PARTNER INSIGHT:The challenge for the UK Equity Income sector over the coming months will not be the often-discussed search for dividends, but how managers will navigate the potential volatility of the domestic UK equity markets.
Exclusive research from PureGroup, below, reveals how the Franklin UK Equity Income Fund could continue to outperform even in the face of rising rates and falling dividend yields.
The arrows within each chart depict which direction the specific macroeconomic factor is likely to move in over the short term. The positioning of the fund and peer group on each chart reveals how 'sensitive' the Fund and peer group are to each of the factors.
Positive sensitivities to a factor indicate an investment is likely to have a positive contribution to its performance if the factor increases or expands. A negative sensitivity suggests an investment is likely to have a positive contribution to its performance if the factor decreases or contracts. The size of sensitivity indicates the relative significance of the expected contribution.
UK default spread (fig.1) is the measure of yield difference between high quality (AAA) and lower quality (BBB) corporate bonds. The reason this factor is analysed here is because it is a good leading indicator of business uncertainty, as during periods of increased market stress investors expect to be compensated more for the risk that they are taking. This causes the default spread to expand as lower quality corporates need to offer a higher yield.
Importantly the Franklin UK Equity Income fund is neutral to this factor (which is falling currently), and therefore it is likely to be less impacted by any unfavourable news or increase in market volatility.
Looking at wider equity market valuations, the Franklin UK Equity Income fund has a positive sensitivity to UK dividend yields (fig 2.). The movement of this factor during an economic cycle has two drivers: the overall dividend and its underlying valuation.
Long-term central bank quantitative easing policies have led to a broad appreciation of most global equity markets. It is this valuation increase that has the biggest current impact on the factor.
The fund's positive sensitivity means that currently it would face a headwind to its performance. However, if valuations were to fall back, then the Franklin UK Equity Income Fund would be expected to outperform the peer group. Primarily, there have been two levers that have been used by central banks to stimulate the economy, the first is to reduce interest rates to near zero levels and the second is to have asset purchase programmes to repurchase issued government bonds.
Global central banks are all at different stages of progress on their own QE programmes, however most have either started or will be looking to initiate a removal of these monetary policies over the coming months and years. Monetary tightening is likely to see domestic short-term interest rates increase. UK term spreads (fig.3) (the difference in value between long and short-dated government bond yields), are also likely to increase. In both of these scenarios, the Franklin UK Equity Income Fund would have a positive impact to its expected return.
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