Income For The New Age

The testimony of Fed chairman Jerome Powell and Treasury Secretary Steve Mnuchin on Tuesday have put the two primary supporters of the US economy in the spotlight again. Both said versions of positive phrases like, ‘whatever it takes, more stimulus, and back to work’. Markets anticipated the statements and reacted positively all week. Part of that rally can also be attributed to progress on the vaccine front. As we move into the post-pandemic era, investors are naturally interested in the best places to generate income. Here are some considerations:

Sources of Income Return

Non-US stocks have been leading the pack for years with solid +4% dividend yields. Those yields are available from big companies and small companies in the developed and developing worlds. Now, both the yields and their sustainability are called into question. Countries outside the US do not have a powerful Federal Reserve to take control of the national balance sheet and the entire yield curve. In addition, a large number of companies may not be able to pay those dividends in the future. We have seen dramatic declines in individual stock prices when dividends get cut. Right now most of the dividend cutting is happening in the energy sector, but there are other areas of concern as well. For the time being, we remain cautious about sourcing dividends from international equity investments.

Private and Public Real Estate 

Private real estate is a good source of income and is likely to be so in the future. That’s because the owner/investor has a high degree of control over structuring rental income. 

Public real estate is another matter. Both US and non-US real estate offer attractive yields with the US yield well above 4% and the non-US yield above 6%. However, the same warning signs are flashing on both these sectors. There clearly will be more dividend distribution cuts coming. Many of the real estate holdings were built before the pandemic era and can’t be easily modified for another use. Shopping malls are the best example of the rigidity of public real estate stocks. Publicly traded real estate is now a minuscule 2.75% of the S&P 500. 

The High Yield Market

High yield bonds continue to offer 6+% yield in both the index and actively managed vehicles. You can track the high yield spread here. Again, the Fed put a floor under high yield prices by buying high yield funds last week through BlackRock. One benefit of owning high yield may be the opportunity to earn equity-like returns while being higher up in the capital structure (via owning the bonds rather than the equity). Striking a balance in high yield is crucial. As always, there is “fools yield” lurking in the BBB down to the lowest quality tranches. 

The Inflation Market

There is one way to stay up with inflation and inflation’s effect on your fixed income investments, and that is with inflation-indexed US Treasury bonds known as TIPS. We have been investors in both short and long term TIPS for a long time. Of course, if inflation hits 2% (the Fed’s target), that is exactly the yield you would get. 

With the longer-term TIPS you get a little over 2% yield because you have a long term bond component added to your annual inflation adjustment. Since yields have been going down for so many years, both investments have worked out well, preserving capital after inflation. The real question now is if interest rates can go even lower on the long end of the curve. There is a risk of loss on the long term TIPS market if long term rates rise significantly. Even if a rate rise seems unlikely, it’s still worth noting as a risk. Of course, social security is the best inflation hedge of all if you are old enough to qualify. Your monthly social security payments are indexed to inflation for as long as you live. 

A Substitute For Income

Hedge fund manager Paul Singer cites ‘fanatical debasement of money by all of the world’s central banks’ as the reason for his renewed interest in gold. He reasons that inflation is the only way to outgrow mounting debts worldwide. There is a tailwind for gold because there are many hints of inflation coming. The extreme printing of money, no end to fiscal stimulus (the House passed a new bill on May 15th), and targeted interest rates along the entire yield curve argue that inflation is just waiting to happen when the economic recovery takes hold for good. Singer points out that bond yields are negative after inflation. Gold is not an income vehicle but it can be a source of return that beats high quality low yielding bonds. We agree that a position in gold will offer decent returns for some time to come. 

What is different this time

The shutdown and slowdown of all global economies is voluntary, and that is the difference between this record-breaking economic decline and all others. In all the other declines the precipitating events were high interest rates, a bubble, a recession or a crisis. Because this decline was initiated it can also be revived. It’s almost as if the patient was put into a medically induced coma and then brought back to life when he/she was capable of functioning on his/her own. Chairman Powell has said many times he has ‘more tools available’ and ‘we are not going to run out of firepower’. 

Secretary Mnuchin says more fiscal stimulus is needed. His disagreement with the House is simply on the timing. Mnuchin would like to see another government program in a month. He has stated no objection to the current amount: $3 trillion, and foresees more government programs. The US has already passed nearly $3T worth of fiscal response legislation and the Democrats just proposed another $3T. The yields available from both the bond and stock markets will change as the US economy recovers. 

The US – Centric Approach

More and more, the US-centric approach looks like the best place to get income. Our Treasury securities yield more than Europe’s or Japan’s along the entire yield curve. Granted, the yield is not much, but it is positive. Regarding real estate, we have more flexibility in our range and pricing of underlying properties. While international real estate is diversified, it is not diversified in every country. The diversification comes from owning real estate exposure across many countries. If the retreat to home country investing continues, the non-US real estate fund will suffer. 

Preparing for the future

It’s always difficult to modify an income portfolio to a new environment, and the COVID pandemic is no exception. The future is not priced at a discount (by traditional standards) and it is led by visionary operators like Musk, Bezos, Gates, and Cuban to name a few. Regardless of your growth interests and your retirement necessities, owning growth assets that are periodically sold in order to meet cash flow targets may yield better results. In any case, the goal of family wealth investing remains the same: to generate reliable compounded returns over long periods of time.

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