A long-term perspective soothes day-to-day fears
Investors are often concerned, even frightened, when equity markets suffer the sort of day to day volatility seen in August and September this year. However, these moves need to be put into perspective. One of the unfortunate aspects of the reporting of stock markets by much of the media is the emphasis on the closing price of the major indices – for example the short term focus on the fact that the FTSE100 index has fallen from close to 7000 to close to 6000 since the spring.
A long term investor should remember some of the key reasons for buying stocks and shares, directly or via a fund or investment trust. Of course capital gains and losses matter, but over time study after study shows that the majority of gains from buying shares come from dividends and re-invested dividends. These mount up over the years, especially via the power of compound interest.
At this particular stage of the investment cycle, equity income funds also have their rewards, as well as some risks which need to be noted. Income funds, whether their foundation is equity or corporate bond or commercial property, are supported by the very low levels of interest rates in all the major economies, and thus historically low government bond yields. Put another way, it is well known that the gap between dividend yield and government bond yield is rather wide, whether we look at the situation in nominal or inflation adjusted terms. On top of this a useful feature of the UK and US equity markets has been share buy backs, adding about another 1% to the yield on average. Compound average annual dividend growth was 4.6% for the FTSE100 and 6.7% for the FTSE250 stocks from 1986-2015 - although those figures do include a period when inflation was rather higher than today!
A turning point in the cycle beckons – or perhaps a fork in the road is a better distinction. Central banks in this country and the USA have been at pains in recent months to warn markets that interest rates could start to rise, if the necessary conditions fall into place. If this does happen, and base rates rise every three or six months, then of course the yield from equity income funds will need to be re-assessed. However, another aspect of the MPC’s or the Fed's decision also needs to be considered – the only reason why they would want to tighten monetary policy is if the economy is strong enough. We look to be a world away from the top of an inflation cycle! Such a background should be helpful for corporate sales and therefore company earnings. This is particularly so for smaller firms.
What about the other fork in the road? There are undoubtedly risks ahead. Emerging economies are in a long drawn out economic slowdown, which is feeding through into worries about the profits for corporates elsewhere. Geopolitical risks are mounting, for example developments in the Middle East, while the regulatory environment is not always supportive for business. The good news is that stock selection can help in difficult times. For example fund managers can look for firms with strong corporate balance sheets, reflecting the fact that dividend cover on FTSE250 stocks is about 2.25 times, versus just over 1.5 times for FTSE100 firms. Capital gains and losses do matter if the effect has to be crystallised. Otherwise, in a lengthy environment of low inflation and low yields, many investors will appreciate the advantages from holding equity and other income producing assets to help protect portfolios and provide long term returns even during volatile conditions.
Andrew Milligan, Head of Global Strategy, Standard Life Investments