This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Alice Gaskell and Andreas Zoellinger, co-managers of the BlackRock Continental European Income Fund, say that the prospect of rising interest rates in today’s markets will not reverse the appeal of equity income strategies.
Given an improving macroeconomic picture and lower political risk across the eurozone, we believe European equities generally have attractive investment potential. That said, shifts in central banks’ monetary policies, however gradual, will mean some change in emphasis for equity investors.
In Europe, we are expecting acceleration of GDP growth as we come out of a period of extreme fiscal austerity. As the economy improves, dividends of many high yielding companies are increasingly offering better visibility. Corporate balance sheets are strong and the average dividend yield is in line with its long-term average. As corporate earnings recover from a low base, we expect to see European companies grow their dividends. In the meantime, valuations of high dividend companies remain attractive.
Since 1973, European equity markets have seen annual nominal dividend growth of 7.6%. Current 2014 dividend growth forecasts are for 8.2%, mainly driven by cyclical sectors, such as diversified financials (41% growth), information technology (25%), banks (15%) and consumer discretionary (10%).
Dividend yields of Pan-European companies are also attractive, both in absolute and relative terms. While they have come down over the last twelve months, at 3.3% they compare favourably to other asset classes. Within European equities, the utilities, telecoms, real estate and energy sectors currently offer the highest dividend yields.
Given that rising bond yields are indicative of a changing opportunity set, we have reduced our exposure to stocks with high momentum and those with significant exposure to emerging markets, the latter having been the main beneficiary of cheap money supply from the developed world.
We have also shifted our focus towards sectors exposed to structural dividend growth, such as healthcare and media; beneficiaries from lower risk premiums in Europe, such as insurance and infrastructure; and financial companies with secure dividends. We seek companies with excess cash on their balance sheets, which typically enables them to pay special dividends or increase ordinary dividends.
We particularly favour insurance, telecoms and domestic infrastructure. Many of the stocks in these sectors would not be part of a traditional equity income approach but do meet our quality criteria. One example is Atlantia (1257), an Italian operator of motorways which benefits from predictable long-term income streams in a highly regulated European infrastructure industry. The company offers a dividend yield of 4.4% that is expected to grow at 5% in the near term.
We also like 
Swiss Re (SREN), a Swiss reinsurance company, which offers an attractive dividend yield of 4.4%. The company stands out in its sector due to its significantly overcapitalised balance sheet. Such financial strength allows the company to invest in the expansion of its underlying business, to grow its ordinary dividend and offers the option of paying special dividends.
While interest rates are likely to rise from here on, we expect this to take place gradually over the next few years. Given the likelihood of continued market volatility, we believe that actively managed equity income strategies have the potential to continue to outshine the broader equity market, as well as bonds.
