Whilst stock market conditions may have improved recently, the rationale underpinning our view that we have entered a lower return world remains as relevant as ever. With Asia established as the world's low cost producer, companies are getting used to coping with constant downward pressure on global prices. However, this may not necessarily be bad news for investors, especially those concentrating on income strategies.
Although falling prices (deflation) are often associated with economic depression, they can equally represent a symptom of factors such as technological innovation, and do not necessarily infer economic collapse. For example, between 1871 and 1876, a rapid improvement in productivity caused prices in the US to decline by 35%. However, over the same period real economic growth expanded at 4.2% per annum. The countries indicated by the International Monetary Fund as being at greatest risk from bad deflation today, such as Japan, are victims of specific factors not endemic to the rest of the world. However, there can be little doubt that global prices are likely to remain under pressure, with Asia now established as the world's low cost producer, exporting deflation to the rest of the world. This trend is likely to separate the winners from the losers among companies, as competition in today's globalised industries becomes increasingly fierce. Whilst this will inevitably put pressure on wages growth and employment, disposable incomes should benefit from lower goods prices.
Mr Darcy is a £10,000 a year man
The likelihood that we will see 'pockets of deflation' across the global economy coupled with sustained low levels of inflation leads us to believe that interest rates should remain relatively benign. In fact, the rates that prevail today are more akin to the long run trend than the experience of the 80's and 90's.
This has implications for investors seeking income. In Victorian times, prices fell due to productivity improvement and increased international trade. As a result, interest rates remained subdued for a long period. Income growth was the focus of attention for the investor of the day, with the prospect of rapid capital appreciation at the back of people's minds. Parallel's can be drawn between then and now.
The case for equity income remains compelling
The problem for investors in the current environment is how to generate a meaningful income given that falling interest rates and strong demand have pushed bond yields down to historically low levels. However, share valuations have moved in sharp contrast to this, and we have seen a corresponding improvement in yield. As a result, we have viewed equity income as a relatively attractive investment opportunity for well over a year now.
Pessimistic forecasts likely to be unwound
The tone of the UK stock market has certainly improved over recent months. The question is, how sustainable is this? It is interesting to note that the typically strong relationship between analysts earnings forecasts and the actual earnings reported by companies has broken down since 2001.
The chart illustrates that reported earnings have not fallen anywhere near as far as analysts had expected, instead maintaining an improving trend since the beginning of 2003. When analysts start to upgrade forecasts for future earnings from current depressed levels, the stock market may find fresh impetus. But are we likely to see a return to growth/style investing? We don't think so. Much of the growth during the bull market was driven by investors who had high expectations of the results of capital intensive projects and corporate activity. Now these dreams have been shattered, companies are focused on enhancing operating efficiency by reducing costs and indebtedness – a positive environment for income investors.
Positive trends make a case for dividends
In recent history, the problem for investors seeking income from equities has been the absence of dividend growth. However, signs that the tables are turning have emerged in 2003. Underlying free cash flow seems to be improving, which supports the view that dividends are sustainable. Secondly, the proposed removal of double taxation in the US is encouraging UK based multinationals to increase the amount they distribute to shareholders through dividend payments.
Plenty of calls on cash flow
However, there are many demands on corporate cash flow at this stage of the economic cycle. Weakened balance sheets need replenishing and contributions must be made to under-funded pension schemes, not to mention the fact that cash must also be found to fund future organic growth. This makes the task of identifying companies whose dividends are sustainable as important as ever. What is clear to us is that, as the chart shows, long-term returns are likely to comprise predominantly of dividends supplemented by earnings growth. Valuation driven gains seem unlikely.
- Price deflation is not necessarily bad news for investors
- Low interest rates and inflation enhance attractiveness of income
- Earnings expectations may be revised upwards
- Several factors support dividends going forward
- Dividends are likely to represent an important part of future returns
The opinions are those of Graham Ashby as at 10/09/03 and may not reflect those of DWS Investments. Past performance is not necessarily a guide to future performance. The price of shares and the income from them may fall as well as rise and investors may not get back the amount originally invested. Income from the funds is not guaranteed and may fluctuate. Our equity income funds take annual management charges from capital. Whilst this increases the yield, it reduces the potential for capital growth. Current tax levels and reliefs will depend on your circumstances and may change. Issued by DWS Investment Funds Limited, One Appold Street, London EC2A 2UT. Authorised and regulatedby the Financial Services Authority.
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