Ben Lofthouse, Head of Global Equity Income, says stock valuations look reasonable heading into 2020, but that dividend investors should stay focused on companies with the potential to deliver strong free-cash-flow growth as the business cycle ages.

Key Takeaways

• Although equity markets performed strongly in 2019, we believe valuations remain reasonable, with select regions and sectors – having been overlooked by the market – now particularly attractive.
• In 2020, we think investors should focus on finding companies that have the potential to generate strong free-cash-flow growth to support and grow their dividends.
• We also think it is critical for investors to avoid “value traps,” companies whose stocks appear inexpensive but that face structural headwinds. These firms’ dividends could be at risk given the extended nature of both the economic and market cycle.

What key themes are likely to drive markets in 2020?

We think the pace of global economic expansion will be the single most important thing that shapes the market next year. Why? Interest rates around the world remain at low levels but prevailing bond yields indicate a lack of confidence that this is enough to allow growth to stabilize. Potential fiscal stimulus, the U.S. election outcome, and some sort of resolution to the U.S.-China trade war and Brexit are important contributors to the growth debate, but their primary impact will likely be on specific stock and sector performance. Higher volatility could also be a feature of markets over the next 12 months, given significant valuation differentials between asset classes and sectors.

Equity markets have performed strongly in 2019, with the U.S. market hitting all-time highs in recent weeks in what is now the longest bull market in history. Despite this, equity valuations remain reasonable and continue to look attractive relative to bonds. We think there are a number of areas that have been overlooked by the market and where valuations are now compelling, offering investors the potential to earn attractive returns over the medium to long term.

Where do you see opportunities and risks within global equity income next year?

Global equities have been driven higher by the outperformance of the U.S. market and growth stocks, with other major regions in the world and value stocks lagging behind. In our opinion, if there is one thing that is being missed by the market, it is the amount of restructuring that companies are doing as they try to prove their value and adapt to the shifting global landscape. We expect this could become more obvious if these firms report better-than-expected results. If the market doesn’t react to this, we anticipate more merger and acquisition activity, given the availability of cheap financing.

We believe investors can find undervalued opportunities both geographically and at a sector level. Europe as a region looks attractive, while at a sector level health care and some selective financials appear to offer value. We also see a number of opportunities within the technology sector where companies are generating high levels of free cash flow, which is being returned to shareholders via dividends and share buybacks.

How have the experiences of 2019 shifted the outlook for 2020?

For global equity income investors, we think it is important to focus on companies that generate strong free cash flow and pay a sustainable dividend, as well as have the capacity to grow dividends over the medium to long term. In the last few years, a number of these companies could be found in the technology and consumer staples sectors, which have subsequently performed well. As we enter 2020, we think it will be important to monitor whether these companies can continue to deliver strong free-cash-flow generation and dividends at a compelling valuation.

Conversely, stocks that have underperformed and that are now generating higher yields need to be assessed to determine whether they are “value traps,” companies whose stocks appear inexpensive but that face structural headwinds. In our opinion, avoiding value traps and companies that may be forced to cut their dividend payments will be critical for investors in 2020, especially in light of the extended nature of both the economic and market cycle. Similarly, given the breakdown of the relationship between growth versus value stocks and bond yields, as well as the disconnect between growth versus value in terms of valuations and underlying earnings, it will be important to monitor these for any signs of reversal or normalization.

An Age of Extremes

In recent years, growth stocks have significantly outperformed their value peers.

[caption id=”attachment_253274″ align=”alignnone” width=”1052″] Source: Bloomberg, data are from 12/30/83 to 10/25/19.[/caption]