McFarland points out that certain sectors have become quite cheap – notably banks. “They are seeing a rising dividend yield and should benefit from a rising interest rate environment. As such, we see good potential for capital appreciation,” he says.
European dividends
Coutts’s biggest country overweight position is to Europe. In the recent market turmoil, the group has been taking money out of cash and allocating it to European equities, based on the twin factors of valuations and dividends.
McFarland says: “European equities offer an attractive dividend stream, which continues to show strong growth. Some of the banks, insurers and energy companies are offering attractive dividend streams, and we are reassured this will grow because of the strength of cash flow for European companies. This can only improve if there is a turnaround in growth globally. We consider the outlook for dividends across Europe to be very positive.”
Europe is also likely to benefit from improving earnings, and on this basis, equity markets still look cheap relative to their developed market peers, particularly in the US. McFarland says the US is now trading on a cyclically adjusted price-to-earnings ratio of 22x. Europe’s cyclically adjusted P/E ratio is trading far lower, which is appealing.
McFarland says: “Within the Eurozone, in countries such as Italy and Spain, the economic recovery is in its infancy rather than maturing, as it is in the US. We try to look at both valuations and the potential growth in earnings. This is why we have liked the bank and energy sectors this year – they have been so beaten up.”
Eastern promise
The group has also been allocating to Japan in the recent rout. McFarland likes Japan at a microeconomic level: the government is driving reform of the corporate sector and there has been a change in the pensions rules, which should support the equity market going forward. He points out that earnings growth for Japanese companies remains strong and Japanese equities are still reasonably valued.
Asia Pacific is another favoured area. McFarland says: “China is still showing great opportunities and we are still overweight the H-share market. We are also overweight Singapore, where there is a good dividend yield. We also like India, where companies’ return on equity makes it appealing.”
Fixed income is a more difficult decision. McFarland believes there is a risk of capital loss in some parts of the fixed-income markets as interest rates rise and, as such, they are trying to hold fewer and fewer G7 government bonds. He believes the decline in yields makes the asset class very vulnerable. The group is also selective on investment-grade credit but recent underperformance has made yields more attractive relative to low-yielding sovereigns.
