The US Federal Reserve’s plan to gradually reduce its bond-buying programme, combined with a significant move higher in US 10-year treasury yields, has prompted investors to rethink allocations based on low growth, low interest rates and high liquidity. This has led to increased volatility across a number of asset classes, including Asian equities, which have fully participated in the downturn. Is this the first indication that the yield trade has run its course?
The sell-off in US treasuries has been understandable but the case is less clear for equities. Although the valuations of equities are impacted by expectations of long-term interest rates, the attraction for most income seekers is the comparison of dividend yield with the rates available for cash on deposit. Comments made recently by Ben Bernanke suggest that short-term interest rates are likely to remain low for some time, given the still weak (but improving job market) and low inflation and as a result the appeal of dividend yield over cash is still very much in place.
Asia also offers some distinct advantages over other equity income strategies. With the yield from some traditional sources compressed to unattractive levels, we believe that dividend growth will become an increasingly important driver for income strategies. Underlying economic growth is expected to remain robust, especially compared to the anaemic recoveries seen in most western economies. This should provide superior earnings growth and hence higher dividend growth over time. The structural argument is even more compelling. Asian companies have changed in the last 10 years and now share similar characteristics to their western peers. Capital expenditure is more rational and as a result cash generation compares favourably with companies in the US and Europe. This excess cash has been used to pay down debt and now many companies sit with net cash on their balance sheets. In the years to come we expect more and more shareholder enhancing announcements such as special dividends, share buybacks, and capital reductions. Most importantly, we think regular dividend distributions will rise because pay-out ratios (the percentage of net profit paid out as dividend) are at record lows.
The chart below shows how dividends across Asia have failed to track earnings over the last three years as companies have been reluctant to increase dividend distributions in a volatile period. This illustrates how immature the dividend theme is in the region but it is encouraging to see the number of companies that have raised dividends in the last nine months given a more benign global environment. With companies continuing to accumulate cash we believe this more positive trend will continue and the gap between earnings and dividends will close. We would not be surprised to see dividend growth outstrip earnings growth in Asia over the next five years.
Source: Bloomberg, Monthly data rebased to 100 from 29.07.05 to 31.07.13.
In addition to the changes in the corporate sector, we believe government policy and increased maturity will drive structural demand for yield. Asian consumers currently hold significant levels of cash, mainly held in bank accounts on deposit. As the penetration of financial services such as insurance and wealth management increases over time and government initiatives improve the social safety net, the need to hold cash will recede. As this money gradually finds its way to more sophisticated savings vehicles, the need for yielding assets will increase significantly.
In summary, we believe the recent weakness in Asian markets is an opportunity to acquire the region at valuations that look compelling compared to history and relative to other equity markets. The positive story for Asian income remains in place both from a cyclical and structural standpoint. Short-term interest rates are likely to stay low for some time ensuring that the premium of dividend yield over cash rates remains attractive. The yield trade is not over, it’s just cheaper than it was!!!
Mike Kerley is manager of the Henderson Horizon Asian Dividend Income Fund