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).
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.
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