The lead manager of our Global Equity Income strategy discusses risks and opportunities for income-seeking investors in a turbulent time for markets.
Read this article to understand:
- The outlook for dividends in the face of rising inflation
- The ongoing reallocation from growth to income stocks
- The key role of ESG in income investing
War in Europe. Inflation at decades-long highs. Fears of recession. After the relative calm of 2021 when economies bounced back after the disruptions of the coronavirus pandemic, the global market environment looks daunting once again.
But the data suggests income-seeking investors have cause for optimism. After record payouts of $1.97 trillion in 2021,1 dividend growth has remained buoyant into 2022, despite the economic fallout from Russia’s invasion of Ukraine. During the first three months of the year, global dividends rose 11 per cent over the previous quarter.2
Dividend growth is likely to moderate, however, if inflation continues to rise and the global economy slows. In this Q&A, Richard Saldanha, lead manager on the Aviva Investors Global Equity Income strategy, argues income investors can navigate these challenges by focusing on companies with robust balance sheets, good growth prospects and strong environmental, social and governance (ESG) credentials.
How has the challenging market environment affected income investors in 2022?
This year has been a litmus test for income investing, and income funds in general have held up well. A focus on income leads investors to companies with robust cashflows and strong balance sheets that can grow their dividends over time. That approach has come into its own in recent months.
Income investing highlights companies with more defensive business models
When you think about the reasons for the market sell-off this year – worries about inflation and growth – income investing offers some shelter because it highlights companies with more defensive business models that can grow dividends to help offset inflation. Conversely, growth companies have been harder hit.
The COVID-19 pandemic had a big impact on dividends. How have companies been able to grow or protect their dividends as we enter this new economic phase?
While it is true companies cut dividends during the pandemic, these were mostly focused in the worst-hit sectors, such as travel and leisure. Given the massive disruption caused by lockdowns, it was no surprise companies in these industries slashed payouts. Banks were also compelled by regulators to suspend dividends during the period. But beyond these sectors, many companies still paid dividends – especially in the US, where the vast majority of firms were able to either maintain or grow their dividends.
By and large, we are still finding attractive rates of dividend growth. Many companies are offering high-single-digit rates of growth, which should be enough to offset inflation; in some cases, firms are even growing dividends at double-digit rates, although those figures are likely to moderate over the coming months.
Are companies that have historically offered strong dividends, like oil and gas, driving dividend growth or is this trend evident across the board?
We see dividend growth across many sectors, from energy to tech, healthcare and staples to industrials. That may change if we enter a sharp slowdown or recession, but there is nothing on our radar that points to dividend cuts or even a significant slowdown in dividend growth. It’s worth remembering corporate balance sheets are in relatively good shape and that should continue to support payouts.
European companies have been more acutely hit by the economic fallout from Russia’s invasion of Ukraine
There are some regional nuances, however. For example, the UK’s bias towards energy and materials stocks has helped support dividend growth in that market, but companies in these industries have historically been forced to cut dividends when commodity prices fall, which may affect the sustainability of those payouts going forward. Similarly, with banks, in periods of economic stress we have seen regulators step in and curtail payouts. And, on the whole, European companies have been more acutely hit by the economic fallout from Russia’s invasion of Ukraine, so we will be continuing to monitor the impact of the conflict there.
Is the reallocation away from growth towards income stocks likely to persist?
In a world where investors are worried about inflation and economic growth, income stocks are likely to be favoured. What is interesting is that, amid the sell-off since the start of the year, companies that would usually be considered growth stocks are now offering attractive yields.
Take luxury goods companies, such as France-based Kering. This is usually perceived to be a growth company; the brands it owns, such as Gucci and Yves Saint Laurent, have benefited from strong demand over recent years. Kering’s share price has de-rated sharply this year, largely due to concerns over how China’s stringent lockdown policy is impacting the retail sector. But in our view the company retains significant pricing power, and its business model is not impaired to the extent the market reaction suggests. We believe it can continue to grow and the stock is now trading on an attractive yield with the potential for strong dividend growth.
Semiconductors are another good example. Companies such as NXP Semiconductors and TSMC would usually be viewed as growth stocks. But as shares have fallen sharply across the sector, these companies are offering attractive dividend yields; they could now be viewed as income stocks, and we expect them to deliver strong cashflows despite the dip in their share prices. These dynamics create opportunities for global income investors.
How important is pricing power?
Pricing power is a key element of how companies can manage the current environment. In the case of Kering and other luxury goods companies, given the nature of their brands, and the high-net-worth customers they attract, they are likely to retain pricing power despite significant cost pressures.
Consumer staples companies are successfully pushing through price increases to offset inflation
Another sector where pricing power is evident is consumer staples, where companies are successfully pushing through price increases to offset inflation. Procter & Gamble is a good example. Thanks to its strong brands across different consumer product lines, the company was able to raise prices while still recording organic volume growth of three per cent in the first quarter of 2022.3
Companies with high margins also provide some shelter against rising inflation, as they can absorb some of these cost pressures more easily relative to companies that have lower margins.
Would you pick out any other sectors that look attractive?
We are targeting sectors where resilient business models are combined with good prospects for growth over the longer term. One example is stock exchanges, which tend to benefit from increased trading revenues during periods of market volatility. But some exchanges, including the London Stock Exchange, also have significant data-analytics businesses, which are less sensitive to trading volumes and could offer stable, recurring revenues over the longer term.
We are also looking at industrial companies, including elevator and escalator manufacturers. Around 75 per cent of the profits of these firms come from servicing existing installations, and these revenues should prove resilient during periods of volatility (lifts will need to be maintained whether the economy is in recession or not). But there is also a growth opportunity in this area, because many firms are now rolling out technological upgrades to enhance their maintenance services in areas such as remote monitoring. That is another sector combining resilience and growth characteristics.
Given companies in less-sustainable industries, such as utilities and energy, often offer the most attractive dividends, is it difficult to maintain an ESG focus as an income investor?
ESG considerations should be at the forefront of any income investor’s mindset – if you want to find companies that can grow their dividend sustainably, you need to focus on the sustainability of their business model.
Now, income investors can find companies that pay and grow dividends across a much wider spectrum of industries
The nature of income investing is changing. A decade ago, the opportunity set for income funds was limited to the likes of healthcare, staples, energy, utilities or telecoms. Now, income investors can find companies that pay and grow dividends across a much wider spectrum of industries. This means there is greater scope to identify companies that align with ESG priorities. It is also easier than it was in the past to find companies that combine strong dividends and protection against downside risk, which are the cornerstone of income investing, with capital growth.
Many companies with attractive income characteristics have a pivotal role to play in the energy transition; we see opportunities among firms that specialise in helping connect wind- and solar-energy installations to the main network grid, and those that offer services to improve efficiency across economies, a particularly important theme given the recent spike in energy prices.