Investing for income in a post-Covid world

Many companies have withdrawn or cut dividends to help deal with the Covid-19 pandemic. Jon Cunliffe, Chief Investment Officer, looks at the strategy income seekers need to adopt.

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  1. Jon Cunliffe

Since the financial crisis a decade ago, central bank policy has consistently rewarded borrowers at the expense of lenders. Following the outbreak of the Covid-19 pandemic, this is likely to continue for longer.

From a policy perspective, there is much support for this approach. Levels of indebtedness are high, and the record-low level of interest rates and bond yields are a key policy tool to support economic activity – which will reduce the risk of a damaging wave of companies defaulting on their loans. A natural consequence of the central bank reaction to the pandemic is that we remain, more than ever, in a world characterised by a structural shortage of income-generating assets.

This policy comes at a price. Savers may feel the need to set aside a greater proportion of their income to generate the yield they need from their savings. Pension fund deficits will increase, as future liabilities are calculated using bond-based discount rates. There is also the risk that capital will be misallocated in favour of investments that currently offer an attractive high yield, but which have poor quality earnings growth and stressed balance sheets. This has certainly been the case in the UK stock market. 

The chart shows the total return of a well-followed UK equity income strategy compared with the FTSE 350 over the last 15 years. It tells us that the higher income strategy has come at the cost of overall investment returns. Why is this the case?

The large dividend payers have tended to be in sectors that are most stressed by the economic environment that has existed since the financial crisis – and this has been amplified by this year’s pandemic. These sectors include oil and gas majors, materials and large financials. The lack of vigour in the global economy over recent years has been a significant headwind for these more cyclically-exposed sectors. With many investors holding their shares for their above-average income, many companies have had to engage in financial engineering to support high and potentially unsustainable dividend payouts. 

Dividends - chart

If the macroeconomic environment has been generally challenging for high dividend payers, it has been a boon for others. Companies that can demonstrate an ability to grow their earnings at an above-average rate – without an unwelcome degree of cyclicality – are attractive prospects right now. Investors have been crowding into these shares which, as a consequence, have attracted a higher market rating. 

Although volatility is likely to remain, the world economy is expected to ‘muddle through’ this crisis, helped by policymakers using all the tool at their disposal. With central bankers committed to support equity markets, investors are likely to be willing to continue to pay a premium for companies with a high degree of future earnings visibility. This means their valuations will probably stay elevated.

Elsewhere, UK equity investors need to be aware of the high degree of dividend concentration within the FTSE 100. As I write, 55% of expected dividends are accounted for by the top ten dividend payers – and almost three-quarters of dividends come from the top twenty.

If the outlook for corporate earnings was constructive – and the proportion of dividends covered by earnings reasonable – this would not be such an issue. But, clearly, neither of these is the case right now. We expect corporate earnings will not recover to pre-pandemic levels before the end of 2021 – and some of the largest income payers have earnings that do not cover, or barely cover, their dividend payments to shareholders.

All of this suggests that UK equity investors should, where possible, adopt a total return approach – avoiding too much exposure to higher-yielding equities with a high degree of indebtedness, earnings cyclicality and low dividend cover.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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