Dividend derivatives buoyed by fundamentals in 2023

Lorenzo Longo, Goldman Sachs

What are your expectations for the European dividend market for the rest of this year?

We expect and see that 2023 will continue to play out as a very, very strong year for the European dividends market. We are already seeing pricing levels in the Euro Stoxx 50 that we haven't really seen since the global financial crisis. We are also finally enjoying a few sequential years of significant growth in dividends. Our overarching view is that there's clearly been strength in earnings from companies globally, with Europe being a relative standout - both in 2022 and 2023.

This has led to a higher dividend re-rating relative to other regions, but also compared to the history of Europe itself. We expect this trend to continue - as it stands, there's clearly a lot of uncertainty in the economic scenario globally but in Europe we have seen a general resilience in economic activity. So, while there is not much economic growth out there, there is enough resilience that companies should be able to sustain growing dividend payments for the remainder of the year.

What are the drivers of those expectations?

There is economic and earnings resilience but as well as that, inflation, and the environment that we've been in for the last couple of years is mechanically a boost to dividends. This is because dividends are really a claim on the nominal earnings and nominal cash flows of companies.

In a relatively high inflationary environment where you still have real economic growth, with boosted nominal growth, a product that gives an investor exposure to that nominal growth is powerful and will be supported and that's what we're observing thus far.

This is an advantage that dividends have in this macroeconomic environment compared to equities. Investing in the latter, you have to worry not solely about nominal earnings, but also how to discount those earnings. Whereas with dividends you get exposure, just to the numerator of that equation.

If you want to have exposure to nominal cash and nominal earnings, dividends can give you that. I don't see any other product that can deliver that return profile in such a neat way. It's not perfect but it is difficult for us to identify anything that is a better expression of nominal earnings growth.

What are the advantages of using dividend derivatives in trading strategies?

lf we look historically at the dividend futures market, a large percentage of the volumes in the product itself was predicated on structured products and risk coming from such a product that exotic desks would be looking to hedge. Using dividend derivatives was a very nice and efficient way to do that.

Banks are the natural sellers in this market, which is the root cause of the supply and demand imbalance that typically causes these products to trade relatively cheap to fundamental expectations.

One factor that continues to make us feel bullish about the asset class and see the curve steepen over time, is that we expect contracts further out in maturity to appreciate more than at the front end.

This is largely due to two factors. Firstly, because of the moves seen during Covid there's been less risk appetite from banks to issue products with this dividend profile after some very public mark-to-market losses.

There's since been a pivot to issue products that would carry less dividend risk for the dealers.

Secondly, in the positive rates world that we live in now, you just have naturally less demand for that type of product, such as autocallables, which were at the forefront of the dividend risk profiles that banks were carrying.

That was a product that the end user mainly saw as a way to earn some coupons and carry. You don't need that type of product so much in a world where interest rates are at 3-4% in Europe.

We are now seeing investors going back to products that were more popular before the global financial crisis, structured in a capital-protective form and carrying a very different risk profile for banks. So, we see and expect less exotic structured product activity from dealers and therefore less need to use the asset class as a hedging instrument.

As a result, we expect that the risk premia currently in the curve should be compressing over time. This is already playing out to some extent in 2023 and should continue to strengthen as a trend.

That should create a stronger two-way flow where there is less natural supply from banks. And dividends become more of an asset class where two sides express their views on dividends.

There will still be net long risk from dealers and constraints that are still lingering after COVID, but future flows should be more driven by macro and micro fundamental expectations of what dividends will be realised. That dynamic has existed before but usually only at the very front end of the curve.

Which dividend contracts do you anticipate demand for during the rest of this year and why?

The constituents of the Eurozone bank dividend index have been in focus during the last couple of years for various different reasons, but in the environment that we're living in, clearly banks are doing well from an earnings perspective, reaping the benefits of higher interest rates and expanding their net interest margin for the first time in over a decade.

European banks also have very solid capital positions. even if they have been caught in the crossfires of what has happened recently to US regional banks. Due to their different regulatory positions, we don't generally see them impacted from the same issues. But the dividend futures still give significant discounts relative to expectations and company guidance.

We think that dividend bank contracts continue to suffer from a post Covid hangover coming from regulator recommendations to consider limiting cash distributions in 2020 and the resulting FY19 dividend cancellations. As such, bad news continues to over affect the contracts versus what expectation should be. This is even happening in an environment where these companies are significantly more profitable than they have been in well over a decade.

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About Lorenzo Longo

Lorenzo is head of EMEA Equity Forwards Trading at Goldman Sachs. Previously, he was a member of the Synthetics Product Group. Lorenzo joined Goldman Sachs in 2012 as an analyst and was named managing director in 2019. Lorenzo earned a BSc in Economics and Finance and an MSc in Finance from Bocconi University in 2010 and 2012, respectively.

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