2012 was a good year for investors at both ends of the risk spectrum.
Gilts produced solid single-digit returns and equities delivered robust double-digit gains after a difficult 2011. The progress in gilts came at the expense of income, as rising prices compressed yields.
In contrast, equity returns were stronger, but came with the ever-present issue of renewed downside risk. However, healthy dividends proved sufficiently attractive recompense for those investors willing to embrace the inherent volatility of equities.
Indeed, investors increasingly recognise that we are living though an era of prolonged low interest rates, boosting the importance of dividends to total return going into 2013. With this in mind, we outline three income themes advisers may wish to consider.
The first is supportive US tax policy. In the US, markets rallied sharply following a last-minute solution to the ‘fiscal cliff’. However, what was not so widely reported was that taxation regarding US dividends was also finally clarified.
Income and capital gains will continue to be treated equally. This is particularly significant given the increased number of US companies, such as Apple, that have chosen to pay dividends to shareholders. Maintaining the status quo should be supportive for these companies, as US pension funds will not feel compelled to reduce allocations to the sector. Following significant sector expansion, advisers now have far more US income funds to choose from than a year ago.
Secondly, there are significant opportunities in emerging markets. Growth in emerging markets dividend funds has been remarkable. A year ago, we analysed half a dozen, none of which had a three-year track record. Now, the universe has more than doubled and, while still in its infancy, the case for sustainable yield in emerging markets looks compelling.
More than 25 per cent of companies yielding more than 3 per cent in the FTSE World index are listed in developing markets. The success of Asian income funds shows that emerging income could enjoy similar growth as more companies pay dividends. In addition, we have seen some exchanges imposing payout ratios.
And finally there is the potential opportunity in Japan. Domestic demand for equities in Japan evaporated within the deflationary environment and Japanese government bonds provided positive year-on-year returns with enhanced purchasing power.
The Bank of Japan’s attempts to create some much-needed inflation may change this, as success could prompt capital reallocation from bonds into equities. Japan might surprise on the upside and, with the Topix providing a similar yield to the S&P 500, provides an income stream too. Sterling investors may start to reconsider this much maligned sector and hedge the associated yen exposure.
The concurrent rallies in equities and government bonds in 2012 are likely to prove unusual, with modest yields from bonds leaving little scope for further capital appreciation. Indeed, the much more attractive yields from equities – combined with their income growth and capital appreciation potential – are likely to garner increasing investor attention this year.
