Uncertainty, much of it political, due to the looming fiscal cliff in the United States and the ongoing problems with the euro and government debt in Europe provide headwind for the financial markets and in particular equity markets. Investment managers who want to provide reasonable returns for their investors have to go back to the basics of investing with strategies that among others focus on dividend income, says Robert Pires, CEO of BIAS.
If the US Congress cannot agree to a compromise on the budget, the United States will face automatic spending cuts and the reversal of certain tax breaks that are going to force the economy back into recession. Add to that the persistent uncertainty in Europe and investment managers have to get back to the basics to deliver reasonable returns to investors, said Pires during the latest BIAS Quarterly Market Briefing at the Westin Casuarina on 20 November.
Contrary to the period of the 1980s and 90s, where markets were up 30 per cent per year and people came to accept that as the norm, today’s market reality is different, Pires says.
The 25 year period from 1983 to 2008 was characterised by government tax cuts and a leveraged private sector that drove up asset values. Investors preferred capital growth, taxed at a more beneficial capital gains tax rate, to dividend income. However, capital appreciation and upward price momentum were combined with an irrational exuberance that ultimately ended in a stock market bubble.
“What we have observed is that we have gone back to a more gentle phase,” Pires says.
A period that is more reminiscent of the 1950s and 60s, where dividend yield is becoming more important and higher than the yield on bonds, given the prevailing low interest rates. The Fed Model which compares the S&P 500 earnings yield with the US Treasury Ten-Year bond yield shows that stocks are yielding much more than Ten-Year Treasuries. “When this happened in the past it was followed by quite aggressive growth in the stock market,” says Pires.
Meanwhile there is a thirst for yield; investors are looking for consistency of income flows and companies are increasing their dividend payouts. Even companies that historically did not pay dividends like Apple are now changing tack.
BIAS believes this is the overlooked sweet spot for dividend centric portfolio investing.
In addition to rising dividend and stock yields, this strategy is supported by the lower volatility of dividend paying stocks compared to stocks that do not pay dividends. For instance the S&P 500 Dividend Aristocrats – large cap, blue chip companies within the S&P 500 that have followed a policy of increasing dividends every year for at least 25 consecutive years – have performed significantly better than the S&P 500 and S&P 1200 at lower volatility and thus provided a better risk-return profile, the BIAS presentation showed.
Historically there have only been a few periods, for example during the tech bubble in 2000 and 2001, when this trend was reversed.
Generally much of the investment return from equities comes from dividends rather than share price growth. From 2000 to 2010 87 per cent of the total return of the S&P 500 derived from dividends. If the 1990s are included, still nearly half of the total return (43 per cent) was dividend-based.
Equity markets returned over past 12 months
Despite the largely negative investor sentiment, the S&P 500 was the best performing asset class over the past 12 months with a gain of 15.2 per cent, followed by the global equity index S&P Global 1200 with 10.6 per cent and corporate bonds (8.7 per cent for a 1 to 10 year bond index). Emerging market stocks only showed modest growth at 3 per cent and the price of gold was largely unchanged with a gain of only 0.3 per cent during the past 12 months.
During the past four months however the picture was slightly reversed with gold and emerging market stocks leading the rally with 7.7 and 7.3 per cent gains respectively.
Many people are surprised that the markets are performing that well, Pires notes. Because of a focus on Southern Europe and quarterly reporting periods, performance and investor sentiments are not always on sync.
The effect of the fiscal cliff on economic growth
Yet over the next months uncertainty will return, not least due to the question whether the fiscal cliff in the US can be averted.
BIAS director Mark Melvin explained that the 2011 Budget Control Act mandates from 1 January 2013 automatic spending cuts of about $109 billion, the end of Bush era tax cuts of about $296 billion and the end of a 2 per cent payroll tax relief worth approximately $115 billion. The result would be a $520 billion drag on the US economy.
According to the Congressional Budget Office this would leave the US with a baseline deficit of $641 billion in 2013, which if extrapolated would enable the federal budget deficit to decline to 58 per cent of GDP from currently 73 per cent.
In the meantime however the US economy would be forced into another recession with an expected contraction of 0.5 per cent during 2013 and a higher unemployment rate of 9.1 per cent, according to a Budget Office analysis.
An alternative scenario that would see the extension of certain tax cuts and the prevention of some spending cuts would mean a growing budget deficit and an increase of the US federal debt to 90 per cent of GDP over the next 10 years. But the immediate economic impact, according to the CBO, would be a 1.7 per cent growth of the US economy next year and a lower unemployment rate of 8 per cent.
Depending on the outcome of the “fiscal cliff Kabuki dance” the financial markets will be impacted in different ways, Melvin argues. Under the fiscal cliff, equities and commodities would be depressed, whereas demand for bonds would rise. Under the alternative scenario, the effect on equities and commodities would be positive and the demand for bonds would be flat.