Income investors: What to expect in the current environment
Joining the dots between market volatility, company dividends and fund income
Covid-19 has triggered a major disruption to the global economy, challenging businesses, companies and governments. We are all experiencing the shockwaves, whether that’s the impact on our health, family life, schools, or travel. For income investors, as for all investors, the crisis also has implications for the companies you invest in, either directly or indirectly via collective funds. It is therefore important to understand the link between the covid19 pandemic, the economy, stock markets, individual companies, and how your investments are affected.
Let’s start with companies. The crisis has obvious implications for a company’s cash flow. With so many people unable to work – whether they are suddenly unemployed or furloughed – consumer spending has fallen sharply as people choose to be more careful with their money. This is exacerbated by the fact that in many areas people have been unable to spend even if they wanted to. For example, restaurants, cinemas, gyms and pubs, amongst others, have been forced to close due to the lockdown and airlines can no longer operate scheduled flights, meaning companies operating in those areas will see a sudden decline in their revenue.
The cash those companies had forecast to receive (based on previous years’ earnings and their own research and knowledge of the market) has evaporated. With less cash to hand, companies’ ability to continue operating in the way they had planned is hampered, affecting their entire business strategy, including the number of products they can manufacture, the number of employees they can afford to pay, and the dividend they would normally pay to shareholders.
Company dividends under pressure
When a company’s cash flow dries up, it becomes extremely difficult for them to pay a dividend to shareholders. Those companies that have relied on borrowing and therefore have debts to service are particularly vulnerable at such times. As a result, company management teams across the world have been making difficult decisions on whether to maintain, reduce or even suspend their regular dividend payments.
There is also pressure on companies – especially those that may receive government help during the crisis –to take a prudent approach and conserve their cash, even if they can afford the dividend. In other words, it might be better to cut the dividend now, conserving their cash to ensure they emerge well-placed on the other side.
There has also been regulatory pressure on some companies not to pay dividends at this time. For example, the Bank of England’s Prudential Regulation Authority formally requested that banks cease dividend payments in order to be more agile and ready to support customers and the wider economy, during this period.
The upshot of this is that we have seen over 140 companies announcing cuts to their dividends in the UK1 and in the US a fall of over 25% in the value of dividends paid out by S&P 500 companies in 20202is expected. It will be similar across the world.
Stock market volatility
At the same time as individual companies were coping with the crisis, investors across the world were reacting to the lockdown measures introduced by governments, understanding immediately that it would hit company cash flows. It is no surprise, then, that many began selling equities. Particularly hard-hit were those companies operating in areas most likely to be affected, such as retail, leisure, transport, and media stocks3. As above, those companies that had borrowed excessively (to fund expansion, for example) and were therefore carrying a little too much debt felt the worst of the market sell-off.
That said, the scale of the crisis has prompted such extreme market volatility that it has not just been those companies most directly linked to the lockdown that have been affected. Many companies’ share prices have been driven down as negative sentiment among investors took hold, while the collapse in the oil price has also hit companies in the oil sector and beyond.4
Active fund managers can react and respond to the crisis and position themselves well for the eventual recovery, however all funds will experience volatility during this time and many of the companies held in funds may struggle, at least in the short term. For some the impact may be far longer.
During crises, experienced active fund managers may look to restore calm and seek opportunities rather than panic. Similarly, experienced investors know that what can feel like an emergency in the short term may not hold as much significance 10 years down the line. Indeed, long-term investing helps smooth out the peaks and troughs of the stock market and can be a more successful strategy than trying to time the market.
The global impact of Covid 19, combined with its unprecedented nature, means that the recent market falls have been very aggressive, but we have seen some markets start to recover already.
Impacts for fund income in this environment
Currently, the volatile stock market and a severe decline in corporate cash flows has very real implications for investors, both in terms of their capital and any income they draw from their investments. The general performance of most equity funds will have been negatively impacted by the stock market downturn, for example, in the UK the FTSE 100 is now trading at levels last seen in the lows of 2016.
The income that funds distribute to investors is derived from the dividends the fund receives from the companies it invests in, this ensures that the capital value of the fund isn’t affected by distributions to investors. As companies have been unable to pay the dividends to shareholders that they had forecast, the ability of funds to also deliver income to their investors might also have been affected. We believe the impact will differ across funds, depending on the nature of the fund and its investment universe.
Last month the Investment Association (IA – the UK industry body which oversees fund sector classifications) announced it would relax rules regarding the level of yield funds within its UK Equity Income sector category need to meet in the short term. The IA said it recognises that 2020 will be a challenging year for income funds to meet the sectors’ yield target. It said that the UK equity income sector is particularly affected by the economic consequences of Covid-19, and by relaxing the rules it would mean funds can continue to “function effectively in the best interests of savers and investors”.5
As a frame of reference, we saw the market dividend falling 33% peak-to-trough during the global financial crisis a little over a decade ago – the fall that could be on the cards this time around may be even higher. This means that it is likely many funds may themselves have to seriously reduce the income they had been set to deliver to investors.
While markets have experienced a large shock, global central banks have responded forcefully to assist economies, and the shock is likely to be a temporary one. Columbia Threadneedle Investments expects a “U- shaped recovery” in 10 quarters (i.e., a recovery by the end of 2022), but this recovery path could be complicated by a second and third wave of infection within the recovery period.
Dividends play a vital role in capital markets, not least in the pensions and savings of the public. In the short term, dividends paid by companies are likely to be reduced significantly, which will have an impact on the income paid to investors. However, looking past this period of disruption, more regular conditions will likely return, and dividends will likely be back.
In the meantime, active managers may be looking to balance their portfolios in such a way as to ensure their income-seeking investors are not unduly affected, and certainly not over the medium to long term.
1 Columbia Threadneedle Investments, 30/4/2020.
2 Bloomberg, as at 22/4/2020.
3 Bloomberg, 30/42020.
4 Bloomberg, 30/42020.
5 IA issues new guidance on equity income sectors in light of Covid-19, theia.org, 22/4/2020.
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