Markets are transforming, reflecting sweeping, long-lasting demographic and economic shifts. In the U.S., baby boomers are approaching retirement, while in Japan, Europe and China older looks to get bigger. This situation confronts a global economy on weak foundations, clouding profit outlooks, prompting episodic volatility in equity markets and forcing central banks to push interest rates to historic lows. China continues to revamp its economy. Europe confronts a three-pronged dilemma of high debt, negative inflation and increased flows of migrants from the war-torn Middle East.
Despite these changes, many investors remain anchored to the past. Some focus on the energy and material stocks that delivered strong returns commensurate with China's rapid growth. For those approaching retirement, the shadow of the 2008 financial crisis looms large, resulting in defensive investment postures.
We believe new leadership is emerging in U.S. equity markets, led by stocks of higher-quality, dividend-paying companies. The thirst for income, one of the drivers, should remain high as aging investors find little yield from traditional fixed income investments. Meanwhile, an uncertain profit outlook and bouts of episodic volatility should continue to favor higher-quality companies with solid balance sheets, stable cash flows and sustainable dividend growth.
The Old Guard and the scarred
According to World Bank figures, from 2003 to 2007 China averaged real annual growth in gross domestic product (GDP) nearing 12%. While this five-year growth spurt did not surpass those of the mid-to-late 1980s (12.1%) or the mid-1990s (12.4%), its effect was more pronounced due to increased interconnectedness of the global economy coupled with the larger absolute size of China's economy. In supplying China's infrastructure and trade-oriented growth, the Energy and Materials sectors enjoyed turbocharged returns. From 2003 to 2007, Energy was the top-performing sector, with a compound annual growth rate (CAGR) of 27%, far ahead of the 11% rate of the S&P 500 index. Materials stocks also outperformed the S&P 500, with a CAGR of 16%. As a result of their relatively recent, prolonged outperformance, these sectors remain popular with many investors. We see them, however, as the Old Guard.
Meanwhile, the 2008 financial crisis scarred many investors, significantly denting their expectations for investment returns at the start of the decade. This, along with the bursting of the tech bubble in 1999, has gradually reduced their appetite for equity investments. According to a recent Gallup Poll, the percentage of Americans with equity holdings reached an 18-year low in April 2016. For the baby boomer cohort in particular, the most prominent scars from these setbacks are notable shortfalls in financial assets earmarked for retirement that have arisen at a very inopportune time.
Aging populations find a drying well
Aging populations are a worldwide phenomenon. According to United Nations statistics, 37% of Japan's population is expected to be over 60 years of age by 2030, up from 33% in 2015. In Europe, 30% of the population is projected to be over 60, versus 24% last year. In China and the U.S., the proportions are expected to be 25% and 26%, up from 15% and 21% in 2015, respectively (See Exhibit 1). In aggregate these countries are expected to see a 44% increase in the 60-and-older cohort from 2015 to 2030, with China contributing the most to this increase. These aging populations should drive a continued thirst for income-producing investments over the coming years.
Confronting this thirst, however, is a drying well. According to BofA Merrill Lynch (BofAML) Global Research, today's environment features the lowest global interest rates in 5,000 years! (See exhibit 2) The organization also estimates that negative-yielding assets total roughly $13 trillion. This historic fall in global interest rates has resulted from major central banks scrambling to bolster economic growth by adopting ultra-low policy rates and engaging in QE, the buying of various types of fixed income instruments aimed at lowering borrowing costs for the economy. This aggressive monetary stimulus has helped offset a lack of fiscal stimulus from governments since their initial response to the 2008 financial crisis.
The Tortoise and the Hare
The U.S. Federal Reserve embarked on its first QE program in November 2008, which was complemented by the U.S. government's fiscal stimulus package in February 2009. Both helped establish a floor for U.S. equity markets in March 2009 and sparked a bull market that continues to this day. Lower-quality companies, identified by S&P Capital IQ as those with subpar grades for long-term growth and stability of earnings and dividends, outperformed versus higher-quality companies. Subsequent QE operations by the U.S. and other countries helped prolong this relative outperformance. The hare has sprinted ahead. However, a turning point may be at hand.
Since late-2014, global equity markets have experienced increasing bouts of episodic volatility, despite the extraordinary monetary stimulus. Outlooks for corporate profits have been clouded by generally subpar U.S. growth, China's continued push to rebalance its economy and the eurozone's integration effort in the face of deficient growth, creeping deflation and high debt. Diminished returns from monetary stimulus have shifted policy discourse from Federal Reserve officials, suggesting fatigue with monetary stimulus may be setting in. BofAML Global Research suggests that the combination of this QE fatigue, with the increased global uncertainty and resulting episodic volatility, plays in favor of the tortoise, or higher-quality companies. Indeed, recent market performance suggests the tortoise is beginning to catch up (see Exhibit 3).
Watch your yield
While aging populations and ultra-low interest rates have been powerful drivers in the outperformance of dividend-paying stocks, we advise investors to exercise prudence in pursuing yield, particularly in light of elevated valuations in pockets of the equity market benefitting from these trends. We advise following a "get paid to wait" strategy. Investors should embrace income as a more substantial contributor to total returns while favoring companies that can raise dividend payout ratios over time by expanding cash flows through competing in secular growth industries. We recommend a risk-managed approach incorporating diversification among asset-classes and equity sectors, with an emphasis on higher-quality companies, to help mitigate volatility as we transition from a cycle dominated by central bank policy to a new one supported by fiscal policy.
Portfolio Considerations: We believe new leadership is emerging in the U.S. equity market consisting of higher-quality, larger capitalization companies with sturdy balance sheets and stable cash-flows. These characteristics should help provide sustainability of dividends and their growth.
Central banks, by embarking on extraordinary monetary easing, have suppressed interest rates to record lows. This is drying up the traditional fixed income well in the face of a historic thirst for income on the part of the swelling ranks of older investors. These trends have resulted in higher demand for some sectors that have historically paid dividends, which has resulted in stretched valuations.
Despite unprecedented monetary stimulus, continued uncertainty in the global economy has resulted in episodic volatility in equity markets and has shifted policy rhetoric in a way that suggests increasing QE fatigue and the growing possibility of a shift towards fiscal stimulus. This development may add to the uncertainty and volatility, which requires a prudent, risk-managed approach when searching for yield. The "get paid to wait" approach espouses income as a greater contributor to total return and favors high-quality, dividend-paying companies with strong balance sheets, global brands, the ability to generate and grow cash flows and low dividend payout ratios. While the trend favoring dividend payers and growers is not new, we expect it to continue (see Exhibit 4).
While the focus today is on the search for yield, even more important is finding stable and growing cash flows to sustain it. Equity markets may be starting to reflect this. Higher-quality companies, after years of lagging lower-quality ones, are beginning to catch up. According to BofAML Global Research, in the wake of the financial crisis in 2008, we have seen a significant shift in the sector composition of higher-quality companies. In particular, there has been a large increase in the numbers of Tech and Health Care companies at the expense of Financial and Consumer Discretionary companies. Given the seismic and persistent nature of these demographic and economic trends, we believe the shift to core income-producing and higher-quality equities is likely to continue for years to come.
3 Questions to Ask Your Advisor
- With today's historically low interest rates, do bonds still make sense for me?
- How can I identify high-quality companies with sustainable dividend growth?
- Are there mutuals funds that focus on these new market leaders the article discusses?
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