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.
Using the balance sheet
Corporate balance sheets are generally in a rude state of health, as costs have been controlled and investment pared back until greater clarity emerges, which means that the financial risks associated with equity investment are the lowest for some time. The focus from an investment perspective is now on companies at the operational level and the leverage that they can deliver from their existing operations. If companies are nervous on the outlook for their sector and unwilling to commit further capital, or if the increased activity of regulators is putting additional burdens in their way, balance sheet strength and surplus cash can be
used to increase the dividend payout or fund buy-backs, both of which are good news for investors and income yields. Increased regulation is a particular issue in sectors with some of the largest companies such as oil, telecommunications and utilities. Regulation makes growth difficult and therefore provides a strong incentive to return cash to investors.
M&A activity is another alternative method of using balance sheet strength as typically it is cheaper to acquire a business than to build one.
The strength of balance sheets and the need to put cash to work, I believe, means that activity is likely to be cash based rather than companies issuing new shares. Historically, in western markets M&A activity accounted for 6-7% on an annual basis, but recent years has seen this figure drop below 5%, so there is likely to be some pent-up demand within the system just waiting for greater clarity. Indeed, we may have seen the start of a period of enhanced activity with Warren Buffet’s Berkshire Hathaway investment company agreeing to buy Heinz for $28bn in the fourth largest food and beverage acquisition of all time, at a 20% share price premium.
One of the important aspects of this and any other cash based deals is the demand injection into the equity market, with investors receiving cash that they will want to re-invest.
Greater political and economic clarity is essential before companies gain the confidence needed to expand through M&A activity. With the US election out of the way, work started on addressing the spending side of the fiscal cliff and the Fed committing to keep interest rates low until unemployment drops below 6.5%, clarity is probably greatest in the US.
So I would expect to see M&A activity start in the US first before moving to the UK and Europe, possibly led by US companies looking to expand overseas. The other incentive for cash to be a driver of transactions currently is the low cost of borrowing for companies with solid balance sheets and strong credit ratings.
Out of bonds into equities
January 2013 saw strong inflows into US equity mutual funds with $22.2bn in the week to 11 January alone, including $8.9bn into traditional long-only funds.
We have seen such periods before as the chart highlights around the end of 2010 and early 2011 so the question is as confidence grows in the prospects for a future global economic recovery will we see a major bear market in bonds along the lines of that experienced in 1994. The short answer, I believe, is no not yet as there is still too much uncertainty, as evidenced by the results of the Italian elections and the shiver they sent through equity markets.
But the need for investors and asset allocators to generate an attractive level of income means they are likely to progressively transfer further assets into equities at the expense of bonds.
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