Central banks around the world are engaged in unconventional monetary policy on a massive scale.
The end result of this is unclear, and it is possible that central banks will be unable to remove stimulus quickly enough after the economy gains traction, which could trigger an inflationary spiral. While no financial assets benefit from inflation, equities are better placed than fixed income – particularly as most bonds currently offer little or no real yield above inflation.
In a yield-starved environment, equities can also offer investors a robust total return, and in a period of rising inflation they can offer protection. While bonds and equities are both vulnerable to the ills of inflation, research shows that equities are generally resilient versus other asset classes, as displayed below.
This outperformance is not too surprising as inflation is essentially corporate pricing power, which impacts earnings and ultimately dividends, providing some level of insulation. In addition, as dividends tend to grow more quickly during periods of rising inflation, we would expect high yielding equities to be more resilient than bonds should inflation accelerate.
In contrast, 10-year Treasury bonds yielding below 3 per cent are clearly vulnerable to increasing inflation. This is true for corporate bonds as well, particularly during a mildly deflationary environment, as depressed earnings may not be sufficient to service debt. We feel high-yielding equities offer an attractive risk-reward profile due to their resilience in a range of inflationary environments and yields that are currently more competitive relative to fixed-income alternatives than usual.
In our view, the merits of investing in high-yielding stocks remain intact: historical outperformance driven by the efficacy of a dividend yield screen to identify undervalued companies, and the capital discipline that a regular dividend payment encourages.
In addition, we currently see an opportunity to take advantage of the one area of the global capital markets—equities—where yields are above their historical average. As we see it, dividend coverage is relatively strong and is expected to further improve, and the dividends that were vulnerable in a weak economic environment have already been reduced to more sustainable levels. We believe that the combination of regular income and the potential for capital growth, should the economic recovery persist, are attractive in these uncertain times.
We feel an unconstrained opportunity set offers a range of opportunities for income, from mega-cap bond proxy type stocks that currently appear relatively expensive, to less efficient markets which offer greater potential to benefit from fundamental analysis.
While sentiment on equities seems to be improving, the environment remains uncertain. As such, we feel that a broadly diversified equity income approach is a compelling option, as it offers an attractive income stream while seeking to capture the upside in future rallies.
Pat Ryan is the portfolio manager of the Lazard Global Equity Income fund