The bears have all come out of the woods at the same time

The headline to the previous Inside Money column in February was ‘Will the last bear in the room please stand up?’ Few commentators or investors were expecting them all to stand up at once.

February and March marked a return to volatility in equity markets, with a vengeance. For some, mainly active, fund managers left behind by the seemingly inexorable momentum-driven rise, this was a welcome development. When shares get marked down, some are sold indiscriminately, which gives fund managers an opportunity to buy stocks they believe offer value.

Many investors reckon the ructions of February and March were a temporary blip: just a passing phase of a few bad days. For others, they were a red flag signalling that valuations had got ahead of themselves, particularly in the overheated US stock market, and that forecasts for the pace of interest rate rises had been underestimated.

Certainly, stock markets have reached an inflection point. The Facebook/Cambridge Analytica fiasco is a titillating sideshow. The growing threat of a trade war between the US and China is clearly concerning. But of more concern is the danger of a real and escalating conflict between the US and its allies, and Russia and Iran. Suddenly, the most recent of the depravities that have consistently punctuated the seven year Syrian civil war are a convenient excuse for dropping bombs.

There is nothing like a war, not to mention other recent media-diverting events, to draw attention away from what really matters: little things such as Donald Trump’s mental health and the merry-go-round of White House appointees, or how the outcome of Brexit ‘negotiations’ will most likely depend on the status of the Ireland/Northern Ireland border.

All of this will have a bearing on investor sentiment to varying degrees, but I believe we should also pay more attention to what marked the return to volatility back in February, namely the revised expectation for inflation and interest rates. It’s a real concern because of the amount of debt that has built up around the world. Far from deleveraging after the financial crisis, investors, companies and consumers (not to mention governments) have loaded up on the cheap debt made possible by quantitative easing.

That’s fine if you have a long time to repay at a low fixed rate, but otherwise a doubling or trebling of rates over the next year or two will really hurt. And that goes for banks and corporates as well as consumers.

Equity income angst

One group of funds that has borne the brunt of the sell-off is equity income funds. Returns from internationally oriented equity income funds have been depressed by the strength of sterling, while UK equity income funds have performed particularly poorly in the first quarter. One reason is that UK equities generally are viewed in an unfavourable light by global investors. A recent global survey of asset managers by Bank of America/Merrill Lynch found that fund managers are more pessimistic about UK prospects that at any time in the past 20 years.

However, equity income funds that invest in big dividend-paying companies will continue to find it particularly hard going this year. Chiefly this is because interest rates and government bond yields are creeping up in tandem with rising inflation expectations, so the shares of so-called ‘bond proxies’ – large global companies with secure cashflows and good dividend-paying characteristics – have been weak as investors step away and tiptoe back into bond markets, or retreat into cash.

To illustrate this point, put yourself in the shoes of an institutional investor and ask yourself this question. After nine years of virtually uninterrupted stock market growth, does a 2.8 per cent yield on a 10-year US Treasury bond offer a more secure total return than that offered by a bond proxy? Further, is that bond proxy a good investment when the dividend has been part-funded via the issuance of corporate bonds and the yield compressed by persistent share price strength?

Private investors, however, especially in UK equity income, need to ask another question: do I have time to ride out a potentially nasty fall in equity income funds? Dividend cover on FTSE 100 firms remains well under the comfort zone of two times the previous year’s earnings, for the fourth year running. According to stockbroker AJ Bell’s quarterly dividend monitor, dividend cover for the FTSE 100 as a whole is 1.7 times prospective earnings for 2018. For the 10 highest-yielding shares (yielding 7.9 per cent on average), the dividend cover falls to 1.4 times prospective earnings.

One can’t help but suspect that crunch time is coming for many big dividend-paying firms, particularly those previously viewed as bond proxies. Sterling’s strength over the past year – especially against the dollar – will depress dividends paid by many firms that derive earnings from overseas. In the aftermath of the Brexit vote in 2016, when sterling collapsed, the reverse was true.

Also, the UK’s post-Brexit prospects are uncertain, which may not bode well for the dividend-paying behemoths that are more heavily exposed to the UK. High-yielding FTSE 100 shares in this cohort include Persimmon, Barratt Developments, Taylor Wimpey, SSE, Direct Line, BT and Marks & Spencer, with yields ranging from 9.3 down to 6.8 per cent. Are these sustainable yields? While shares in these companies have mostly fallen further than the market, analyst estimates of their dividend payments have remained unchanged, according to consensus forecasts.

Should they prove unsustainable, investors will be hoping that banks and oil majors can take up the slack. The buoyant oil price should provide support for the latter, but the capital constraints placed on banks by regulators may limit their scope to raise payouts beyond what analysts already expect.

A sensible strategy for UK equity income investors to consider is to favour investment trusts with decent dividend reserves that can help them maintain and even increase payouts in times of stress. More far-sighted investors should also consider trusts that seek out progressive dividend payers further down the corporate size scale. One added attraction of such firms is that they are less researched by analysts, allowing eagle-eyed fund managers to spot current and future winners.

We live in an age of financial repression, where savers and investors are forced to shoulder ever-growing risks to maintain a real return on capital. Investors, particularly those for whom capital preservation trumps gains, may wish to consider allowing inflation to erode the value of cash for now, rather than risk the markets eroding the value of invested capital more rapidly. 

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