Equity income at a time of higher interest rates

Luke Bartholomew, senior economist at abrdn, and fund managers from The North American Income Trust, abrdn Asian Income Fund and Murray International Trust, share their views on income and the current state of the economy.

• Equities must now compete with fixed income for investor attention

• Inflation is moderating, with most countries avoiding recession

• It creates a benign backdrop for dividends, but still warrants caution

Rising interest rates have created a better environment for income investors. After a decade when there was no real alternative to the stock market as a source of inflation-protected income, equities must now compete with fixed income for investor attention. How is this new environment shaping equity income investing today?

Fears of both a recession and persistently high inflation have abated. Inflation appears to be returning to a more consistent level, while countries are generally still experiencing economic growth. The labour market remains extremely strong, and consumption has been robust. Those sectors that are most interest rate sensitive – the housing market, construction, industrial production – had started to slow, but have started to revive.

Luke Bartholemew, senior economist at abrdn, says: “On the inflation side, there has been significant progress. While year on year CPI inflation in the US is 3%, sequential inflation – a measure of how much inflation is being generated now – is at 2%. It will take time for year-on-year numbers to reflect that, but if we stick at these levels, that gets us to the Fed’s target.” This supports the consensus view that the US will experience a soft landing.

He believes it is safe to assume that central banks are at or near the peak in interest rates in much of the developed world, even in the UK. He says investors also need to be prepared for falling rates in the US next year. He adds: “Monetary policy has long, and variable lag effects and credit conditions are clearly tightening.”

“In the US, it is reasonable to be talking about an interest rate cutting cycle. In China, we are already seeing rates start to fall. There is likely to be a recession in Europe, and probably a recession in the US, even if the path to a soft-landing has widened. The interest rate cycle will start easing next year, which will be supportive of growth and sentiment.”

Finding income

 
What does this environment mean for income seekers? It creates a relatively stable environment for bond yields, but also suggests that companies will be operating under a benign backdrop, making it easier for them to pay and grow their dividends. Inflation is unlikely to disappear as an issue, and investors will need to be aware of it when making their decisions.

For Samantha Fitzpatrick, investment director on Murray International, the key to generating a consistently high and growing income has been to look broadly across a range of markets, drawing in diverse sources of growth; “We are as diversified as we ever have been. We have around a quarter of the trust in Europe, a quarter in North America, a quarter in Asia, 12% in LATAM, 5% in the UK, and 7% in bonds. This helps with consistency of income.”

The trust is a blend of more traditional high yielding stocks such as healthcare and energy with non-traditional areas. The team has managed to pick up some higher growth companies, such as Broadcom, when they were out of favour, securing a high yield when no-one was interested.

Yoojeong Oh, fund manager on the abrdn Asian Income Fund, says investors can’t neglect growth, with dividend growth becoming more important at a time when it is easier to get a high static income from bonds: “We have five themes to drive growth in areas as disparate as banks and online retail, as well as global leaders in semiconductors and electric vehicle batteries. We hold Samsung and TSMC, but we also own a lot of the supply chain.” This growth objective steers the trust away from areas such as energy and healthcare.

Growth remains easier to achieve in Asia, she says: “Some of the major economies are still expected to grow at 5%. There is also support from favourable demographics and the revival of investment into infrastructure and capex. There is job creation, and support for the local consumer.”

A more normal environment

 
In the US, a more normal monetary policy environment is likely to favour a different type of company to the mega cap growth stocks that have been in favour over the past decade. Fran Radano, manager of The North American Income Trust, says: “We never try to predict mean reversion, but given the interest rate backdrop, valuations are going to matter a lot more. There has been a big rocket up in inflation, which has now come down. Pricing power for companies is paramount.”

He believes investors need to be careful to avoid the ‘bond proxies’ – companies paying bond-like income, but without real growth prospects: “Rates are 5% for a money market fund. Our fund pays 3.8% so there is competition for capital. As such, we not holding a lot of telecoms stocks and REITs. We have some utilities but bought them when they were a lot cheaper. Telecoms have derated and we’ve avoided those.”

Samantha says company debt levels are important in this environment, adding: “It affects the flexibility companies have to pay dividends.” Fran agrees: “Rates are higher and refinancing costs have gone up. No-one likes to talk about balance sheets, but if a company has got a lot of debt at 1% that now needs refinancing at 5-6%, does it have the wherewithal to invest in the business?”

For the time being, most managers report healthy dividend growth for the companies in their portfolio, with dividend cuts rare and idiosyncratic. Nevertheless, says Yoojeong, it remains important to look at the outlook for each company: “We’ve been through a lot of macro cycles and challenges over the last 15-20 years. We’ve had massive inflation cycles, particularly in some of the emerging Asian countries. It is important to escape the macroeconomic noise by focusing on the characteristics of individual companies.”

 
Companies selected for illustrative purposes only to demonstrate the investment management style described herein, and not as an investment recommendation or indication of performance.
 
 

Important information

Risk factors you should consider prior to investing:

• The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.

 Other important information:

 
Issued by abrdn Investments Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

Find out more at www.asian-income.co.uk , www.northamericanincome.co.uk, www.murray-intl.co.uk or by registering for updates. You can also follow us on social media: Twitterand LinkedIn.