Ratings

29 May 2020

  Fidelity

Fidelity: It's not all negative news for income seekers

Economic data is finally reflecting the impact of economic lockdowns, and markets have seen a meaningful risk rally. Given the extent of the economic slowdown and the unknown duration of the crisis, Eugene Philalithis, portfolio manager of our Multi Asset Income range explains why he still thinks it's too early to move to a risk-on posture. But it's not all negative news, he also dissects the far-reaching policy responses from governments and central banks and explains why dividend investors shouldn't lose hope.

Key points

  • Given the extent of the economic slowdown and the still uncertain duration of the crisis, we think it is too early to move to a risk-on posture.
  • Income investors have hit headwinds in dividend-paying equities, but our equity research analysts are still seeing dividends being maintained in 70%-80% of our exposure.
  • The economies of North East Asia and Singapore have the potential to recover lost growth quicker as their government’s management of the Covid-19 outbreak facilitates a quicker rebound in activity supporting internal demand within the region.
Given the current environment, we maintain our bias towards positions higher up the capital structure, and we have strong conviction in some areas of the credit markets. As the worst of the sell-off hit, credit spreads widened meaningfully and significant indiscriminate selling led to more attractive valuations, even in corporates with strong balance sheets and cashflows. While we turned constructive on investment grade in March, the Fed’s policy support has provided the catalyst for our view to become positive on high yield in the US, where we had been cautious until recently. In addition, we have shifted exposure from emerging markets local currency debt into US, Asia and European high yield. We don’t think ‘fighting the Fed’ or other major central banks is prudent, and until we see a meaningful turnaround in the economic backdrop, our preference for adding to risk is likely to remain for debt over equity securities.

 

Dividends are a bump in the long and winding road to recovery

As income investors, we are of course acutely aware of the headwinds for dividend-paying equities as earnings are likely to struggle throughout the year. The recession is also likely to drive greater dispersion among current dividend payers, while the overall level of equity income falls. This view certainly feeds into our bias to credit overall, and highlights how a multi asset approach to income investing offers up the flexibility needed to navigate the challenges of this market environment. But behind the dreary headlines on dividends lies a lot of nuance, and we work closely with our colleagues in equities to gain some clarity on the high levels of dispersion within the universe of dividend paying equities. Even given the bleak forecasts for the global economy, so far dividend cuts have occurred in the areas hit hardest by the economic shutdown and Fidelity equity researchers still see 2020 dividends being maintained in 70%-80% of our exposure. But there could be meaningful regional differences.

 

Looking to Asia for guidance

The economies of North East Asia and Singapore have the potential to recover lost growth quicker as their government’s management of the Covid-19 outbreak facilitates a quicker rebound in activity supporting internal demand within the region. Companies there may not need to adjust dividend pay-outs or any that do may be able to return to previous levels quickly. Asian companies showed how nimble they could be after the Great Financial Crisis, reducing dividends in 2009 but returning to previous pay-outs in 2010, in contrast to European companies that have yet to reach pre-2009 dividend levels because of economic stagnation. Also, the longer the recession the higher the chance of insolvency and then regulation becomes a key factor. The US government’s bailout program under the CARES act requires companies that receive help to stop paying dividends and buying back shares. France will take the same approach. UK and European regulators appear to have been more aggressive by recently requesting that banks and some insurers stop paying dividends for a short period. Importantly, these are dividend deferrals and not necessarily permanent cuts.

 

There is big divergence across markets

There are also major differences across sectors and companies. Some of the oil majors are well known dividend stalwarts, and they are under significant pressure from low oil prices. Meanwhile, some sectors will be able to maintain pricing power and could even increase revenues, such as gaming and tech companies. Key determinants of a company’s ability to maintain dividends include the percentage of fixed versus variable costs, the flexibility in operational costs and balance sheet leverage. Knowing corporate management is very important as some dividend policies are more conservative than others.

In this environment, we would also highlight that caution is required in taking a passive approach to equity income investing, as this can inadvertently lead to relying too heavily on the traditional income-generating sectors like oil producers. These sectors often feature in the top exposures among income-orientated ETFs, for example. A passive approach can also come with other issues. A rules-based based approach to passive management often only alters positions once a dividend payment has been missed and foregoes the benefit of reacting to announcements on dividend cuts. An active approach to income investing will potentially never be more valuable.

Another strategy that features in the Income range is an enhanced income approach, which makes use of call overwriting. This approach gives up some upside potential to returns to deliver higher distributions. But the potential upside from today’s valuations may still offer a decent return for these strategies, while their often more diversified sector mix avoids the pitfalls of a passive approach.

In this challenging environment, a multi asset approach to income investing can incorporate all of these many considerations into portfolio positioning. We believe our income-focused strategies are positioned well to deliver on our objectives through our ability to allocate dynamically across the full spectrum of income paying assets.

Important information

This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The Fidelity Multi Asset funds use financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Investments in overseas markets, changes in currency exchange rates may affect the value of an investment. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between different government issuers as well as between different corporate issuers. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the fund investing in them. Changes in currency exchange rates may affect the value of investments in overseas markets. Investments in small and emerging markets can be more volatile than other more developed markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.


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