In 2019, the 50 constituents of the Eurozone's blue-chip equity index, the EURO STOXX 50® (SX5E), paid out EUR 102.7 bn in regular dividends (i.e., dividends paid out of profits and cash flows generated by the core business.) Converted to index points, this was equivalent to 122.09 points. So, where the index itself ended the same period at 3571.39, regular dividends represented a simple yield of 3.4%.
Most equity investments, especially in Europe, are made for their returns and a vast part of this return is based upon future dividend expectations. The prospect of continued dividend payments as a source of revenue or, better still, the expected dividend growth are drivers for market valuation.
Additionally, apart from the equities themselves, there is a huge derivatives market, both exchange-traded and in other forms such as structured products. Here, the key determinant of valuation is the price of equities in the future. In this low-interest rate environment, expected dividends are the most crucial input in deriving this forward price.
In 'normal' times, the path of expected dividends is much like any good economic forecast – the near term has higher levels of certainty than the longer term, based on specific company factors and more macroeconomic inputs, such as inflation. There is also an asymmetric fact that executive boards are motivated to maintain or increase dividends, and none wants to cut dividends unless absolutely necessary.
This 'normal' was still the case going in early 2020. On 19 February 2020, the SX5E closed at 3865.18 and dividend expectations (as priced by the Eurex December 2020 dividend futures FEXD) stood at 123.30 points, representing a simple yield of 3.2%. February was also the start of the Q4 reporting period and full-year 2019 results, including the to-be-approved dividend proposals at the forthcoming AGMs, giving a high degree of certainty around the expected amounts paid.
Then, the world changed – and for European dividends, it was a triple whammy. First, companies, especially those in exposed sectors, immediately started to conserve cash by pulling (in some cases already announced) dividends. Secondly, AGMs, which are obliged to approve dividends often in person, were canceled or postponed, fueling further uncertainty, not just on the amount but also on the timing. And finally, banks and insurers, traditionally large dividend players, were asked to stop dividends through regulatory guidance to conserve capital.
By 19 March 2020, the 20 December FEXD closed at 91.40, suggesting a 25% fall of dividend expectations in a month and reached the all-time low on 3 April at 52.70, a 58% decline in 44 days. For the record, the final 2020 value stood at 83.03 dividend points, representing EUR 69.5bn in dividends.
This significant fall in dividend expectations also impacted market participants hedging the SX5E Index itself (also in steep decline) and where the EURO STOXX 50® Index Futures (FESX) is the key instrument to do this. To compound the issue, the March expiry was approaching, with the futures contract itself in the ‘roll period,’ a period where open positions in the March Expiry are "rolled" to the next expiry. Pricing this roll incorporates the heavy European dividend season expectations (most European dividends are paid in Q2) but is usually quite static due to the certainty of expectations.
The price of the futures roll moved around significantly as dividend expectations were re-assessed and caused significant dislocation in the markets at a time of already significant stress. According to Amy Borgquist at Goldman Sachs, due to this dividend uncertainty, the calendar spread basis traded in a range up to 90 times of what was observed in the Sep/Dec 2019 roll (1.85% vs. 0.02%).
Now, just over a year on, we still have overhanging issues making dividend expectations less certain than before, even in the short term. Firstly, despite the recovery in valuations, there are still sectors where recovery has not yet impacted cashflows enough to be certain of distributable profits. Furthermore, there are still regulatory restrictions on dividends from financial sector entities until September this year – with further guidance due from the ECB soon. This continues to make forecasting dividends in the near term challenging.
One thing is certain; we have also seen a new understanding of the risks that dividend expectations can have on the derivatives market, not just on the expected amounts but also on the exact timings of those dividend payments.
Eurex has seen a shift in the market demand for hedging instruments for dividend expectations in Europe – and has responded by introducing additional semi-annual and quarterly expiries in both the SX5E Dividend futures and single stock dividend futures. Instruments that have already seen more than twelve million contracts traded since its launch in late 2020.
Of course, where some participants see risk and seek to hedge it, others perceive opportunities. When the SX5E dividend futures hit all-time lows in early April 2020, we saw new opportunistic participants entering the market. We have also seen increased activity in the last twelve months in the EURO STOXX® Banks Index Dividend Futures (FEBD), with average daily volumes now over 3000 contracts and active liquidity provider participation. This shows that even in this, most challenging sector, there is a lot of focus and likely diverse opinions.
After the Taleb-esque events in the segment in the first half of 2020, the dividend derivatives market has bounced back, but with a lot more clarity, insight and focus on the true impact of dividend expectations.
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