For many investors, equity markets have, in recent times, been the ‘yield generator’ of choice, as bond yields have struggled to move above historic lows. But looking into 2018, headwinds from central bank tightening, the resulting likely domestic currency appreciation, as well as notable geopolitical flash points, mean that equity markets could be under pressure. I asked our ETF strategist, Morgane Delledonne, why she believes a ‘covered call’ ETF strategy could be your best income option in these conditions.
Christine: What is the main risk for equity markets in 2018 as Western central banks start normalising monetary policies?
Morgane: While the improving global economy is generally supportive for equity markets, the likely appreciation of currencies in developed economies along with tighter monetary policies pose risks to equity markets in 2018. Equity indices that include large multinational companies are the most vulnerable to an appreciation of domestic currencies as it results in lower, or negative, currency translations on foreign earnings. For example, overseas sales represent about half of the total sales for the S&P 500 and the Euro Stoxx 50 companies, and almost three-quarters for the FTSE 100 companies. With reduced central bank dominance, volatility can rise, mostly driven by currencies and political events.
Sources: Bloomberg, BMO Global Asset Management as at 8.12.17.
Christine: Do you think the BMO Enhanced Income strategy will be favourable across Western developed markets in 2018?
Morgane: Yes, but not for the same reasons. In the UK, with the Bank of England starting to normalise monetary policy, the real interest rate differential between the UK and the US is likely to put upward pressure on sterling, which clouds the outlook for the FTSE 100 index. In this context, we believe the defensive nature of the strategy can outperform in a likely range-bound market. In the US and the eurozone, the strategy may underperform slightly in strongly rising markets but it can help to reduce volatility in the long run. In the US, the current equity bull market is vulnerable to a more aggressive-than-expected increase in interest rates amid new Federal Reserve governance and rising inflation. Furthermore, the rise of political uncertainty amid the probe on alleged Russian intervention in Trump’s election campaign, as well as persistent geopolitical risks with North Korea and China, has increased market volatility in the past month. In the eurozone, stronger economic activity and loose monetary conditions are likely to continue to support the Euro Stoxx 50 index. However, the index typically exhibits higher volatility than its US and UK counterparts.
Sources: Bloomberg, BMO Global Asset Management as at 8.12.17
Christine: What sort of investors may be interested in the strategy?
Morgane: Because the strategy is first and foremost aimed at generating income, both fixed income and equity investors can find it attractive – although from a different perspective. As with traditional fixed income instruments, the strategy distributes a continuous stream of income from writing call options on the underlying index. However, the cash flows received from option premiums do not have duration (price sensitivity to changes in interest rates) or credit risks, and the option yield ranges between 2 to 4% compared to money markets which yields below 2%. In addition, the defensive nature of the strategy can be utilised as an alternative to ‘low volatility’ and ‘high dividend yield’ equity factor investing, or as a good complement to ‘riskier’ conviction investments as it can improve the risk-adjusted return of the overall portfolio.
Christine: What is the time horizon to fully benefit from the strategy?
Morgane: The time horizon should be long term to benefit from the higher level of income and reduced volatility, as well as the potential for capital gains.
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