Despite the recent upturn in global equities, Richard Saldanha explains why investors should be cautious in chasing a cyclical rally.
Read this article to understand:
- Why dividend expectations don’t necessarily align with earnings
- Why investors should focus on resilience rather than getting carried away by the rally in cyclical names
- How to play the transition to renewables as an income investor
2022 was a year of surprises: the Ukraine-Russia war, skyrocketing energy prices, inflation at levels not seen in decades.
To understand what the coming months might bring for income investors, we put the questions to Richard Saldanha, manager of the Aviva Investors Global Equity Income strategy.
After a period of above-trend earnings growth and profit margins, some commentators predict an earnings correction in 2023. How could this impact the income outlook?
Earnings expectations have come down considerably over the past year – current forecasts are for one per cent growth this year, which compares to expectations of nearly seven per cent a year ago.
This year, growth certainly looks more challenged. Companies have been conservative in their guidance as macro pressures start to bite. The pressure on consumers is reflected in weaker sales growth, which businesses have looked to offset through higher prices.
In broad terms, we are likely to see continued weakening of demand and the ability of companies to push through higher prices will become more difficult. Once you throw those two things into the mix, it suggests earnings will come under pressure. We’ve already seen a correction in terms of market expectations, but I would argue they may still be overly optimistic.
However, this is not necessarily going to affect dividends across the board. Historically, during periods where earnings have come under pressure, dividends have as well, but nowhere near to the same extent. That suggests dividends should hold up better than earnings and gives us comfort that we can continue to see income levels sustained, especially from companies in more resilient sectors.
Figure 1: S&P 500 dividends versus earnings per share, YoY growth (per cent)
Source: Aviva Investors, Bloomberg. Data as of December 31, 2022
Which sectors look more vulnerable?
More cyclical dividend payers (banks, basic materials, consumer discretionary, some industrials) are challenged. But if you look at consumer staples, healthcare or utilities, even in recessions, companies in these sectors don't tend to cut dividends thanks to the more defensive nature of their businesses.
Consumer discretionary stocks and banks have had a roaring start to the year
That is why we have not chased cyclical names. Consumer discretionary stocks and banks have had a roaring start to the year. Some pockets within the cyclical parts of industrials have also done well. Our view is that conditions could worsen from here and there isn’t much margin of safety in terms of valuations given how some of these sectors have re-rated.
We prefer to focus on where we can find resilience in businesses and some degree of certainty in terms of earnings and dividends. We've been adding to more defensive sectors that have trailed the rally this year, such as healthcare. Health insurance providers are a good example of demonstrating resilience in prior downturns. Yet their current valuations, relative to the wider market, look attractive in our view.
How are rising rates impacting consumer spending, and what is the read across for dividends?
US consumers have held up far better than Europe, and a lot of this has to do with energy costs being higher in Europe. But while the US consumer continues to look resilient (based on spending data from credit card companies like Visa and MasterCard), there are signs of pressure. The rate of consumer savings has come down considerably, as consumers draw down on excess savings that had built up thanks to stimulus cheques and other COVID-19 relief measures.
We are seeing some deterioration this year as people cut spending
In Europe, consumer weaknesses are more visible. Although they were able to absorb price increases in 2022, we are seeing some deterioration this year as people cut spending. There will be some relief in terms of falling energy prices, but the environment is still challenging.
Conditions for consumer discretionary companies could weaken, which is why we have an underweight to the sector. The outlook for dividend growth here looks more challenging, and there is even the potential for cuts should these challenges persist.
On the other hand, the outlook for dividends from consumer staples looks more robust. Consumers have been relatively inelastic in the face of price increases so far. We have not seen much evidence of retailers pushing back as people are still buying these more essential products.
What about inflation?
There are signs inflation has peaked; even central bankers are starting to acknowledge it. Much of the reduction we have seen so far has been down to base effects (as we lap the impact of significantly higher energy prices a year ago).
Wage inflation and other aspects such as housing costs remain high
However, even if headline inflation weakens, the core elements are proving stickier. Wage inflation and other aspects such as housing costs remain high. Despite expectations of rate cuts later this year, we would challenge this narrative. If core inflationary pressures remain high, we could see central banks keeping restrictive rate policies in place for an extended period. That is what central bankers have been trying to signal, but the market seemingly doesn't want to believe this.
The Financial Times recently called the recent upturn in stock prices a “trashy rally”, with assets hit hardest in 2022 rebounding the most. Is this likely to continue?
We have been swimming against that tide. There are certainly elements within this rally that should cause concern – like unprofitable tech, for example. Given these companies don't generate any earnings or cash, it is quite remarkable in this environment that they have significantly outperformed others that are profitable with much more visibility in terms of underlying earnings and cashflows.
Anything that indicates market excess is reason to step back and think hard from a positioning standpoint
Anything that indicates market excess is reason to step back and think hard from a positioning standpoint. The “dash for trash” is a strong way of putting it, but there are grounds to believe this rally is not going to persist.
In some cases, we trimmed more cyclical elements of our portfolio, because some of these names are pricing in a benign economic scenario. Home Depot is a good example. It is still a quality business, but the risk-reward has become less attractive.
The International Energy Agency expects we will add as much renewable power in the next five years as the last 20. Is our positioning shifting to reflect this?
A significant proportion is already invested in companies that will benefit. On the utilities side, we have significant exposure to companies such as National Grid in the UK, which has investments in wind projects as well as battery storage; NextEra, the biggest US renewables developer with major investments in solar and onshore wind; and Enel, one of the biggest renewables operators in Europe.
We need to see a wave of investment into grid networks
However, while people focus on the shift from fossil fuels to renewables, the big question is: can the grid handle it? We need to see a wave of investment into grid networks. The way we play that is through owning companies like Hubbell in the US, which sells transmission and distribution products that go into grid infrastructure, and Siemens and Schneider in Europe, which have solutions to ensure the grid can handle different energy mixes in the most efficient manner.
Having delivered bumper profits recently, what’s your view on oil majors?
These companies have generated huge profits and cashflows over the past year, which has supported dividends. But in past downturns, as commodity prices come under pressure, we have seen these companies cut dividends. Also, their return on capital is not particularly high through the cycle, which is why we have limited exposure.
We would rather have exposure to companies playing directly into the renewables transition
While these companies are trading on cheap multiples, they are too slow in pivoting their business models, in particular the need to invest further in renewables and away from fossil fuels. We would rather have exposure to companies playing directly into the renewables transition. Total is the one energy major we do own, which we see as a leader in terms of adjusting its business model with one of the strongest balance sheets in the sector.
Are the US IRA, CHIPS Act and infrastructure bill creating opportunities in US equities? And what does that mean for European stocks?
This is probably more of a 2024 story and will have significant implications, particularly for US industrials, which are providing solutions around energy efficiency.
Through reshoring we expect increased spending on automation
Reshoring is also something to keep an eye on. Through this process, we expect increased spending on automation, as companies bring manufacturing operations back onshore.
There is noise about a similar stimulus package in Europe, particularly given the tax and spending incentives the US is offering. The likelihood is you will see a policy response from Europe, which could be meaningful for industrial companies like Schneider and Siemens that have a key role to play in terms of both electrification as well as industrial automation.
How could the reopening of China’s economy shape the outlook?
The Chinese government’s decision to abandon its zero-COVID policy should unleash pent-up consumer spending. We are assessing who could benefit, including luxury goods companies. We own Kering, a European-listed company with significant exposure to China. That theme of Chinese consumers going out, spending again and buying luxury goods should play out through the year.
We have seen with Europe and the US that the path following reopening is not always smooth
We also have holdings in industrial names with exposure to China, which should benefit, as well as semiconductor companies (such as NXP Semiconductors) that stand to gain as this should help ease some of the chip shortages that have impacted their ability to deliver to end customers.
At the same time, we have seen with Europe and the US that the path following reopening is not always smooth. Investors should still be prepared for volatility.