Equities can fill the income gap, says F&C’s Peter Lees

Peter Lees, director of Equities at F&C has argued that there are reasons why investors can look away from sovereign bonds to equity again in the search for income.

We are in an income hungry world and one where investors are increasingly looking away from sovereign bonds as a source of income and towards equities as a solution. While we seem to be in a period where investors want to put an increasing amount of risk back on the table in search of income, the back-drop remains one of uncertainty.

The economic back-drop Investors like clarity, which enables them to assess what discount rate they should be using when trying to value assets and the attractiveness or otherwise of the income they can potentially produce. In normal times we would be mid-way through an economic cycle and approaching the phase where companies should be looking to grow, but this is far from a normal cycle with a number of issues that continue to cloud the situation.

Politics – The US fiscal cliff has been deferred not resolved so the coming months will see it come back to the fore. The results of the Italian election and any impact this will have on its economic resolve and potential need for a bailout. The results of the German election in the Autumn and any change in its willingness to support the euro. And China, what will be the policy initiatives of the new Chinese government now that the transition of power has been completed?

Economic – Interest rates look set to remain at historically low levels for some time to come given the US Fed’s statement that it wants to get unemployment below the 6.5% level, which means net new jobs of over 2.3 million will need to be created before they consider any rate rises. With economic growth in the UK stagnant at best and the EU in recession interest rates there too look set to remain low, with the Bank of England even discussing negative interest rates on deposits for banks. Sovereign debt downgrading is likely to remain an issue with the UK the latest to see a rating cut from one of the big ratings agencies.

Regulation – Doing business anywhere is becoming more expensive as playing fields change driven by greater regulation from governments wanting to reduce the risk of another financial crisis and the need for them to step in and bailout
companies that were deemed ‘too big to fail’ at a time when their finances are
under severe strain.

Why equities for income?

At a recent conference I attended the question was posed that if investors wanted to increase their equity exposure why not just invest in ETF as it would provide low cost market exposure. The answer is that in the vast majority of cases an ETF will not produce any income and it is the income that many investors and asset allocators are seeking.

In valuation terms equities continue to look attractive and in the minds of a growing number of pension scheme actuaries are attractive because of the income yield they are able to provide. There is also a growing feeling that current valuations are underpinned by a yield in an asset class that experienced a 40-50% correction from peak to trough and which is also starting to see an inflow of new investment.

What is clear is that the dramatic fall we have seen in interest rates in recent  years has had a significant impact on the yields delivered by the traditional sources of income for many investors, and as mentioned previously the likelihood of a significant move in the opposite direction in the near term is somewhat limited.

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