Recent events – from the political to the economic – have conspired to test the mettle of even the most seasoned investors. Savers, particularly those using bond markets, have had their reserves eroded by a combination of inflation and a long period of very low interest rates. With the normalisation of monetary policy (the US Federal Reserve, for example, expects that rates will be increased “a few times a year” until the end of 2019) bond yields should rise. But while this is a positive for those trying to generate an income using bonds, the consequences for global equities could be less positive: stocks look less attractive to investors under such circumstances. Although some equity markets, particularly those in the US, have surged in recent months, there seems to have been little real foundation for the gains. Instead, they have been built on bombast and political rhetoric.
This brings us to another potential headwind for equities: the recent surge of populism in the political sphere. At the time of writing, it is unclear to what degree Donald Trump will implement the protectionist policies he touted during his election campaign, although he has not shied away from controversy in the early days of his presidency. In addition, we do not yet know the terms of the UK’s exit from the European Union. A worldwide decline in free trade could have severe implications for corporate earnings.
There is also the conundrum presented by an environment of increasing inflation and low economic growth. Before the Brexit referendum, Mark Carney, governor of the Bank of England, warned that leaving the EU could create just such a scenario — sometimes known as ‘stagflation’— for the UK. He predicted that a Brexit-induced decline in sterling could push inflation higher. Since the vote, the pound has fallen sharply and inflation in the UK recently touched its highest level since July 2014. Although equities are sometimes viewed as a hedge against inflation, increasing consumer prices have the potential to drive volatility and put pressure on future cash flows. And the UK is not the only country at risk from the phenomenon: we are yet to see the effects of Mr Trump’s policies on the US economy, while political tensions in Europe remain high.
Collectively, these circumstances seem to paint a pessimistic picture for those looking to gain an income from investing in global equities, but there is a potential upside: we have become relative veterans of political instability and uncertainty; we have lived with bank bailouts, national recapitalisations and dramatic government change for ten years. Now, as through those times, we believe that a focus on high-quality businesses combined with discipline on valuation will stand investors in good stead.
When it comes to finding these high-quality businesses for our income portfolios, we have several important considerations. Individual companies have to satisfy our criteria that they are likely to grow both their profits and their dividends. We also look for companies in regions that are experiencing economic tailwinds, rather than headwinds. Where is there potential for interest rates to come down? Where are corporate profits beating expectations? The answers to these questions are Asia and Latin America. Both regions have underperformed in recent years, but they have companies with strong balance sheets, good profitability and robust dividends.
Emerging equity markets had a very strong 2016, but we should view this performance in the context of the last five years and net investment withdrawal from the region. The rebound itself is unsurprising, given the depth of pessimism about the region at the beginning of 2016. There is scope for further improvement, should the trend continue.
Dividends, it seems, go in and out of fashion, but they are always of significance for individual investors. In some markets, however, they are ascribed little importance and there may be an almost inherent opposition to returning value to shareholders in this manner. Markets such as the US and Japan tend towards this view and as such, our portfolios are underweight in these areas.
In other regions — the UK among them — dividend coverage has become stretched and capital expenditure by companies has been very low. From this perspective, we must carry out exceptionally thorough research. We look deep into companies, choosing those that have good cash flow and are investing for the future, but that also have surplus cash available to pay dividends. It really is all about balance sheet strength and businesses having the desire and will to return cash to their shareholders. These in-depth research techniques make it possible to earn a steady income stream from a diversified portfolio of high-quality companies, even in the most difficult markets.
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