Global equity income
With several parts of the world appearing to be moving into or already in recession, which types of company are likely to be able to withstand this and continue to maintain or increase dividends?
Daniel Roberts, manager of Fidelity Global Dividend Fund (GB00B7778087)
We're able to find a number of attractively valued opportunities across a variety of sectors and regions, in businesses with the predictability and visibility of cash flows that we look for.
We continue to find such opportunities in the financial sector where our focus is on higher-quality, defensive businesses. Our non-life insurance companies have strong capital positions, should benefit from higher rates and show low correlation with the economic cycle – insurance contracts are non-discretionary purchases that should show resilience in a recessionary environment. Similarly, the outlook for our exchanges in the portfolios remains strong despite the macro backdrop. These are oligopoly businesses with low balance sheet risks which benefit both from higher interest rates as well as higher levels of market volatility that are likely to characterise the year ahead.
[The fund's top 10 holdings at the end of November included Zurich Insurance (CH:ZURN).]
Among the risks we must continue to monitor is the risk of government intervention. We have seen governments step into energy markets this year and may see other industries come under the spotlight, particularly with consumers under pressure. Factoring this risk into valuations will be key.
We won't alter our approach in 2023. We will continue to invest in high-quality companies with strong balance sheets, at attractive valuations and where we have a high level of confidence in the persistence of cash flows across the cycle which can support an attractive, growing dividend. We will resist the temptation to become more bearish as asset prices fall and instead will stay alive to opportunities in high-quality cyclicals if they fall further out of favour.
UK equity income
With deteriorating economic conditions in the UK, which sectors and companies are most likely to be able to maintain or increase dividends?
David Smith, manager of Henderson High Income Trust (HHI)
While the UK economy is deteriorating, there is an argument to suggest that dividends will be more resilient to any potential recession. Given the significant dividend cuts, suspensions and postponements as a result of the pandemic in 2020, dividends in some sectors are still only just recovering. At an aggregate level, market dividends are only back to where they were in 2016, while the dividend cover for the market is at a much healthier level now than in 2019.
There will of course be some dividend cuts. For example, mining sector dividends have probably peaked in the short term given dividend payments are linked to commodity prices that have fallen from their highs. And a slowing UK housing market could see UK housebuilders cut dividends. But on the whole, we expect payouts to grow at the market level next year.
For dividend security, the sectors that probably have the most certainty over dividend payments are pharmaceuticals, consumer staples and utilities, given their profits are typically less impacted by an economic cycle. These sectors continued to pay and grow their dividends through the pandemic.
[Henderson High Income Trust's top 10 holdings at the end of October included Unilever (ULVR) and AstraZeneca (AZN).]
Ironically, investors could see the best dividend growth in more cyclical sectors despite the prospects of a recession. Banks' dividends are forecast to grow at double-digit levels next year as the full benefit of higher interest rates offsets the possibility of increased impairments, assuming any recession is likely to be mild. While there is always a risk that the regulator may limit dividend payments from the banks, as it did during the pandemic, given the strength of capital ratios and more stringent lending standards over the past decade, we believe that they can still afford higher dividends even in a more difficult economic environment.
Bonds
Interest rates and inflation are on the rise. How can bond investors mitigate against this – where and how do you invest?
Mike Riddell, manager of Allianz Strategic Bond Fund (GB00B06T9362)
One of the most important things to understand when trying to predict where markets are likely to go is to appreciate what is already priced in. The reason that bond markets have been decimated in the past 12 months is because in summer 2021, markets were pricing in inflation rates broadly in line with central bank targets over the next few years, with very few rate hikes priced in. As inflation moved higher, the market priced in a huge number of rate hikes, central banks hiked at the fastest pace since 1982 and bonds saw the biggest correction in 40 years.
UK interest rates were at 3 per cent at the end of November, but the market is fully pricing in interest rates rising to 4.5 per cent by May next year, and they're expected to stay at around that level thereafter. It's a similar dynamic in many other countries, including the US.
So it's not about whether interest rates or inflation have risen this year, but rather about whether they are likely to rise or fall by more than what is already priced in next year.
My team's base case view for the past nine months has been that we are going into a severe global recession and that this greatly increases the risk of some sort of financial crisis. Markets are clearly now pricing in the risk of recession which was not the case at the beginning of this year. But we still feel that they are not pricing in an actual recession and definitely not the risk of crises.
A severe recession is likely to mean that we are very close to a peak in interest rates and there is growing evidence that inflationary pressure is now rapidly falling to the point where we think central banks could be in a position to rapidly cut interest rates in the second half of 2023. Bond markets are barely pricing in any rate cuts at all, at any stage.
Therefore, within our portfolios, we are very bullish on government bonds – in fact the most bullish we have ever been. We're also worried about risky assets such as corporate bonds, where the additional yield over government bonds appears insufficient for the risks. If interest rates start to fall, our funds could experience large capital gains.
Bond markets have recently been moving in line with equity markets. Will this continue, and how can bond investors make positive returns next year?
Ariel Bezalel, manager of Jupiter Strategic Bond Fund (GB00BN8T5596)
Inflation at multi-decade highs forced central banks to rapidly raise interest rates within a short period of time, pushing up bond yields across the board. That provided little respite to those looking for a diversification from equities as both asset classes suffered at the same time. However, we are now nearing the end of the rate hiking cycle as growth concerns increasingly occupy the minds of policymakers. For this reason, we would be inclined to expect lower government bond yields going forward and this has two important consequences.
Firstly, on a total return basis, we would expect once more to see a positive contribution from bonds in the context of a broader asset allocation. Such returns should come in part from the decrease in government bond yields but also from the higher initial yield offered to investors.
And secondly, bonds, especially high-quality government bonds, should once again be a diversification tool. In other words, we would expect once again to see negative correlation between equities and bonds.
Looking more granularly at the bond market, we find government bonds in the US, Australia, South Korea and New Zealand very attractive over the medium to long term. Valuations across parts of the developed market high-yield and investment grade corporate bond space are also looking compelling. Still, credit selection is important in this environment since default rates are set to climb in the coming years. Therefore, we prefer defensive sectors and secured paper in areas such as telecoms and cable, for example.
Global equities
With deteriorating economic conditions in many economies across the world, what is the best strategy for growth equity investors? What types of companies and which sectors can deliver growth?
Will McIntosh-Whyte, co-manager of the Rathbone Multi-Asset Portfolio funds
Our approach has always been to focus on high-quality businesses that can produce sustainably high returns on invested capital, are profitable today, and have sensible levels of debt, moats around their business models, a good degree of pricing power and management teams who understand how to benefit from or avoid disruption.
These high-quality businesses often come at a more premium valuation given the quality and resiliency of their earnings. That resilience is key, although the risk is that any disappointment from businesses perceived as resilient could result in an outsized negative share price reaction. Many of the companies which meet our criteria might be what people refer to as growth stocks – but not all growth stocks are the same.
Tech stocks continue to be an attractive area for investment. However, unpicking this increasingly disparate sector is key. Many companies that traded on incredibly lofty valuations in the past few years did so without the aforementioned quality characteristics. Many were not profitable, didn't have a truly defensible business model or, in some cases, didn't yet deliver a product or service to the market – for example, some of the more speculative technology stocks. We continue to avoid those companies and focus on quality, although you need to accept that while resilient, the majority of companies operating in this space have some degree of cyclicality.
The growth of cloud computing is one area of technology we continue to be positive on, and we own Amazon.com (US:AMZN) and Microsoft (US:MSFT) which we see as leading players in this space, as well as Alphabet (US:GOOGL). Again, we may see a slowdown in spending here and other parts of their businesses may prove more cyclical – this is especially the case with Alphabet. But this is starting to be reflected in their valuations.
We also remain positive on the semiconductor space, given its vital and growing role in the economy finding smaller, and more powerful and efficient chips. Demand in this area is moving from smartphones to applications in autos and industrials, among many others. We have a number of positions aligned to the semiconductor industry, including ASML (NL:ASML), the Netherlands-based producer of the most advanced machinery required by semiconductor fabrication plants. We also hold Cadence Design Systems (US:CDNS), a US based company that specialises in designing automation software, in particular the software for designing and testing semiconductors which are faster, more powerful and smaller.
Healthcare also remains resilient, with a number of structural growth tailwinds that should be supportive through a difficult economic downturn. This includes companies such as Dexcom (US:DXCM), which makes high-quality glucose monitors to help patients manage diabetes – a growing problem. And Sartorius Stedim Biotech (FR:DIM) is a leader in equipment and services for the development, quality assurance and production processes of the biopharmaceutical industry, and helps this burgeoning industry to develop and produce drugs safely and economically. LW
US
With a likely US recession, rising or high interest rates and inflation, and a likely drop in consumer spending how can US equity investors best position themselves for growth – at least over the long term?
Cormac Weldon, lead manager of funds including Artemis US Select (GB00BMMV5105)
Buy non-cyclical stocks – not every business finds its fortunes tied to economic growth. Healthcare, for instance, has its own drivers. The ageing population shapes demand for health services and products – regardless of the economic cycle.
Another area independent of consumer demand is infrastructure. Within our portfolios, we hold several stocks that should benefit from the huge amount of planned government spending on infrastructure and the transition to a net zero world. And there are powerful geopolitical tailwinds you can exploit. Concerns about China and over extended supply chains are encouraging some companies to relocate manufacturing or [at least] part of it back to the US, which also necessitates infrastructure spending.
Also seek bargains among the beaten-up stocks. There will probably be a slowdown in 2023: interest rates are higher than they have been for some years, although investors can overplay concerns. Usually, recessions follow big booms in consumer and corporate spending but we have not seen that excess.
Rising interest rates have resulted in the price/earnings valuations of growth stocks tumbling. Mortgage costs have risen for homeowners from around 3.5 per cent to 7 per cent in a year and demand for new homes has fallen markedly which has also had an impact on share prices in this sector.
Warren Buffett has said that it is only when the tide goes out that you see who is swimming naked. Dare to look closely and you can find plenty of businesses in beaten-up sectors whose share prices are being unfairly marked down because the market is making unwarranted assumptions about their attire.
We have begun adding selectively to software and housing-related stocks. We expect to build these positions over the coming six to nine months. At some point inflation will be tamed and interest rates will turn, and we expect share prices in these sectors to recover. You cannot wait until the fundamentals turn around to buy these things. The time to buy is just before the mood changes.
UK
What kind of recession are UK smaller company valuations now discounting, and where might we find resilience in a slowdown?
Anna Macdonald, co-manager of TB Amati UK Listed Smaller Companies (GB00B2NG4R39)
Most economists agree the UK is already in a recession; the debate centres on the length and depth of the coming slowdown. Much depends on how many more rate rises the Bank of England deems necessary to bring inflation under control. A resolution of the war in Ukraine would be deflationary, a resurgent Chinese economy would not. Further geopolitical tensions could rattle all markets.
Many domestic names are discounting continued pressure on revenues, as well as higher operational and financing costs, into 2023. How much of this is ‘in the price’? Valuations are at multi-year lows. However, there could be further downside. Some analysts have yet to fully reflect higher interest costs and exchange rate hits in their current and forward forecasts. It pays to be selective and consider which companies are vulnerable.
The cost of living crisis is hitting consumers, as they face higher mortgage costs, rents, energy and food bills. This has put retailers, housebuilders and leisure operators under pressure. Low labour force participation, with Covid and Brexit both impacting on the availability of staff, is forcing up wages. However, some companies are better positioned than others – the ones that face into advantaged households, and the ones who have hedged input costs and have low or no gross debt.
Well-run companies that have sector-leading advantages and the ability to pass on price increases will continue to grow revenues and earnings, and that growth should be well rewarded by the market. There are some resilient sectors, such as ones that benefit from continued trends towards outsourcing or help public and private companies digitalise safely. Defence spending in the west is set to rise, leading to revenue growth for related stocks. We expect that the UK will continue to be an attractive searching ground for private equity and corporates who saw valuations as compelling in 2022 and likely will in 2023.
Europe
With energy costs still at the forefront for many European equity investors, are energy-intensive industries to be avoided or do they look attractively valued?
Tal Lomnitzer, senior investment manager on the global natural resources team at Janus Henderson
Several energy intensive industries in our eyes look attractively valued despite the rise in energy costs.
European utilities have faced headwinds from rising interest rates impacting the net present value of their long duration cash flows, alongside windfall taxes as governments step in to protect consumers from rising electricity and gas costs. With the rate shock well understood by financial markets and clarity provided on interventions (with most countries having announced their windfall taxes) there is now more certainty around 2023 earnings estimates, and it looks like these companies are trading at attractive levels offering excellent dividend yields. With governments finally putting fire-fighting behind them, the next focus should be on the growth plans for supply to alleviate the current energy pressures.
The aluminium and steel industries are also energy intensive, indeed aluminium is sometimes described as solid energy given the large amounts of electricity required to refine bauxite into alumina and then into aluminium itself. The price of aluminium is deep into the cost curve, meaning that it does not have much room to fall. Aluminium markets are tight because many smelters have shut down in reaction to high power prices. This positions the sector well and makes current valuations look quite interesting for the larger companies with stronger balance sheets.
Steel prices have also been falling and look to be bottoming. Although we cannot rule out another setback, a recession looks fully discounted at current valuation levels. Meanwhile, balance sheet quality is at a multi-decade high, with huge amounts of cash parked in cyclical working capital and ready to be released, setting the sector up well for strong shareholder returns.
Japan
Is the value case for Japan still intact? What are the main arguments there now?
Richard Aston, portfolio manager of the CC Japan Income & Growth Trust (CCJI)
While the global economic and geopolitical backdrop looks increasingly complex, Japanese equities appear to offer compelling investment opportunities for international investors. The delayed economic recovery post-pandemic and the clear evidence of improved corporate governance create an investment environment that is somewhat differentiated from other regions at this point in time. The recent yen weakness, which has accompanied the monetary policy developments elsewhere in the world, only serves to enhance the value to be found in Japanese equities over the medium term.
For an investor seeking to capture a total and compounding shareholder return over time, Japanese companies are in a quantifiably more favourable position compared with their international peers with fewer financial constraints on their balance sheets and higher levels of dividend cover. The benefit of these characteristics has been clearly demonstrated during the past three years with a more consistent level of distribution to shareholders, in the form of both dividends and share buybacks, despite the sluggish trends in the domestic and global economies.
Aggregate dividends for the Japanese equity market are now at an all-time high and share buybacks have returned to record levels established pre-pandemic. This very clearly demonstrates the financial resilience of the corporate sector, the willingness of managements to adapt to the new era of governance in Japan.
A further revision to the Japanese corporate governance code in June 2022 and the restructuring of the Tokyo Stock Exchange indices in April 2022 have maintained the momentum initiated by former prime minister Shinzo Abe and are consistent with the clear objectives of improving capital efficiency, corporate governance and shareholder returns. As such, these have become primary considerations for senior managers of listed companies in Japan in a way that seemed unthinkable 10 years ago. It is shareholders now who are reaping the rewards.
Asia
Which regions look most interesting beyond China? And what are the main issues/risks to be aware of?
Yoojeong Oh, member of the portfolio management team of Abdn Asian Income Fund (AAIF)
Asia’s dividend stocks remain an attractive option for investors seeking inflation-adjusted income and resilient capital growth from their investments. The region is home to some of the world’s highest-quality businesses spread across sectors and countries – with robust balance sheets, relatively low levels of debt and the financial freedom to continue investing in growth and reward shareholders. We have seen dividend payments in the region rebound from the pandemic lows of 2020, even as central banks continue to tighten monetary conditions.
The sources of dividends are diverse across sectors, complemented by Asia’s structural growth trends. For example, an expanding middle class is fuelling demand for wealth management services, which creates opportunities for banks and insurance companies. We own DBS in Singapore as well as Kasikorn bank in Thailand – both of which are well known for their digital platforms and innovative ways of offering value to their customers. Elsewhere, policy support across Asia is shifting towards a lower-carbon future which benefits green technology companies in areas such as energy storage and electric vehicles – all of which we have exposure to in the portfolio through companies that are also committed to growing dividends.
Our largest positions are in markets like Singapore, Australia and Taiwan – where dividends are high and growing. This defensive portfolio has proven to be a welcome relief from the headlines coming out of China over the course of the past year. While financials, real estate and telecoms companies provide a steady stream of dividends, the company also invests in quality stocks that offer both capital and dividend growth. We find good opportunities in the technology sector, where we own industry leader Taiwan Semiconductor Manufacturing (TW:2330) which benefits from growing consumption of data via personal devices, cloud and the metaverse. At the same time, we also invest in companies such as Power Grid Corporation of India (INDE:POWERGRID) that manages power transmission across India while also investing in renewable energy sources.
There are risks that investors should be aware of: rising interest rates and sticky inflation have the potential to hamper a company’s growth prospects. Regulation may also cause further hindrance. In situations like these, active investing is key. We are able to manage such risks by doing thorough due diligence and relying on our bottom-up stockpicking approach that places quality at the forefront.
China
How do you counter the concerns that China has become uninvestable, and which sectors appeal most?
Mike Kerley, Asia Pacific equities portfolio manager at Janus Henderson
Although China has become a more challenging destination for investment in recent years, to say the country is uninvestable is a step too far. A lot of concerns emanate from the national congress in October, where president Xi fortified his standing by appointing allies to leading roles and messages emerged focusing on security and the continuation of the zero-Covid policy. Considering the environment these events should not be a surprise and the policies announced subsequently suggest that the leadership are well aware of the issues that face the country. It is important to remember that China needs growth to achieve its longer-term ambitions both in terms of economic development and security, as the only way this will be accomplished is to increase opportunity for its people and avoid the middle-income trap caused by an aging population.
As has always been the case it is important to invest alongside government objectives rather than against them. This is more important than whether the company is state or privately owned. Opportunity abounds in supported sectors and that includes the internet sector now regulatory lines have been drawn. Companies, individuals and investors are free to make money in China as long as it supports common prosperity, party policy and is not at the expense of the people.
The most obvious beneficiaries of China loosening the restrictions on Covid are in the consumer discretionary, travel and leisure sectors. Pent-up demand was a huge boost for economies in the west as Covid restrictions eased but could be even more powerful in China considering the huge amount of accumulated savings. These themes fit with government objectives and will be encouraged as they try and diversify away the economy’s reliance on fixed asset investment and exports.
Considering the fact that China will be the only major economy with higher gross domestic product (GDP) growth in 2023 than in 2022 and that the rest of the world will be experiencing anaemic growth or even contraction, the relative case is attractive. In addition, valuations are at decade lows, suggesting plenty of upside should reopening measures prove successful.
Emerging markets
With a global economic slowdown looking likely, where can an emerging market investor find resilience?
Nick Price, portfolio manager of Fidelity Emerging Markets (FEML)
When times are tough, the banking sector may feel like an unlikely destination for stockpickers. However, the financial services industry in the developing world has a distinct advantage and can benefit when inflation is high and rates are rising. In the main, emerging market central banks have hiked interest rates proactively and aggressively, to try and get ahead of inflationary pressures. Across central and eastern Europe and Latin America, we find banks capable of translating these higher interest rates into higher earnings.
In turn, improving fortunes underpin particularly attractive dividend yields. Of course, there is a need to be discerning, this is not an indiscriminate sector-wide call; it’s crucial to understand a management’s approach to running the business through the cycle. We like prudent, disciplined management teams at the helm of well-capitalised banks.
Furthermore, solid loan origination practices which can limit the extent to which loan books could be exposed to bad debts is critical. Elsewhere and perhaps unsurprisingly, more traditional food retail formats which offer shoppers good value have caught our attention. Select food retailers in South Africa and Poland must contend with inflation, but we believe some have more scope to pass on price increases.
Where the offering has strong appeal, this should drive higher footfall and market share gains, which can compensate for higher costs. We also believe that some parts of the market have particularly beaten up in 2022 given rising fears about the outlook for the global economy.
Here again, we believe the discerning investor can take advantage. Overall, the price of metals that are abundant in the developing world have been punished indiscriminately, but we are of the view that so-called ‘future facing’ commodities which are vital to decarbonisation and electrification can perform well. Their fortunes seem starkly at odds with the likes of steel, which will suffer in the wake of weakness in the property sector.
