Recent events – from the political to the economic – have conspired to test the mettle of even the most seasoned investors. Savers, particularly those using bond markets, have had their reserves eroded by a combination of inflation and a long period of very low interest rates. With the normalization of monetary policy (the U.S. Federal Reserve, or Fed, expects that rates will be increased “a few times a year” until the end of 2019, for example), bond yields should rise. But while this is positive for those trying to generate an income using bonds, the consequences for global equities could be less positive, as stocks look less attractive to investors under such circumstances. Although some equity markets, particularly those in the U.S., have surged in recent months, there seems to have been little real foundation for the gains. Instead, they have been built on bombast and political rhetoric.
This brings us to another potential headwind for equities: the recent surge of populism in the political sphere. At the time of writing, it is unclear to what degree Donald Trump will implement the protectionist policies he touted during his election campaign, although he has not shied away from controversy in the early days of his presidency. In addition, we do not yet know the terms of the UK’s exit from the European Union (EU). A worldwide decline in free trade could have severe implications for corporate earnings.
There is also the conundrum presented by an environment of increasing inflation and low economic growth. Before the Brexit referendum, Mark Carney, governor of the Bank of England, warned that leaving the EU could create just such a scenario — sometimes known as “stagflation”— for the UK. He predicted that a Brexit-induced decline in sterling could push inflation higher. Since the vote, the pound has fallen sharply, and inflation in the UK recently touched its highest level since July 2014. Although equities are sometimes viewed as a hedge against inflation, increasing consumer prices have the potential to drive volatility and put pressure on future cash flows. And the UK is not the only country at risk from the phenomenon; we are yet to see the effects of Mr. Trump’s policies on the U.S. economy, while political tensions in Europe remain high.
We have become relative veterans of political instability and uncertainty
Collectively, these circumstances seem to paint a pessimistic picture for those looking to gain an income from investing in global equities. However, there is a potential upside: we have become relative veterans of political instability and uncertainty; we have lived with bank bailouts, national recapitalizations and dramatic government change for ten years. Now, as in those times, we believe that a focus on high-quality businesses combined with discipline on valuation will put investors in good stead.
There are several important questions income investors should ask when building their portfolios:
- Is this company likely to grow both its profits and its dividends?
- Is the company located in a place where there is potential for interest rates to come down?
- Where are corporate profits beating expectations?
Many of these opportunities can be found in Asia and Latin America. Both regions have underperformed in recent years, but they have companies with strong balance sheets, good profitability and robust dividends.
Emerging equity markets had a very strong 2016, but we should view this performance in the context of the last five years and net investment withdrawal from the region. The rebound itself is unsurprising, given the depth of pessimism about the region at the beginning of 2016. There is scope for further improvement should the trend continue.
Dividends, it seems, go in and out of fashion, but they are always significant to individual investors. In some markets, however, they are ascribed little importance, and there may be an almost inherent opposition to returning value to shareholders in this manner. Markets such as the U.S and Japan tend to have this view. In other regions, however, dividend coverage has become stretched, and capital expenditure by companies has been very low.
When looking for income from equity investments, it is important to select companies that not only have good cash flow and are investing for the future, but that also have surplus cash available to pay dividends. Balance sheet strength, as well as the desire and willingness to return cash to their shareholders, are other very important characteristics. Above all, in-depth research is key when to achieving the objective of earning a steady income stream from a diversified portfolio, even in the most difficult markets.
Image credit: Ikon Images / Alamy Stock Photo
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).