote in 2016. However, a look at relative valuations in the US (which tends to account for a significant portion of overseas exposure) when compared to the FTSE currently would indicate that now might be an opportune time to reverse the tide and dial up UK weightings again.

Over the past three years, strong economic and earnings growth in the US has largely been reflected in higher valuations, more latterly driven by the dominant five FAANGs technology stocks (Facebook, Google, Netflix et al) which, at the end of September, had accounted for more than 50 per cent of total US stock market growth between them this year.

In contrast, while the UK market has delivered admirable earnings growth, dividend growth, and returns over the same period, the weight of negative market sentiment around EU/Brexit has led to a significant fall in valuations. Over the last three years (to end of September 2018) the valuation of the FTSE All-Share Index as measured by the price earnings ratio (P/E) has fallen by almost 25 per cent, from 17x to less than 13x.

The yield on the FTSE All-Share Index has now risen to 4.1 per cent, which is a very competitive starting point for income seekers when compared to cash and gilts. UK equities continue to offer attractive dividend growth prospects, which can go a long way to protecting the real value of your income against inflation. Diversification is key, so targeting core, proven UK strategies offering a minimum 4.5 per cent yield alongside global funds holding income friendly assets (like infrastructure) would be a sensible approach.

Corporate bonds

Bonds have enjoyed a strong 30-year run, delivering solid income and significant capital growth – why? Mainly because we have experienced a structural collapse in UK inflation and interest rates. At the higher-quality end of the corporate bond market, rising inflation and interest rates are leading to capital erosion, and income yields will not return to attractive levels until we have experienced further rate rises. Higher yields can be obtained by investing in lower-rated bonds, but this comes with greater risk, more closely linked to the fortunes of the individual companies to whom you are lending. Bond funds continue to be useful as a diversifier away from equities, but income seekers may wish to target shorter-dated funds that offer floating rate yields, which will increase as interest rates rise; these are offering yields of 3.5 per cent or more, which compares very favourably to cash and ten-year gilts (1.5 per cent).

Outlook for 2019

Based on RPI inflation averaging around 3.5 per cent during 2018, we believe that long-term charity investors seeking income should continue to favour a significant bias towards equity funds offering a diverse spread of exposure to quality UK and international businesses. Minority weightings in bonds and property continue to play their role in managing capital volatility, but it is equities that continue to offer the greatest potential to deliver high and growing income streams and UK equities look to be offering more compelling value right now. Far from abandoning our home market in favour of more overseas exposure, we would encourage charities and other long-term investors to consider taking advantage of the recent market turbulence and increase UK equities exposure while income yields remain high and lowly valuations relative to the majority of other world markets offer attractive buying opportunities.

Richard Macey is director of charities at M&G Investments

Charity Finance wishes to thank M&G for its support with this article