2022 won’t be remembered fondly by many UK investors. With inflation spiralling higher and central banks raising interest rates, global equities and bonds have weakened. Government bonds have been particularly affected by inflation and interest rates, not to mention the UK’s chaotic political system. When markets and economies are mired with increased uncertainty, the natural instinct might be to sell. But bond yields have risen to levels not seen for many years, and opportunities for both income and capital growth are now arguably compelling.
My word is my BOND
The last time 10 year gilts yielded over 4% was 14 years ago, before the Global Financial Crisis (GFC). Gilt yields rose to these levels following the UK government’s mini budget in September, as you can see in the chart below. This is a staggering jump, considering these yields were less than 1% only a year ago, and particularly in bond markets where sharp moves aren’t common.
Source: Trading Economics, United Kingdom 10Y Bond Yield over the past 25 years, data to 19th October 2022
When bond yields rise it’s at the expense of capital, primarily caused by rising inflation and interest rate expectations. Lower risk investors with higher allocations to fixed interest have felt the most pain. While we don’t know when the market will bottom, it’s often at the point of extreme pessimism. We’ll only know for sure once it’s happened.
We believe most of the downside is priced in so we expect to see meaningful long-term recovery. With government bond yields at current levels, and corporate bond funds yielding nearly double that, we can’t ignore this is an extraordinary period for fixed interest. Risks remain in the UK with further macro and political uncertainty, and further interest rate rises as the Bank of England looks to contain inflation. But once inflation visibly slows down, we’ll have a better idea of when and at what level interest rates may peak, and the bond market outlook should improve significantly.
Paying dividends
Like bond yields, UK dividends also arguably look attractive. Since recovering from Covid, company balance sheets are healthier, and businesses previously seeking to replenish their cash flows and dividend cover have started growing their dividends. There are many companies with strong pricing power passing on higher input costs to the end consumer, so inflation hasn’t significantly impacted their profits and dividends have been somewhat protected. However, inflation risks remain and may start to impact the earnings of those companies unable to pass on higher costs, but this is already being priced into equity markets.
The chart below shows the dividends paid each year in the UK since 2007. Since the dip in 2020, UK dividends have increased. Similarly, global dividends rose by 11.3% in Q2 2022, with the UK and Europe the key drivers and pay outs growing by 28.7% and 29.3% respectively (1). This been boosted by the strong dollar, but regardless of currency movements, dividend pay outs are seeing an upgraded forecast for the rest of the year.
Source: Link UK Dividend Monitor, Q3 2022
When combined with capital, income can be an important element of total returns. During the period when markets were driven by growth stocks, income (and value stocks) fell down the pecking order for many investors. But in a more subdued environment, income will be more sought after - providing we don’t fall into a long drawn-out recession. Higher quality companies with strong balance sheets should be able to withstand more difficult conditions and maintain dividend payments.
All about balance
Fixed Interest and UK Equity Income are just two of the many assets we look at, and form an important part of our decision making. Our ultimate goal is maintaining balance by asset class, market cap and style so our portfolios deliver as expected. No matter how challenging this year has been, we remain fiercely disciplined. We won’t be swayed by short-term noise, but we’re not afraid to take advantage of long-term opportunities either (where the mandate allows). We believe this will lead to better consistency of risk adjusted returns over the longer term.
(1) Janus Henderson Global Dividend Index, August 2022
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity.
Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.