The Strengthening Case of Income in a Portfolio
What happened last week?
All three major indices were down with the S&P 500, Dow Jones, and Nasdaq off -1.94%, -1.86%, and -2.34%. Nonfarm payrolls rose by a higher-than-expected 256K last month and the unemployment rate fell to 4.1%. This led the market to price in a Fed pause in its rate cutting cycle and the 10-year Treasury yield rose to 4.78%.
During the past 30 years of tech-led growth, reinvested dividends have contributed to roughly half of equity total returns. We’ve long highlighted consistent dividend growth as a useful proxy for quality. Firms that regularly raise dividends across business cycles tend to boast resilient business models and a strong management culture.
3 Things to Know
The Bull of 2023/24 Has Quieted 2022’s Bear Market
The 57.9% total return for the S&P 500 during 2023-2024 “closes the loop” from this multi-year period. It reversed the bear market of 2022. The latest two-year rise in share prices also reflects expected gains in corporate profits and monetary easing.
When we look at medium-risk global portfolio returns of these past two years, 23% reflects gains in asset prices. Only 6% reflects gains in portfolio income, resulting in an approximately 80/20 split between price gain and income. This is even as interest rates are now dramatically higher than circa 2020. While complicated in measurement, the historic average for this ratio is 57% and 43%, respectively, over the past 10 years. Our takeaway: The much higher ratio of capital appreciation of late is only the norm of a strong bull market.
Returns Have Been Driven by Asset Price Appreciation
With this in mind, we believe the value of income rises in the calculus of returns for this year and on average in the future. The wide spread on high yield bank loans above US policy rates seems to reflect the expectation of policy easing ahead.
The asset class should benefit some from the modest scale of Fed easing that is likely compared to recent decades when the Fed funds rate averaged just 1.75%. As such, in our tactical asset allocation, we’ve used loans to significantly fill our allocation to high yield.
Given our expectation of robust real GDP growth this year of 2.4%, we expect credit spreads to be relatively stable and defaults to decline somewhat from current levels.
Moreover, ample liquidity from both the public market and increasingly the substitution of “private credit” lending has reduced public market supply.
Moderately Bullish on the S&P 500 but not at 2023/24 Levels
We’ve long highlighted consistent dividend growth as a useful proxy for quality. Firms that regularly raise dividends across business cycles tend to boast resilient business models and a strong management culture.
Indeed, dividend growers have outperformed the S&P 500 over the last 30 years. Of course, the growth-driven Nasdaq 100 outperformed even this. But on a volatility-adjusted basis, dividend growers have shined.
Since November’s US election, dividend growth strategies have underperformed high beta and lower quality shares. Hopes for a more pro-business policy environment grew to arguably exuberant levels by mid-December, with unprofitable small caps tied to themes like AI, crypto, and quantum computing surging far ahead of blue-chip large caps.
Some of this excitement has since been tempered by the sharp rise in long-term yields over the past three weeks, leaving investors with a notably higher risk-free rate to contend with.
A backdrop of somewhat higher interest rates only heightens the importance of owning quality businesses that can deliver cash to shareholders in the near future — and diminishes the attractiveness of shares years away from achieving profitability.
See our weekly CIO Strategy Bulletin for more details