Scramble for yield favours high income global equities

If investor sentiment in 2012 was characterised by a flight to the safe haven of cash and bonds, 2013 is likely present new and different challenges, as interest rates remain at historically low levels and cash struggles to provide acceptable returns. 

Battle weary investors are starting to look further afield and ask where the smart money can find outperformance now.
 
The answer could well be high yielding global equities, says Stephen Thornber, Portfolio Manager at Threadneedle Investments. 

“In the current low yield world, the right global equities have the potential to give investors both a stable source of income, as well as potential capital growth,” he says, “and for investors looking for a reason to exit the save haven assets, that’s a heady mix.”
 
Mr Thornber explained that the move to cash in 2012 was the result of investors trying to mitigate the risks associated with three key global themes; the fiscal cliff, the effect of the leadership transition in China, and the drag of the Eurozone crisis.  

“Any uncertainty unsettles markets, and investors were understandably attracted to the safety of cash and bonds,” he said.
 
This year however, the situation is quite different.  Mr Thornber explained that as 2013 unfolds, fears of impending doom are starting to abate.

“There is increasing optimism about the global economy,” he explained “a compromise was reached on the fiscal cliff, concern over the Eurozone is starting to ebb, and signs are emerging that the Chinese economy is picking up pace.” 
 
However, interest rates remain at historically low levels, and with global economic growth still sluggish, this is unlikely to change in the near future.  Cash will not be able to provide the high returns and income that investors, particularly those heading into retirement, are looking for.  All of these factors have combined to encourage investors back into risk assets such as equities as a means of taking advantage of the potential upside associated with improving global economic conditions.
 
Mr Thornber said that contrary to what some investors might think, global equities have been relatively stable over long periods of time, and that on a yield basis alone, are still holding up well.
 
“And while many high yield assets are becoming more and more expensive, many equities, relatively speaking, are cheap at the moment.  And what makes high yield global equities even more attractive to us is that we are starting to see payout ratios increase in the US, Europe and Asia.”
 
“Following the GFC, many companies sought to protect and consolidate their balance sheets and as a result there was a significant compression in payout ratios.  However, with improved global economic data and stronger corporate profits in many sectors, payout ratios are starting to improve,” he explained.
 
Mr Thornber concluded by saying that he believes investors will continue to rotate into risk assets in 2013, but only where there are prospects of real returns. 

“And that’s where Threadneedle’s Global Equity Income strategies have been able to perform well.  We leverage the insights of colleagues from across the investment floor covering various asset classes to gain a better perspective and understanding of the key macroeconomic developments and themes that are likely to play out. We then pick stocks that meet our yield targets and also provide the potential for sustainable growth,” he said.

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The search for income – already a powerful investment theme – is set to grow in importance over the next decade and beyond. There are a range of near-term and longer-term drivers:

• low interest rates and bond yields are driving a broader search for yield
• slower economic growth in many developed nations burdened with high debt levels is likely to put greater emphasis on income returns versus capital gains
• two large corrections in stock markets in 10 years have deflated sentiment towards equities, forcing investors to reassess their strategies
• the funding challenges facing governments hamstrung with public debts is likely to lead to responsibility for retirement saving increasingly falling on individuals
• aging populations with people living longer will increase retirement saving
• the need to maintain or grow real income levels during retirement to protect the purchasing power of savings from inflation will support investment in real, income-paying assets.

The investing environment of tomorrow is set to be quite different to the one which investors became accustomed to in the last 25 years.

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However, bank term deposit rates have fallen and are likely to fall further, possibly to around 4%, as the RBA continues to reduce the cash rate to help the economy. So it makes sense to look elsewhere.

Our view is that the RBA will cut official interest rates from 3.5% currently to 3% or just below over the next six months on the back of sub-par business and consumer confidence, disappointing growth and benign inflation. While the RBA is currently putting out a relaxed and comfortable message it should be noted that it put out a similar message earlier this year only to commence cutting interest rates again in May.

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30 July 2012

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2011 is the time to implement proactive wealth building strategies after a volatile year in which investors and advisers focused on rebuilding investment portfolios and digesting multiple Government reviews, according to leading independent technical strategists Strategy Steps.

Led by Assyat David and Louise Biti, the firm provides high level investment and technical strategy advice to financial planning firms.

“2010 was a mixed year for investors as their recovery from the GFC was hampered by volatile share markets, a surging Aussie dollar and a swag of government reviews in the financial services sector,” said Assyat David, Director of Strategy Steps.

“For financial advisers, 2010 marked a year of fundamental change in their industry as they face a legislated ban on commissions, which has prompted a rethink of the advice value proposition,” she said.

Reduce exposure to Australian shares

As investors and advisers develop wealth building strategies for 2011, Ms David said investing only in Australian shares is an increasingly risky proposition with financial and materials stocks now representing a staggering 60% of the Australian share market (S&P/ASX 200), and the top 10 stocks representing 52% alone.

“Investors have enjoyed a love affair with Australian shares which is understandable given our home country bias and the lure of franked dividends, but this is an increasingly risky strategy, given the very narrow focus of our market,” said Ms David.

“There’s also a view that investing in globally-focused Australian companies is a good way to get overseas exposure but this is misguided as it only increases an already risky proposition.”

“While the commodities boom is a great story for Australian investors, history has repeatedly shown mining booms follow a volatile boom bust cycle, so investors should take heed and spread their exposure across sectors and markets,” Ms David said.

Manage longevity risk and generate income

Ms David says many previously high flying income products such as mortgage funds and listed property trusts came to grief during and after the GFC which taught investors that higher-thanaverage yields can carry structural risks. 2011 calls for a new approach focused on balancing income generation and an investor’s longevity risk.

“A crucial issue in designing an income strategy is to determine the type of income required by an investor, including whether it is essential income or discretionary income,” Ms David said.

Louise Biti, Director of Strategy Steps, said an individual’s longevity risk is also increasingly part of a savvy income generation strategy.

“The greatest fear of retirees is that they will exhaust their savings before they are ready to give up activities in retirement which require discretionary income, including travel and leisure pursuits,” Ms Biti says. “Planning ahead can go a long way towards alleviating longevity risk, and a strategy may include a combination of account-based pensions which provide access to capital, annuities which guarantee essential income, and then if required, reverse mortgages and social security solutions.”

Return to gearing – responsibly

Ms Biti said 2011 is also a good time to return to gearing, but the lesson from recent market experience is to stay in control of a gearing strategy at all times, she said.

“With any gearing strategy, whether this is a mortgage, a margin loan or limited recourse borrowing in your SMSF, it is crucial to manage the loan-to-valuation ratio, ensure you have access to other income, have adequate insurance and set up the right structure.”

Build your superannuation – Maximise contributions and avoid ATO penalties

In 2011, investors and advisers should focus on ways to maximise superannuation savings, Ms Biti said. The lesson from recent experience is to use the rules carefully to avoid tax penalties for excess contributions.

“You need to keep track of all contributions, often over several years, to stay within the caps. And if you are an investor aged over 50, aim to maximise the $50,000 a year pre-tax concessional contributions cap before it becomes means tested in 2012.”

“If you are a business owner, consider transferring your business real property into an SMSF and/or contribute sale proceeds to super using small business CGT caps to give your savings a boost,” Ms Biti said.

Seek holistic advice

In 2010, advisers had to rethink their value proposition to position for a fee for service regime, therefore investors should start asking what services their financial planning firm can offer them outside of pure investment advice, Ms David said.

“In 2011, advisers should seek to build their value proposition by taking the same advice they give investors, that is, they should look to diversify their business offering with value added services including aged care and estate planning advice,” Ms David said. “Strategy Steps is already assisting forward thinking financial planning firms to do this.”

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About 135 million people around the world are estimated to have escaped from poverty between 1999 and 2004. That means that a population greater than Japan’s (126 million) was added to the pool of global consumers in just five years.

Over the next few decades, the number of people considered to be in the “global middle class” is projected to jump from 430 million a decade ago to 1.2 billion by 2030, according to the World Bank. Most of the new entrants will come from China and India, where consumption is surging. The World Bank predicts that by 2030, 93% of the global middle class will be from developing countries, up from 56% ten years ago. (The bank defines the global middle class as individuals earning an income between the per capita income of Brazil and Italy.)1

These facts explain why so many companies are developing presences in emerging markets; from Asia to Brazil, from sub-Saharan Africa to Russia. They want to capture rates of consumption growth that are unimaginable in mature western economies.

Asia’s potential consumption is huge. The outlook, though, is complicated by a preference for saving that is partly due to the lack of a social safety net. China’s government, for instance, boosted the incentive to save when it privatised housing and the pension system in 1999 and suggested households should be responsible for their own education and healthcare needs.

As a result of the global credit crunch, however, countries including China have conducted massive stimulus programs and many governments are under pressure to implement social reforms. A combination of income growth and social reform would ignite Asian consumption in coming decades.

While China may be one country everybody is watching to see the consumer revolution take hold, private consumption in India accounts for a higher share of GDP than in China – about 55% versus around 50% in China and about 70% in Australia. In India, rising incomes and readily available retail credit have encouraged consumption growth of 5% to 7% a year over the past decade.2

The outlook for further growth is compelling thanks to India’s rising proportion of young workers. McKinsey forecasts that India’s middle class will grow from 5% of the overall population now to 41% by 2025.

As this occurs, Indian spending habits are likely to change. At present, spending in shopping malls is a tiny percentage of total spending because most money is spent with small traders in public markets. The difficulty for foreign retailers is that India bans foreign investment in multi-brand retailing, so local players such as Reliance, Bata India and Pantaloon Retail are gaining footholds in the expanding formal shopping market.

While consumerism is still to fully grip China and India, it is embedded is some emerging markets such as Brazil, the most western of the BRICs. The South American country, for example, is now the third-biggest market for beauty products after the US and Japan.

Changing patterns

As incomes grow in emerging markets, the proportion that is spent on necessities shrinks. As the disposable income of emerging consumers grows, so too does the allure of the coolest fashions and the latest gadgets. Consumption patterns in emerging markets are already changing as this trend develops.

While western consumers grow resistant to advertising, forcing companies to be more innovative, multinationals are using time-tested aspirational advertising to build brands in emerging markets.

Guinness, for example, is what the upwardly-mobile Nigerian man ought to be drinking, according to an advertising campaign in the African country. And drinking it he is. Nigeria has recently become the largest market for Guinness in the world.

Another area reliant on advertising that is growing strongly in emerging economies is western-style fast food. Yum! Brands, whose portfolio includes Pizza Hut and KFC, has opened 200 restaurants in India that are achieving revenue growth of 40% a year. In China, the company has around 3,000 KFC outlets and 500 Pizza Huts. Incredibly, it sees the potential for 20,000 restaurants in China.3

Tourism and leisure are classic areas of discretionary spending that are set to surge thanks to the growth in the middle class. Companies such as Ctrip.com, which is China’s dominant online and telephone travel agency, stand to benefit. Li Ning is the leading player in sports apparel in the mid-end segment, just below the high-end names of Nike and Adidas. So it’s well placed to capture consumers trading up from the low-end of the sports clothing market.

And then there’s the potential for the luxury goods market. The elite in emerging markets are happy to indulge in ostentatious purchases to underline their status and reward themselves for their endeavours. This invariably means luxury western brands are in great demand from a relatively small, but high-spending, portion of the population.

The western luxury goods companies have noticed. They have expanded their presence in key financial centres where wealth has accumulated, such as Shanghai and Moscow.

These companies benefit from the fact they have no local competition. In the low- and mid-market areas, there are abundant local competitors who can compete on price. The top end, however, enjoys the exclusivity and allure that comes with high prices. Companies such as Burberry, LVMH and Richemont are poised to benefit as the top strata of the emerging middle class expand.

While industrial investment themes may reward investors only over specific parts of the investment cycle, the steady growth in consumption represents a compelling and enduring theme over the 21st century that deserves long-term inclusion in any equity investor’s portfolio. After all, every few years there’s another Japan worth of new middle-class consumer to target around the world.

Massive growth in the global middle class

World Bank. 2009

1 World Bank. worldbank.org. As quoted by Citigroup. “Emerging market consumerism”. 15 September 2009
2 DataStream. National statistics. June 2010
3 Citigroup. “Emerging market consumerism”. 15 September 2009
All information comes from Bloomberg and Citigroup unless stated otherwise.

Important information

References to specific securities should not be taken as recommendations.

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