Comment: Have we seen the best from equity income?

Bill Jamieson
Bill Jamieson
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A STRENGTHENING recovery, upbeat growth forecasts and business optimism rising – just the conditions for stepping up your equity market investments to ride the incoming tide.

Or not, as the case may be. For the good news on the economy has brought with it a warning from Bank of England governor Mark Carney that a break-out from ultra-low interest rates is likely to come earlier than the Bank’s previous forecasts.

Now the biggest single influence on stock market behaviour at present, here and in the US, is monetary policy. When the market believes rates will stay in their current low level, share prices will hold up.

But the minute that belief is clouded by concerns over a rise in rates, investors are altogether more cautious. Higher rates may act as a dampener on business and household spending, casting doubt on earnings prospects. At the same time higher returns on cash and deposits acts as a counter-pull to equity investment.

Last Wednesday saw a sharp drop in the FTSE 100 index as the market reacted badly to the Bank of England’s raised growth forecast, fearing that rates could soon be raised. Conversely, in the US, Wall Street rose on suggestions by Janet Yellen, set to replace Ben Bernanke as chair of the Fed, that she would continue the accommodative policy of recent years: no early change in rates. But a surge in US employment suggests the onset of “tapering” – weaning the economy off its $85 billion (£52.7bn) a month quantitative easing support – cannot be far off.

All this has prompted me to wonder whether my strong preference for income-orientated funds and trusts over the past four years needs re-visiting.

The investment trust Global Growth and Income sector is up 29.3 per cent over one year, by 41.9 per cent over three years and 118.8 per cent over five years. Some trusts have done extraordinarily well – Scottish American Investment Trust (Saints) has risen by 142 per cent over five years, Martin Currie-managed Securities Trust of Scotland by 139 per cent and Murray International by 131 per cent. Similar strong performances have been mounted by trusts in the UK Growth and Income sector.

But many of these trusts are now standing at a premium to their net asset value – Securities Trust of Scotland, for example, is standing at a 4.1 per cent premium, Standard Life UK Equity Income at 3.3 per cent and Murray International at 7.9 per cent.

That is a signal to investors that the trust is so popular that the shares are priced higher than the value of the underlying assets. You have to be confident, not just that the market will continue to rise, but that this particular trust will continue to outperform.

Neil Woodford, who manages Edinburgh Investment Trust and Invesco Perpetual income, told the TrustNet website last week that the rally in defensive stocks over the past 12 months is unlikely to continue now that many undervalued areas have re-rated.

“This year has seen strong performances from a wide spread of sectors, including those perceived as defensive,” he said.

“Investors have favoured stocks where they have confidence in their dividend-paying ability and the prospect of sustainable growth. We would caution, however, that returns over the next three years are likely to be somewhat lower than over the last three years.”

Woodford is not alone in this view – and some suspect his decision to leave his huge income funds may have reflected a concern that the best may be over for now.

And there are concerns over a more general fall ahead. Gervais Williams, who manages the CF Milton UK Multi Cap Income fund, says a big pull-back is looking likely, prompting him to take out a put option against the FTSE 100. 
He warns: “We’ve had five great years, which has made a lot of people feel more comfortable. Well we’re not.” 

All this poses two concerns for investors: a reluctance to dispose of investments that are generating a good income stream, and capital gains tax problems.

I don’t think there’s a strong case for investors to sell out of holdings built up for income. While there is a sea-change underway in perceptions about interest rates, there is unlikely to be any immediate change. And so long as inflation remains subdued, it is unlikely that it will trigger a quick-fire series of rises.

However, investors could usefully undertake some pruning of weak non-performing holdings and build up cash for now for better buying opportunities that any “correction” will inevitably throw up.