It’s been a tumultuous year for most investors. Given high inflation, central banks have continued the path of rising interest rates, which has had adverse consequences on bonds and global share prices. To top it off, the shenanigans of British politics in September brought further instability to markets, although there seems to be more calm under Rishi Sunak’s stewardship. Only time will tell.
At the point of extreme pessimism in markets, investors instinct might be to sell. On the contrary, this might be a time to revisit some assets such as bonds and equities given bond yields are at levels we haven’t seen in many years and dividends (plus capital growth) from equities look attractive.
Time to get bond…ing
The last time 10-year gilts yielded more than4% was 14 years ago, before the global financial crisis (GFC). Gilt yields rose to these levels following the UK government’s mini-Budget in September, as you can see in the chart below. Although yields have since come down from those highs, it’s a staggering jump nevertheless considering these yields were less than 1% only a year ago. Even at current levels they remain very attractive.
Source: Trading Economics, United Kingdom 10Y Bond Yield over the past 25 years, data to 16th November 2022
When bond yields rise it’s at the expense of capital, primarily caused by rising inflation and interest rate expectations. This means investors with high bond allocations in their portfolios may have felt the most pain this year. While its no consolation, we believe a lot of the downside is now priced. While there may still be short-term volatility, we now expect to see meaningful long-term recovery.
With government bond yields at current levels, and corporate bond funds yielding nearly double that, we can’t ignore this is an extraordinary period for fixed interest. Risks remain in the UK with further macro and political uncertainty, and further interest rate rises as the Bank of England looks to contain inflation. But once inflation visibly slows down, we’ll have a better idea of when and at what level interest rates may peak, and the bond market outlook should improve significantly.
Dividends are not dead
Like bond yields, UK dividends also arguably look attractive. Since recovering from Covid, company balance sheets are healthier, and businesses previously seeking to replenish their cash flows and dividend cover have started growing their pay-outs. There are many companies with strong pricing power passing on higher input costs to the end consumer, so inflation hasn’t significantly impacted their profits and dividends have been somewhat protected. Inflation risks do remain and may start to impact the earnings of those companies unable to pass on higher costs, but this is already being priced into equity markets.
The chart below shows the dividends paid each year in the UK since 2007. Since the dip in 2020, UK dividends have increased. Similarly, global dividends rose by 10.3% in the third quarter of 2022. In general, dividend pay-out foecasts are being upgraded for the rest of the year, helped by the energy sector.
Source: Link UK Dividend Monitor, Q3 2022
When combined with capital, income can be an important element of total returns. During the period when markets were driven by growth stocks, income (and value stocks) fell down the pecking order for many investors. But in a more subdued environment, income will be more sought after. The key risk to dividends is a long drawn-out recession, but higher-quality companies with strong balance sheets should be able to withstand more difficult conditions and maintain dividend payments.
A balancing act
Fixed Interest and UK Equity Income are two of the many assets investors can tap into but it is imperative investors maintain balance across a number of asset classes and take a long-term view. Short-term market movements may be worrying, but patience can also be well rewarded. No matter how challenging this year has been, its important not to be swayed by short-term noise, and consider taking advantage of long-term opportunities.
Meera Hearnden is investment director at Parmenion. The views expressed above should not be taken as investment advice.