Scott Kelly, Portfolio Manager for the DNR Capital Australian Equities Income Portfolio & Fund provides his insights on the current market for income investors.
Well, the record 47 billion in dividends has been declared or paid so far this year and we’re expecting dividends to be substantially higher again during the forthcoming reporting season. It’s largely driven by the big miners and energy companies, but we should also see stronger earnings and high power ratios as well as capital management initiatives for the broader industrial companies. The market’s forecasting gross yields of around 6% for 2022 and that’s still very attractive compared to alternatives. That’s despite the recent surge in interest rate expectations, particularly with the outlook for inflation and real rates and Australia’s well positioned relative to global markets too. In fact, the yield differential between Australia and global developed markets is currently at a record high with global developed market dividend yields at just 2% currently.
Well, the big miners is in energy stocks are expected to account for over a third of the dollar dividends generated by the market for 2022, whilst the big four banks will generate about 20%. So well over half of the dollar dividends to be generated in 2022, essentially coming from just a handful of stocks or put another way the rest of the market comprised mainly of industrial companies are currently generating average yields of just 3%. So of course this doesn’t mean you should have the basket of high yielding stocks in your portfolio at the expense of all others. In fact, we strongly caution against this. Chasing short term yields often comes at the expense of long term capital, and we position our strategy in high quality businesses that offer a combination of growing dollar income over time, franking benefits, but importantly also attractive valuations.
Well, the short answer is yes. However, this largely depends on three key factors. Firstly, we’re expecting earnings downgrades on the back of inflationary pressures and softening demand. The key question is how significant will they be. Consensus forecast for the ASX 200 industrials index expect profit margins to be 7% and that’s the highest level since prior to the financial crisis. In our view profit margins are likely to suffer as softening demand meets high costs. So consensus earnings downgrades are likely and in turn that will impact dividend expectations. Secondly, are we going into a recession and how severe will it be. Right now we’re in a period of uncertainty with an uneasy mix of slow growth, high inflation, faster policy normalization with global central banks tightening at the fastest pace in decades.
It must be said here in Australia we are better positioned on numerous fronts, particularly in terms of our terms of trade on the back of strong commodity prices, our high savings and lower inflation versus other economies, but risk are skewed to the downside and toward a more evident slow down in 2023. So in our view the prospect of a global recession is above 50%. The third key factor is where commodity prices will land and commodity prices have been softening, but any further weakness, particularly in iron ore and oil and gas prices, that’ll ultimately feed through to lower free cash flows and dividends. So in summary I think the risk for lower dividends for 2023 is modest and probably down in the region of around 5%.
Well, the dividend opportunities still appears to be in resources and energy, particularly relative to banks. Firstly, the resource and energy sectors typically produce better returns during hiking cycles, but we also expect near record levels of dividends to be announced during August. Whilst commodity prices have been weaker recently our views unchanged that the medium term fundamentals driven primarily by supply side constraints remain attractive. Our preferred exposures continue to be BHP and Woodside, long term commodity prices are not in current share prices and both companies are generating attractive double digit free cash flow yields. Woodside is a key portfolio holding for our income strategy. The merger with BHP Petroleums transform the business, transform the balance sheet, provide significant flexibility for the company to fund growth and distribute excess capital to shareholders.
And the Russia Ukraine situation has really highlighted how difficult it is to deliver new LNG supply quickly into regions that need them and Woodside is particularly well placed as well as compared to other multinational energy companies which dominate the industry. But in terms of the banks, we are happy to maintain the substantial underweight position here. Investors will see the early benefits of the RBA rates rate cycle with net interest margin expansion to be evident during our reporting season, but a quick and aggressive tightening cycle. Whilst it might provide support for margins it will also potentially lead to weaker housing and mortgage market pressure in the probability of a recession scenario and gross yields are just not really that attractive compared to the market around 6%. So valuations are looking fair to full depending on the extent of the bad debt cycle.
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