October 2008 Dividends matter Without a doubt 2008 proved to be a very trying year for global equity markets and investors are more likely than not to face further turbulence as the current financial market turmoil works its way through the system. Then again, it is not all doom and gloom. Amidst it all, Citi analysts believe that dividends may offer a silver lining.
Dividends matter While they have been largely ignored, dividends have been an important contributor to historical equity market returns. Chart 1: MSCI World Dividend Performance In Earnings Downturns Source: MSCI, Citi Investment Research. As of 30 September 2008. Recession fears overshadow Wall Street bailout America s much-anticipated US$700 billion financial sector rescue plan finally got the green light on Friday October 3, when the House of Representatives reversed an earlier vote and passed a modified version of the legislation, which included a raise in the limit for federally insured bank deposits. While the programme is unlikely to solve all the problems faced by the banking sector, without it, financial institutions are likely to find it harder to attract private capital, leading to more losses and deleveraging. However, a pre-vote US stock rally soon gave way to growing concerns about the economy and a widening of the credit crisis in Europe, sending major US indices to end the week at new lows for the year. US factory, employment and consumer spending data showed that the world s biggest economy was looking less resilient than thought. At the same time, the liquidity freeze faced by US banks spread to Europe, with governments there forced to bail out a number of banks. It may be some time before the current financial turmoil works its way through the system and equity markets are more likely than not to remain volatile. Moreover, prospects for the US and global economy remain fragile. With expectations of more turbulence to come, where can investors turn to, to tide through these uncertain times? Dividends may offer a silver lining While they have been largely ignored, dividends have been an important contributor to historical equity market returns. In fact, they have made up 3 of the annualised total return from global equities since 1970. What s more, Citi s analysis of previous global earnings downturns has highlighted the resilience of dividends during those periods corporate earnings have on average fallen by 25%, yet dividends have risen by 2.4%. Rising payout ratios have helped offset the earnings declines, enabling dividends to hold up. In this cycle, global dividends are up 6.7% since corporate earnings peaked in late 2007, against an earnings decline of 5%. In Citi s opinion, a low payout ratio (36%) at the start of the earnings downturn should also support dividend resilience this cycle, even under worst-case earnings scenarios. At the regional and sector level, relative earnings resilience during earnings downturns has typically led to strong relative dividend growth and price outperformance. This is likely to favour defensive sectors over cyclicals. Citi analysts are as such positive on Consumer Staples and Health Care. The Financials sector on the other hand looks most vulnerable to dividend cuts this time around.
Chart 2: S&P 500 Index Chart 3: Dow Jones Stoxx 600 Index -5% -5.08% -5% -9.08% -15% -11.15% -13.9-15% -25% -25% -20.57% -23.61% -3-35% -29.78% -32.24% United States Health of financial sector continue to weigh on outlook Euro-Area First ECB rate cut likely in the fourth quarter of 2008 In recent weeks, intensifying stress in the core of the US financial system has triggered a fundamental restructuring by the US authorities, with officials continuing to focus on tools to aid market functioning. Citi Faced with headwinds from the negative lagged impact of prior euro strength and the slowdown in global demand, Citi analysts believe that exports may probably slow next year. analysts believe there is a large possibility that the Federal Reserve (Fed) may cut its policy interest rate by another 50 bps to 1% before year end, given deteriorating financial conditions. Nevertheless, Citi analysts expect the prolonged period of economic weakness to help bring down inflation and reduce risks of second-round effects from earlier oil price increases. Meanwhile, the earlier boost to consumer spending from tax rebates appears to have dissipated while Citi analysts think that relief from high fuels bills is likely to be dulled by slowing income gains and negative wealth effects. Against this backdrop, Citi analysts now expect the European Central Bank (ECB) to incrementally lower its interest rates to 2% by the end of next year. Nevertheless, the combination of rising economic slack and financial restraint on demand supports Citi s view that an eventual moderation in inflation is likely to aid investor confidence and improve prospects for economic recovery later next year. In light of the unsettled credit environment, investors risk appetites continue to remain suppressed as they shift towards less risky asset classes. Nevertheless, equity valuations continue to remain at attractive levels and Citi analysts believe that bailouts may help equity markets find a floor. In view of the economic and market developments, Citi analysts have trimmed their 2008 year-end S&P 500 and Dow Jones Industrial Average targets to 1,200 and 10,800 respectively. Against this setting, Citi analysts continue to favour high dividend yielding companies with strong balance sheets and positive earnings trends. In particular, Citi analysts are overweight defensive sectors such That said, Citi analysts maintain that the equity market is reasonably as Health Care, Food & Beverage and Telecoms while underweight Banks, Autos, Construction and Retail. well positioned to contend with the overriding concerns over the longerterm; and point to attractive valuations, solid corporate balance sheets (excluding financials), and strong free cash flow generation as drivers for equities going forward. Within US equities, Citi analysts favour small and mid cap stocks over large-cap stocks given their historical pattern of outperforming large-cap stocks as markets rebound in anticipation of an economic recovery.
Chart 4: Topix Index -5% 2 1 Chart 5: MSCI Asia ex Japan Index 8.63% -15% -13.33% -25% -23.0-3 -17.08% -3-35% -26.31% -32.74% -4-5 -39.02% -39.56% Japan A delayed return to trend growth Asia Pacific Asian macroeconomic policies likely approaching a turning point Private consumption is likely to remain lacklustre in coming quarters, as some hikes in food and energy prices are still in the pipeline and wage growth remains tepid. Moreover, despite the recent drop in oil prices, the current price level still poses some downside risk to corporate profits. In this context, Citi analysts believe that business investment is Recent economic data such as moderate export growth and sluggish industrial production all point to weakening economic activities in the months ahead. Meanwhile, despite volatilities in the oil market, the general downward trend of commodity prices and slowing aggregate demand may substantially reduce Asia s inflation risk. likely to remain flat. As such, Asian macroeconomic policies appear to be rapidly Meanwhile, export growth may probably be modest given the slowdown in major trading partners economies. But exports to commodity producers could likely provide some support. As such, Citi analysts believe that a return to trend growth may probably be delayed until the approaching a turning point from tightening to easing, due to a shifting of balance of policy concerns toward growth. In particular, Citi analysts expect short-term interest rates to move lower in coming months, most likely in Hong Kong, China, Taiwan, Thailand and Singapore. global economy potentially picks up in the second half of 2009. Asian currencies are likely to remain weak in the next 1-3 months as Citi analysts expect the Bank of Japan (BOJ) to maintain status quo in monetary policy (0.5%) through 2009. Uncertainties surrounding the global economy and financial markets, coupled with sluggish domestic demand is likely to continue to dissuade the BOJ from hiking interest rates. Moreover, increasing evidence of a slowdown in the global slowing growth, rising financial risk and lower interest rates continue to exert further pressure. However, Citi s 12-month outlook for Asian currencies appears to be somewhat brighter, given the generally healthy external position of most Asian economies and especially if US financial conditions stabilizes. economy, including Japan s important trading partners in Asia, will probably make a rate hike extremely difficult in 2009. Citi analysts note that investor sentiment is poor with many stocks trading below their 200-day moving average. With only 11 months into Citi analysts forecast the fair value for the Tokyo Stock Price Index (TOPIX) to be around 1,500 at end-2008, but anticipate range bound the current downturn, Citi analysts believe that Asia equities may be halfway through a 21-23 month slide from peak to trough valuations. trading for the rest of 2008. Against this backdrop, Citi analysts suggest that investors focus on Although Japanese banks are likely to remain volatile, Citi analysts see potential opportunities, as balance sheets appear conservative, while leverage and exposure to problematic credit markets appear low relative to foreign banks. markets and sectors that offer attractive valuations, strong cash flows and high dividends. Hence, Citi analysts continue to favour banks, telecoms, utilities and tech sectors, and prefer large caps to small and mid caps, and North Asia to China, India and Southeast Asia.
Chart 6: MSCI Emerging Markets Index 3 2 1 18.99% Favour high-grade corporate bonds US Treasuries Citi analysts remain underweight US Treasuries as current rates appear over-valued. However, for long-term investors seeking exposure, Citi analysts favour the 2- to 10-year portion of the yield curve. -3-4 -17.71% Performance data as of 29 August 2008 Emerging Markets -36.82% -34.69% Sharper disparities across emerging markets US Corporates Citi analysts prefer high-grade corporate bonds given that the risk/reward trade-off seems more attractive and valuations appear compelling. On the other hand, Citi analysts are cautious on high-yield bonds, as high yield spreads have typically risen further during recessions. Euro Bonds Inflation pressures combined with slowing growth are likely to steepen the euro yield curve. For investors desiring exposure, Citi analysts prefer the 2- to 3-year maturities on a slower growth scenario. The rise of financial distress, along with lower capital flows and risk appetites, is likely to weaken growth emerging markets and at the same time drive sharper disparities within countries. In particular, the recent spate of weak data out of the European Union Emerging Market Debt Citi analysts remain neutral on emerging-market bonds. For investors who are seeking exposure, Citi analysts favour countries which have sound economic fundamentals and minimal amount of political risk. (EU) is likely to put pressure on central and Eastern Europe. On the other hand, industrial production in Latin America may see some slowdown, given strong trade ties to the US. In the meantime, while weaker commodity prices appear to be creating a drag on countries in Latin America, CEEMEA s 1 terms of trade may see improvements. That said, Citi analysts believe that the financial crisis along with lower oil prices may lessen concerns for commodity-driven inflation and is likely to create room for monetary policy easing, albeit selectively, across emerging markets e.g. Mexico, Czech Republic and the United Arab Emirates. In Latin America, Citi analysts now favour Brazil given improved domestic fundamentals, still solid earnings momentum and compelling valuations. Sector wise, Citi analysts are overweight Materials and Telecoms. In CEEMEA, decent valuations and lower political risks lead Citi analysts to favour Romania and Croatia. On the other hand, markets such as Kenya and Jordan appear expensive and somewhat more exposed to macro risks. 1. CEEMEA is the collective term for Central and Eastern Europe, Middle East and Africa. 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Without a doubt, 2008 has proved to be a very challenging year for investors and one that looks on track to be amongst the most volatile years for global equities since 1970. As the current financial market turmoil works its way through the system, we take a step back in this issue of Investment Insights and take this opportunity to underscore some evergreen investment principals. Dos and Don ts in a volatile market Do s & Don ts Expect higher volatility Don t Make Rash Decisions: Despite the volatility, moving in and out of your investments can be extremely costly Think Portfolios: Be positioned for a market recovery Don t Sit on the Sidelines: Markets can rise as quickly as they fall. Sitting out in cash may mean missing out on the recovery opportunity Review and Rebalance according to your investment objectives Don t take Excessive Risk: While you may want to consider reentering overbought markets, you should also hold some developed market equities Invest regularly: During volatile markets, investing regularly may reduce investments average costs Be Diversified: As investors may become more risk averse, it is important to hold a variety of assets according to your risk appetite Don t Panic: It is natural for markets to correct. Long term goals cannot be met by panic selling at the first sign of volatility Don t Chase Momentum: Waiting for markets to recover may diminish your potential returns. Consider re-entering the market in stages Evergreen Investment Principals There s Never The Perfect Time: There is unlikely to be an extended period without some geo-political or economic crisis. However, over the long term, markets tend to trend up. It s Time In The Market, Not Timing, That Matters: It is impossible to time the market perfectly. So consider your long-term investment objectives and STAY Invested. Fright Or Flight? Hold On To Fundamentals: Don t be panicked by short-term trends. Bear in mind that markets can rise as quickly as they fall. If the recent fall caught you by surprise, the rise may also be SO RAPID that you are unable to re-enter the market in time to reap the POTENTIAL BENEFITS. Source: Citibank N.A., Singapore Branch, Regional Wealth Management. General Disclosure The Investment Insights section is for general reference and educational purposes only. Hypothetical scenarios presented are only to illustrate approaches to wealth management that are not and should not be relied upon as investment advice; each person s individual situations may differ. Nothing contained in the material constitutes a recommendation for the purchase or sale of any security and/or currency. Although the statements of fact in this report are obtained from sources that Citibank consider reliable, we do not guarantee their accuracy and any such information may be incomplete or condensed. Any person considering an investment should seek independent advice on the suitability or otherwise of the particular investment. Investments are not deposits or other obligations of, guaranteed or insured by Citibank N.A., Citigroup Inc., or any of their affiliates/subsidiaries (unless specifically stated), or by any local government or insurance agency, and are subjected to investment risk, including the possible loss of the principal amount invested. Investors investing in investments denominated in non-local currency should be aware of the risk of exchange rate fluctuations that may cause a loss of principal. Past performance is not indicative of future performance, prices can go up or down, Mutual Funds are not available to US Persons and may not be available in all jurisdictions. 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