As the Federal Reserve continues to taper its asset purchase programme, equity income managers are worried about the dangerous impact this could have on so-called bond proxies.
Managers are now looking for opportunities which pay stable and growing dividends and looking to shift away sectors which are paying good dividends now but could stagnate as tapering takes hold.
Fidelity Global Dividend fund manager Dan Roberts believes the market has factored in tapering uncertainty, with the MSCI World High Dividend Yield Index underperforming by about 5 per cent since the prospect of tapering first emerging last May.
Roberts, who runs the £80m fund, sees bond proxies as utilities, real estate companies and oil companies. The fund has a strong consumer products focus, with 27.8 per cent invested in consumer products as at 31 January, according to FE Analytics. The IMA Global Equity Income peer group has a 14.3 per cent weighting to the sector.
Roberts says while sectors with limited potential dividend growth are likely to be hit hardest by rising interest rates, tapering will also have a wider impact.
He says: “We should not kid ourselves that it is just these bond proxies that have benefited from this bond money – it is the whole market.”
He expects to see valuations to revert to average earning ratios and sees little promise of earnings growth. Roberts believes that in the current environment large utilities and other companies with regulated income streams are more attractive than similarly valued open market companies, as they are less likely to surprise on the downside with earnings.
Roberts says: “Corporates have never had it so good. If people think that the market will revert towards trend or something more normal over the medium term, maybe it is better to buy a utility on 16 times regulated earnings rather than a potential peak profitability company elsewhere on 16 times earnings.”
Lowes Financial Management investment analyst Paul Milburn says defensive, bond proxy companies have slightly underperformed lately, especially tobacco businesses.
He says as the economy improves with a reduction in unemployment, this will in turn feed through to corporate profits, higher wages and greater consumer confidence.
Milburn says this will see people start to spend more on discretionary products, that is, “those big-ticket items that people have not purchased in the last few years as they tightened the purse strings a bit”.
He says investors who chased the yield offered by riskier emerging markets have been hit the hardest by tapering so far and that is likely to continue. Milburn says yields rise in developed economies and money flows back out of emerging markets, the valuations of many emerging market companies have been pushed downward.
Lowes has kept emerging market allocations in its model portfolios but moved away from funds investing in traditional high-growth ideas to those exposed to more stable stocks with growing dividends.
Standard Life Investments Global Emerging Markets Equity Income fund manager Mark Vincent says dividend growth is essential to ride out tapering.
Vincent, who runs the £285.7m fund, says: “In this tapering environment what you do not want to have is a significant overweight in bond proxies, stocks where effectively your investment case is mostly about receiving a coupon and there is not necessarily a growth angle.”
He says companies with pricing power and those with growing dividends are more likely to thrive in an increasing interest rate environment.
Conversely, businesses that have supplied steady but stagnant dividends up until now could start to underperform in the next few years.
He says: “We agree tapering is a headwind for the asset class but we think that has been pretty well priced in in terms of the market moves we have had.”
Vincent says he has looked for solid companies with good yields and growing businesses in emerging markets that were not hit as badly as the wider market during the market falls caused by tapering last year and the beginning of this year.
He gives the example of the Bank of Georgia, which the fund bought in December 2012 after an electoral change caused a sell-off. The Bank of Georgia continues to deliver the 3 to 4 per cent yield it offered at the time and the share price has more than doubled.
Old Mutual Global Investors UK Equity Income manager Stephen Message is avoiding consumer products, which he thinks will be hit hardest by tapering.
The £81.3m fund has just 2.4 per cent in consumer products compared with the sector benchmark of 9.1 per cent. Consumer product companies Message has chosen to avoid include Unilever, Reckitt Benckiser, Diageo and SABMiller.
He has instead looked to financials, with 34.9 per cent allocated to the sector, mostly in the life companies. The benchmark is 18.9 per cent.
Whitechurch Securities managing director Gavin Haynes says the effect of tapering on bond proxies is a danger for equity income managers.
He agrees financials are likely to receive a boost from further tapering and a higher interest rate environment.
JP Morgan global market strategist David Lebovitz says investors should be comforted by the doveishness of the Fed.
Lebovitz says: “The key thing for investors when thinking about tapering is it marks the end of the most extreme monetary policy experiment the world has seen.
“The last thing the Fed is going to do is pull the rug out from under the US economy before it thinks the economy can stand on its own.”