By Damien Boey, Portfolio Strategist, Wilson Asset Management
From time to time, changes in the market cycle favour income investing. For example, if interest rate uncertainty rises, short-duration value stocks (those that offer dividends, cashflow or earnings today) tend to outperform long-duration growth stocks (those that offer dividends, cashflow or earnings longer term). This is because value stocks are, by definition, cheaper than the market and are less sensitive to higher interest rates and changing market expectations.
In addition, long-duration growth stocks can underperform short-duration value stocks if investors become less confident about the future economic outlook or question whether projected growth will be realised. These considerations are particularly relevant today as investors assess the implications of artificial intelligence (AI), persistent inflation and central banks that remain cautious about lowering interest rates.
Since 2019, central banks have cushioned financial markets from volatility shocks, helping to ensure disruptions in markets don’t spread to consumers and the broader economy. Unsurprisingly, inflation and inflation uncertainty have remained elevated compared with historical norms. This heightened inflation risk has triggered many investors to seek out extra compensation. The asset management community has responded by offering income products that reach further out the credit risk spectrum. Reflecting this, we have seen credit spreads compress in response to higher inflation expectations in bonds in recent years (whereas previously, causation would have run from credit spreads to inflation expectations).
(Source: WAM)
In the background, hedge funds and primary dealers have used leverage to profit from pricing differences created as capital has shifted from government bonds to corporate debt. In this process, dealer balance sheets have become stretched, making it relatively inconvenient for them to hold physical bonds, and driving swap spreads into negative territory. Further, hedge funds domiciled in the Cayman Islands have become the biggest buyers of physical government bonds. So-called “basis trades” have become large enough to attract the attention of regulators and central banks. Yet policymakers have continued to support liquidity and stability in funding markets, helping to sustain the conditions that allow these trades to exist.
For income investors in credit, the post-2019 regime has been a very favourable one, and policymakers have given investors little reason to think that they would allow the regime to unravel. For income investors in equities, a disruption to the post-2019 regime might be detrimental to more leveraged names – but it would also see bond yields rise, supporting short-duration value and dividend stocks.
Structural tailwinds for income investing in Australia
In the Australian context, there are structural factors favouring income investing in equities. First, there is the Australian Prudential Regulatory Authority’s (APRA’s) decision to phase out bank hybrids – that is to stop new issuance of convertible debt instruments from the major banks from now on. While existing hybrids will remain in circulation until called by banks, and insurance companies will continue to issue them, there is now a scarcity of hybrids at the margin, making it virtually impossible for investors to build a portfolio around them. We estimate that over the next three years, roughly $7 billion per annum of hybrids will be redeemed by banks without replacement. This will free up money that has to find a new home, preferably in lower-risk income-producing investments that are near substitutes.
Second, capital gains tax (CGT) changes announced by the Labor government favour income investing over growth investing. Investments producing capital growth will now be taxed more heavily because of the reduction in the CGT discount. Further, the new CGT regime makes it more administratively difficult for investors to net out capital gains and losses. For as long as dividend franking remains in place, this policy shift should see tax-efficient investors move toward dividend paying assets.
Seasoned Australian investors will be well aware how much tax changes can impact corporate behaviour. For example, using Reserve Bank of Australia (RBA) analysis of the late 1980s when the dividend imputation system was introduced, shows that dividend payout ratios increased noticeably. However, while history will show that the market payout ratio has trended higher through time, applying RBA estimates of the impact of dividend imputation, we find that the payout ratio would have remained flat around its long-term average of 50%. If we fast forward to the present, the risk is that by taxing capital growth more onerously, the funding cost for corporates could effectively increase, reducing incentives for investment and constraining long-term productivity growth.
(Source: WAM)
What this could mean for future returns
Based on current market valuations and Australia’s long-term productivity trends, the Australian sharemarket may deliver returns of around 4% per year over the long term. While this is only an estimate, stronger productivity growth could lead to better outcomes, while weaker growth may result in lower returns. Importantly, the Australian market currently provides a dividend yield of around 3.3%. This suggests that a large portion of future returns may come from dividends rather than share price growth. If productivity growth remains subdued, investors may place an even greater value on income-producing investments, particularly if policy changes reduce incentives for business investment and economic growth.
(Source: WAM)
