The steady rise of asset prices since the global financial crisis has made asset owners better off. But it has caused headaches for individuals relying on income from their portfolios to meet living costs, or institutions who need investment income to meet future liabilities such as insurance claims. European equities could be the remedy.
Lower bond yields for longer
Not so long ago, many economists and investors were worried that loose monetary policy from central banks would trigger higher inflation. So far, this hasn’t materialised. Indeed, many market observers say today’s investment backdrop is one of “lower for longer”, where both interest rates and inflation have remained subdued for a significant period of time.
This is reflected in the forecasts Schroders’ economists are making for government bonds in the next decade. As the chart below shows, most regions are expected to see a meaningful reduction in bond yields over the next ten years.
Some government bonds are generally seen as safe assets, in that capital will be returned to investors on the maturity of the bond. But as the chart shows, given current valuations, the prospective future returns are very low.
Where could investors who need income look instead?
One potential option is the European equity market, although investors would need to accept the higher level of risk that comes from investing in an asset class where capital is at risk. They would also need to be prepared to invest for a longer period, such as five years, to give their investment a good chance to grow.
Europe has long been a fertile hunting ground for seekers of income from shares. It has traditionally offered a higher dividend yield than other developed markets such as the US and Japan, as the chart below shows.
The US stock market has performed very strongly since the global financial crisis. However, it tends to have less to offer to income-hunters.
There are some good explanations for this. In particular, the US market’s gains in recent years have been largely driven by fast-growing technology companies such as Facebook, Amazon and Google. These types of companies typically prefer to reinvest their profits to fuel further growth, rather than distribute profits back to shareholders via dividend payments.
By contrast, Europe has a far less dominant technology sector, and in general companies are far happier to return cash to investors.
The chart below shows three-year, five-year and ten-year total returns for a number of stock market regions. The total return investors have received has been split between capital appreciation and dividend growth.
As we can see, the US has enjoyed far greater capital appreciation over the last ten years. However, in Europe, dividends have typically made up a far higher percentage of total return investors receive compared to the other regions.
Rupert Rucker, Head of Income Solutions at Schroders, says:
“Stock markets have gone up for nearly a decade. This may continue but history suggests that this level of capital growth cannot be sustained forever and will eventually slow.
“Looking ahead, there is therefore a case to be made for dividends pay-outs to play a greater role in total returns. Europe is a mature stock market with a strong culture of giving cash back to investors.
“Clearly, investing in shares involves greater risk than investing in government bonds or simply using a cash savings account. But with these options offering very low returns, investors who are seeking higher income will need to take a higher level of risk with their capital.”
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The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.