This lack of yield forced income-seeking investors into the equity markets and, amid weak post-crisis sentiment, they primarily focused on equities that were the most appropriate substitute for bonds; mega cap, defensive income stocks from the developed markets.
These “bond proxies” now appear expensive. Further adding to their unattractiveness, defensive income stocks have historically struggled amid rising interest rates, an environment generally expected going forward as rates revert to more typical levels. Historically, income-seeking investors rotate from defensive income stocks to safer government bonds when rates become sufficiently attractive. In contrast, more cyclical income stocks can still perform well when rates rise.
Although bond yields globally have rebounded during the past year, as the economy slowly recovers and central banks discuss removing monetary stimulus, the yields available in the equity market still remain competitive.
Historically one would typically have had to give up yield to shift from corporate bonds to high-yielding stocks, but in the current environment this shift would enhance income generation. Another benefit of equities versus bonds includes the ability to grow dividends over time, as well as offer some protection from rising inflation as dividends have historically grown faster during periods of accelerating inflation.
With sources of income beyond bonds still required, and the obvious sources of income in the equity market unappealing, where does an income-seeking investor find the best high-yielding stocks in the equity market?
We believe investors need to take an unconstrained approach to equity income investing that considers a wide variety of high-yielding companies, many of which are more attractively valued than mega cap, well-known defensives.
While high-yielding stocks outperform on a global basis, the alpha generation of a yield screen is even stronger among emerging markets and mid-cap stocks. We also believe that emerging-markets equities are currently oversold, with 2013’s market pullback obscuring what remain strong fundamentals.
Developed-market equities have rerated dramatically post the Financial Crisis and now trade at 18 times earnings, in large part because the United States trades at nearly 19 times earnings. In contrast, emerging markets trade at only 12 times earnings and the relative price/earnings of emerging-markets companies versus their developed-market peers has rarely been wider.
Unlike the United States, where high-yielding stocks trade at an uncharacteristic premium to the broad market due to demand for bond-like income, emerging-markets high yielders do not possess this valuation premium.
Additionally, emerging-markets stocks are currently generating a higher return on equity than the developed markets, as they have consistently for the past five years. Emerging-markets companies are also generating a higher free-cash-flow yield than developed-market companies, which is quite surprising since many developed-markets companies are hoarding cash rather than building factories and hiring people, while emerging-markets companies must spend to meet growing demand.
What has created these regional valuation anomalies are a variety of macro concerns, including the impact of the US Federal Reserve’s (the Fed) tapering of its bond purchases on emerging economies and the general slowdown in those regions during recent years.
Although such fears are not wholly unfounded, they ignore what are still generally structurally-sound markets.
However, there is an overriding argument addressing the current issues facing the emerging markets that we feel history has already disproven.
Concerns about the decline in emerging- markets growth, coupled with an enthusiastic outlook in the United States, as low energy prices are perceived to be driving a “manufacturing renaissance”, have led to the idea that global economies have “decoupled” and that developed markets can generate robust growth while the emerging world languishes.
The term “decoupling” brings back memories of 2010 when many investors assumed that a “decoupling” would take place where the emerging markets continued to grow stronger, due to their many structural advantages, and the developed world languished in debt and low growth, all caused by a financial crisis of its own making.
This flawed thesis set the emerging world up for four years of underperformance as ambitious growth forecasts were consistently missed. Analysts and commentators are again talking about decoupling, only this time in reverse. Again we disagree and for the same reasons.
Economies are increasingly integrated and the weakness or, in the current climate, strength of the developed world will continue to drive the health of exports in emerging markets. We feel the current enthusiasm for the developed world and the deeply negative sentiment on the emerging world are difficult to reconcile in an increasingly integrated global market.
If the economic recoveries in the United States and Europe turn out to be nearly as strong as 2013’s sharp equity-market rallies in those regions would suggest, emerging markets can conceivably expect a substantial boost in export demand.
While emerging economies have slowed, many of the traits that encouraged investors in 2010 remain. Government debt to GDP in the emerging markets in aggregate is low and falling while the developed world in aggregate has a high debt-to-GDP ratio, which is nearing the 90% level that has historically inhibited growth.
While growth has slowed in many emerging markets, consumer spending has been remarkably resilient as living standards continue to rise and many consumers gain access to credit for the first time. Emerging economies are also much larger and more diversified than they were in the 1990s when changes in Fed policy disrupted economies.
