Investing in inflationary times: looking to European income

High inflation, rising interest rates and increasing concerns about a slowdown in global growth have created considerable turbulence in stock markets this year. With no end to the current macroeconomic challenges in sight, investors need to look ahead and consider what strategies can enable them to protect and grow their capital during this difficult period.

Building resilience

The idea that the post-pandemic inflation seen in the second half 2021 would be transitory has been thoroughly discredited. In the UK, the consumer price index (CPI) hit 10.1% in July. The Bank of England expects inflation to reach 13% in the autumn as energy prices soar.

Rising interest rates, meanwhile, and the increasing possibility of recession as a result of tightened monetary policy have created a bleak outlook – in the short term, at least – for stocks across a range of sectors.

We believe, however, that an investment strategy focused on companies that have the ability to continue returning income to shareholders, and which are well-placed to withstand inflationary pressures, can prove resilient in the current environment. In particular, we think the dividend landscape in Europe (excluding the UK) stands out from the crowd in terms of its potential.

What sets Europe apart?

High levels of uncertainty continue to be part and parcel of equity and fixed-income investment in 2022. Nonetheless, the European income sector has a number of dynamics that appeal to us. With valuations of both growth and value stocks remaining depressed, dividend income plays an ever more important role in total returns. We expect so-called ‘bird in hand’ stocks – those with strong, resilient cashflows, and the ability to pay attractive dividends while also reinvesting in organic growth – to continue to do well.

Such stocks can be found across several European markets, where there is a strong, long-standing culture of returning dividends. It’s worth noting that dividend distribution from European ex UK equity income fell more slowly and recovered more quickly than from comparable stocks in the immediate aftermath of the Covid-19 crisis in 2020.

Historically, companies in this sector have tended to offer a material dividend yield premium when compared with their counterparts in the US. And while current Europe ex-UK yields are at similar levels to those on corporate and government bonds, we believe such fixed-income assets will come under pressure while prices are rising as the nominal yields they offer are eroded in real terms.

European stocks in general are also highly rated from an ESG (environmental, social and governance) point of view. Consequently, they tend to be better positioned in terms of sustainability criteria such as climate-change risk – an important medium- and long-term consideration.

We expect so-called ‘bird in hand’ stocks to continue to do well.

Withstanding inflation

Another question for investors is: which stocks are best placed to withstand the inflationary pressures that are likely to persist for the rest of this year and into 2023? In our view, companies in sectors such as energy, utilities and financials are well suited to thrive in this climate. For example, energy and utilities firms tend to be better able to pass on higher prices to their customers. Energy stocks can also take advantage of the high commodity prices that have been a significant element of recent rises in inflation rates. Meanwhile, companies in financials are likely to benefit from a rising interest rate environment.

Formulating the right strategy

So what approach should investors take to building an income-focused portfolio? Given the current elevated levels of uncertainty, diversification among a range of companies is vital, avoiding the risks associated with relying on a small pool of stocks to provide dividends.

Nor should there be too great an emphasis on income itself. Businesses that are returning large amounts of cash to shareholders in the form of dividends or stock buybacks may lack the resources to invest in future growth. The current challenges will not last forever, and it is important that portfolio companies are able to benefit from any upturn further down the line.

Final thoughts…

However volatile markets have been so far this year, it makes sense to focus on what comes next. We believe the Europe ex-UK equity income sector ticks a number of boxes in terms of being able to deliver income in a high-inflation and possibly even recessionary environment – while having the potential to take advantage of improving economic conditions in the future.