UK equity valuations no longer as compelling for income investors

0:11David Thorpe: Hello and welcome to the latest edition of the FT Advisor podcast. I'm David Thorpe, Senior Investment Editor at FT Advisor. Today's topic is constructing an income portfolio. Following almost a decade where bonds yielded basically nothing and most of the best performing equities similarly would have struggled to justify a role in an income portfolio allocators now have almost the opposite problem with plenty of yield around but also higher interest rates and inflation to contend with as well as acutely high levels of volatility joining me to discuss the topic are stuart rhodes who runs the mng global dividend fund hillary blandy who runs the jupiter monthly income bond fund and nick stanhope senior portfolio manager at morningstar nick if we come to you first markets have rapidly repriced interest rate expectations in the us and uk this year and inflation is now or a more persistent level of inflation is now baked into many calculations but how is that impacting how you run the income strategies that you look after at Morningstar.

1:27Thank you very much for having me here today. Post the very sharp increase inflation that we experienced in 2022 and the sharp increases in interest rates, our asset allocation in the income portfolios at Morningstar very much was skewed towards fixed income. And actually our allocation towards equities is as close to the bottom as we would typically have. As inflation had been coming down, our expectation had been that we were likely to start to reduce our exposure to fixed income and gradually increase our exposure to equities. However, with this sharp increase in energy prices and a lot of uncertainty, we do think inflation is likely to rise, albeit we don't think we're going to see the same levels of inflation that we saw in 2022 because it's not coming with huge amounts of fiscal stimulus and monetary policy easing as well and the opening up post-COVID as well.

2:29So nonetheless, we do think inflation will be there. What we've seen in the UK and in the US is that interest rate expectations at the short end of the curve have risen and therefore the yield on offer is actually more attractive at the short end. So where we thought we were going to be allocating more to equities, I think our allocation will stay skewed towards fixed income and actually we're seeing more opportunity at the short end.

2:57David Thorpe: Thank you. Hilary, on that fixed income topic, I guess higher inflation and rate expectations is kind of the kryptonite for a fixed income manager. How are you thinking about all of that? Yes, I mean, you know, we have seen a pickup in short term inflation expectations as a result of the war in Iran. But, you know, I think it's important to remember that that's also in the context of an environment in which inflation has been very elevated, you know, very persistently. If you look at core inflation, which is the measure that central banks focus on, that's been above target in the US and UK and many other countries for over five years now.

3:34So what we've got here is an inflation impulse in an already very inflationary environment. and the consequence for bond markets is that drives much higher levels of volatility. And if you want a clear example of that, if you look at what two-year gilt yields did in March, that was the fourth biggest one-month move in data that goes all the way back to the early 90s. But the first and second biggest moves were in 2022 and the third biggest was in 2023. So in my portfolio, generally we keep the duration of the fund relatively low. Because if you invest with lower duration, you reduce your exposure to interest rate risk and you reduce your exposure to macro shocks.

4:18In recent months, we've been tactical around duration where we can. But generally, our bias has been to the lower end of our normal range. But what I would say around positioning is there's a huge amount of uncertainty in the market at the moment. And we don't really feel that this is an environment for taking some very big directional calls. In macro environment is really, really important. But it's inherently unpredictable. If you think about the pandemic, Ukraine, what's happening now in the Middle East. And instead, if you use an approach where you're perhaps more focused on company fundamentals, where you're looking for good companies that generate high levels of free cash flow, that have appropriate capital structures, that in some ways is easier to predict and over a three to five year period, you'll probably do quite well.

5:15David Thorpe: Thank you. Last but certainly not least, Stuart, as an equity income investor, what have you made of the recent market movements? Particularly, I suppose, there's been a charge back into those large US tech stocks, which are not necessarily a haven for dividend searchers. How has that impacted how you see the world? And just a generally higher level of rate expectations, how does that impact what goes into your portfolio? Sure. So on the inflation topic that we've just been discussing, I think it is kind of a long-running thing that we've had inflation as more of an issue to deal with for four or five years or so.

5:58And it's still taking the market a bit of time to grapple with this because what it's done is it's upended what was a very popular trade for the best part of a decade, where we had sort of the quality part of the market, the bond proxy part of the market, do exceptionally well for such a prolonged period post the global financial crisis. And then the kind of recurrence of the reoccurrence of inflation coming through has really sort of stopped that trade in its tracks. and we've seen the quality part of the equity market certainly underperform for the best part of three years or so and underperform quite dramatically.

6:37And that has taken a lot of people quite a bit of time to get used to. And this is really kind of, I guess, an education to people of the damages that inflation can do, that if you're not growing to kind of offset that, then it really will eat into your returns. So I guess the low growth kind of quality part of the market has been very difficult for a prolonged period of time. Most of the reason for that is because it was very expensive to start with. And that is gradually being eroded down and the valuations are getting more reasonable there. But really, I think the skill has been not to jump in too early to that part of the market and stay disciplined on waiting for the valuation to get to the right point.

7:21so I think that's been a big part of equity markets for three four years and then as you quite rightly highlight you know the technology side is the other other side which has really been a phenomenal trade for a long long period of time so as a dividend manager we've just got to work very hard on identifying the companies that are relevant for our strategy that do pay dividends and do grow their dividends and then be very patient and wait for the opportunities that you get to buy them. And whilst, you know, you might think that you haven't had many of those opportunities, they do materialize.

7:56But in recent times, you've had to be very quick to pounce on them. So if I think about the last year or so, you know, the initial reaction to the Trump tariffs back, you know, April last year, that gave you a window to buy technology at very reasonable prices. Admittedly, it didn't last long, but the window was there. And then I guess more recently, the initial reaction to the iran war as well you know these are the moments you have that if you're brave enough to be taking the other side of that trade that that is often the entry points that are reasonable to buy you know the great technology businesses that do pay dividends you know the microsoft pays a great dividend for a long period of time tsmc's paid a dividend for a long period of time you know the options are there you just have to to wait patiently for the time to strike

8:41David Thorpe: Thank you. Hilary, one of the challenges, I guess, that anybody has that runs an income strategy is trying to strike that balance between income generation, which obviously it's in the name of your fund and clients are going to be interested in that, but also capital return. and as a fixed income manager how do you think about that challenge I mean you could load up on high yield stuff and have a very nice yield but there are risks in that or you could buy something now yielding and it preserves capital but it doesn't pay the yield what's the balance like? Yeah I mean absolutely so in the strategy that I run we invest in a blend of investment grade and high yield bonds and as you say if you look at the long term performance of various corporate credit indices over the long run returns tend to be driven by that income component and it really comes back to this sort of old thing that in credit you know unlike in equities your upside is capped so you're never going to make 200 times your money in nvidia and so really as an asset class it's much more suitable for a more income focused approach and the nice thing about that is if you You can generate a really decent yield on your fund that provides you with a kind of cushion or buffer to any deterioration in your underlying asset prices.

10:09So essentially what it does is it positively skews your return. So alongside that for us, of course, there's also a component of capital appreciation. That's much more around valuations. It's around looking to buy bonds that you think are mispriced by the market. selling them when you think they're expensive. It's around adding risk when risk looks cheap. But essentially for us, our core objective is to generate yield with relatively low volatility. So for us, it's much more around harvesting income whilst also balancing the risks in the fund and also doing that from a bottom-up perspective, from an issuer level.

10:50So avoiding those defaults. Sure, as an equity income manager, I mean, there have probably been challenging years where an index fund that is overloaded with things that don't pay a dividend has performed very strongly relative to an income strategy

11:07David Thorpe: because you have to get a yield and that presents challenges for anyone running an income fund or trying to grow an income fund. But in your strategy, how do you think about that balance of a total return that is attractive versus owning the income generating stocks that maybe don't top the charts when it comes to capital appreciation? Yeah, sure. It's kind of a patience and a discipline point to focus on what you can control. So this is I'm about to finish my 18th year running this fund. So we've been doing it a long time. And, you know, we're still focused on delivering kind of the same outcome when we first launched, which is to offer a competitive starting dividend yield today.

11:49So somewhere around three, three and a half percent. And then grow it and then grow it every year and try and grow it at a rate that will comfortably see off inflation. And obviously in the first 10, 15 years of doing that, inflation wasn't a particularly difficult barrier to get over. And we were able to do that very easily. but now obviously the inflation target is a bit higher so we've got to make sure that we are still growing at a rate you know eight nine percent something like that where we can see off that inflation rate and it's to focus on those kind of issues rather than get too caught up in what's happening this quarter or this year and we acknowledge there will be certain times when you know those big tech stocks or or the the growthier part of the market at high valuations is what's driving returns.

12:35And we will work as hard as we can to try and cling on to the market at that point and keep pace with it, knowing that in different markets, we will be in a position to deliver much more competitive returns without the benchmark. 2022 was a good reminder for everyone about that. So 2022 was probably the last year where technology had a really difficult year. And you'll see that quite a lot of more traditional kind of dividend funds delivered very outsized returns during that that kind of period so you know i'm i'm much more focused on what we can deliver over 10 20 years and build and compound those returns knowing that in short term periods it it might be difficult in the environment you describe or actually in some cases it might we might have a huge tailwind behind us and we need to acknowledge that as well

13:26David Thorpe: thank you um nick at morningstar obviously that as a firm you have clients who choose an income strategy clients who choose a growth strategy etc etc uh with the with your income hat on how do you think about that that balance and you mentioned earlier um material exposure to fixed income for example um which is less of a capital appreciation asset but so how do you think about the balance? So yeah within our income portfolios we're trying to generate a return above the base rate 1 % for the cautious fund and actually 2 % for the moderate fund above base. So to some degree you know what's going on where the income is coming from is going to be a large driver of you know where we can put money to work for income or where we can put it towards capital growth.

14:19Actually, what we've seen in recent periods, actually, some of our key building blocks that we would use to generate income have actually performed very strongly. So UK equities, for example, still remains a very high dividend paying part of the equity market and has actually performed very well. Utilities, obviously a classic part of the market for income managers, has also performed very strongly, picking up as a beneficiary of the AI story to some degree. But with the high yields on offer within fixed income, this has allowed us to put some money to work in some of those other ideas that we have, which are very much there for capital appreciation.

15:06So one of the ideas we've had in the portfolio for a while is South Korea. And this is about the story about the memory cycle linked to AI. We are value-driven investors, and it's something that we picked up on early when those valuations looked very cheap. Something that we still have in the portfolio today. and one of the more recent ideas that we put in the portfolio is Latin America, particularly Brazil, where valuations are very cheap, but actually in this instance yields are also very attractive within that as well. So this has allowed us to not only pay a decent income, but actually have decent capital appreciation.

15:48Thank you.

15:50David Thorpe: And Stuart, how do you think about diversification? Even within an income strategy, there are certain types of equities that people associate with income, such as utilities or banks, for example. But a lot of those, if you just had those, you'd have a very significant skew towards value, which might be your plan. But is that your plan or is it something else? And how do you try to even out any factor biases? Yeah, I think the best way that we think about diversification is to be as diversified as you can without crossing any red lines in terms of valuation or what you believe in. So we always kind of make the promise to our investors that we will diversify across geographies and sectors and currencies as best we can, assuming we can find the ideas that enable that to happen.

16:43so if we are coming across a specific geography or more kind of a sector really in reality is where the challenges occasionally happen when we can't find an idea or we think valuations have simply become too stretched then we're willing to have a hole in the portfolio that doesn't we don't diversify for the sake of it we actually say no we'll take that risk on and not own anything that sector if we think valuations are unreasonable but you know the best thing about running a global portfolio is that you have a lot of choice and so your ability to be able to maneuver and diversify and have quite a few names to choose from helps you in achieving that goal but there are times in the market where a pocket of the market might get so popular that you simply have to be strong enough to to to not own any and then performance over the short term might be uncomfortable but at some point when that evaluation gets too extreme and starts to roll back the other way then then that's where a big source of your outperformance will come from.

17:44David Thorpe: Nick, on that diversification point, is it at the asset allocation level, i.e. allocation is fixed income versus equities versus something else, or is it within the asset classes or something else again that you try to achieve diversification? So I think it's both of those when we consider it, but certainly within the asset classes, taking fixed income, for an example, you know we can get a high yield on offer from high yield today however the spreads versus government bonds are pretty tight and so therefore we're very mindful of that and although we have an allocation to high yield in these portfolios they're very much towards the bottom end of what we would normally expect.

18:27We also have in there some emerging market bonds which we actually think look quite attractive, particularly local currency emerging bonds within there. And within the equity portion, you know, you've got those traditional parts that you'd expect to see an income fund. But as value investors, you know, we, very similar to what Stuart said, we're very mindful of valuations when they start getting expensive, that we don't want to own too much of this. So, for example, although utilities has performed very well, actually, we've been reducing this exposure there and it's actually quite low to what you you might normally expect and you know we are looking for alternative places of income and you know we we will be patient with that and you know as i sort of mentioned earlier you know latin american equities also gives us some other diversification brazil for example net exporter of energy has been quite well placed during the recent turmoil.

19:28David Thorpe: Thank you and Hilary as Nick alluded to spreads are quite tight in fixed income markets or maybe I think they're quite tight but many perceives them being quite tight but they and they didn't really blow out very much at all during the recent market turbulence I think investment grade moved out maybe 30 and high yield maybe 50 so they even proved resilient then um what sort of challenge does that present for you when you are trying to have diversified sources of return in a fixed income strategy yeah i mean it's an interesting point around spreads because you know the spread environment is quite tight as you say but yields are very elevated um and actually if you look at long-term averages yields are really at the sort of wide end of where they've historically traded and it sort of comes back to this point around positively skewing your returns so when we construct our portfolio we're investing in a blend of investment grade and high yield if you can do that and keep your duration relatively moderate that combination of very attractive level of yield, low levels of duration can actually really create quite a resilient portfolio.

20:48So when we stress test our positioning, we find that in all but really very extreme scenarios, you still generate a positive return on a one-year view. So I think it's that yield point is the reason why the asset classes have still been quite well supported, even given and events that are going on, that's still pushing investors into those parts of the markets, even though the spread environment is quite tight.

21:16David Thorpe: Thank you. Nick, the perception of the UK market is that for all its challenges, it is a place that one can come to for income, whether that's on the equity side or indeed the gilt side at the moment. But does the UK, do UK assets deserve an overweight allocation in portfolios right now? Do you have such an allocation? We still have a reasonable allocation to UK equities. They still form one of the higher yielding parts of the global equity market. Although it's fair to say that UK equities have performed very well in recent periods. And therefore, the valuation of UK equities isn't as attractive as what they used to be.

22:01But nonetheless, we still think in the context of developed markets, we still think they are one of the most attractive areas. And often when you're buying UK equity companies, you're often buying market leading companies. Actually, their revenues aren't necessarily coming from the UK economy. They're more sort of global leaders. So, you know, with that in mind and the fact that, you know, with UK market is still getting a bid from private equity as well, suggesting that overseas buyers see the same attractiveness we still think that they they deserve a place in an income portfolio thank you Stuart as an equity uh global equity manager

22:45David Thorpe: obviously you you can own UK equities but are you overweight or how attractive are they really for an income investor right now it's not it's not really how we look at it so we would just we're much more interested in judging each individual company by its own merits and then seeing how that stacks up against our other suite of options and and can we invest in the uk company versus a company in the same sector but listed in a different market is there a discount to the uk one yeah there's been a lot written about that for the last couple of years i think it's actually i'm not sure as far as i'd say it's a myth but it's i i don't think the valuation discount is is as large as it's been made out to be.

23:28And actually, if you look at the global companies that you can genuinely put up against other options that you've got internationally, that the valuation discount in many cases isn't that significant to certainly warrant us having this huge sort of UK overweight within a global portfolio. So we haven't really felt the need or it to be necessary to take on a UK overweight at all, really. It's much more about us trying to identify and find the companies that we want in a global context that are going to deliver the income objectives of the fund.

24:00David Thorpe: Thank you. Hilary, it's a slightly different question, I guess, for a fixed income manager, but what do you make of the suite of sterling-denominated bonds in the corporate world and of guilds? Are they more attractively priced than peers? Yeah, I mean, it's a really interesting one because actually if you look at the long-term performance of equities, there's definitely a sense that the UK is the sort of underdog, especially compared to global equities, US equities. A lot of that comes back to US tech. And I think when investors think about the UK, they think of Brexit, political upheaval, soft growth, tight fiscal headroom.

24:44It's overall quite a pessimistic view. But of course, in credit, your upside's capped. So we actually haven't really suffered that longer term performance gap. And actually, what we've seen in recent years is that if you look at sterling credit spreads and you compare them to euro or dollar equivalents, actually sterling credit spreads tend to be a bit wider, perhaps reflecting this more sort of pessimistic view of the UK. But that spread advantage is actually compounded over the years. And we've actually seen some quite clear outperformance in the UK market, particularly over the last three to five years and in the sort of high yield end of the market, which is obviously much more spread driven.

25:25So if you look at sterling high yield, you know, over the last three years, that's done 36%. If you compare that to US high yield hedged back to sterling, that's returned 28%. So it's actually really quite a reasonable gap. So for us in the fund, we look at the global sort of credit universe that tends to be quite heavily weighted towards the US, but we take a much more currency and regionally agnostic approach. And we're finding plenty of good opportunities in UK credit. And at the moment, about half of the fund is held in sterling denominated bonds. Thank you.

26:09David Thorpe: Stuart, just for the final question, really, I'd just love to get your thoughts on the dollar. We had a prolonged period where the dollar was weak relative to sterling. and we know from many of our listeners who are financial advisors that that was presenting a slightly awkward conversation with their clients because their clients thought they were in the S &P or whatever and that returned 17 but they didn't get 17 so the dollar nicked a bit of it back and that was after a long period where dollar strength relative to sterling was boosting portfolios but do you have to think about the dollar or currency more generally presuming most of your clients are in the UK and have starting denominated liabilities?

26:56Yeah, well, we have clients everywhere, but I think for a global portfolio, the US dollar is the currency you've got to think about because it's the one that can take performance away from you or give you a lot because it's such a big part of the global index. So if you just look at what the US equity proportion is of the index, It's very significant. And then if you overlay that with some of the dollar exposures on top of that, then it really can be a significant driver. So I think anyone's got to be aware of how much they have within their portfolio and how that relates to the benchmark. So our attitude towards it actually is to try and minimize the risk as much as we possibly can, because currency calling is not something we think we're particularly strong at.

27:45So we want to make sure that I'm not getting to the end of the year saying we've had a wonderful year because of a position on the dollar or a bad year because of a position on the dollar. We're trying to reduce that as much as we can. And the dollar is the big one because it can, from a global context, it can really play quite an outsized portion. if you think about how much, even in some of the more international markets, you've got some big companies that will still have a big chunk of their earnings and revenues that are driven by dollars. So we do think we've got to think about that very carefully.

28:18And it does play a big role in terms of income contribution. How many dividends do you receive in US dollars? How much do you receive in sterling? How much do you receive in euros? And you've got to be aware of all of that when constructing your portfolio to make sure you're building that higher and higher payment out to your client each year. Thank you.

28:37David Thorpe: And Hilary, is currency and particularly dollar strength or weakness something that you have to be conscious of? Does it impact your returns? Yeah, we normally try to keep FX out of the picture. So we would hedge our non-selling denominated bonds when we buy them. So the consequences for us are more indirect. It's more around the impact on portfolio companies. And there we're looking at, you know, does the company have hedging in place? Do they have the pricing power to reflect any potential sort of cost increases that come through as a result of FX? So, I mean, for us, really, our focus is on credit or picking the right companies we hedge out um rfx exposure so we wouldn't really expect big swings in dollar sterling to significantly impact our income generation thank you and um nick uh what are your your thoughts on that um do you have to uh do you have to try to ensure that you're not too overexposed to to non-sterling currencies or or do you try to ride the wave of them or how do you think about it?

29:48Yeah we're certainly not making a call on different currencies but I think it's definitely something you've got to consider within the context of the income portfolios we have a much lower exposure to the US dollar than what we would see for example in our target return portfolios but that's not to say it doesn't have an impact you know so for example we own some hard currency emerging market debt so a strengthening dollar there may not be helpful to that. So it's certainly a consideration, but I think from an income perspective, we're pretty well diversified. We do obviously have to think about the risks of different currencies versus sterling, but the dollar itself doesn't have a huge impact on the income of

30:32David Thorpe: portfolios. Thank you for that, Nick. So much, much food for thought there for those of you listeners who have clients with income as a priority and thank you to Stuart Rhodes who manages the M &G Global Dividend Fund to Hilary Blandy who runs the Jupiter Monthly Income Bond Fund and to Nick Stanhope Senior Portfolio Manager at Morningstar and thank you all for joining us please do remember to tune in for future editions of the FT Advisor podcast released on Fridays Thank you.