Rethinking equity income as market uncertainties rise

It was a rocky start for equity markets. Concerns over the U.S. economy, as trade policy spurs recession fears amidst still sticky inflation, has created uncertainties over the Federal Reserve's (Fed’s) interest rate trajectory, keeping markets on edge. Geopolitical tensions and fiscal responses around the world also add to market volatility, with visibility into the remainder of 2025 still low. This volatility has been costly for investors. In fact, despite peaking at a 5.7% return year-to-date (YTD) in mid-February, the MSCI AC World index (ACWI) has since relinquished all of its gains, now down -1.5% return at the time of writing. As such, rather than attempting to predict the next policy actions and announcements, which is challenging, this sharp reversal has prompted investors to reconsider how long volatility will remain elevated and to explore defensive investment strategies that perform better during volatile periods while maintaining exposure to equity markets.

Uncertainty is the only certainty

Current levels of market volatility are driven by multiple uncertainties, with the main concerns centered around the economic health of the U.S. due to government policies.

• Regarding growth, the rapidly evolving series of tariff announcements and proposals from the Trump administration will continue to complicate business planning, while retaliatory tariffs also reduce output and profits for U.S. producers. The lack of clarity in the details and timing of the proposed corporate tax cut extensions adds further uncertainties and delays business investments, while plans to reduce the federal workforce could depress consumer sentiment, posing headwinds to U.S. economic activity.
• Regarding prices, the immediate effects from tariffs would be to raise prices for domestic consumers, keeping inflation sticky in the short run. Immigration policies focused on deportations and reducing immigrants could also lead to a tighter U.S. labor market, resulting in higher wages and adding to inflationary pressures. 

These government policy uncertainties are central to driving market volatility, with the VIX reaching 27.9 by earlier this week, surpassing the long-term average of 19.5 (Exhibit 1). However, uncertainties extend far beyond the impacts of government policies alone. 

Uncertainties also rose on the monetary policy front. With the latest inflation expectations¹ still unanchored and well above the Fed’s 2% inflation target, and recent consumer price index prints trending back up to the 3% level, disinflation progress appears to have stalled, thus posing a challenge for the Fed. Comments from Fed Chair Jerome Powell continued to be cautious, highlighting the uncertainty in monetary policy decisions.

Moreover, after a strong year of consumer spending activity, domestic sentiment in the U.S. is finally showing fatigue. The latest reading shows that the Conference Board consumer confidence index dropped to 98.3 in February, marking the sharpest monthly decline since mid-2021, and echoing the modest reading from an earlier University of Michigan consumer sentiment report. This weakness is noticeable across different age, income and wealth groups, as consumers increasingly fear the potential impact of tariffs on goods prices and are uncertain about their purchasing power.

Outside of the U.S., from hopes for a Ukraine-Russia peace deal over the past month to European governments stepping up to increase defense spending, both positive and negative developments continue to sway markets, with geopolitics remaining fluid and volatile. That said, market impacts are relatively more benign compared to U.S. policy changes.

This limited visibility on the above mix of factors all contributes to an uncertain outlook for 2025, creating a volatile macro-environment for equity markets. Additionally, from a market structure standpoint, as outlined in a previous note, high market concentration tends to lead to more volatile periods. Given that the U.S. equity market is largely concentrated in growth-biased sectors and the outlook for another year of strong growth is dimming, this has opened up other opportunities within and beyond the U.S. equity market.

Sheltering from stretched valuations

The past decade of momentum-driven and growth-biased rallies has led to increasingly stretched valuations on mega-cap names in the U.S. With a highly uncertain macro-outlook, the risk of de-rating seems more imminent. This has prompted a need to seek complements alongside the U.S. mega-cap names when it comes to equity investments.

The simplest approach is to diversify. Beyond U.S. markets, European and Asian equities, at a cheaper valuation, could provide a buffer to potential pullbacks. Light consensus expectations and tariff impacts mostly priced in are also tailwinds for the region. Beneath the expensive mega-caps, higher dividend names are trading at a 35% discount based on the MSCI ACWI index (Exhibit 2) relative to the broader market, presenting a compelling valuation case.

Another approach is to reposition portfolios along the equity return component spectrum. Instead of relying on valuation expansion, which is increasingly unlikely, an equity portfolio that is more tilted towards income generation should fare better in a volatile landscape, thereby benefiting higher dividend names.

Moreover, the growing emphasis on corporate governance, especially in Asia, has translated into better shareholder management. Companies with strong free cash flow generation backed by resilient business models, which are abundant in the high dividend space, can afford to increase dividend payouts, providing a tailwind for dividend-focused strategies.

Trading volatility for stability

Taking a step back, global equities have seen double-digit returns over five of the past six years as valuation multiples continue to expand. However, a weakening consumer sentiment suggests a more modest market in the coming year, with limited upside on further rerating. In this case, covered calls, which write call options as an overlay to the portfolio, could provide another source of income, thereby mitigating part of the volatility while retaining equity exposure.

To put it simply, covered calls mean selling partial upside on the underlying investments in exchange for collecting option premium as additional income stream when investors seek ways to monetize market volatility. This means that, although this strategy will forfeit some of the upside in a bull market, it will provide additional income to the portfolio in a flat market and can provide an offset to some of the decline in a bear market with the downside buffer.

Investment implications

Amidst growing uncertainties around government policies, geopolitics and monetary policies, alongside a weakening domestic sentiment in the U.S. and a tightening concentration risk, the case for elevated volatility over the short to medium term is building. This marks a prime time for investors to rethink and reassess investment portfolios which better shelter from uncertainties, volatility and stretched valuations.

Defensive and income-seeking strategies, whether by organically leaning towards higher dividend names and cheaper markets or by inorganically trading upside potential for premium incomes, should fare better when market performances are muted. Given the mutual exclusiveness, both ideas could be incorporated together to add further defense to portfolios and provide downside protection.

¹4.3% from the University of Michigan's survey and 6.0% from the Conference Board, next 12-month forecasts.

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