FocusPoint

Looking for a “double dip” insurance policy

Economic double dip recessions are extremely rare, with only one clear example in post war history, being the 1980 – 1982 period. Even so, financial markets have recently become nervous about the risk of another double dip. Although most economists see such an outcome as very unlikely, investors appear sceptical. And given the potential of financial markets to create their own economic reality, poor investor sentiment is not without risk itself. In any case, uncertainty is high, so let’s have a look at some safety nets.

The last double dip took place when the developed world made a transition from the very inflationary seventies to the more balanced growth in the following decades. Right now the developed world is facing another transition period; the modest inflation of the past decades appears to be transforming into a more disinflationary trend, with risks of deflation. This transition, which is partly caused by huge debt reduction plans of governments, has no historic comparison. It is therefore surprising that most economists are so convinced that the current recovery will follow normal historic parallels, with a manufacturing recovery automatically being followed by increased consumption growth.

Despite the double dip fears we note that in the first half of 2010 the expensive cyclical stocks have generally performed better than the cheap defensive stocks. Among the latter the telecoms and utilities have disappointed most, in spite of their exceptionally high dividend yields. In Europe, companies in these two sectors often offer dividend yields between 6 and 8%. This is even more remarkable when one realises that these companies tend to have decent “investment grade” balance sheets and therefore only have to pay 3.5 to 4% yield on their corporate bonds. So they offer twice as much yield on their equities than on their bonds, which is historically unprecedented.

The high divided yields and relatively defensive business models in these two sectors should provide investors with a safety net (an “insurance policy”) in case of an economic double dip. However, also in case of an ongoing economic recovery it is likely that these sectors will be able to at least keep up with the broad equity market, given the increasing attractiveness of their dividends in a world where inflation and interest rates are likely to remain lower for longer.

One can wonder whether the equity market is not implicitly telling us that the dividend policies of telecoms and utilities are unsustainable and that dividend cuts should be expected. It has to be said that in certain individual cases this may happen. Some utilities are increasingly at risk of regulatory measures (like tax increases) being taken by debt burdened governments who are looking to extract money from this sector. And telecoms face an environment with slow or no growth, in which the decline in “voice”- revenues may not be fully compensated by the growth in “data”- revenues. Both sectors therefore face issues which may force some companies to announce modest dividend cuts in the future, a trend which will be (partly) compensated by other companies which can still raise dividends. Thus, for the sectors as a whole substantial dividend cuts are not expected.

The developments at BP in the oil sector have once again stressed the need amongst investors for diversification. The same can be said about investments in utilities and telecoms. For investors who want to buy exposure to these relative safe havens in uncertain times, it is wise to consider sector funds.