5th November: 2020 will be remembered for one thing: COVID-19. The pandemic has created a set of global challenges that have at times felt insurmountable and there is still enormous uncertainty as to how the next 12-months will play out for businesses, travel and everyday life. Against this backdrop though there are other major difficulties being created in the area of wealth and, more specifically, in the production of income. As the world’s population grows older, the need for income derived from savings to support retirement and broader lifestyles has increased dramatically. And yet the opportunity set for investors to meet these income requirements has declined significantly. Internationally over a third of government bonds now offer a negative interest rate and many central banks, including the European Central Bank and those of Japan, Sweden and Switzerland have negative rates. New Zealand’s interest rate structure is now offering close to zero yields and the Reserve Bank of New Zealand has indicated it may move to negative rates from March 2021. With New Zealand banks now offering 12-month deposit rates below 1%, and with the potential to go lower, savers are being forced to reconsider what they do.
In the face of COVID-19, the world was forced to confront an extreme level of economic and social disruption. Governments scrambled to determine the most effective health response with strategies ranging from complete lockdown to attempted herd immunity. Central banks were also challenged, with the potential for a collapse in economic activity due to lockdowns and as social distancing measures were implemented. Many businesses stared into a dark void. Of benefit to policy makers though was their recent experiences with the Global Financial Crisis (GFC) in 2007/08. The lesson for many of them was that their responses this time around needed to be rapid and on a massive scale. The financial system needed to keep working. Critical to this provision of liquidity and support was interest rates. Globally, central banks have responded in a coordinated fashion and essentially cut their overnight cash rates to zero percent. And this is where they are going to stay for a long time.
Investor confidence in this proposition was recently strengthened after the US Federal Reserve affirmed that they are taking a new direction with their policy settings. In simple terms, they are going to be a lot more tolerant in the future with respect to inflation and unemployment. Contrast this with 2015 (when they last began a cycle of raising interest rates), when inflation was at 1.2% and unemployment had fallen to 5%. As of August this year though, Chairman Jerome Powell signaled that no tightening will occur until inflation is above 2% and the unemployment rate is below 4%. The goal posts have materially shifted. After the GFC, the Federal Reserve kept short-term interest rates at zero percent for seven years. This cycle appears to warrant at least this much stimulus again. The bottom line is that monetary policy will remain ultra-accommodative for the foreseeable future.
This is a critically important reference for policy frameworks globally and New Zealand is no exception to this development. In fact, our Reserve Bank, which is well versed in the world’s economic challenges, is now considered by many to be on the more aggressive side in its approach to policy settings. As noted earlier, they have recently joined the ranks of some other central banks by openly contemplating the prospects of implementing negative cash rates. Not all agree with this strategy, and in recent days we have seen senior representatives from our major trading banks voicing their opposition to this concept. But Governor Adrian Orr appears determined to ensure that this potential approach is clearly understood as being a tool within his arsenal. The regular public annunciation of this possible framework suggests that interest rates in New Zealand are very likely to remain anchored at record low levels for years to come.
This is the backdrop which is creating a major dichotomy for investors. Fueled by the extraordinary policy stimulus, equities have enjoyed the sharpest bull market seen in over 100-years. Low interest rates are sponsoring the same outcomes that we observed after the GFC, in driving the prices of shares and other real assets, such as property, higher. But for those people who have traditionally considered fixed interest opportunities (such as bank deposits and corporate bonds) as an integral part of their investment portfolios, and the source of much needed income, the current environment is becoming increasingly difficult to navigate.
The inevitable consequence of this dynamic has been that consideration of “non-traditional” sources of income has become a necessity. This redirection of interest has seen demand lift in areas such as commercial property and to a larger extent, high yielding shares. In this respect our local markets, New Zealand and Australia, are very well positioned. Despite the recent rally in share prices, the NZX50 Index today generates a cash (after tax) yield of 3.1% (if low dividend paying companies a2Milk and Fisher &Paykel Healthcare are excluded) whilst the ASX200 Index is slightly more attractive, yielding 3.2%. These are internationally competitive when considered against the US S&P500 and Japan’s Nikkei 225 indices, which both pay 1.75%.
The attractiveness of these domestic dividend yields has seen a lift in interest by offshore investors in our equity market, with the foreign ownership of the NZX50 increasing from circa 30% soon after the GFC to slightly higher than 60% today. Our market faces headwinds when it comes to its lack of size and liquidity, but the nature of the businesses represented here are very well positioned for the current global climate. Many of our businesses can be described as being mature, in strong competitive positions, enjoying stable margins, and generating strong levels of free cashflow. Such conditions are supportive of large and reliable dividends.
Notwithstanding the attractive yield being generated by the broader market, for those investors who are specifically looking to build share portfolios which target those companies which pay out the largest sustainable dividends, the opportunity set is even more productive. Some good examples of this include Devon’s Dividend Yield strategy or our Diversified Income Fund. Faced with the challenge of COVID, many businesses took a conservative approach to their capital management, but we were particularly conscious of this in our research process. Encouragingly we therefore succeeded in directing our investments towards those companies that were in a position to continue paying dividends, despite operating conditions being volatile. Spark is a good example of this, and it has been an excellent performer for our portfolios. Management were particularly successful in navigating the government shutdowns and have committed to paying a fully imputed 2021 gross dividend, yielding 7%. Further to this, growth in 5G will allow Spark to expand its fixed wireless offering, supporting higher margins and offsetting their declining revenue from copper line revenue. There are many examples of similar opportunities across New Zealand and Australia including our listed electricity companies and property trusts.
These returns from higher dividend-yielding securities are becoming increasingly attractive for income investors, especially when they are accessed through managed funds (or PIE’s – Portfolio Investment Entities) which enjoy favourable tax treatment. The top tax rate applicable to income generated under a PIE structure is 28% and there is generally no tax on realised or unrealised capital gains on listed Australasian shares. While currently investors who have a marginal tax rate of 33% benefit from this difference, it will become even more pronounced when Labour increases the top tax rate to 39%. For example, if the proposed 39% tax rate proceeds then, based on current distributions, the gross yield for investors who invest into the Devon Dividend Yield strategy would be about 8.2%. In comparison the yield opportunity though investment into traditional bank deposits, almost regardless of term, is currently about 1%. Of course, there is always capital volatility to consider with equities but for longer-term investors this income gap is hard to ignore.
Unfortunately COVID-19 remains extremely challenging across multiple fronts. It is hard to know how this situation will develop in 2021 but one thing remains certain; the global economy will need a continuation of support for economic activity to recover. Interest rates will remain at record low levels and as such investors will need to consider alternatives. Higher yielding but good quality equities are becoming an increasingly compelling part of the solution.