Income investing has become ever more pressured. Central banks have kept developed market interest rates at record lows, causing bond yields to fall and income seeking investors to move up the yield curve to beat inflation. But even high yield bonds are now no longer living up to their name thanks to considerable inflows.
Yield hunters looking for 4% plus have no choice but to turn to equities, which present their own concerns. Before the credit crisis, there was a large variety of shares rewarding investors with supposed-excess cash. Once the global recession hit, banks all but disappeared from the dividend game across the UK, US and Europe and overleveraged businesses were forced to use cash previously distributed in dividends to sort out their book.
As stock markets have rallied, the dividend market has improved, but equity income investors now face a different challenge – one of valuations. Thanks to the considerable bull run, the S&P 500 is now yielding less than 2%, great for those investors who got in early and have benefited from the total return, not so attractive for income seekers looking for fresh opportunities.
Rosie Bullard, James Hambro & Partners said that investors should expect falling payouts in the near term.
“Recent years have been characterised by companies returning cash to shareholders through share buybacks and special dividends due to demand from investors,” she said. “However, a greater level of acquisitions and rising capital expenditure may affect companies’ abilities to increase dividends in the short term.”
Artemis Global Income manager Jacob de Tusch-Lec agreed, saying that the last five years have been a sweet spot for large defensive income paying developed market stocks – and that the next five years will not deliver in the same way.
“When government bonds and interest rates and investor confidence are low you want stable income producing countries listed in developed markets,” he said. “These bond proxies have done incredibly well, they have been cash machines.”
Tusch-Lec says that this will no longer be the case and it is time for income seekers to get more nimble.
“The hunt for yield will not go away just because interest rates start to rise – it will be a slow process, but now defensives look expensive and vulnerable.”
Instead, income seekers should look to non-traditional income stocks, ones that pay a low dividend with the potential for growth – stocks that are not pharmaceuticals, utilities or REITS.
European stocks face similar difficulties. While the macro backdrop on the continent is not as healthy as across the pond, Andreas Zoellinger, manager of the BlackRock Continental European Income fund admits that valuations are not as attractive as they were two to three years ago but says that they are still below long term averages.
“With an improving macro-economic environment and falling political risk premium, we can anticipate more upside, in absolute terms, to European equity markets in the next 12 months,” he said.
“Over the last few months, the European equity markets, like the global equity markets, have seen a strong rotation out of sectors with very high momentum into sectors that have not performed well. Within the high yield dividend space in Europe, the infrastructure, insurance and real estate sectors are home to a number of companies offering good dividend yields which will be sustainable over the next few years.”
While dividend paying stocks in the US are relatively expensive, the valuation of emerging market dividend paying stocks remains particularly attractive on a relative basis.
Newton’s paper a Perspective on Returns details how in 2012, investors poured money into emerging markets in the hunt for yield.
“In a world of increasingly globalised trade and capital flows, shocks and the impact of policy settings in major economies have almost immediate spill-over effects internationally. Emerging economies have been the recipients of huge capital flows as a direct result of loose western policy settings and the 'hunt for yield' that those settings have encouraged.”
But since Ben Bernanke’s announcement last May that the US was going to taper its quantitative easing programme emerging markets have been volatile, and income investors have been put off by currency fluctuations. While many emerging economies have been doing their best to pay down their deficit, another threat looms on the horizon – rate rises in the UK and US.
As most emerging markets are still so capital intensive and rely on the cash flow from both corporate and private investors in the West, rate rises could halt the emerging market recovery.
Tusch-Lec says that although he is positive on equities over the long term, now might be time to take stock – and pause before investing.
“It is not the right time to be making market calls,” he said. “Once we have more clarity over rate rises, this will create opportunities globally. But at the moment we don’t know whether interest rates will rise over one, two or even five years. At the moment there is a policy mistake premium in the market.”
