Income in a time of higher inflation

One of the consolations of those market conditions was the same persistently low inflation that benefited the stocks with little dividend yield, and given the very low inflation, the level of natural income required to pay bills was also lower, so that an income portfolio which yielded 2 per cent was often beating inflation. 

But the much higher inflation we are all experiencing this year has changed that equation. In the first instance, higher inflation and higher interest rates have caused a shift in market sentiment, with many clients preferring to own so-called short-duration assets, that is, assets which generate cash flows today.

Many such assets pay a dividend, and so have outperformed against more early stage businesses that have yet to pay a dividend.

Financial repression

But Carl Stick, investment director and manager of the Rathbone Income Fund at Rathbones Unit Trust Management, says the challenge for investors now is that they are experiencing “financial repression”, that is, seeing the real value of their savings depleted by inflation.

He says: “For many people this is a very difficult and different experience. As an equity income fund manager, I know there is equity market risk to consider, but if we can provide a level of income that is competitive with the level of inflation, then we are in some ways helping clients deal with the financial repression.

"Higher inflation doesn’t really change how we run the fund, but it does mean there is more priority and focus on income now.”

The renewed demand for global equity income funds can be seen in the most recent data from the Investment Association, which revealed inflows into the sector of £678m in April.

The financial consequences of inflation on wider society is also on the mind of Ian Pyle, who runs the Shires Income investment trust at Abrdn, but his focus is on the impact on the economy as a whole.

He says: “There is a very clear issue that those least able to afford rising prices have to spend a greater proportion of their income on essentials.

"From an investment point of view we need to be aware of this dynamic when thinking about consumer demand, but also the possibility of regulation and government action to address the imbalance, with the energy windfall tax an obvious example.

"While this is an area of concern for the UK, we should also expect to see lower income segments receive better than usual wage inflation."

Pyle adds: "The UK labour market is particularly tight right now, and it is notable that as a direct result of Brexit this is being seen in areas of the job market that are traditionally lower qualified and more mobile.

"Hospitality, distribution, manufacturing, transport and construction are a few of many sectors where we are seeing the impact of staff shortages. That should hopefully have an impact on raising incomes, offsetting some of the pressure from inflation.” 

Stock selection

In terms of how to address the issues from the perspective of stock selection, Stick’s co-fund manager at Rathbones, Alan Dobbie, says: “It is noticeable that in recent months, defensive stocks have started to outperform against some cyclical shares. This is because of the nature of the inflation we have, with supply constraints.

"But the general picture is that the market is shunning the steady-eddie type stocks, such as pharmaceuticals, and maybe those stocks that usually underperform when bond yields are rising because of strong demand in the economy are actually an opportunity now because they have been out of favour with the wider market.”

The types of stocks referred to by Dobbie often underperform when bond yields are rising as their predictable income stream looks relatively less attractive when compared with the income from a bond.

Higher inflation doesn’t really change how we run the fund, but it does mean there is more priority and focus on income now.Carl Stick, Rathbones

But in their latest macro outlook, analysts at Bank of America’s wealth management unit revealed they are switching towards those types of equities, as they feel bond yields may have peaked, and so the income from those equities will have an increased appeal.

Richard Saldanha, global equity income fund manager at Aviva Investors, is less keen on those stocks, often called compounders, because while the dividends are consistent, and relatively high, those businesses are often not growing much, and so the dividends are not growing in line with inflation.

Instead, Saldanha is targeting companies that may have lower yield now but are growing their yield at faster than the rate of inflation. 

One area he finds particularly interesting is DIY stores. He said the pandemic pushed the share prices very high, and made the yields look relative meagre, but the shares subsequently fell as the market moved away from "pandemic winners", but Saldanha says hybrid working means those companies, usually viewed as very cyclical, are now on a longer-term growth path, and this is reflected in dividend growth. 

The general picture is that the market is shunning the steady-eddie type stocks, such as pharmaceuticals.Alan Dobbie, Rathbones

Pyle says that while equity markets could not, right now, reasonably be called “cheap”, valuations are “reasonable”, but his favoured way to generate the income required from equities right now is commodities. Those tend to rise in price whenever inflation is rising, regardless of the type of inflation or its origin. 

He says: “At the sector level you want to own those where prices are generally aligned with inflation or are defensive. Commodities benefit from rising prices and demand in a typical inflationary period, banks from rising interest rates and healthcare and luxury goods generally have the ability to pass through inflation effectively.”   

david.thorpe@ft.com