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A Dearth of Income

The plight of the saver is a difficult one these days.

It is increasingly difficult to get a return on non-risk assets. Short-term cash deposits yield practically nothing in any of the supposedly safer jurisdictions of the Eurozone, the US or UK. Yields on longer-dated government bonds in these same regions are below 2%, and they offer no growth and no protection against inflation. In Ireland, one can get better cash deposit rates but, with the ECB overnight rate at 1% and the central bank continuing to provide ample liquidity to banks across the Eurozone, how long can these teaser rates from the Irish banks last?

And the problem of low returns on non-risk assets appears most likely to persist. The deflationary impact of the entrance of highly competitive economies from China, India, the Far East to Latin America into the global economy over the past two decades has led to unprecedented global trade imbalances, and a glut of savings in the emerging markets. As a colleague of mine recently observed, even if currencies in the likes of China and the rest of the Far East appreciated in value, it would still probably not alter the trade imbalances much. And, in the past decade, the glut of savings has continuously found its way back principally into US dollars (treasuries) allowing US interest rates to stay low despite escalating debt levels in this key global economy.

The side effects in the developed world of the global trade imbalances and surplus savings have been a series of destabilising events. Cheap money has led to bubbles in many asset classes and markets where effective controls over credit creation were not in place or not utilised - initially in equities, then property and now most likely in long-dated government bonds.

And we remain in an unbalanced world where debt levels in the developed economies are likely to drag on growth for several years to come. Loose monetary policy globally coupled with a structural rise in the demand for commodities is likely to cause frequent inflationary bursts in the emerging markets. Is it any wonder investors can't decide to protect against inflation or deflation?

The saver has to contend with the fact that interest rates may stay low for a long time. Quite simply, the developed world cannot afford higher interest rates given the debt load. And with deflationary forces in the developed world making the debt burden increasingly onerous, the temptation for governments and central banks to print money rather than pay a market rate for increasingly risky debt is high. Is it any wonder gold, the only currency that cannot be debased by central bank money printing, has been in a bull market for the past eleven years?

Risk assets, like equities and property, offer better yields and better all-round value than bank deposits or traditional government bonds. The Eurozone equity market, for example, with an earnings yield of 10% and a dividend yield of circa 5%, is as cheap as it has been since the early 1980s. The key US equity market may be valued modestly above its long-term average but, compared to interest rates, even this equity market looks like a bargain. And the emerging markets, which have traded sideways to down for going on two years now, are competitively priced versus historical norms.

But the risks in equities are above average. In the developed world, the deflationary forces of excessive debt suggest recession, which leads to lower corporate earnings and possibly lower dividend yields, is a more constant threat than historically, leading investors to remain extremely hesitant on risk assets.

A possible investment sweet spot in the current environment must surely include the global consumer franchise stocks. In the US, such stocks might include Coca Cola, Johnson & Johnson, Colgate, Proctor & Gamble, Wal-mart, McDonalds, Heinz and other similar stocks. In Europe, the equivalent stocks might include Nestle, Reckitt Benckiser, Unilever, Diageo and others. The low ticket price and repetitive nature of consumption of their products explains why demand for their products is not normally dented by recession. In addition, their brands provide them with pricing power, which protects margins, and their global reach ensures they are benefitting from the growth of the consumer markets in the emerging economies.

Defensive growth should be highly prised by investors in the current environment of extremely low returns from non-risk assets. But it is not. Collectively, the above named companies offer an earnings yield of just below 7%, which supports an average dividend yield of just above 3%. An important additional feature is that financial risk is low in the majority of these consumer giants. They are, individually and collectively, financially stronger and growing faster than most governments and countries.

A secure 3% plus dividend yield with growth attached looks fairly compelling compared to the alternative - supposedly risk-free - yield of under 2%, with no growth, on long-dated government bonds in the US, UK and Germany, economies that can hardly be classed as financially secure. Stretch your risk tolerance a little further and a reasonably secure 4% plus dividend yield is easy enough to obtain from good quality defensive equities (stocks and funds) in the developed markets.

With non-risk assets offering generational low returns, the pressure on monies to flow to where returns are higher is exceptionally strong. If markets have turned, as I think they have, and are in the process of pushing higher from here, a significant part of the reason is because there is no where else for the money to go. 

Rory Gillen
21st January 2012