A Silent Revolution

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By Rudi Filapek-Vandyck, Editor FNArena

There's something not right with this rally on global equity markets. No, I am not referring to price action itself, or to ex-machina stimulus from major central banks across the world, I am not even referring to weather-boosted economic data, including the latest jobs market update in the US.

Global equities have climbed the wall of worry since experiencing extreme turbulence in August last year, with most indices troughing out in September-October and rising by double digits since. Yet, according to the latest data, investors have been withdrawing money from equities. Yes, that's right. On a net basis global allocations to equities for the first week leading into March printed a negative result.

It turns out, most of the net outflows stem from investors in exchange traded funds, or ETFs. Even if we leave this latest ETF-driven net funds outflow aside and concentrate on what has transpired since the beginning of the year, there has only been a net 0.3% gain in investment funds flowing into global equities. Ironically, most net inflows happened via ETFs (so we shouldn't leave ETFs out because any result for stand alone equities would simply be more negative).

Meanwhile, the Financial Times reports, trading volumes for US equities in the first two months of this year are the lowest in 14 years. Wait a minute! This means volumes this year are lower than last year's even when this year's performance has been noticeably better?

What is going on? Could all of this be caused by "Greece" and other European uncertainties? No doubt, there's a role for "Europe" somewhere in those numbers, but I don't think that's the story investors should be focusing on.

Let's throw in a few other observations I made recently:

– allocations to corporate bonds in the US are at record highs for the first two months of the year (yields have now fallen to an all-time low)
– net allocations to global bonds continue to be positive; at a net growth of 3.0% thus far this year bonds remain the number one destination for global funds
– funds inflows for income funds remain in a steep uptrend since going negative in 2008
– the Australian dollar has remained stronger-for-longer even with growth in China weakening and base metals pulling back since the early-year optimism
– outside the mining and energy services providers, solid dividend payers have proved the stand-out outperformers in the Australian share market

Regarding the fourth observation, note that, since August last year, securities in Australian Pipeline Trust ((APA)) have appreciated by over 31% while the share market overall has barely gained 5%. Securities in Envestra ((ENV)) are up by 26% since August. Challenger Infrastructure ((CIF)) is up by 29%. ConnectEast ((CEU)) has rallied 25%.

Normally, these securities are highly sought after when times are tough and the future looks bleak. Their main characteristic is a high, solid, secure looking dividend payout. These are not the kind of names one expects to see on the list of market outperformers at a time when Greece's problems are successfully being postponed and economic data in the US are surprising to the upside, with economists upgrading their growth projections for the year (not to mention quantitative support from central bankers around the world).

So what is going on?

I call it "the silent revolution". It is there for everyone to see, but only few are genuinely paying attention, yet the ramifications will be significant for investors and financial institutions of all sorts and kinds. Maybe this story will help alerting many more to what is happening?

Another way of describing it is there's a growing global thirst for yield and increasingly fewer places to get it. Government bonds in Japan and the US do not offer much in terms of yield/income and while yields are higher in Europe, especially in the peripheral countries, so too are the risks (see Greece last week). This is why global investors are increasingly turning towards Australian bonds, effectively providing extra-support for the Australian dollar which is why AUD/USD is still trading at 1.05 and not closer to parity where it should be according to some pundits on the basis of China/metals weakness.

One anecdote might prove the point: a quick market analysis of Japanese financial institutions by one analyst in Australia recently led to the "discovery" of no less than 24 different institutions that were actively promoting Australian bonds to Japanese investors.

I think it'll only be a matter of time before part of these global funds will find their way into the Australian share market (if that isn't already the case – see APA, ENV, et all above). Until I now, I suspect, what still makes international investors a bit cautious is the perception of a highly priced Aussie dollar and continued prospects of lesser demand for commodities from China. After all, two days of weakness in the currency can easily wipe out a whole year of yield. A stabilisation in commodity markets in combination with the RBA moving from its mild loosening bias to neutral -it'll happen at some point, with or without additional cuts- may well provide enough confidence to make Australia the destination for a larger part of international investment funds.

Last year, during my presentation at the ASX Investment Hour (the one with the alien costume*), I said most investors in Australia had it all wrong; the stand-out feature for the Australian share market is not the abundance in resources and energy stocks, it is the above average dividend yield that is here on offer via listed companies such as Telstra ((TLS)), Adelaide Brighton ((ABC)), GPT ((GPT)), Consolidated Media ((CMJ)) and many, many others. I am pretty confident in making the prediction that an increasing number of international investors is going to agree with that statement in the years ahead.

This is even more the case since this international thirst for yield is not only borne out of the fact that quantitative policies by central banks are depressing bond yields in many a developed country, but there is strong demographic momentum behind all this as well. On recent projections published by Macquarie, the Australian population currently counts 7.2m over 50-years old. By 2021 this number is forecast to rise by 27% to over 9.1m. By 2031 this number will have grown to over 11.1m, an increase of 55% on today's situation.

Note the US, Japan, Europe and even China equally have aging populations. On current estimates, across the G7 countries there will be 31 million more people over the age of 65 over the next 10 years. This is not taking into account that the overwhelming equities culture that has dominated the global financial industry since the early eighties is now due for a serious correction on its own account now that investors have been burned badly twice within one decade.

Another, equally important factor, is that overall acknowledgment is growing that equities have entered an era of lesser returns. The latest example of this is a strategy update by Macquarie last week in which the strategists drew one straightforward conclusion: smaller returns ahead means a bigger part of these returns will come from dividend yields. Whereas investment returns from Australian equities pre-2007 were running above 11% per annum, market strategists are now more and more projecting returns of circa 8% per annum for the decade ahead.

Note most of the dividend outperformers I mentioned earlier are, post their market-beating performances, still offering forward looking yields between 6-8%. ConnectEast is the exception, now only offering around 4% yield, while Challenger Infra is the exception to the upside, still offering 9.8%.

Note Australian investors have the added benefit of franking credits, which international funds do not enjoy. This means industrial companies might be more attractive for local shareholders. As an example, Consolidated Media ((CMJ)) has rallied by 28% since August last year. The shares are still offering 6% yield, fully franked.

Note also that long term investing generates the best results when dividends are combined with steadily growing profits and revenues. This is why Monadelphous ((MND)) has been the champion stock in the Australian share market over the past decade. Whoever bought Monadelphous shares in 2003 will this year receive more than the original outlay in cash as dividend pay-out – not to mention the stellar share price performance over the period.

Analysts at BA-ML offered a few more reasons as to why stocks that pay healthy dividends are likely to attract more attention from here onwards:

– monetary and fiscal policies incite high demand for yield and/or income
– global dividend yields are still rising and stocks with high yields are outperforming on a global scale
– dividend yields are now exceeding both sovereign and corporate bond yields

BA-ML analysts have offered an alternative strategy to play this theme, suggesting investors should concentrate on companies whose dividend yield is now higher than the yield on their corporate bonds. The list of 39 candidates selected across the globe, with names such as Telefonica, Santander and Mitsubishi, also contains a few Australian names: Wesfarmers ((WES)), Westpac ((WBC)), ANZ Bank ((ANZ)) and National Australia Bank ((NAB)) – in no particular order.

Note that Australian government bond yields are amongst the highest in the world, only beaten by the likes of Spain and thus arguably a (much) better risk-reward offering. The same goes for Australian dividend yields.

(This story was originally written on Monday, 12th March 2012. It was sent in the form of an email to paying subscribers on that day).

* Those who want to watch the broadcast of my presentation, in alien suit, about investing and dividends at the ASX Investment Hour, can do so via the following link: http://www.brr.com.au/event/frame/81534

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