The income conundrum

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While companies around the world cut, suspend and/or defer dividends, Newton’s head of equity income, Ilga Haubelt remains confident about income investing. Here, she and BNY Mellon Investment Management chief economist Shamik Dhar discuss their thoughts on dividend cuts and what implications it could have for the future.

Shamik Dhar (SD): We’ve seen a pretty severe economic recession to say the least. The UK economy may have shrunk by about 20% in Q2 and the world economy by about 10%. But on the other hand, we’ve also seen quite a lot of fiscal and monetary stimulus. Globally, we’re talking about something north of 15% of global GDP in terms of fiscal and monetary stimulus. In the income world, how does that all stack up? How severe do you think the cuts to dividends against this background have been?

Ilga Haubelt (IH): I’ve been around during the global financial crisis as well and so it’s really interesting in a way to compare both crises. I would like to answer the question from a global perspective and, consider three aspects. The first one is how many companies have cut dividends. If you look at consensus numbers, around one third of companies have cut their dividends so far.

I stress so far because the crisis is not over yet and we don’t know how long it will last and how severe it will be in the end. If we compare it with the global financial crisis, half of the companies cut their dividends. We’ve seen unprecedented policy response as well from a fiscal and monetary point of view. It’s quite difficult to figure out right now how severe the cuts will be in the end.

I would say the second aspect that I think is interesting is to ask ourselves is ‘How deep have the cuts been so far?’ again, it links into fiscal and monetary support. So year to date, if you look at the global universe, dividends have been cut by around 14%, but if you dig a little deeper into the dividend-paying companies universe, companies that yield more than 4% those have cut dividends by more than 25%. We’ve seen big differences between sectors and regions as well, which brings me to the third aspect of the question: ‘Which regions have done better than us?’ Asia and Europe have been leading the cuts, Japan and the US have done much better and I would say there are a couple of reasons for that. First of all, the US and Japan have much lower payout ratios of around 40% while in Europe and in Asia we have payout ratios of 70%.

SD: That’s really interesting and underreported. It’s fascinating that you say things are pretty bad but not as bad yet globally as during the global financial crisis. I think a point not everyone has considered.
And you’re right: I do think there are cultural and historical differences between Europe on the one hand and the US and Asia on the other. Also, I think the nature of monetary policy in Europe and the US, the fact that we’ve gone to zero rates is encouraging some companies to level up and indulge in buybacks rather than traditional dividends. So maybe this has accelerated that process, but it’s really interesting to hear you talk about those differences against the background in which actually the declines we’ve seen today, aren’t as severe as they were in the financial crisis. What’s your view on how different sectors have fared?

IH: Well, I don’t know how you feel about it, but my view is that the crisis seems to have accelerated the headwinds and tailwinds for specific sectors. If you think about online shopping and digitalization trends, for example, they’ve really accelerated through the crisis.

The COVID crisis is a health crisis. So it’s different from the usual credit-driven recessions the two of us would normally discuss. We’ve seen ESG playing a bigger role and, to be honest, there’s just a bigger awareness of how companies need to consider all stakeholders across society. This means there’s been a clear bifurcation between winners and losers. The losers have definitely been the sectors that have been in the eye of the storm, if you think about consumer discretionary or sectors like airlines, travel, leisure or automobiles. Then, in the financial service sector, bank and insurance companies have more often been told by the regulator not to pay dividends.

SD: I think you’ve made some really important points there. My view is that if we can get back to the pre-crisis level of aggregate spending, then obviously the economy will be deeply changed coming out of Covid-19. But that needn’t mean mass unemployment or permanent recession or depression or anything like that. We might see huge compositional changes in the economy and I think that’s absolutely where your point about different types of spending coming to the fore is really important. What about as a fund manager? How are you adapting to this changing landscape?

IH: Everything has happened very, very fast and I still have the feeling that we’re in an evolving situation and we don’t know how long or short this situation will go on for.

It’s hard for me to comment on how fund managers have adapted to the changing landscape. I’ve heard that some of our peers have used complex derivative products to enhance their income level if their mandate allowed them to do so, but I’ve not seen any hard facts or figures yet.

In regards to how we’re managing the situation, we simply stick to our approach. We believe it’s really important to stick to our discipline right now. Our focus has always been on actively investing in global high dividend paying equities. I think quality will prove its worth now more than ever. The crisis clearly highlights the necessity to focus on dividend quality instead of rewarding investors that simply go for quantity. As tragic as the current crisis is, in a certain way it plays to our strengths. It highlights how important it is to know the companies well you invest in. I also think it’s necessary to keep in mind, there will be a recovery and the current situation is only temporary. In a way, in the end, the core attractiveness of income investing has not changed: the compounding return of stable income strains will continue to generate attractive returns over the longer term.

SD: I agree with you, and that sounds like a very sensible approach. This is obviously a hugely traumatic and tragic event, but one of the complaints of the previous 10 years was that maybe monetary policy or policy more generally hadn’t allowed stock selectors to differentiate significantly or properly, according to traditional market signals, simply because a rising tide was lifting all boats. And like I say, as tragic as it is in some sense, a big shock like this does weed out the truly strong from those that were a bit more challenged.

Now, obviously the real task is for the government to make sure that genuinely strong companies aren’t threatened by what is a temporary loss of income and therefore focus fiscal policy on income replacements and on loan guarantees for genuinely strong companies. As you say, as we come out of this, then some of those companies should go from strength to strength, even the ones that have been put under regulatory pressure to hold back on dividend payments. What about inflation? If we were to get inflation, would it alter the income investing landscape significantly?

IH: I think it’s too early to tell to be honest. Time will tell. We are very alert to change and we closely watch the fiscal policies that we see.

When doing the company analysis it comes down to the same company-specific characteristics. In case we see more inflationary pressure, what we really look out for with the companies we invest in is finding quality companies that have pricing power, because pricing power will ultimately be the one thing that matters if you want to pass inflation to your end consumers.

SD: I think the interesting thing will be next year or the year after. If inflationary pressure does start to build, it really depends on what central banks do in that situation. If they stick to their mandates and find that in the face of inflationary pressure they have to raise interest rates sooner than markets currently expect then that’s going to be a bit of challenge, both for bonds and equities.

If on the other hand they decide ‘We could do with a bit of inflation, let’s let it rip for a bit’, then it seems to me that that’s trouble for the fixed income market in some ways, although less than if interest rates go up, but actually things like income generating stocks may do very well in that situation. Because as you say, as long as you’re picking the right ones with some pricing power, then stocks and real assets generally act as a bit of a hedge against inflation. So it won’t necessarily be a terrible thing. I’m sure it’s all about picking quality companies and sticking to the themes that are right.

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