by Francois de Bruin, Fund manager and Head of Listed Real Estate
Income investors like the economy to be “just right”. Too hot, and inflation takes hold, driving real yields higher and, ultimately, capital values lower. Too cold, and defaults rise while dividends come under pressure, much as we saw in March 2020 when economic activity contracted sharply around the world.1,2 The ideal scenario for income investors is one where the economy is strong enough to walk but not run.
With Joe Biden’s presidential victory in the US, but no ‘blue wave’ in the House and Senate, conditions are ripe for a ‘Goldilocks’ environment to return, similar to the one that benefitted investors in the years spanning 2011 to 2014.3
With a weaker mandate than expected, the Biden administration will likely have to give up the blue-sky scenarios of outsized fiscal spending touted during the campaign. Instead, gridlocks and filibusters, such as those that plagued President Obama’s second term, are likely to be a feature of this presidency as well.4
For income investors, that backdrop might prove to be “just right”. But three bears are lurking that may catch investors unawares if they are not careful.
Papa Bear: Inflation
Investors have long feared the risk of perpetual quantitative easing and its potential to drive inflation to dangerously high levels. Over a decade on from the global financial crisis, and after nearly US$6 trillion in asset purchases by central banks globally, that risk has not materialised, even with employment levels exceeding policy targets. But where monetary policy failed, expansionary fiscal policy may succeed in rousing inflation out of hibernation.
Figure 1: Inflation trends, 1980-2025
Source: IMF, as of November 25, 2020
The $2-3 trillion of planned government spending touted during the Democratic campaign is likely to be off the table now that the Senate majority is projected to remain Republican, making an agreement for a package of $500 billion to $1 trillion the most likely outcome.5
At almost 2.5 per cent of US GDP, $500 billion is still a significant amount, but it would be more of a nudge for inflation than the strong push a $3 trillion package would have given. Regardless, income investors could consider allocating to dividend-paying equities and real assets, both of which should benefit if aggregate prices in goods and services start to rise.
Mama Bear: Regulation
Democratic governments are elected by the people, for the people. Yet governing for the people can sometimes lead to decisions that entail significant hardships, as witnessed this year. Stay-at-home orders are a prime example, like a mother bear forcing her cubs inside the den when danger lurks.
Positive vaccine developments from a number of laboratories offer a roadmap out of this divisive but necessary intervention, and stay-at-home orders may no longer be necessary a few months hence.6However, some policies could linger even as we gradually emerge from the health crisis.
For income investors, government or central bank-imposed dividend freezes – for banks in the United States and financial institutions in Europe – may remain in place for some time. The European Central Bank has extended the suspension of dividends at European banks into 2021 and will only change its stance once it deems their capital buffers adequate. Governments may want to impose rules around pay-out ratios as well, even if capital ratios are well in excess of regulatory requirements.7
Income investors should guard against this risk by ensuring they have a well-diversified portfolio receiving income from a range of sources. Among others, parts of emerging market bond and equity markets still offer an array of opportunities with income-friendly policies and attractive yields.8
Baby Bear: Tantrums
Federal Reserve (Fed) Chairman Jerome Powell has admitted that the Fed’s premature tightening in the spring of 2013 left scars on those involved in the decision, when he was a relatively new member of the board then led by Ben Bernanke. This time is different.9
With the Fed’s 2020 framework review leading it for the first time to tolerate temporary overshoots of the two per cent inflation objective, there is little reason to believe official interest rates will be raised any time soon. If anything, the Fed remains more committed than ever to supporting the economy; even a tapering of asset purchases should remain a measure of last resort.10
In 2018, when the Fed last tried to shrink its balance sheet, financial market participants threw a tantrum to signal their displeasure at the policy. At the beginning of 2019, the bank duly reversed course. However, market expectations have now moved to the tantalising prospect of continued fiscal support, and another tantrum-induced volatility spike could be on the table as they adjust to the idea of a less eye-catching stimulus package from Washington.
The key difference is that, unlike monetary policy which is decided frequently at the Fed’s quarterly meetings, fiscal policy is likely to progress far more slowly, if at all. While fiscal support from Washington has bipartisan approval, its mode of implementation is polarising, especially as lawmakers are likely to pay more attention to their approval ratings than to market behaviour. They may not feel the same urgency as the Fed when it comes to drying market tears.
As a result, income investors should focus on the fundamentals of the companies whose shares and bonds they purchase, since policy support may not come at the pace or scale markets expect. Balance sheet strength, supply chain flexibility, ruthless cost management and the ability to maintain competitive advantages and market share are all factors investors should consider when building their portfolios.
While investing always incurs risks, a scenario of supportive fiscal and monetary policy, a recovering but not overheating economic trajectory, and official interest rates anchored at or near-zero should provide a favourable backdrop. Focusing on strong fundamentals while maintaining a healthy appetite for risk assets has the potential to provide income investors with a portfolio outcome which could be “just right”.
