Why we like equities in our income strategies

Today’s low bond yields and rising interest rate expectations provide a challenging backdrop for fixed income investors. Bond market returns are likely to be modest this year and investors are having to manage their expectations accordingly. On the other hand, we believe that the current market environment provides a favourable backdrop for equities.

The divergent outlooks highlight the benefit of generating income from different asset classes. In this note we explain why we think the equity component of the Invesco Pan European High Income Fund can help to deliver attractive income and capital growth this year.

Income generation from equities

First, equities provide an important source of income for the fund.  Given the relative valuations of bond and equity markets, the yield of the equity component is currently higher than the bond component.

Bond component             2.9%

Equity component           2.1%

Moreover, this income comes from a diversified pool of high quality European companies with strong balance sheets whose dividend yield is often significantly higher than the bond yield.

Capital growth from equities

Second, the fund’s equity prices have been rising sharply and due to the current economic and market backdrop, we see potential for this to continue.

There are several interesting factors which point towards a vigorous expansion in the global economy: huge fiscal stimulus, household and bank balance sheet strength, extreme interest rate policy accommodation, upgrades to global growth forecasts and surging money supply.

Fiscal stimulus

Globally, fiscal stimulus is being conducted on a huge scale.  In the US, the just-approved American Rescue Plan is a $1.9trn stimulus package that follows on from the $900bn package approved in the last days of the Trump administration and the CARES Act, worth $1.8trn, in April 2020.  According to the IMF, these combined packages amount to 20% of GDP and dwarf the $830bn American Recovery & Reinvestment Act fiscal package passed in 2010.

In Europe, a smaller but still significant fiscal plan known as NextGenerationEU, a €750bn package consisting of loans and grants, is in place.  This is the largest ever stimulus announced by the EU and is worth 4.5% of GDP.  In addition, government loans, guarantees and capital injections amount to 17% of GDP.  

This chart shows the size of the fiscal boost in OECD economies as a result of higher spending, tax shortfalls and loans and guarantees. 

It’s clear that the consensus view on fiscal policy is very different to that of the post GFC climate as today is it hard to detect any political pressure to moderate this fiscal expansion.  Recently, Victor Gaspar, the head of the IMF’s fiscal policy unit articulated this new consensus when he stated that “the pressure to have debt coming down is something that we can let play out over a long time horizon and that the adjustment in the public debt ratio should be mostly gradual.” 

Household sector in good health

In the US, fiscal expenditures have led to a huge boost to disposable income.  The CARES Act payments alone saw US disposable income rise to a +20% year on year pace.  Combined with the enforced curtailment of expenditures, this has created a significant improvement in US household  balance sheets and the potential for a big increase in expenditures as the year progresses. 

As the chart below shows, typically, US households save $100bn per month but last year that increased to between $200bn and $500bn.  The chart also shows that US net saving (disposable income minus outlays) has reached $1.75trn, or 8% of GDP. 

A similar trend can be seen in Europe where excess savings could rise to in excess of 3% of Eurozone GDP.

Banking sector balance sheets still strong

Another feature of the recession has been the relative health of the banking sector.  Banks in the US and Europe have plentiful capital and liquidity and were well able to withstand the collapse in economic activity last year. 

Banks in Europe were forced to suspend dividends but most remained profitable even through the peak of the crisis.  Indeed, many banks have recently posted better-than-expected results, helped by lower-than-feared loan losses. 

The capital distribution ban (dividend and share-buybacks) resulted in banks accumulating excess capital which is now slowly being returned to shareholders via dividends.  Some management teams are even already announcing/preannouncing the resumption of share-buybacks.

The health of the banking sector suggests that it could be a support, rather than an impediment, to recovery in sharp contrast to the post GFC era when many institutions were focussed on balance sheet repair.

Strong monetary support

Against the backdrop of strong fiscal stimulus and a fully functioning banking sector, central banks have been very clear in their intention to keep policy rates low in order to support the recovery, which they believe can be achieved without generating overly strong inflationary pressures.

Interest rates are at record lows and central bank balance sheets continue to expand.  In the US, the Federal Reserve is still buying $120bn of securities monthly and the ECB has extended its purchases under the PEPP programme until at least March 2022.

Economic growth forecasts moving higher

The combination of economies emerging from lockdowns, fiscal stimulus and pent up demand is leading to a strong economic recovery, for which forecasts have recently been revised upwards.  GDP estimates for this year in the Euro area are close to 4% yoy and more than 6% for US GDP.

Strong money supply

Another interesting feature of this recovery has been the recent explosion of money supply as a result of quantitative easing and fiscal stimulus.  M3 (the broadest measure of money which includes currency, deposits and liquid financial products), is in the OECD growing at the fastest pace since the 1980s.  Although increases of this rate are unlikely to be sustained, if money supply growth stays elevated, this should lead to higher nominal growth.

Steepening yield curves

In response to these signs of economic recovery and rising money supply, investors in government bond markets are already starting to price in higher future nominal growth by demanding higher yields further out in the maturity spectrum, steepening the yield curves.

This yield curve steeping has led to losses in government bond markets.  For example, the ICE BofA Euro Government Index is down -2.5% YTD and the ICE BofA All Maturity US Government Index is down -2.9%.

Given the tightness in credit spread, higher quality corporate bond markets have also posted losses.  For example, the ICE BofA Euro Corporate Index is down -0.9%.  By contrast, higher yielding bonds that are less affected by duration and produce higher income have been able to produce gains, with the high yield market up just over 1% in 2021. 

Value versus growth

By contrast, the current economic and market backdrop is an attractive environment for equities, especially those which tend to do well in a cyclical upswing.  Indeed, in recent months not only have equity markets been rising but cyclical and value-oriented equities have outperformed the broader market for the first time in several years.

Equity component of the Invesco Pan European High Income Fund

The equity component makes up a fifth of the fund and typically consists of 45-55 positions.

Given the focus on income, the dividend yield of the equity component is also consistently higher than that of the MSCI Europe ex UK Index.

Whilst the focus in equities is on income, the investment process places importance on valuation and as a result, the price to earnings multiples are consistently lower than the index.

This focus on higher dividend yielding shares and more attractive valuations indicates the equity component’s style bias and as value stocks have started to outperform the broader market, so too have the fund’s shares. 

Outlook for equities

European equities have started to rise and we see real potential for this trend to continue. The cyclical economic upswing is likely to persist as economies are reopened, strong fiscal support is maintained, interest rates are kept low and money supply surges.  Nonetheless, valuations in European, and particularly value-oriented shares remain attractive having been suppressed for some time.

Conclusion

Against a backdrop of low bond yields, equities in the Pan European High Income Fund boost income.  The fund’s equities are also providing strong capital growth at a time when duration sensitive fixed income markets are posting losses. 

We believe that the Pan European High Income Fund is an important component in clients’ portfolios.  Its diversification means it can produce income and return in different market conditions.  This year, although the overall outlook for fixed income markets is modest, we are optimistic about the fund given its lower sensitivity to duration and its exposure to attractively valued European shares.