The multiple expansion phase of the yield trade is over. However, with bond yields likely to remain low (~3.0% for the 10 year), earnings growth muted (~5% ex resources), valuations still above LTA (~14.5x) and volatility higher than in recent years, the hunt for sustainable and high quality yield is not, and perversely, dividends may actually comprise an increasing proportion of total risk adjusted returns over the coming year.
Stronger growth and not higher yields pose the biggest threat to relative performance and re-rating potential of Australian yield stocks. A rotation away from yield needs confirmation of stronger growth and not simply an exogenously driven rise in the discount rate.If our economic growth assumptions are correct, bond yields are not likely to rise enough to unwind the thirst for high quality yield. Equally, growth is not likely to reach escape velocity anytime soon.
Nevertheless, the yield trade is becoming more nuanced and paying for unsustainable dividend growth is over as the tailwind from a declining cost of capital reverses and the payout ratio pushes an all-time high. What goes up can also come down and de-rating risk for stocks where earnings growth is not a sufficient offset to a higher cost of capital, which may have been mispriced on more questionable dividend distribution policies and/or have undergone significant multiple expansion is rising even if growth concerns are falling.
From here, defensive growth and yield stocks are more likely to see upside commensurate with EPS growth (provided we are not on the verge of a revenue shock). Our call – Energy, Materials and Domestic cyclicals (Industrials and Discretionary) will take market leadership with the greatest PE expansion through 2016. We just don’t have perfect foresight on timing this turning point and we think it remains too early for a strong cyclical over defensive tilt.
The market is overly concerned on dividend sustainability for both banks and Telstra. Provided our assumptions of a muted growth and rates backdrop is correct, bank dividends are not at risk and Telstra has the potential to raise its dividend distribution in coming years (buy banks for yield + PE expansion but TLS for yield).
Point Break
The “pure” multiple expansion phase of the yield trade is over. The hunt for (sustainable) yield has not ended. At a global level, continued bouts of deflation/disinflation, weak growth recovery, ongoing supportive central bank monetary policy and aging demographics suggests limited alternatives for high quality yield income.
Domestically, the backdrop for yield seekers is somewhat similar. The dividend yield in excess of the bond yield is close to 2.5%. Even if this proves unsustainable via a lower payout ratio and/or bond yields surprise on the upside, the yield gap will remain relatively attractive at a market level. We think this is particularly true if yield is viewed as a derivative of “quality” against a backdrop where volatility is high and earnings growth still muted. In fact, we think dividends will become even more important as a proportion of total returns in the coming quarters as the market lacks an clear upside directional driver, stock leadership remains weak and as the distinction between yield and sustainable yield becomes more differentiated. While expectations of the December Fed rate hike is creating concerns around an unwind of the yield trade, we think stronger growth and not higher yields pose the biggest challenge. Stronger growth and higher real yields usually go hand in hand but the big driver of relative return will be confirmation of a cyclical recovery. If our growth assumptions are correct, than bond yields are not likely to rise enough to unwind an unrelenting demand for yield. Equally growth is not likely to reach escape velocity anytime soon suggesting a more sustained risk-on rotation is not imminent. This is a holding pattern for cyclical versus defensive stock and sector selection rather than a catalyst to rotate out of yield before the start of 2016.
That said, paying unreasonable prices for unsustainable dividend growth is over. In an environment where the tide has gone out on the tailwind from a declining cost of capital , de-rating risk is non trivial especially if earnings growth is not a sufficient offset to firms which have more questionable dividend distribution policies, face a disproportionate rise in the discount rate, have undergone significant multiple expansion and where more broadly speaking the market faces a potential decline in risk adjusted returns on the back of rising volatility.
Analyst certification:
We hereby certify that all of the views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We also certify that no part of our compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. The Analysts responsible for preparing this report receive compensation from Macquarie that is based upon various factors including Macquarie Group Ltd total revenues, a portion of which are generated by Macquarie Group’s Investment Banking activities.
General disclosure: This research has been issued by Macquarie Securities (Australia) Limited (ABN 58 002 832 126, AFSL No. 238947) a Participant of the Australian Securities Exchange (ASX) and Chi-X Australia Pty Limited. This research is distributed in Australia by Macquarie Equities Limited (ABN 41 002 574 923, AFSL No. 237504) (“MEL”), a Participant of the ASX, and in New Zealand by Macquarie Equities New Zealand Limited (“MENZ”) an NZX Firm. Macquarie Private Wealth’s services in New Zealand are provided by MENZ. Macquarie Bank Limited (ABN 46 008 583 542, AFSL No.237502) (“MBL”) is a company incorporated in Australia and authorised under the Banking Act 1959 (Australia) to conduct banking business in Australia. None of MBL, MGL or MENZ is registered as a bank in New Zealand by the Reserve Bank of New Zealand under the Reserve Bank of New Zealand Act Any MGL subsidiary noted in this research, apart from MBL, is not an authorised deposit-taking institution for the purposes of the Banking Act 1959 (Australia) and that subsidiary’s obligations do not represent deposits or other liabilities of MBL. MBL does not guarantee or otherwise provide assurance in respect of the obligations of that subsidiary, unless noted otherwise. This research is general advice and does not take account of your objectives, financial situation or needs. Before acting on this general advice, you should consider the appropriateness of the advice having regard to your situation. We recommend you obtain financial, legal and taxation advice before making any financial investment decision. This research has been prepared for the use of the clients of the Macquarie Group and must not be copied, either in whole or in part, or distributed to any other person. If you are not the intended recipient, you must not use or disclose this research in any way. If you received it in error, please tell us immediately by return e-mail and delete the document. We do not guarantee the integrity of any e-mails or attached files and are not responsible for any changes made to them by any other person. Nothing in this research shall be construed as a solicitation to buy or sell any security or product, or to engage in or refrain from engaging in any transaction. This research is based on information obtained from sources believed to be reliable, but the Macquarie Group does not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. The Macquarie Group accepts no liability whatsoever for any direct, indirect, consequential or other loss arising from any use of this research and/or further communication in relation to this research. The Macquarie Group produces a variety of research products, recommendations contained in one type of research product may differ from recommendations contained in other types of research. The Macquarie Group has established and implemented a conflicts policy at group level, which may be revised and updated from time to time, pursuant to regulatory requirements; which sets out how we must seek to identify and manage all material conflicts of interest. The Macquarie Group, its officers and employees may have conflicting roles in the financial products referred to in this research and, as such, may effect transactions which are not consistent with the recommendations (if any) in this research. The Macquarie Group may receive fees, brokerage or commissions for acting in those capacities and the reader should assume that this is the case. The Macquarie Group‘s employees or officers may provide oral or written opinions to its clients which are contrary to the opinions expressed in this research. Important disclosure information regarding the subject companies covered in this report is available at www.macquarie.com/disclosures.