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No happy medium for equity income; Emerging markets get crowded out

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The latest episode of the Asset Allocator Podcast is out now. Nathan Sweeney, deputy chief investment officer for multi-asset at Marlborough, joins us to talk about the potential for a sustained style rotation and how he is allocating in response. To listen find us on SpotifyAcastApple Podcasts and most other podcast platforms.

Middle ground?

It won’t be a surprise to any asset allocator that the final quarter of 2021 was a bumper period for UK dividends, especially when  compared with the arid periods of 2020 when lockdowns were a way of life and profits were an endangered species. 

But what’s more interesting in the latest data from the Link UK Dividend Monitor is that mid cap stocks showed the greatest dividend growth. 

Dividends in that part of the market rose by 40 per cent in 2021 compared with the previous year, twice the rate of growth achieved by FTSE 100 companies, which delivered a 20 per cent uplift. Those are underlying figures, excluding special dividends of which there were many in the FTSE 100,especially among the miners. 

But peeling away the headline figures reveals a slightly different story. The total dividends paid by FTSE 100 companies were back to levels last seen in 2016, when Brexit was merely a contested portmanteau and the word pandemic was likely to conjure nothing more harmful in a fund buyer's mind than a bad sci-fi movie. 

But the dividends in mid cap land, despite the 40 per cent growth, were only reverting to levels last seen in 2014, and indeed no higher than the level achieved in 2007 and 2008, indicating that stagnation, rather than revival, is the name of the game for these companies.

For 2022, Link expects underlying dividend growth of 5 per cent in the UK market as a whole, equating to a yield of 3.5 per cent.

It might have once seemed churlish to judge mid caps on the basis of their income, rather than growth, potential. But an uncertain outlook for many of the large-cap dividend stalwarts means many investors will be looking for alternatives.

If a combination of ESG concerns, technological disruption and regulation dent the ability of miners, banks, oil companies and retailers to grow their dividends, looking further down the market cap scale may not be the panacea some had hoped for.

A winner emerges

Last week we highlighted the curiosity that while many of the fund managers who responded to Bank of America’s monthly survey expect inflation to fall away in 2022, they are also negative on emerging market equities.

That’s despite an assumption that this region should benefit if monetary tightening is ultimately tamer than some have priced in - as it would probably be if inflation were to fall away.

Data from the Investment Association shows that despite sentiment, portfolios were certainly pivoting towards emerging markets in 2021, with a net £1.5bn going into these funds. That was comfortably the best year in terms of inflows since 2016, when £600mn was deployed. 

As the chart below shows, there were only two negative months in terms of inflows in 2021. 

2020 was the only year in the past five where there were net outflows from the asset class, suggesting rates weren’t a worry pre-pandemic. 

Emerging market equities typically do badly when rates are rising in the US because they push bond yields higher, meaning an investor can get a higher return for lower risk, reducing the appeal of riskier assets such as emerging market equities. 

In addition, higher rates in the US are viewed as signalling the end, or beginning of the end, of the economic cycle, and so hurt the more cyclical assets, such as commodity producers, which have historically been strongly represented in emerging markets.

On the other hand, emerging markets should do well if the global economy is expanding, and a period of above trend economic growth looks on the cards, as the asset class benefits from the same cyclicality.

The flow data since November 2020, when the first vaccine was approved, indicates investors have been backing that cyclical story. Will that survive the sentiment shift we have seen at the start of 2022? We will have to wait and see. In the words of Mike Tyson, everyone has a plan until they get punched in the face.

Exit, pursued by a bear

Rathbones’ Investment Management’s new-ish co-chief investment officer Ed Smith hasn’t felt the January blues despite the rapacious market sell-off. 

Smith believes that while markets may be in the grip of a "correction", that is a decline of 10 per cent from peak, such sell-offs are relatively commonplace, and don’t typically herald the start of a bear market, which he defines as a drop of 20 per cent from peak.

He says such a precipitious decline would only occur in the event of a recession, and that’s a low probability event this year.

Indeed he expects most markets to be in positive territory by year end. 

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