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Euro STOXX 50 dividends: Taking stock

Equity Derivatives 27 October 2008
Eamonn Long
eamonn.long@barcap.com +44 (0)20 7773 8737 www.barcap.com

The Euro STOXX 50 dividend curve has undergone enormous change over the past three weeks. There is a 55% decline priced in for dividends over the next two years, followed by approximately 3% average growth thereafter. We offer explanations for this dramatic sell-off in dividends. We probe the current dividend curve and provide potential interpretations. In addition, we investigate the opportunities that await investors as well as analyse the risks, drawing parallels with some historical cases. Finally, we recommend that investors go long strips of dividends from 2014 dividends onwards, either outright or by replacing the equity portion of the portfolio.

Euro STOXX 50 dividend plunge

What happened and why
Since the start of October, implied index dividends on the Euro STOXX 50 have sold off by between 36% and 44%, with the greatest decline occurring for 2009 implied index dividends. By way of comparison, the Euro STOXX 50 equity index has declined by approximately 27% over the same period.

Figure 1: Sell off in implied Euro STOXX 50 dividends

170

150

Expected 2008 dividends 2009 Euro STOXX 50 dividends

130

2010 Euro STOXX 50 dividends 2016 Euro STOXX 50 dividends

110

90

70 29 Sep

04 Oct

09 Oct

14 Oct

19 Oct

24 Oct

Source: Barclays Capital

This report has been prepared in whole or in part by foreign research analysts who may be associated persons of Barclays Capital Inc. These research analysts are not registered/qualified as research analysts with FINRA, but instead have satisfied the registration/qualification requirements or other research-related standards of a foreign jurisdiction that have been recognized for these purposes by FINRA. This is a product of the London-based Equity Derivatives Research Group of Barclays Bank PLC, an affiliate of Barclays Capital Inc. Please read the Required Disclosures and the Foreign Affiliate Disclosures starting on page 6 of this publication.

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We can trace the origins of the dividend sell-off to four main factors: Political: government rescue packages and their impact on dividend policies. On 6 October 2008, the Danish government announced a bank bailout scheme, the terms of which included the suspension for two years of dividends by participating banks. This latter point became more real a few days later as the UK government followed suit in banning dividends from banks participating in its rescue package. Technical: the possibility of banks paying stock dividends to preserve capital stock dividends are currently not included in Euro STOXX 50 dividends. On 5 October 2008, UniCredit announced a plan to pay the 2008 financial year dividend (ie, the dividend paid in 2009) in stock all part of a capital-boosting exercise. Supply/demand: the persistent fear of leveraged investors having to unwind outright long dividend positions. Fundamental: companies having trouble funding themselves. For example, it has become clearer that insurer dividends were under question this followed the announcement by ING that it would not pay a final dividend for the financial year 2008 (this dividend would have been paid in the calendar year 2009).

Figure 2: Breakdown of 2008 Euro STOXX 50 dividends by sector. Implied 2009 Euro STOXX 50 dividends are now pricing in no financial dividends, plus an 8% cut in dividends elsewhere
Sector Financial Base Materials Industrial Consumer, Non-cyclical Consumer, Cyclical Communications Utilities Energy Diversified Technology Grand Total Source: Bloomberg, Markit, Barclays Capital Dividend points 63.9 7.9 8.4 9.3 5.4 26.9 18.4 16.8 0.8 0.9 158.6

Where we are now?

The Euro STOXX 50 curve is consistent with having priced in a worst-case scenario for financials ie,. no financial dividends at all in 2009 together with a bearish scenario for non-financials a cut of around 8% in 2009 followed by another 17% cut in nonfinancials in 2010, together with no financial dividends in 2010. Thereafter, there is priced in an average growth rate for dividends of around 3% per annum for the entire index. However, it is worth pointing out that, currently, in the euro zone: Only the German government requires the suspension of dividends by those participating in its stabilisation fund. Elsewhere, the French government has lent money to banks. The French banks on the Euro STOXX 50 have responded by issuing statements to the effect that this will not change their dividend policy. Spain has set up a fund to buy assets, but has not yet intervened in bank equity.
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We have also not yet seen any announcement by the Italian government that affects the dividends of companies. Hence, it seems reasonable to conclude that the curve is pricing in much more negative dividend news than has been received already. It is also possible that at least some of the recent price movements are due to de-leveraging, forced or otherwise.

Figure 3: Implied y/y dividend growth and market implied y/y inflation. Little real growth is implied on the back-end of the dividend curve
4.0% y/y dividend growth Inflation

3.5%

3.0%

Real growth Real growth

2.5%

2.0%

1.5% 2012
Source: Bloomberg, Barclays Capital

2013

2014

2015

2016

What next?
Risks
It is difficult to imagine the dividend curve moving lower, based on fundamental reasons already mentioned above. Here, we are not considering what might be described as tail-events such as the potential break-up of the Euro.

Figure 4: Worst drops in realised dividends on the S&P 500, trailing realised volatility of Euro STOXX 50 dividends.
Top-ten worst drops in dividends on the S&P 500
Year 1932 1877 1938 1885 1918 1942 1931 1894 1914 1933 y/y growth in realised dividends -39.0% -36.7% -36.3% -22.6% -17.4% -16.9% -16.3% -16.0% -12.5% -12.0%

Trailing 6M realised volatility of Euro STOXX 50 implied dividends

45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Trailing 6M realised volatility of implied dividends on the Euro STOXX 50 and of the Euro STOXX 50 itself

2008

2009

2012

2013

2016

Spot

Source: Bloomberg, Barclays Capital

Barclays Capital

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To put this into some context, the greatest y/y dividend drop ever observed on the S&P 500 was in 1932 when it declined by 39%; the current y/y implied drop on the Euro STOXX 50 is 45%. It should also be recognised that the 1930s was a decade of severe turmoil in the financial markets. Furthermore, the average annual dividend in the last four years of the 1930s was 32% higher than that recorded in 1932. Nevertheless, if the past behaviour of implied dividend swaps is anything to go by, we can still expect some volatility in dividend swaps lower than that of the equity markets but nevertheless following the equity market volatility. For example, the trailing 6m realised volatility of the 2016 Euro STOXX 50 implied dividends is 34%, compared with the trailing 6m realised volatility on the Euro STOXX 50 index of 41%.

Rewards
Here, we focus on the longer-end of the dividend curve. Our idea here is that that the market will eventually stabilise for better or otherwise and possibly according to some previously seen dynamic. We think that three cases are worthy of comparison: Japanese dividends in the 1990s; Swedish dividends from the early 1990s; and the average dividend growth rate on the DAX. Our interest in Sweden and Japan stems from the problems that both countries had with various asset bubbles and the resultant strain on their financial systems. In any event, as we show below, the outcomes from both situations were markedly different. For example, in Sweden, five years after the response to the banking crisis, realised dividends had approximately tripled. In contrast, in Japan, realised dividends throughout the 1990s were largely flat to down. It could be argued that the Swedish case is more relevant. The received wisdom seems to be that, whereas the Swedish government acted quickly and decisively, the Japanese were possibly more deliberate and cautious. As a third comparison, if the 2014, 2015 and 2016 Euro STOXX 50 dividends, when computed over the 2008 realised dividend level, followed the average six year growth rate on the DAX, they would average around 215 dividend points. Given the most recent markets, the average implied dividends over 2014, 2015 and 2016 or, equivalently, the strip of dividends is around one third of these levels.

Figure 5: Dividends in Sweden and Japan after the respective banking crises; in both cases, dividends outperformed equity subsequently
OMXS30 realised dividends from 1993 onwards
40 OMXS30 Dividends Rebased OMXS30 Index Rebased

Nikkei 225 realised dividends from 1993 onwards

3 2.5 2 Nikkei 225 dividends Rebased Nikkei 225 Index Rebased

30

20

1.5 1

10

0.5
0 Sep 93

Sep 96

Sep 99

Sep 02

Sep 05

Sep 08

0 Jun 93

Jun 96

Jun 99

Jun 02

Jun 05

Jun 08

Source: Bloomberg

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Barclays Capital

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As many investors will recall, the savings and loan crisis in the US in the late 1980s and early 1990s is worth mentioning here. However, it seems clear that this crisis was on a significantly smaller scale to what we are encountering now. To be sure, between 1986 and 1995, the lowest y/y growth rate for dividends on the S&P 500 was 2.3%.

Steepener or outright?
The upshot of the preceding discussion is that we believe that longer-end dividends are very cheap. Investors should consider that, in order to benefit fully, they might be holding the trade for some time and could suffer some mark-to-market losses in the meantime. However, it seems unlikely to us that the curve will move much lower in absolute terms. Furthermore, we recommend that investors accumulate strips of longer-end dividends as: i) it is unclear how long the current recession will last, and the investor does not want to be timing a recovery; ii) strips also reduce the risk of future perceptions of event risk in a given year; and iii) accumulation allows investors the possibility to obtain a large position without necessarily moving the market. For the investor who wishes to take a more leveraged position, or who wishes to take a view on the growth of dividends between two successive maturities, a steepener is more appropriate. Indeed, much of what we have been saying could be distilled to the following: dividend growth after the current instability settles will likely be quite high, in our view, whereas the dividend curve is pricing in comparatively little growth. To be clear, by steepener we mean buying the longer-end and selling the shorter-end. While there are many ways to do this, we will highlight the two simplest conceptually. One way is to go long the difference in index points between two maturities ie, long and short in equal notional per index point. The second way is to go long and short the dividends of the respective maturities in equal notional this second method is effectively buying the growth rate between the two maturities. Obviously, the risk to steepeners is if the dividend curve drops and/or flattens between the two maturities. A particular way in which this might occur, which deserves to be mentioned, is if the perception of length and depth of the current slowdown changes. For example, it is conceivable that 2010 implied dividends rise higher than 2009 implied dividends if it is adjudged that some bank and insurers would restart paying dividends, but that 2011 implied dividends would drop below 2010 implied dividends in the presence a perception of a further deterioration of conditions. To overcome this possibility, for example, an investor could buy strips of 2014 through to 2016 versus selling strips of 2009 through to 2011.

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Important disclosures
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Analyst Certification: The persons named as the authors of this report hereby certify that: (i) all of the views expressed in the research report accurately reflect the personal views of the authors about the subject securities and issuers; and (ii) no part of their compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in the research report. Important disclosures: On September 20, 2008, Barclays Capital Inc. acquired Lehman Brothers North American investment banking, capital markets, and private investment management businesses. During the transition period, disclosure information will be provided via the sources listed below. For complete information, Investors are requested to consult both sources listed below. http://ecommerce.barcap.com/research/cgi-bin/public/disclosuresSearch.pl http://www.lehman.com/USFIdisclosures/ Clients can access Barclays Capital research produced after the acquisition date either through Barclays Capitals research website or through LehmanLive. Any reference to Barclays Capital includes its affiliates. Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Barclays Capital may have a conflict of interest that could affect the objectivity of this report.
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Equity Derivatives Research Analysts

Barclays Capital 5 The North Colonnade London E14 4BB Aaron Brask Head of Equity Derivatives Research +44 (0)20 7773 5847 aaron.brask@barcap.com Eamonn Long Equity Derivatives Europe +44 (0)20 777 38737 eamonn.long@barcap.com Colin Bennett Equity Derivatives Europe +44 (0)20 777 38332 colin.bennett@barcap.com Min Tang Equity Derivatives US +1 212 412 2169 min.tang@barcap.com Abhinandan Deb Equity Derivatives Europe +44 (0)20 7773 2481 abhinandan.deb@barcap.com

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