The changing shape of income investing

Many trustees think about diversified portfolios in terms of risk management – which makes sense. But a well-diversified portfolio has the other big advantage of helping investors adapt to changing market conditions. In 2022, with significant shifts coming in markets, Perpetual Private expect a subtle change in how they generate income from portfolios.

In this article we briefly review investment outcomes for 2021 and look at the forces set to dominate 2022 – and how we’re structuring portfolios to manage those changes.

The past year was a banner year for equity investors – whether you were holding Australian shares, global shares or listed property companies.

• For calendar year 2021, the S&P/ASX 300 returned 17.5% including dividends.
• Australian investors in unhedged international equities earned over 25% (MSCI ACWI Index)
• Listed property companies surpassed that. Aussie investors in global Real Estate Investment Trusts (REITs) harvested returns of 33% . Locally focused REITS returned 27% for the year¹.

Cash upped and ready to click ‘buy’

What’s underpinned all this good news? Australian companies continued to grow earnings, there were low interest rates and rising Chinese demand for our iron ore. Despite lockdowns, unemployment never took off – it’s just hit a 13-year low. Many consumers had pockets stuffed with savings they were looking to spend and whilst Delta took its toll, the Australian economy held up surprisingly well. September quarter growth was down by only 1.9% – less than many expected.

In other developed economies, markets enjoyed continued support: high spending governments, low rates and a move away from punishing lockdowns thanks to higher vaccination rates – and Covid-weary electorates.

For those who invested in equities in search of growing income, 2021 continued the recovery from 2020, when many companies were forced to cut dividends by Covid pressures (and in the banks’ case by their regulators).

As we look forward, whilst Covid concerns remain, Omicron appears to be less dangerous than Delta and so it is not expected to affect investment returns significantly in 2022.  However, a number of other headwinds endure.

The swing factor

So what’s most likely to change the pattern of investment markets in 2022? The answer is inflation – which hit 7% in the US, its highest rate since Ronald Reagan lived at 1600 Pennsylvania Avenue. Around the world, supply chain issues proved not so ‘transitory’ and cashed up but homebound consumers spent big on goods not services. So goods prices rose (less so in Australia) and Central Banks started to push up rates to lean against inflationary pressures. In 2021 that was bad news for bonds.

More recently, there has also been heightening geopolitical tensions between Ukraine, the West and Russia, as well as increasing trade tensions between China and the US and possible conflict over Taiwan.

With this as a backdrop, in 2022 we anticipate continuing moderate to strong economic growth but with lower and more volatile returns in risky assets. In a rising rate environment, equities should continue to outperform bonds, however it’s unlikely that the exceptionally strong market returns of 2021 will be repeated as central banks take action to cool economies.

Say goodbye to TINA

If inflation persists, rates will rise and that resets market dynamics. For some years, paltry cash rates kept investors saying, “There Is No Alternative (TINA)” to equities. With rates on the rise, more money will flow into bonds and less into companies with uncertain future earnings – such as promising but unproven tech stocks. Companies with more predictable earnings, like banks and miners, could do well. That’s good news for Australia as our stockmarket boasts plenty of those.

Kyle Lidbury, Head of Investment Research at Perpetual Private says 2022 will see a subtle shift in how diversified portfolios generate income.

“Equity markets should continue to generate good income,” says Kyle. “We’re likely to up our allocation to quality ‘value-style’ stocks – those with pricing power and the ability to generate predictable earnings and dividends.”

Even with rising rates, cash returns are likely to remain low. But it’s in fixed income and credit that the biggest changes will come.

“For the past 20 years, in an environment of ever-declining rates, passively holding government bonds was a winning strategy,“ says Kyle. “But bond markets are likely to be volatile in ’22 so actively managing your fixed income portfolio will be important to generate good returns.

“Given inflation pressures, inflation-protected securities and assets like infrastructure and property will be better sources of predictable income, knowing that they have a natural inflation hedge built into them.” says Kyle.  “We’re moving income-focused portfolios in that direction while always looking to ensure portfolios are resilient and can adapt to changing market conditions.”

Originally published by Perpetual Private Insights