Growth style investing has largely dominated returns since the global financial crisis, driven by superior earnings growth that has led to higher valuations. But as the economic outlook across the globe starts to slow, the reliability and security of income within total returns and increased geographical diversification is starting to hold increasing appeal for investors.
The benefits of compounding accrued income for medium to long term investors are well documented, as you can see in this chart:
Source: J.P. Morgan Asset Management, July 2024
Obviously, there have been some bumps along the way. Many companies reduced, suspended or cancelled dividends during Covid. Yet steady, sequential dividend growers over the long term have delivered superior risk adjusted returns. With volatility expected to remain spiky, the defensive characteristics of dividend distributions are valuable sources of growth for multi asset portfolios.
Source: Capital IQ, Bloomberg and First Trust, 2003
When valuation expansion is capturing the limelight and dominating investor total returns, income generation and dividend growth could easily be forgotten. But in leaner times, and especially when valuations are extended, dividends and accrued income come to the fore. We believe this is where we’re heading now.
The timing feels right: we’ve passed ‘peak rates’ and central banks are shifting to easier monetary policy. This is our opportunity to ensure broad diversification of investment styles and geographical exposure are incorporated within portfolios so we can benefit from the anticipated declining rate environment.
Different sources of income
Within defensive assets (which includes bonds and diversified alternatives) lower rates support the relative attractiveness of their yields, along with longer duration exposure. You can read more about this in our recent article, Why duration is a client's best friend.
Global government bonds tend to have longer duration, offering insurance and protection within a diversified portfolio against unexpected negative growth surprises. 10-year Gilts and US Treasuries currently yield around 4%, offering scope for positive real returns, even if inflation sits slightly above central bank targets of 2%.
Investment grade corporate bonds yielding 5%+ with strong balance sheets, steady cashflow and a stable refinancing outlook also offer investors a favourable source of income with modest risk.
Within diversified alternatives, infrastructure looks well positioned to regain investor interest. Stable recurring operating cashflow reflects the quality of the underlying assets and our holding in Gravis UK Infrastructure Income has a historic yield of over 6%. This will become even more appealing as we move into a lower interest rate environment.
Among growth assets, the highest yielding regions are the EU and UK, with the FTSE All Share yielding 3.6%. In a falling interest rate environment, the sectoral composition of these markets makes them increasingly attractive. They have greater exposure to cyclicals, which typically do well as rates come down. Furthermore, UK payout ratios are still much lower than pre Covid, and with economic growth sequentially improving since the Q4 2023 technical recession, scope for upside surprise in dividend distributions is rising.
In the US, where economic growth is clearly slowing from elevated and, arguably, unsustainable levels, even tech stocks are including dividend distributions as a form of shareholder returns. As there are no discernible tax advantages in doing this, it’s likely an attempt to appeal to a wider investor base and reduce share price volatility.
Under the radar
Since interest rates reached their peak almost a year ago, regional yield factor returns have been quietly and consistently positive, other than in the US where the Magnificent 7 has overwhelmed all other factors. You can see this in the chart below. Even here, the last six weeks suggest things are changing. History shows that stealth-like drivers of positive return such as yield style investing should not be ignored.
Source: FTSE Russel and LSEG, July 2024
Dividends offer good long-term returns and diversification
Dividends are an important component of stock market total returns. When markets decline, dividends have the potential to offset losses, and when markets rise they have the potential to enhance returns. The power of compounding dividends is all too easily forgotten in the urge for immediacy. The diversification benefits from incorporating yield-focused assets within a multi asset portfolio are invaluable to strengthen the resilience, robustness and consistency of delivering attractive risk adjusted returns. That’s true, no matter where we are in the market and economic cycle.
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.
