The past three weeks have seen the cooling off of once-ravenous animal spirits driven into a frenzy by the abundance of liquidity in financial markets. Yet even as the NASDAQ 100 subsequently corrects from this stampede towards tech stocks, Citi Chief Investment Officer (CIO) David Bailin and his team see ample opportunities in the stock market that can be capitalised by diversified asset allocation from dividends and certain fixed income substitutes.
Citi’s CIO Office has expressed scepticism about the hype surrounding technology stocks even as such assets to more than 40% of US market capitalization this year. The defensive and growth characteristics of technology stocks and their role in sustaining the global economy through worldwide lockdown measures have seen such counters being the main beneficiaries of the Covid-19 pandemic.
“With Technology, Media and Telecom shares surging to more than 40% of US market capitalisation this year, we have been warning that gravity exists even for technology stocks. Does it make sense that the value of Apple Inc. exceeded that of the entire UK equity market or the Russell 2000 index?,” laments the CIO team in a broker’s report dated September 20.
The Citi CIO team is particularly concerned about the low barriers to entry into the tech industry despite the existence of “moats” for first movers. With new competitors able to enter the market relatively easy, he predicts weaker equity returns for technology stocks over the medium term. Firms that lack dominant products and solutions, he says, will see weaker performance post-pandemic.
What the CIO team favours instead is a contrarian approach that favours picking up on stocks that have been punished by the Covid-19 pandemic. Despite the severe economic ramifications of the pandemic, they see Covid-19 as a temporary shock, with “Covid cyclicals” likely to return to stronger economic performance once the crisis is successfully averted.
“More broadly, one of our favorite sets of companies are firms that are able to sustain dividend payments under today’s challenging circumstances. Reinvested dividends have driven roughly half the total return of equity markets over markets such as the record run led by tech shares in the US from 1982-1999,” he writes.
With global interest rates falling below 1% at present, the CIO team thinks that selecting stocks with sustainable dividends and likely future dividend growth could help reduce portfolio risk more than a bond-only portfolio at current yield levels. The relatively low correlation between global interest rates and dividend yields, he believes, could be appealing to investors once long-term interest rates have bottomed out.
“For equities, a portfolio manager’s challenge will be to identify sustainable dividend growth. This is to provide investors with both scarce income and low sensitivity to movements in interest rates,” remarks the Citibank CIO team. These are unlikely to be Covid defensives or typical “bond proxies” like utilities. Investors should look beyond US markets to find stocks with both appreciation potential and income.
The most promising industries for equities include Big Pharma, which has underperformed despite strong fundamentals and regular dividends, and industrials, where potential upsides of counters in the automation space are likely to rise over the next 12-18 months. Commodities have outperformed relatively more innovative industrial firms contrary to expectations, especially among capital goods producers. Unfounded political risk fears associated with Big Pharma regulation and geopolitical uncertainty have pressed down equity prices in this space.
Interestingly, there remain tech stocks that could present good value to investors. “We can still identify select tech stocks trading on attractive valuations, some of which also pay attractive and sustainable dividends. While some company’s strong balance sheets and high dividend yields relative to the broader market have not been rewarded so far this year, it would be unwise to assume that those qualities will remain out of fashion for long,” notes the CIO report.
Despite the low rate environment, fixed income investors may struggle to find assets with good valuations as there could be some long-term yields accompanying the Covid-19 recovery. But they may find rough diamonds among higher dividend yielding equities in cyclical industries, says the CIO team. The Global High Yield Equity Index now yields more than 3% more than the world bond index -- a gap that is near the highest level ever for all but short periods.
Due to unprecedented debt purchases by central banks, the CIO team observes that high quality bond markets have normalized, spreads have narrowed, and bond yields have fallen to historical lows. Consequently, they recommend investors to move down in bond quality in search of additional yield considering their more constructive economic predictions. Value may also be found in longer term bonds, considering the Fed’s preference for five-year bonds.
Bailin and team recommend BBB-rated investment grade debt, which yields 2.3% and has scope for additional tightening. They also express high conviction on high-yield former investment grade “fallen angel” bonds, as these are often depressed or oversold despite providing up to 5% yield at a BB credit rating.
Despite US preferred stock yields averaging 4.0% and European yields 5.0%, the team sees significant value in the preferred stock market, with share valuations similar to similarly-related high-yield bonds. Large banks in particular have a strong fundamental position. Potential common dividend cuts should serve as an opportunity to increase exposure to fundamentally strong large banks.
For real estate assets, the Citi CIO team recommends residential mortgage-backed securities (RMBS) have benefitted from stable home prices, with yields reaching up to 4%. Prices on A/AA-rated commercial mortgage-backed securities (CMBS) still offer yields up to 5.0% and are seen to be relatively immune from potential losses from certain areas of the commercial real estate market. Mortgage equity REITs -- while volatile and leveraged -- are a valuable supplemental holding with 8% forward-looking yields despite being off nearly 40% y-t-d.
But ultimately, the team urges investors not to put all their eggs in one basket but build a diversified portfolio instead. “Combining these opportunities in core portfolios can lower correlation, which can lower overall portfolio volatility and better help investors navigate the current low yield world,” they write.
