What could kill off the safe income theme as we know it
It also prompted a few emails and the question "What could possibly kill the safe income theme"? So with prompting from my friend and colleague Andrew Quin, the Patersons strategist, here are three possible scenarios for the market ahead, one of which includes the end of the safe income theme as we know it.
Firstly, muddling along with Dutch elm disease - the resources engine slows down and other sectors of the Australian economy don't pick up. This is not the best outlook for the market but it is the most likely. Without the Australian economy kicking along, without money in the government coffers, without the Aussie dollar falling over, the market is quickly going to look expensive because it needs a dose of earnings growth to back up the recent share price rises.
Under this scenario the focus on safe income will remain although actually making money will require good stock selection, timing and a willingness to trade. Simply holding safe income stocks will achieve the income but when your capital starts deteriorating 2.5 per cent yields in term deposits are going to start looking good again.
Secondly, a surprise lift in some sectors - this would be best for traders and not great for the safe income theme but not terrible either. It involves miraculous improvement in Chinese growth prospects, the global growth trend or (and most likely) US growth.
If it happens you can forget about your safe income stocks because everyone who doesn't bury their head in the sand of safety will be making a fortune in the resurrection of the currently shunned cyclicals, discretionary consumer and resources sectors.
The problem with this scenario is that it is unlikely or, more likely, will happen only incrementally over a long period in which the whole market including safe income and cyclicals will struggle to justify further price earnings (PE) expansion from here (that means prices going up without earnings going up) and will therefore range trade.
Again, making money will require good stock selection, timing and a willingness to trade. But there is so much money to be made if global growth does kick on that even the safe investor should keep tabs on China and in particular US house prices and US unemployment.
Thirdly, a rise in global interest rates - the one that threatens the safe income theme the most would be a bottom in US interest rates. It would end the safe income theme and reverse the PE expansion in the safe stocks. We got a brief preview of what it would look like last November when the Federal Open Market Committee started to hedge their bets on interest rates.
Suddenly they started talking about raising rates when unemployment got to 6.5 per cent. The resources sector rapidly rallied. It has since petered out but there's nothing to say that the US recovery won't start to gain traction in which case it will happen again.
The lead indicators are US bond yields. In November, they started to rise. Look for that again.
The other obvious clue will be a change in US Federal Reserve rhetoric, they will start to talk interest rates up before they actually move official rates up. Then look for a pull back in quantitative easing, a sure sign that the bottom on interest rates is in.
The stock market hitting record highs also helps, it relieves the pressure on policy and allows the Federal Reserve to relax a little bit. In fact, it may force their hand as Congress starts to ask questions about their aggressive monetary policy causing a bubble in the housing market and the sharemarket.
That sort of discussion is another lead indicator of a change in interest rate trend. If it happened, then our resources sector would fly again, cyclicals (media, builders) would follow and consumer discretionary (retailers) would be close behind. At the same time those banks, Telstra, infrastructure and utility stocks that are all on cyclically low yields and high PEs will suddenly look a lot less safe than we currently give them credit for.
Frequently Asked Questions about this Article…
The “safe income” theme refers to stocks that pay steady dividends and are perceived as lower risk — typically banks, Telstra, infrastructure and utility stocks. Everyday investors like them because they promise predictable income and have benefited from low interest rates and price/earnings (PE) expansion that made dividend-paying stocks look attractive.
The article outlines three scenarios: 1) a ‘muddling along’ economy where resources slow and earnings growth stalls (safe income remains popular but returns are hard-won); 2) a surprise lift in global growth that sends investors into cyclicals and away from safe income; and 3) a rise in global (especially US) interest rates — the last of which is the most direct threat because higher rates reverse PE expansion and make dividend stocks look much less attractive.
Rising US interest rates would push bond yields up and reverse the PE expansion that boosted many safe income stocks. As yields on bonds rise, dividend stocks with cycically low yields and high PEs (like some banks, Telstra, infrastructure and utilities) would look less safe, and their share prices could fall as investors reprice equity risk versus fixed income.
Watch US bond yields (their rise is an early clue), changes in Federal Reserve rhetoric (talk of raising rates before official moves), and signs of a pullback in quantitative easing. The article also notes that record highs in the stock market can prompt policy scrutiny that precedes changing rate trends.
A genuine surprise lift in global growth would likely favour cyclicals — resources, consumer discretionary and other growth sectors — and reward traders and risk-on investors. In that environment, many investors would rotate out of safe income stocks and into shunned cyclicals, reducing the appeal of steady-yield names.
Under that scenario the focus on safe income would likely remain because investors still want income. However, the article warns that simply holding these stocks might not be enough: making money would require good stock selection, timing and a willingness to trade. If capital values deteriorate, term deposit yields (for example 2.5% in the article) may begin to look more attractive.
The article suggests these groups are the most exposed if rates rise. Banks, Telstra, infrastructure and utility stocks that currently trade on high PEs and low cyclical yields would suddenly look less safe, because higher interest rates and bond yields tend to reduce the relative appeal of dividend-dependent valuations.
Keep an eye on lead indicators (US bond yields, Fed rhetoric and QE moves), monitor global growth signals (China and US housing/unemployment), and be prepared to use active stock selection, timing and trading rather than just buy-and-hold. Also consider the relative appeal of cash or term deposits if capital values of dividend stocks look likely to deteriorate.
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