15 Feb 2016
The rise in interest rates in the US and continued quantitative easing in Europe and Japan are putting enormous stresses on global markets. Jacob gives his outlook for the macroeconomic environment – and for the Artemis Global Income Fund as he avoids crowded trades and big contrarian bets.
Jacob de Tusch-Lec has managed the Artemis Global Income Fund since launch in 2010. It is the best performing fund in the IA’s Global Equity Income Sector. Here, he discusses three of the factors that are informing the fund’s composition today:
- Why he foresees pressure on dividends – and why he is placing a greater emphasis on dividend growth.
- What the ‘great unwinding’ of trades made popular by quantitative easing tells us about the prospects for the so-called FANG stocks.
- And why, counter to expectations, the application of quantitative easing (QE) in Europe and Japan is having a deflationary impact on the global economy.
The dividend challenge
As returns from ‘bond proxies’ in January attested, the first rise in rates by the US Federal Reserve in almost a decade did nothing to quench the market’s thirst for income. There was no increase in yields for investors to harvest. In fact, in certain areas of the equity market, yields were compressed (that is, the gap between low and high-yielding stocks shrank) still further.
In part, this was because worries about deflation meant the bond market judged that the Fed would not be able to raise rates again until 2017. In that, bond investors may be getting slightly ahead of themselves. Economic news has certainly been very poor. But, as investors should have learnt, things can change rather rapidly – and predictions will change if there are some stronger economic readings. But it does appear that the path towards tighter monetary policy which the Fed set down last year was too optimistic. We know it wants to increase rates – but the conditions are just not in place. The problem is that whatever the Fed does could be considered a policy mistake after the fact (indeed some voices are already calling for a cut). So even if it doesn’t raise rates again, markets could remain more volatile for the foreseeable future as the probability of a policy mistake is priced in.
In the Artemis Global Income Fund, our tobacco companies (Reynolds and Altria in the US), our utilities (Enagas in Spain), our real estate investment trusts (TLG in Germany) and our telecoms companies (Bezeq in Israel) all did well in January. In a deflationary world, the hunt for yield means that the shrinking pool of equities with bond-like characteristics is in ever-greater demand. Some $6 trillion of bonds issued by governments in developed markets are trading at negative yields. In a sense, our fund is part of this search for yield; hunting for dividends is an important part of what we do. Although we don’t have a dividend target, we buy companies which have the potential progressively to increase cash returns to their shareholders or which are sufficiently cheap that the current dividend yield make them a valid investment.
Since its launch in 2010, the fund’s distribution payments have increased at a compounded annual growth rate of around 8%. If we look forward, however, our quest is unlikely to get easier. On the one hand, the weight of money chasing yielding assets is consistently pushing yields lower. This means it is hard to replace things in the portfolio at the ‘old’ levels of dividend and free cashflow yield.
At the same time, there are clearly significant pressures on the ability of companies to pay (higher) dividends. The challenges are particularly acute in the UK, where there are likely to be wholesale cuts to dividend commitments across the oil and resources sectors, traditionally the two big dividend payers. But even in the US, where energy and mining are a far smaller part of the equity markets, payouts are coming under pressure from a combination of factors.
First: wages. After six years in which wages have stagnated, there is a growing clamour from (populist) politicians for companies to adopt a ‘living wage’. It seems reasonable to expect that labour will start to get a slightly larger slice of the pie. Low unemployment in the US is creating pressure for wages to rise in certain parts of the labour market.
Second: borrowing costs. Thanks to QE and a long period of zero – or near-zero – rates, companies have had access to almost unlimited quantities of cheap capital. That has allowed them to borrow at pre-tax rates far lower than the returns from their investments or any acquisitions they might choose to pursue.
And for many companies, their borrowing costs have been far lower than the dividend yield they have been paying, even after tax. No wonder the practice of issuing debt to buy back shares has been so popular. Today, however, the Fed has gently begun to increase the cost of capital. On top of a higher risk-free rate, corporate borrowing costs – credit spreads – have increased quite dramatically over the last six to nine months.
Third: the need to invest. Since the financial crisis, investment and capital expenditure has been rather low, with many companies able to outsource functions to emerging markets and to sweat their assets. But that trend is starting to go into reverse: companies need to invest if they are to grow. Finally, there are signs that governments also want to grab a bigger share of corporate cashflows and, as Google’s recent experience suggests, they are willing to take a tougher stance on tax to do it.
To me, all this suggests profit margins may have peaked for this cycle. Price-to-sales ratios for global equities are at record highs. And, historically, that is bad news for equities: when profit margins peak, p/e multiples start to fall.
Given these pressures, we think dividend growth could come under pressure – and that companies who are able to produce it merit a premium. So we have moved more towards stocks which produce dividend growth, in some cases sacrificing a high yield today in exchange for the prospect of higher dividends in the future. We have put more capital into companies such as Roche, GE and Apple. These have relatively high dividend growth rates but yield less than the portfolio overall. Not all of these investments have been successful so far. But this shift means that we estimate dividends produced by our companies will grow by 8% over the next year – a significant increase from the 3% we expected just six months ago.
Waiting for the great unwinding
If we measured the amount of money flowing into various asset classes (relative to their size) since the Fed introduced QE and then made a brief list of the most popular investments, it would include: 2010 – emerging-market debt; 2012 – high-yield bonds and MLPs (master limited partnerships – the oil and gas pipelines needed by the shale energy industry in the US); 2013 – MLPs again; 2014 – investment-grade debt.
Last year, as investors looked ahead to the first rise in US rates for a decade, we saw some of these QE-driven trades being unwound, sometimes dramatically. That provided another potent demonstration of how the weight of money chasing returns in a world starved of yield can cause respectable investment themes to become crowded trades. Flows follow performance. So, as we see these former darlings selling off, we must think about which assets will roll over next.
Might it be today’s popular trades: tobacco, US staples, food & beverage stocks? Multiples in those sectors are above their historic norms. But these valuations have much stronger underpinning than the heroes of 2015 – the so-called FANG stocks (Facebook, Amazon, Netflix and Google). It was this latter group that started to feel the pull of mean reversion in January. Market history tells us that at some point momentum trades go into reverse and that the results can be messy. If we do see a change in the macro environment, the corrections in once fashionable areas could be dramatic. Fast-growing companies (FANG stocks) and more defensive but high-quality stocks (food, beverage and tobacco) have done very well. Although it might be too early to rotate from ‘growth’ into ‘value’, we sit somewhere between the two styles aware there is no reason why cheap value stocks shouldn’t start to outperform the more expensive parts of the market.
So, this is not an environment to take big, contrarian bets on stocks that remain resolutely out of favour. The poor recent performance of our holdings in cyclical value stocks (especially those with gearing) has demonstrated that. But nor is this the time to chase momentum blindly. Instead, we are watching data on the economy closely and monitoring the market’s response. We proceed with caution.
Why quantitative easing is deflationary
When the Fed stepped away from QE, investors thought – or hoped – it was passing on the baton to Europe and Japan. The application of QE in the US was controversial – but it worked: asset prices rose and the deflationary pressures in the economy were staved off while employment recovered. As the wealth effects from QE rippled through the economy the US recovered somewhat. The hope was that the creation of new reserves by the ECB and Bank of Japan would have a similarly positive effect. But it doesn’t seem to be working. In fact, it is becoming apparent that QE works much better in the US than it does in the rest of the world. Why? Perhaps because in the US the banks were cleaned up and their balance sheets rebuilt, allowing them to act as an efficient mechanism for transmitting loose monetary policy (we are seeing signs of a credit cycle emerging in the US). Further, there was enough underlying growth to allow QE to have a multiplier effect.
In more deflationary economies, QE has simply driven the dollar higher, sent commodity prices down and so hurt emerging markets, which are important export destinations for Europe and Japan. This creates a feedback loop, putting pressure on central bankers to apply even more QE. In a world with no underlying growth, deflationary QE is worse than useless. Policymakers in these deflation-prone economies might need, at some stage, to turn to a solution even more politically controversial than QE – fiscal stimulus – to kick-start growth. Now who wants to tell Wolfgang Schäuble?
Jacob de Tusch-Lec manages the Artemis Global Income Fund
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