On the heels of the historic S&P downgrade of the U.S. Treasury credit rating, the Federal Reserve announced a new monetary policy target intended to keep its extremely low Federal Funds target rate near zero until the middle of 2013. Reacting to fears of a double-dip recession (1) and uncertainty about the European debt and banking crisis, U.S. Treasury bond yields collapsed. The 10-year U.S. Treasury bond fell to a record low of under 2% on August 18, and the yields on the 10-year U.S. Treasury Inflation-Protected Security (TIPS) (2) went negative for the first time in history.
These low yields imply that U.S. debt, despite the downgrade, is still viewed as the principal safe haven (3) investment of choice. The market believes there is zero possibility that the United States Treasury will ever default on its debt, since the Federal Reserve will always give the Treasury any money it needs to fulfill its obligations, and the Fed has unlimited funds to lend. That said, the threat from excessive lending by the Fed is higher inflation. In that case, all U.S. fixed income instruments, whether they are issued by AAA (4) corporations or not, will see their values erode.
The paltry interest rates offered on U.S. Treasuries and the threat of inflation reinforce our belief that U.S. Treasury bond prices are at historic highs (as bond prices move in the opposite direction of interest rates; a decrease in interest rates corresponds to an increase in bond prices). Investors are handing over their money to the U.S. government for 10 years and accepting a negative “real” return over that period.
Economic theory and past evidence indicates that the real yields on TIPS bonds should approximate the real growth of the U.S. economy. Although growth has certainly slowed over the past decade, there is virtually no possibility, in our view, that it could be negative over the next 10 years, as currently implied by TIPS prices. In fact, even the purveyors of the “New Normal” theory of economic growth predict 2% real growth for the economy.
The zero GDP growth expectations now embedded in the 10-year TIPS prices would require that both productivity growth fall to zero (which is more than 2 percentage points below its long-term trend) and the labor participation rate decline at twice the rate it has over the past 10 years, a decline which in itself was unprecedented in our history. Our own view is that productivity growth is more likely to accelerate, not decelerate, in the future as the global economy becomes more connected and firms are able to use their resources to accomplish more with less.
We believe this means that the risks of changes in interest rates are biased strongly in favor of an upside move sometime within the duration of these long-term bonds, an event that would trigger substantial capital losses on bondholders. We believe that dividend-paying equities currently represent a better alternative to these U.S. Treasury bonds for investors seeking income. Of course, equity investments offer a different and higher risk profile compared to bonds, and the volatility in equity prices means that investors could see more variability in their capital values on a regular basisEVALUATING GLOBAL EQUITY PRICES, AS MEASURED BY INDEX DIVIDEND YIELDS
Note, one cannot invest directly in an index. The following discussion on index dividend yields (5) is simply meant to serve as an indicator of how the average stock price in various market segments is selling relative to the average dividends by the index component securities. Higher index dividend yields generally correspond to lower market prices.
WisdomTree’s dividend-weighted U.S. equity Indexes currently have dividend yields ranging from 3.4% to 4.6%. The U.S. indicated dividend stream grew 10% in 2010; (6) it has already grown more than 10% in the first seven months of 2011, and the long-term dividend growth for the U.S. markets over the last 50 years was about 5% a year, outstripping inflation, which has averaged 4% over that period. (7)
Investors can find stocks trading at lower prices relative to their average dividends if they look outside the United States into the global markets (see table at the end of this article). Broad developed world dividend-weighted indexes currently carry dividend yields ranging from 5% to 6.5%, while an emerging market index has a dividend yield over 7%. (8)
To be sure, the emerging markets present a unique set of risks, ranging from political to inflation risks. Yet, the emerging markets are also the region with the highest dividend growth rates over the past 10 years. Dividend growth in the emerging markets (as measured by the MSCI Emerging Markets Index (9)) averaged 13% per year for the 10-year period ending June 30, 2011, while annual dividend growth in the United States (as measured by the S&P 500 Index) averaged 4% over the same period. The recent evidence also shows emerging market dividend levels surpassing their all-time highs while U.S. dividends remain below their pre-crisis peaks.
In the developed world, Europe is selling for about eight times earnings, a very low price-to-earnings ratio.(10) We think the euro and the European region have their own unique set of economic challenges and that the euro’s exchange rate is too high. There has also been heightened concern for the banks in Europe, which have considerable exposure to the debt of the troubled economies. The European Central Bank (ECB) has committed to buying the debt of Spain and Italy, which they previously refused to do. These actions expand the balance sheet of the ECB and most likely translate into an increase in the euro money supply. More euros could place downward pressure on the euro exchange rate. Currency-hedged investments for foreign markets could thus be an attractive way to access the higher dividends of those markets while being protected from depreciation in the euro.
Investors may also want to consider dividend ex-financials investments as one way to hedge against some of the risk from the European debt crisis. While no sector is likely to remain unscathed in the event of an all-encompassing European banking crisis, the ex-financials investments (both U.S. and international) offer an additional way to hedge those sector-specific risks and maintain a high-dividend investment strategy.CONCLUSION
Despite the S&P downgrade of U.S. debt, Treasury yields have plunged and equity prices have continued lower as economic activity has slowed. For value-seeking investors, we believe the steep sell-off in equities may offer an attractive opportunity to exit U.S. Treasury bond positions and enter global dividend-paying equities at marked-down prices.GLOBAL DIVIDEND-WEIGHTED INDEXES AND EXCHANGE TRADED FUNDS DESIGNED TO TRACK THEM
Note that the index dividend yields discussed in this article are meant to serve as an indicator of the prices of the average stock in the index. The WisdomTree ETFs are designed to track the WisdomTree Indexes. Investors in WisdomTree ETFs should not expect to receive dividend yields represented by the Indexes. A number of factors that can influence fund distribution yields that are not represented in Index dividend yields include: ETF fund expense ratios, foreign withholding taxes and growth in the ETF shares outstanding.
There are risks involved with investing, including possible loss of principal. Foreign investing involves currency, political and economic risk. Funds focusing on a single country or sector and/or funds that emphasize investments in smaller companies may experience greater price volatility. Investments in emerging markets, currency, fixed income and alternative investments include additional risks. Please see prospectus for discussion of risks.
Disclaimer: Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. To obtain a prospectus containing this and other important information, call 866.909.WISE (9473) or visit wisdomtree.com. Read the prospectus carefully before you invest.
WisdomTree Funds are distributed by ALPS Distributors, Inc. Jeremy Schwartz and Jeremy Siegel are registered representatives of ALPS Distributors, Inc. WIS003469 8/2012.
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Index Definitions: WisdomTree DEFA Index: The WisdomTree Dividend Index of Europe, Far East Asia and Australasia (WisdomTree DEFA) is a fundamentally weighted Index that measures the performance of dividend-paying companies in the industrialized world, excluding Canada and the United States, that pay regular cash dividends and meet other liquidity and capitalization requirements. WisdomTree LargeCap Dividend Index: A fundamentally weighted Index that measures the performance of the large-capitalization segment of the U.S. dividend-paying market. The Index is comprised of the 300 largest companies ranked by market capitalization from the WisdomTree Dividend Index. WisdomTree Emerging Markets Equity Income Index: A fundamentally weighted Index that measures the performance of the highest dividend-yielding stocks selected from the WisdomTree Emerging Markets Dividend Index. At the index measurement date, companies within the WisdomTree Emerging Markets Dividend Index are ranked by dividend yield. Securities ranking in the highest 30% by dividend yield are selected for inclusion. Companies are weighted in the Index based on annual cash dividends paid. WisdomTree DEFA Equity Income Index: A fundamentally weighted Index that measures the performance of companies with high dividend yields selected from the WisdomTree DEFA Index. WisdomTree Global Equity Income Index: A fundamentally weighted Index that measures the performance of high dividend-yielding companies selected from the WisdomTree Global Dividend Index, which measures the performance of dividend-paying companies in the U.S., developed and emerging markets. WisdomTree Equity Income Index: A fundamentally weighted Index that measures the performance of companies with high dividend yields selected from the WisdomTree Dividend Index. WisdomTree DEFA International Hedged Equity Index: A dividend-weighted Index designed to provide exposure to developed world, non-U.S. equity securities while at the same
time neutralizing exposure to fluctuations between the value of the U.S. dollar and non-U.S. currencies reflected in the Index. In this sense, the Index hedges against fluctuations in the relative value of non-U.S. currencies against the U.S. dollar. WisdomTree International Dividend ex-Financials Index: Measures the performance
of high dividend-yielding international stocks outside the financial sector. WisdomTree Dividend ex-Financials Index: Measures the performance of high dividend-yielding stocks outside the financial sector.
1: Double-dip recession is defined as a second recession (decline in economic output) that occurs shortly after a previous recession.
2: Treasury Inflation-Protected Securities, or TIPS, provide bond investors with protection against inflation. The principal of a TIPS bond increases with inflation and decreases with deflation, as measured by changes in the Consumer Price Index (which is a measure of inflation, or prices of a basket of goods, in the United States).
3: Safe haven assets are those assets that investors turn to when they want to remove risky securities from their portfolios.
4: AAA is the best credit rating a bond can receive as determined by one of the major credit rating agencies, such as the Standard & Poor’s, Moody’s or Fitch rating services. A credit rating reflects the rating services’ grade as to the ability of the firm or government entity to service its liabilities and debt obligations.
5: The index dividend yield is a measure of the annual dividends of the shares of all index components divided by the index value. The index dividend yield is a measure of dividends as a snapshot in time. Dividends are only one component of returns for an index, as capital gains (price changes) also impact the total returns for an index.
6: As measured by the Dividend Stream of the WisdomTree Dividend Index. The Dividend Stream is calculated as the sum of the indicated dividend per share multiplied by shares of common stock outstanding on a given date for every stock in the WisdomTree Dividend Index.
7: As measured by the S&P 500 Index. The S&P 500 Index is a capitalization-weighted index of 500 stocks selected by the Standard & Poor’s Index Committee designed to represent the performance of the leading industries in the United States economy. It includes both dividend payers and non-dividend payers, while the WisdomTree Dividend Index is an index of only dividend-paying stocks and weights its securities by the indicated dividend stream.
8: The Indexes, referred to in the table at the end of the article, are the WisdomTree DEFA Index, the WisdomTree DEFA Equity Income Index and the WisdomTree Emerging Markets Equity Income Index.
9: The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
10: Source: Bloomberg. The price-to-earnings ratio is a measure of the aggregate market value of an index or set of stocks divided by its aggregate earnings. The price-to-earnings ratio gives investors an idea of how much they are paying for an index’s earnings power. One way to think of the price-to-earnings ratio is how many years it would take for an index to earn its price (market value), assuming no future growth in earnings. A lower price-to-earnings ratio thus is considered a positive feature of an index, assuming future growth of that index is equal to that of a competing index.
Unless otherwise stated, data source is WisdomTree.