Doubts have persisted about the real impact of the US government’s $700bn financial rescue plan and the fundamental problem of capital shortfalls in the banking sector has remained unresolved. The markets are pricing in significant interest rate cuts over the next few months but the credit environment is unlikely to improve until trust comes back to the interbank lending market.
Lower rates are not being passed on to consumers and companies, which might lead to a longer and worse economic downturn than previously thought.
In this environment, risk aversion remains a prominent feature in the volatile equity markets and we continue to exercise caution.
We are avoiding resource stocks as commodity prices continue to fall due to the strengthening dollar and reduced global demand. The outlook for consumer goods and services also remains uninspiring as price inflation and rising unemployment weigh heavily on discretionary spending.
However, the recent heavy stockmarket falls have brought equity valuations in some areas down to very attractive levels. For instance, the pharmaceuticals sector, a long-time favourite of income investors looks good value, particularly GlaxoSmithKline and AstraZeneca, large long-established international companies with strong pricing power and good sustainable dividends.
Another traditionally defensive area which looks attractive is utilities. Here, we favour electricity and multi-utilities because utility stocks with revenues linked to the retail price index have proved relatively resilient against the current backdrop of high inflation. On the other hand, buyers of wholesale energy, such as Centrica, should benefit from falling oil prices.
The oil sector itself also presents opportunities despite not being a traditional hunting ground for income investors. The oil majors continue to offer relatively high yields, underpinned by sustainable defensive earnings, while many companies in other sectors prefer to cut dividends rather than raise funds in the credit market.
We do not expect oil majors’ shares to react strongly to falling oil prices as their response to the record rise had been fairly muted. This is due to the profit-sharing arrangements that both BP and Shell have with governments and national oil companies worldwide, which see profits above a certain level go to government coffers. This way, oil majors can maintain consistent profits year after year as the pain of oil price fluctuations is borne by the producing countries.
Another attractions of oil stocks for UK-based investors is the added benefit of reported dollar dividends, as a 25 per cent fall in the value of sterling has given them a significant uplift.
The long-term outlook for the oil majors is good after successful resolutions to a number of recent issues this year, such as the destruction suffered from hurricanes in the US and difficulties in Russia. New management is now focused on improving production and efficiency after a period of poor performance. This has materially benefited earnings’ growth, with recent positive statements underlining the attractiveness of the sector, in contrast to many credit-constrained areas.
As uncertainty and fears continue to surround the future of banking, we are trying to avoid this area but are neutral towards financials in general. Our holdings in the sector have been cut further recently as dividends for the UK’s major banks are likely to be constrained for some years, reducing their attractiveness for income investors.
In contrast, we might soon see some improvement in fortunes for telecoms, another defensive sector where we were neutral at the time of writing.
We are examining a number of potentially interesting opportunities there that should offer investors good sustainable dividends supported by strong cashflow.
Michael Gifford is manager of the Old Mutual equity fund