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‘Current yield gap calls for an allocation to European equities’

In Europe, the yield gap or difference between equity yields and bond yields is reaching historic highs (again). History shows that this is an important signal to investors. Indeed, the extent of the current yield gap has not often been seen over the last 20 years – and when it has occurred, investors who moved in to equities have been rewarded - not only would they have generated strong total returns, but also locked-in attractive yields for their portfolios. Although against the grain of current market sentiment and commentary, an allocation to European equities could be the remedy for portfolios struggling to find returns and generate income in a world of subdued growth, dovish central banks and lows bond yields.

The chart below clearly illustrates the extent of the current yield gap, with European equities currently offering a 3.4% yield compared to the 0.0% (yes – zero %) offered on German bonds. As depicted by the dark blue line on the chart, this differential is near all-time highs and, we believe, indicative of a clear opportunity for investors. 1

Chart 1: European equity dividend yield vs German 10-year bond yield

 

Source: Argonaut Capital Partners LLP; Bloomberg 22nd March 2019

 

Using the historic peaks in the yield gap as a starting point (circled on the chart above), we show in the table below the subsequent total returns and income delivered to investors allocating to equities at these peak differential levels over the following 6 and 12 months.

Table 1: Total returns and income delivered from European equity market post yield gap peak

Source: Argonaut Capital Partners LLP; Bloomberg 22nd March 2019

** To 21 March 2019

 

It is clear from the above that returns have been substantial and that using the equity / bond yield gap as an indicator to rotate in to equities has been rewarding, even though it may have been counter to the prevailing sentiment at the time. Perhaps one of the reasons for the dividend yield being a reliable gauge of value is that it is based on tangible cash distributions to shareholders and thus far less likely to be affected by accounting distortions. Indeed, the only issue is around the sustainability of these underlying dividends, and when discussing Europe, it is this element which perhaps concerns investors the most.

To this point, whilst it is true that European earnings have not yet recovered to their levels prior to the financial crisis, the same is not true for dividends – these have been far more robust than earnings post the financial crisis, and during the sovereign bond crisis. In fact, not only have they recovered post these crises, they are now at record levels. This underlying strength in European dividend flow is often over-looked by investors, but is indicative of the improving bottom-up conditions in corporate Europe. 

Chart 2:  European dividends versus earnings (rebased to 100)

Source: Argonaut Capital Partners LLP; Bloomberg 22nd March 2019

 

Arguably, one of the main factors behind this robust dividend flow in Europe is the strengthening of corporate balance sheets. Across the European equity market, leverage metrics have more than halved over the last ten years, which in turn has increased free cashflow and allowed more cash to be distributed to shareholders, underpinning dividends. In fact, not only are the underlying dividends robust in Europe, the expected rates of dividend growth are higher than that of the UK and are similar to and exceed that of the US within two years, as shown in the table below.

Table 2: Forecast dividend growth rates

 
Source: Argonaut Capital Partners LLP; Bloomberg 22nd March 2019

 

Importantly, whilst these growth rates are based upon consensus estimates and thus open to revision (both positive and negative), they are nonetheless clearly well above the rate of inflation.

Whilst the bears may say that the “equity premium” (as captured by the yield gap) is justified given slowing global growth and risk of a deflationary environment, investors would do well to heed the extent of the current yield gap and perhaps ask to what degree these fears are already reflected in the prices of bonds and equities. After all, dovish central banks and a low interest rate environment may indeed result in a (surprising?) pickup in economic growth in the second half of the year, particularly if the two major issues surrounding growth concerns, namely the US / China trade dispute and Brexit are resolved. Ultimately though, allocating to equities during periods of extreme yield differentials (such as we are currently witnessing) has historically been very rewarding, and for those investors looking to diversify and enhance the income in their portfolios, European equity income strategies offer a convenient way to achieve this.

 

Greg Bennett

Argonaut Capital Partners

March 2019

 

1 Bloomberg as at 22nd March 2019