Leading indicators point to a recovery in Continental Europe

Olly Russ, manager of the top-quartile Ignis Argonaut European Income Fund, explains why current conditions favour Continental European equity income stocks.

Dividends will inevitably remain under pressure for the remainder of this year with cuts of up to 20% expected in European dividends at the market level. The majority of these cuts will come from the banking sector; a sector historically favoured by equity income funds for its dividend-paying characteristics. Compared to the UK market, however, dividends have held up relatively well in Europe while the economic backdrop is also shifting in the Continent's favour. Olly Russ, manager of the top-quartile Ignis Argonaut European Income Fund explains:

"There are still selected opportunities in the Continental European banking sector where some of the more conservative European banks, notably the French, have maintained their dividends, albeit at a lower level," says Russ. The Ignis Argonaut European Income Fund holds BNP Paribas, for example, which has paid a healthy dividend throughout the crisis despite confirming losses in the fourth quarter of 2008. In contrast to the UK market, none of the top ten yielding stocks in Continental Europe are financials. Russ adds, "Corporate balance sheets in Continental Europe are relatively robust with approximately a fifth of companies having no debt, or even net cash holdings, which will support dividends if top line earnings fall. Outside of a handful of UK mega-cap stocks, the UK market looks relatively geared in comparison."

The fund has several long-standing positions in the telecoms sector where dividend yields are safe and earnings numbers have remained remarkably robust. Telefonica, for example, recently pledged to increase its dividends again next year as cash generation at the Spanish company continues to exceed forecasts. The fund also has significant exposure to Portugal Telecom, which recently upgraded its dividend forecasts to 9% following better-than-expected results. "These companies represent the polar opposite to BT in the UK, which recently announced significant losses and slashed its full-year dividend," says Russ.

While the current rally now looks a little overbought, Russ remains bullish in the medium term with several leading indicators now pointing to a recovery. Among them is the sharp rise in the new orders component of the ISM Manufacturers Survey in the US, albeit that it has yet to break into positive territory. This is mirrored in Europe where the ZEW indicator, which measures economic sentiment, has recovered significantly. "The Continental European markets are much more geared to US earnings and US economic data points than their own, so a return to growth in the US economy would be a strong positive for European equities," says Russ. "The European equity markets are also generally higher beta than the UK markets and, therefore, tend to lead in an upturn."

The fund has, therefore, been gradually rotating into more cyclical stocks, which can benefit from an economic upturn. "Telcos often struggle in the first half of the year and, having collected the dividends from them, we are now trimming some positions to rotate into more adventurous areas," says Russ. A recent addition to the fund is Mediaset, the Italian media company, which is offering a 9% dividend yield. Positions in Deutsche Post and retailers, such as Inditex and Hennes & Mauritz, have also been increased.

Looking ahead, 2009 will be a challenging year from a dividend perspective but the first signs of recovery are emerging. The longer-term outlook is promising for both dividend growth and capital gains. "The worst appears to be over for Continental European equity investors," says Russ. "While the significant returns will come on the capital side, at least in the short-term, the income story is still very much intact in Continental Europe."