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Yield pendulum at the apex

In its latest Australasian Equities Commentary Harbour Asset Management's portfolio managers discuss the outlook for dividend yields.

Wednesday, February 18th 2015, 11:50AM

by Harbour Asset Management

Defying gravity, it seems to us that the search for equity dividend yields has pushed the pendulum to its apex. In recent weeks yield stocks have started to lose momentum as pure dividend plays have become stretched like never before.

Some caution is warranted in pure yield stocks
Moreover, investors have left behind quality companies. Citibank say that globally yield stocks are trading at all time relative highs (since 1995) while quality stocks are trading at relative lows . We are not sure how or when this ends but caution is warranted.

Also as our fixed interest colleagues note, 15% of all government bonds on issue are trading at 0% or less. This isn't normal. Either nominal global growth is heading for 0% or less and central bankers are going to fail to encourage an expansion of activity and prices, or gradually we will see activity levels pick up a bit, and employment and wages improve.

Global growth is better than markets think
We disagree with the markets view that deflation is a current threat for the following reasons:

  • The US job market is as strong as it has been in a decade
  • Wage growth is evident, despite those worrying about deflation
  • The fall in oil prices has generated strong consumer confidence, and
  • While it seems increasingly likely that the US Fed will start raising interest rates this year, we expect this to be very measured.

The problem for markets is that Europe and Japan are not like the UK and the US, so we shouldn't expect a V-shaped recovery.  At best open ended QE in Japan and Europe that targets inflation will buy time for structural reform. In the case of Europe that reform may yet be enforced by markets. But what was scary financially is less so now, that has come at the likely long term repression of savers in Europe. To reiterate, globally the indicators are not as bad as the market is telling us.

Global excess credit growth, believe it or not, is still around 5%. That growth is led by the US, but the liquidity consequences are being felt globally. Excess credit growth (money supply growth less inflation) is correlated with asset prices. Furthermore, economic surprises are still tracking in positive territory, not by much, but by enough. Moderate credit growth and positive earnings surprises are not generally associated with falls in bond yields yet in January bond yields fell. From here, at least tactically we would expect either the economic data to fail, vindicating the bond market, or the pendulum to swing back. The January US employment report in our opinion is part of that swing back.

The fall in oil prices had a very negative first round impact on sentiment and equity prices. Now equity markets have partly decoupled from day to day volatility, and consumer confidence is rising in a number of economies, from the US to Spain. Consumers globally have had a boost to discretionary income.

We thought a year ago that likely returns in global fixed income were poor, now in our opinion they look very unappealing. However, even if many bond yields remain near to their zero bound and investors maintain their search for yield, in our opinion the yields available on growth and cyclical stocks demand attention.

The gap between say a yield on utilities and a portfolio of cyclical stocks is non-existent. Therefore yield stocks are not so appealing. The yield pick-up on a portfolio of growth stocks relative to a portfolio of yield stocks is only a little over 1% . But more to the point the Enterprise Value to EBITDA (EV/EBITDA) of the yield portfolio is higher than the growth portfolio suggesting that yield stocks are more expensive than growth stocks.

Source: Bloomberg and Harbour. Uses forward yield expectations from Bloomberg and compares the Harbour Australasian Equity (Growth) portfolio and the Harbour Australasian Equity Income portfolio.

Valuations in New Zealand equities look extended
But here's another note of caution, while growth stocks may look relatively attractive, valuations in some markets are over-extended. New Zealand valuations are now amongst the most expensive, with the overall market PE reaching 19.5 times at the end of January on a forward looking basis (for the NZS50 index). According to Forsyth Barr that is 28% above long term averages. Even on a median basis the forward PE is now 17 times, 18% above the long term average.

Valuations have risen from depressed levels. We have had nearly six years of a bull market. A significant portion of that rally in equity prices has been driven by valuations rising. Despite the further rally in bond and credit markets, in our opinion it is hard to see equity valuations rising further in New Zealand.

In Australia the perception of the economy remains poor. The Reserve Bank of Australia apparently agrees given that it cut rates unexpectedly in January. We think that while the outlook for the Australian economy may not be robust, companies are well placed.
Many Australian companies face global growth and, outside the resources sector, they are reporting generally strong cash flows and a lower Australian dollar is also helping. In addition the cut in rates sends a signal that the RBA wants to ensure a recovery occurs. It appears to us that this move has triggered renewed interest in Australian stocks from global investors that are underweight Australia relative to their benchmark indices.
From here, companies in both Australia and New Zealand need to deliver earnings and dividend growth and hit or exceed milestones for expansion. Accretive merger and acquisition activity may also be a feature of the market, but we will be wary of promised synergies.

Outlook – the unwinding
2015 starts as the battle to fight disinflation. It seems co-ordinated. And yet growth in 2014 was about 3.3% globally and over 3% in New Zealand. Growth is expected to be much the same globally, the outlook for New Zealand is still strong, but slightly clouded by a drought and lower dairy prices.
We expect bond yields to gradually rise in 2015. The problem is that is unlikely to happen. Markets don't do gradual. Markets have the potential for significant volatility - while the ride down in yields has been a bit like a pendulum nearing the apex, the unwinding, if it happens could be more dramatic.

Expect a more modest return from higher yielding shares
But if, through some miracle, we get an uptrend in bond yields, we should expect globally a more modest return from higher yielding shares. In some parts of the world the doors to exit are narrow and a reversal of recent money flows could be painful. But that is not our central scenario, but it is one we need to consider given the extremes of market valuations.

We think it is rational to focus on companies that are upgrading earnings and dividends in a sustainable way. In a low growth environment we think upgrades should be rewarded more than pure yield.

Boiling that down in a portfolio context - we are sticking to our core exposures in stocks that have strong competitive positions and where possible double digit sales and earnings growth. We think that growth is significantly mispriced by the market and that companies with a reasonable dividend and dividend growth will prove to be the place to be should our expectation of a change in market direction play out in 2015.

Andrew Bascand, Shane Solly, Craig Stent


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