Income Opportunities: Finding Income in an Inflationary Environment

With the Fed announcing its intent to taper asset purchases and the market expecting possible interest rate hikes as soon as 2022, many investors have been looking for a way to find more income in an inflationary environment. Several indicators have been signaling rising prices, and the Fed expects inflationary pressures to remain elevated into next year. For example, the Social Security Cost-of-Living adjustment for 2022 was 5.9% y/y—the highest annual increase since 1982 (The United States Social Security Administration – 2022 Cost-of-Living adjustment). And headline numbers for the Consumer Price Index (CPI) increased 5.4% y/y in September (averaging over 4% annually)[Bureau of Labor Statistics – September 2022 Consumer Price Index Summary].

Recent inflationary pressures have been attributed to several lingering effects of the COVID-19 pandemic. Consumers shifted to buying goods over services, and demand for certain goods like home appliances and electronics increased significantly. Inventories were stretched thin, and supply chains were stressed as they were expected to move more goods on irregular routes. As a result, input costs rose including transportation costs and materials (e.g., copper, steel, semiconductors). Additionally, as many workers took unemployment and stimulus payments, companies scrambled to find workers as the economy re-opened, often having to resort to higher wages as incentive. As costs for corporations increased, companies with strong pricing power have increased prices of goods and services. These include sectors like healthcare and consumer staples, which have relatively stable demand in all economic conditions.

Why are investors concerned about inflation?
Inflation decreases purchasing power. Put simply—when the price of goods and services increases and your income does not increase (or increases at a slower rate), then you need more money to purchase the same goods. For an investor, this means that if inflation is 4% during the year and the investment portfolio also had a 4% total return, then the real return (i.e., inflation-adjusted return) is 0%. Theoretically, the investor could have held onto that money instead of spending time and effort investing.

Inflation can also diminish equity performance. The Fed can increase short-term interest rates in response to inflation. Equities generally react negatively to higher interest rates since the cost of borrowing becomes more expensive, which could reduce capital spending and hurt earnings growth. Additionally, higher interest rates can reduce valuations of future cash flows.

How do dividend investments perform during periods of high inflation?
While dividends are not a perfect inflation hedge, dividend payments are generally less volatile than earnings for several reasons. As mentioned earlier, those companies with strong pricing power can more effectively pass cost increases to customers and can maintain or even grow dividends during periods of high inflation. Even those companies that experience short-term earnings weakness due to inflation may still maintain their dividend payments to shareholders. Generally, dividend cuts are relatively uncommon since they send a negative signal about a company’s financial position and are often followed by price deterioration. When using an indexed product, the effect of one or even a few dividend cuts is reduced when averaged along with other constituents.

Other equity investments may also have additional inflation protection built into their dividends. Midstream companies, for example, often have contract provisions that protect them from inflation and offer the ability to pass on higher costs to customers (Alerian & S-Network Global Indexes – Midstream/MLPs: Well-Positioned for Inflation). REITs also have inflation protection built into their dividend payments since real estate rental prices are typically tied to inflation—particularly for apartment leases which can typically be adjusted annually and for hotel REITs which can adjust room rates almost daily.

In contrast to equity dividends, bond coupons are usually paid at a fixed rate—so if inflation increases, the coupon payment stays low. This also decreases the selling price of the bond as new bonds are issued with higher coupons and older bonds become less valuable.

Bottom line:
Equities which pay dividends are typically better positioned in an inflationary environment compared to the broader equity market or fixed income investments. While negative sentiment related to rising inflation or interest rates can hurt stock prices and temporarily weaken margins (and the price return of an investment), the relative stability of dividend income can help drive a higher total return. The total return for income-oriented indexes has often outperformed the broader market during high inflation years (e.g., 2011 and YTD 2021).