Other than cash, it must be remembered that investment financial assets are typically two-dimensional, that is, having returns and valuation movements. The part of income returns is often forgotten , especially by the media bad news spruikers who simply report market price to market price. They forget (or do not really understand) income and its importance. Whether that income be derived from bonds, equities, property, or infrastructure, they all produce tangible forms of cash income, and whether that be from bond coupons, interest, dividends, or rent. Income is a critical thing to remember always, especially during the more volatile periods in the markets such as we are experiencing in these current times.
What the media do is pretty much always neglect when reporting about the markets is that there also is this vitally important income equation, and not just about the market prices going up and down!
It is nice and reassuring when we see our investment portfolios going up in price, but that is not how markets operate over time. Markets do go down, to varying degrees, on occasions, as we well know. In saying that, and in principle, as investors, we should not be phased by this occurrence as much of it is simply day to day noise; traders jumping at minute-by-minute news; and economic broadcasters simply trying to over-predict outcomes, and often changing (or as they call it, updating) their views in a short timeframe.
So, just why do we invest? Essentially, it is so that we can earn income and growth in our portfolios over time. The income may appear less important in our working lives but, when we are retired, whether fully or partially, the investment income returns become more relevant and essential, as this is what we will live on, and ideally allowing us a comfortable lifestyle in the future. This point is where Passive Income from an investment portfolio replaces Exertion income from our work, as we plan for or as we know already if retired!
In the month of July, we investors receive our main annual dividends and distributions from managed funds and ETFs. This cash fills the ‘well’ which can hold these monies, and other future investment income, that we can and will draw on. And this deliverance of income streams happens year in, year out, with a quality and diversified portfolio, which will, also, have opportunity to grow further over time.
In his book, about quality and value investing, ‘20 Lessons from 20 years’, the well-respected equities fund manager, Anton Tagliaferro of Investors Mutual, illuminates this very point of producing income via dividends. Tagliaferro is absolutely right on the mark when he says that “I have learnt over the many years of investing that there are three reasons why dividends are key to investing in the sharemarket.
1. Dividends are an important part of the return of an equity portfolio.
2. The levels of dividends is not impacted by the level of the sharemarket; and
3. The dividend yield on stocks can act as a ‘safety net’ in times of volatility”.
Tagliaferro further points out that “The level of dividends and the dividend payout ratio of any company is set by their board of directors, and is generally a reflection of a company’s overall profitability, independent of its share price. This is important to remember as it means that during negative periods in the sharemarket (such as exists at present), an investor’s level of dividends from a diversified portfolio, if made up of quality companies with the right attributes, should not vary greatly from year to year, and is largely irrelevant of what is happening in the sharemarket”. So, importantly, dividend volatility is far less than that of the sharemarket volatility, which is quite reassuring to us, being investors, when taking regard of the importance of continual income from our investing over time.
Dividend rates are particularly high in Australia compared with the rest of the world. Historically, they represent over 40% of the total returns in the Australian sharemarket, which also has the additional benefit of having tax effective franking credits added on top of many of the Australian companies returns. Franking credits are even more attractive to investments made through super and pension accounts.
All of the above points hold if you do not have to sell shares. In the main, people do not borrow to invest in shares, and many of us use super for the bulk of our accumulation of investment assets. This helps support the strong case to stay invested in income earning and quality companies despite share price moves.
In the past few newsletters, we have discussed in detail the ongoing topical theme of rising interest rate and inflation conditions throughout the world, including here in Australia. I think we all know where both these variables are at. Taking out a mortgage now, filling up the car, or doing some shopping, will very much be evidence of these rises!
Global inflation rates have sped out to an early, and substantial lead to that of interest rates. The global markets, most notably in the past few weeks’, are expressing the concerns with the rising interest rates on cash and bonds, and weaker equity and property markets. Little is spared from the volatility in any of the asset classes at present! However, this is the adjustment back more to the norm really, which must be remembered. It is also a result of imbalances in demand and supply factors as we have well discussed. Why it appears more dramatic now is that the official responses, that is central bank interest rate rises, are measured in implementation but in a quantum that is slower than maybe it should be.
This divergence between the higher rates of inflation and the lower, but rising, interest rate increases is frustratingly still there. The consequential fear of the impact of interest rate rises includes that global economic growth will retreat and global corporate earnings will slow down despite both continuing to still be well positive. The primary concern seems to be the considerable gap between the rising inflation rates and the responsive interest rate rises. Normality is really to be having official cash rates in line with inflation rates, but this gap shows the current disparity. It will take time to close the gap.
It is early days in this quelling of inflation, but it seems that the fear of the interest rate rises in response to the inflation could be overdone with the aggressive predicted interest rates in the forwards markets. For example, the official cash rate in Australia (and in the US) is predicted to get to above 3.50% in 2023. An economic slowdown and growth rate decline caused through fear before fact may very well see that higher level not reached then. Inflation is artificially high today with the various issues economies face, but it could easily retreat back to acceptable levels quite quickly, particularly if supply constraint issues are alleviated. If so, central banks may well cease the quantum of the rate rises earlier than anticipated by the forward markets.
Until more of an equilibrium point between interest rates and inflation rates is reached, then economic uncertainty and market volatility will most probably continue. Investors must remain focussed and patient in such times, albeit unusual and challenging times, essentially all caused by the Covid-19 pandemic and its ongoing consequences started over two years ago. I had my fourth vaccination today so this shows how it all still lingers, but it will be overcome! Sadly, the one constant in place is this persistent rain! A tough few months for all!
As investors, we must see this market pullback as understandable (i.e. we know why it is happening), but also, to see it favourably, as a good opportunity to add cheaper income and growth producing investment assets to long term diversified and goal focussed portfolios.
As always, should you have any queries please do not hesitate to contact us.
Disclaimer for information provided in this Commentary: This document, and the contents contained within, is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, or plan feature. The views expressed in this are subject to change at any time. No forecasts are or can be guaranteed.