Mind the yield gap!

Wednesday is the day the Federal Reserve is expected to announce the winding up of QE3. Analysts are not predicting any change to the policy in place for most of the year, as month by month the Fed has reduced its bond purchases by $10bn a month from the initial $85bn to the $15bn currently. There will not be a press conference just a communiqué to the effect. The reaction during the year to the gentle reduction in asset purchases has not been what many had predicted. Bond yields have fallen, definitely not what was expected after last year's reaction to the news that the Federal Reserve were contemplating reducing the purchase program. Likewise many who thought equities were being supported by this added liquidity seeking a home, have seen them remain resilient in the face of the reduction. The hope and expectation is that there is enough confidence and optimism for companies earnings to continue to gently now recover to make up the short fall in Fed liquidity. Despite the recent correction in equities it is just possible, as the end of the program is confirmed, that equities have another wobble, as is the case when the peak of a rate cycle is reached. In reality we are far from the peak in the rate cycle, tightening has barely started and is unlikely to in the near future.

Many investors still look to equities for one of the few places to get income, UBS produced a report on Monday looking at the current state of payouts and in particular with comparison to 2007. The gap between high and low yield is near 2007 levels, which may be cause for concern on its own, however the real yield gap between European equities and German Bund yields is 85% of its crisis peak, and that does not compare with 2007. We have often pointed to the relative attraction 10-year bund yielding approximately 1%, and the European equity market yielding close to 4%. 

One sentence in the report that did grab the eye "dividends are recession proof", since 1970 during downturns dividends have fallen about one quarter as much as earnings. The last thing a company CEO wants to do is cut a dividend and as his remit is to grow earnings and over time dividends should reflect that. Payout ratios, currently at 55% of post tax earnings are in line with historical averages. The last observation from UBS, in 1984 the real yield gap was the same level as it is now, total return since then is 60% from dividends. 

Posted on October 27, 2014 .