INVESTMENT INSIGHTS. The rebirth of equities

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1 FOR PROFESSIONAL CLIENTS ONLY NOT FOR RETAIL USE OR DISTRIBUTION INVESTMENT A HIGH YIELD BOND ALTERNATIVE Why dividend growth strategies offer a compelling alternative as monetary policy normalises March 213 OUTLOOK & OPPORTUNITIES PLEASE VISIT for access to all of our Insights publications. IN BRIEF This paper looks at the typical market reaction to an improvement in the economic backdrop, focusing on the likely outcome for different asset classes when central banks begin to unwind the extreme monetary policy actions that they ve put in place over the last five years. We find four main conclusions: The flight to safety has left bond markets looking more precarious than ever, while equities have largely been left behind. Equities typically perform well in anticipation of an end to ultra loose monetary policy. Income seeking investors moving up the risk spectrum in search of attractively valued securities from government bonds, to investment grade bonds, to high yield bonds, and now to equity income will continue to be rewarded with a rising level of income and capital appreciation as the global economy improves. A defensive equity income product offers investors the chance to benefit from an improving economic recovery with strong downside protection. The rebirth of equities It can t go on forever. Extreme monetary policy has to either end soon or be scaled down. This doesn t mean interest rates will necessarily rise, at least not at first. However, once it becomes clear that ultra loose monetary policy is coming to an end, equities the unloved asset class will move, and move quickly. AUTHOR It may sound premature to talk about an exit strategy for central banks, but if you believe the global economy is recovering this will mean that the countries where the recovery is most advanced will start to implement some sort of exit strategy soon. Judging by the recent fall in unemployment and the country s abundant energy prospects, the US is likely to be first to initiate an exit strategy, followed by the UK and the rest of Europe. The inevitable rise in interest rates will not be good news for bond investors. It will, however, be good news for equities. That s because a rise in bond yields from unusually low levels reflects rising growth expectations and lower systemic risks. Alex Robins Vice President, Client Portfolio Manager Global Equities Team

2 INVESTMENT Why dividend growth strategies offer a compelling alternative as monetary policy normalises It s not a case of if, but when monetary policy will normalise The timing, pace, and magnitude of future rate increases is critical to how these risks play out. If policymakers are able to manage a phased transition to higher rates, the potential bond bubble could deflate gently over time. A more sudden, severe rate increase would pose greater risks. However, a continuation of current policies may exacerbate financial market imbalances and the ultimate risks to investors. Late last year the US Federal Reserve (Fed) said that the US shortterm interest rate will remain near zero as long as the jobless rate stays above 6.5% (provided that projected inflation does not rise above 2.5%). Between September 211 and December 212, the unemployment rate dropped by 1.2 percentage points and now stands at 7.9%. Prior Fed communications about the likely exit strategy from accommodative monetary policy suggest that abundant liquidity will end when the unemployment rate is still somewhat higher than 6.5%. Given the now-tight connection between the unemployment rate and the Fed s next policy steps, the market and the Fed have displayed strikingly little reaction to the rapid fall in unemployment. On current Fed projections the unemployment rate is due to fall to 6.5% in 215, implying the Fed will start to scale back asset purchases sometime soon. EXHIBIT 1: US UNEMPLOYMENT RATE, % WITH END-YEAR PROJECTIONS FROM 213 ONWARD % Fed projections Source: JP Morgan Securities Inc., Federal Reserve; data through January 213 with FOMC projections as of December 212 The flight to safety means equities have been left behind The fallout from the Lehman crisis and the subsequent European Sovereign debt crisis has had equity investors running scared in recent years. Since 27 equity outflows from mutual funds have totalled over USD 5 billion (see Exhibit 2). EXHIBIT 2: THE WORLD IS LONG FIXED INCOME USD billion Equities All bonds Source: BofA Merrill Lynch Global Investment Strategy, EPFR Global USD 823bn - USD 562bn It has been a very different picture for bond investors. Fixed income has enjoyed the types of returns you would normally associate from buying risk assets (see Exhibit 3A). Corporate bonds bubbled, yields fell and inflation-adjusted (index-linked) bond yields turned negative. EXHIBIT 3A: THE PUSH AND PULL OF FIXED INCOME AND EQUITIES Yield 16% 14% 12% 1% 8% 6% 4% 2% US 1-year Treasury yield (constant maturity) % Source: BofA Merrill Lynch Global Investment Strategy, Global Financial Data, Bloomberg, Ibbotson 2 A high yield bond alternative

3 EXHIBIT 3B: THE PUSH AND PULL OF FIXED INCOME AND EQUITIES % return 19% 14% 9% Exhibit 5 shows the different loss scenarios for corporate bonds, given a 5-2 basis points (bps) rise in interest rates. If US interest rates were to revert to early 29 levels (a 2 bps rise) a typical investment grade US corporate bond (BBB-rated with a ten-year maturity) could lose 15% of its market value, with a longer duration bond (3 years) suffering a 26% valuation loss in the same scenario. 4% -1% Large cap equity rolling 1-yr annualised monthly returns -6% Source: BofA Merrill Lynch Global Investment Strategy, Global Financial Data, Bloomberg, Ibbotson The bond markets look precarious As interest rates have fallen, even safe fixed income investments have delivered very strong capital returns as well as providing investors with a good coupon. Bond prices have risen to such a large degree that a number of bonds are now trading at a significant premium to par value. Exhibit 4 shows that over 75% of the high yield corporate bond market is trading above par value with some bonds trading at a significant premium (in excess of 25%). EXHIBIT 4: HIGH YIELD CORPORATE BONDS PRICE DISPERSION BY PAR % of companies Last month Current < >=11 EXHIBIT 5: BOND BUBBLE? INTEREST RATES TRUMP CREDIT Loss % of Par bps rate rise 1-year bonds Source: Fitch Ratings, Bloomberg 15 bps rate rise 1-year bonds 2 bps rate rise 1-year bonds 2 bps rate rise 3-year bonds In their thirst for yield, many investors are having to resort to poorer quality bonds issued by companies with unattractive balance sheets, just to achieve their yield objectives. Exhibit 6 shows the types of fixed income securities you are forced to invest in to achieve a 4.5% portfolio yield. One of the issuers that may have featured highly in a corporate bond portfolio offering such a yield is SEAT Pagine Gialle (a European retailer), which became the tenth company to default in 213 after it missed an interest payment on its 217 bonds. This is now the 84th company that has failed to refinance, missed cash payments or gone bankrupt in the last 12 months. In contrast, to achieve a 4.5% level of dividend yield in a defensive equity income portfolio the stocks you will hold are very different. Typically the equity holdings will be in very robust global franchise names with strong balance sheets and that have safer and more sustainable cash flows. Source: Bloomberg as at 31 January 213 In an improving environment total returns for much of the credit market may not exceed coupon payments, as upward pressure on interest rates puts pressure on bond prices. Rates do not need to rise that much in order to erode a small coupon and the fear of such an outcome is already causing bond prices to fall. J.P. Morgan Asset Management 3

4 INVESTMENT Why dividend growth strategies offer a compelling alternative as monetary policy normalises EXHIBIT 6: A HIGH QUALITY EQUITY PORTFOLIO WITH GROWTH... Dividend fund 4.5% yield Portfolio weight Time Warner +3.1 Merck & Co British American Tobacco +2.5 Pfizer +2.5 Royal Dutch Shell +2.5 Vodafone +2.3 Schneider Electric +2.2 Verizon +2.1 Australian & New Zealand +2.1 Wells Fargo VERSUS A LOW QUALITY BOND PORTFOLIO WITH NO GROWTH Global Corporate Bond Fund 4.4% yield Portfolio weight Charter Communications +1.1 NRG Energy +.9 Goodyear Tire & Rubber +.9 Ally Financial +.9 AIG +.9 SEAT Pagine Gialle +.8 Bombardier +.8 JMC Steel +.8 Alliance One International +.8 GXS Worldwide +.8 As Fed tightening approaches we believe it is a good time for clients that are looking for attractive risk-adjusted total returns to consider bond-like equities as an alternative. Exhibit 7 shows the performance of equities in the anticipation of a tightening of monetary policy from extreme levels. A gradual benign rise in interest rates is typically a boon for equity markets. Dividend funds seeing strong flows Lower risk income-producing equities can offer investors an attractive investment opportunity, in particular those investors that are seeking attractive total return prospects with low potential drawdown and low levels of volatility. Exhibit 8 shows that the equity income category has already begun to see significant inflows, even as the broader equity market has struggled to attract capital. EXHIBIT 8: DIVIDEND FUND FLOWS ARE PICKING UP USD mn 2, 1,5 1, 5-5 Monthly flows (lhs) -1, Dec 6 Dec 7 Dec 8 Dec 9 Dec 1 Dec 11 Dec 12 Source: EPFR Global as at 31 December 212 Total net assets (rhs) 3, 25, 2, 15, 1, 5, We believe investors moving from asset class to asset class and up the risk spectrum in search of excess returns over the last few years from government bonds, to investment grade bonds, to high yield bonds, and now to equity income will continue to be rewarded with a rising level of income and capital appreciation as the global economy improves. USD mn Exhibit 7: Asset class performance in anticipation of Fed normalisation Performance of equities vs bonds from 196 to % 16% 14% 12% 1% 8% 6% 4% 2-yr UST yield S&P 5 (rhs) Boon for equities Gradual, benign rise in rates (+1bps in 3 years) 2% '59 '6 '61 '62 '63 '64 '65 '66 '67 '68 '69 Source: BofA Merrill Lynch Global Investment Strategy, Bloomberg Dividend growth companies are attractively valued Within the equity income space we believe an attractive approach could be a strategy that focuses on companies with good dividend yields and the potential for dividend growth. This is for two reasons: 1. Above average dividend growth should reduce the risk of buying a stock whose dividends will be cut. 2. The combination of high yield and high dividend growth has, over time, produced better returns than a simple high yield style. 4 A high yield bond alternative

5 Recently, many investors have chased high dividend yields, and as a result these types of stocks have become expensive relative to history and relative to stocks offering high dividend growth potential. This trend underlies the recent outperformance of high dividend strategies versus strategies that seek attractive dividends supported by dividend growth. However, valuations of stocks with a high current dividend yield are near their peaks relative to high dividend growth stocks (see Exhibit 9), so we believe we are entering the sweet spot for dividend growth strategies. EXHIBIT 9: COMPANIES WITH HIGH DIVIDEND GROWTH ARE ATTRACTIVE ON A VALUATION BASIS Price/Earnings (PE) of high dividend yield vs PE of high dividend growth High dividend growth stocks expensive High dividend growth stocks cheap PE of high div growth vs PE of high div yield Average relative PE PE +1 STD PE -1 STD Source: BofA Merrill Lynch Quantitative Strategy, as at 3 September 212. For illustrative purposes only. A good example of a dividend growth stock is Swedbank, which recently announced a dividend per share that was 5% ahead of market expectations. Swiss Re also announced a special dividend of CHF 4., on top of its common dividend of CHF 3.5. This takes Swiss Re s total distribution to CHF 7.5 (representing a 1% dividend yield). These increases highlight that some companies (even in the banking sector in Europe) are generating strong levels of profitability and are returning excess cash back to shareholders in the form of dividends. As we move further into 213 we expect many more companies to announce strong dividend per share increases, indicating that balance sheets are in very good shape, companies are generating significant amounts of excess cash and they are now returning this to shareholders in the form of dividends. Risk-reward outlook for dividend strategies is more attractive than high yield bonds If clients are nervous about investing in equities, then it s worth noting that the drawdown of defensive income equities is no worse than that of high yield bonds. Dividend strategies are much less volatile than other equity strategies, having lower downside capture than typical equity products. Historically, dividend strategies have fallen significantly less than the broader market in periods when the market has fallen, while participating to a large extent in rising markets. Defensive equities with bond-like tendencies deliver sustainable income streams for investors and dividend cuts in these types of stocks are rare. The impression many investors have is that high yield bonds, although a riskier choice within the fixed income market, represent a far safer investment than the equity market overall. Exhibit 1 suggests that this assumption is true, with the maximum peak-totrough loss from holding global equities for a three-year period coming in at over 5%, while the loss is just over 3% for high yield bonds. But if we compare high yield bonds to equity income we see a different picture altogether. As Exhibit 1 shows, it is difficult to see much difference in the maximum drawdown between dividend strategies and high yield over the past 2 years. EXHIBIT 1: HIGH YIELD BONDS ARE NOT A SAFER INVESTMENT Maximum drawdown from holding global equities, dividend equities and high yield bonds Max 3-year drawdown (%) Dividend equities ML high yield bonds MSCI World Equity -6 Dec 92 Dec 96 Dec Dec 4 Dec 8 Dec 12 Source: Société Générale as at December 212. Dividend equities are companies with strong balance sheets, attractive dividends and high levels of excess cash. These companies are found in defensive sectors with betas of less than 1. J.P. Morgan Asset Management 5

6 INVESTMENT Why dividend growth strategies offer a compelling alternative as monetary policy normalises The pricing power of equities acts an inflation hedge Inflation has remained steady in the US and most developed countries. Deflation has failed to take hold despite low levels of economic activity and high unemployment. Now, easy monetary policies and the commitment of central banks to growth and to low unemployment have started to raise concern about the possibility of an acceleration in inflation. In the Fed s commitment to a 6.5% unemployment rate, there is a chance that some type of monetary policy mistake could potentially spur increases in inflation if the US central bank misjudges the degree of slack in the economy and maintains stimulative policy for too long. EXHIBIT 12: EQUITIES DO NOT TEND TO DERATE UNTIL INFLATION EXPECTATIONS RISE ABOVE 4% S&P 5 average P/E, 1871 to present Inflation range shown 12 m trailing P/E 12m fwd P/E 12m trailing P/E: to -2% -2 to -1% -1 to % to +1% +1 to -2% +2 to +3% +3 to +4% Source: Dimson-Marsh-Staunton data, Credit Suisse research. +4 to +5% 12m fwd P/E: to +6% +6 or above EXHIBIT 11: IS EASY MONETARY POLICY STARTING TO PUSH UP INFLATION EXPECTATIONS? Expected inflation rates Japan (rhs) US (lhs) Eurozone (lhs) Dividend growth strategies outperform high yield bonds and other equity strategies Over the longer term dividend growth strategies outperform high yield bonds and other equity strategies. If you had USD 1, invested in high yielding bonds in 1989 the value of your investment today would be a USD 67,17. And if you invested in high yielding equities the value of your investment would be USD However, if you invested in high yielding equities with a strong dividend growth the value of the same initial investment would be USD 166,663, nearly 2.5 times more than the return from high yield bonds (see Exhibit 13).. -3 May 7 May 8 May 9 May 1 May 11 May 12 May 13 Source: Bloomberg, J.P. Morgan Asset Management. Last data 4 February 213. Note: Ten year zero-coupon inflation swaps. Equities offer dividend growth, which acts as an inflation hedge that is unavailable in almost all fixed income markets. However, the anticipation of the end to ultra loose monetary policy and the initial rises in bond yields may only be positive for equities so long as inflation expectations do not rise significantly. Exhibit 12 shows that the equity market does not start to de-rate significantly until inflation expectations increase to over 4%. EXHIBIT 13: DIVIDEND GROWTH STRATEGIES OUTPERFORM HIGH YIELD BOND AND OTHER EQUITY STRATEGIES Performance of high dividend companies combined with high dividend growth versus high yield bonds 2, 1,8 1,6 1,4 1,2 1, High and growing dividends High yield bonds High yield equities USD 166,663 USD 91,923 USD 67, Source: Merrill Lynch High Yield Bond Index, MSCI, Worldscope, as at 31 January A high yield bond alternative

7 Conclusion: How your clients can protect income portfolios as monetary policy normalises After years of outflows, more recently equities have swung back into favour. Retail investors seem to be taking cash out of money market funds and reducing allocations to fixed income given the weaker value proposition and improving economic backdrop. There is significant risk of capital loss on fixed income investments as the central bank exit point approaches. Compared with bond alternatives, dividend growth stocks offer good riskadjusted return potential and very attractive relative value. Cash generation has been exceptional over the past few years and there is now a very large amount of cash sitting on company balance sheets. A growing number of companies are already announcing healthy dividend increases. EXHIBIT 14: EARLY SIGNS OF THE BEGINNING OF A ROTATION Funds flows Bonds* Money market Developed market equities 15 USD bn/month Source: EPFR, J.P. Morgan Asset Management. Last data 3 January 213. Note, bond fund flows exclude high yield and emerging market debt. Flows include exchange traded funds. As bond yields rise from unusually low levels we believe investment opportunities are the best in a generation in incomeproducing equities and a great prospect for investors in 213. J.P. Morgan Asset Management 7

8 INVESTMENT Why dividend growth strategies offer a compelling alternative as monetary policy normalises To learn more about the Investment Insights programme, please visit us at FOR PROFESSIONAL CLIENTS ONLY NOT FOR RETAIL USE OR DISTRIBUTION. This document has been produced for information purposes only and as such the views contained herein are not to be taken as an advice or recommendation to buy or sell any investment or interest thereto. Reliance upon information in this material is at the sole discretion of the reader. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. The results of such research are being made available as additional information and do not necessarily reflect the views of J.P. Morgan Asset Management. Any forecasts, figures, opinions, statements of financial market trends or investment techniques and strategies expressed are unless otherwise stated, J.P. Morgan Asset Management s own at the date of this document. They are considered to be reliable at the time of writing, may not necessarily be all-inclusive and are not guaranteed as to accuracy. They may be subject to change without reference or notification to you. Both past performance and yield may not be a reliable guide to future performance and you should be aware that the value of securities and any income arising from them may fluctuate in accordance with market conditions. There is no guarantee that any forecast made will come to pass. J.P. Morgan Asset Management is the brand name for the asset management business of JPMorgan Chase & Co and its affiliates worldwide. You should note that if you contact J.P. Morgan Asset Management by telephone those lines may be recorded and monitored for legal, security and training purposes. You should also take note that information and data from communications with you will be collected, stored and processed by J.P. Morgan Asset Management in accordance with the EMEA Privacy Policy which can be accessed through the following website Issued in Continental Europe by JPMorgan Asset Management (Europe) Société à responsabilité limitée, European Bank & Business Centre, 6 route de Trèves, L-2633 Senningerberg, Grand Duchy of Luxembourg, R.C.S. Luxembourg B279, corporate capital EUR 1... Issued in the UK by JPMorgan Asset Management (UK) Limited which is authorised and regulated by the Financial Services Authority. Registered in England No Registered address: 25 Bank St, Canary Wharf, London E14 5JP, United Kingdom. LV JPM5752 2/13