Fidelity: The income conundrum

While investors’ need for income is not going away, it may become harder to find stable and predictable sources of income over the next 12 months. Companies across various sectors are cutting dividends in order to survive, while government bonds are no longer the diversifier they once were, amid rock-bottom yields and ever-expanding balance sheets.

In this environment, investors may need to consider a trade-off between lower, more reliable sources of income and higher, more variable forms, and whether they have the risk appetite for more illiquid assets.

Addressing the income conundrum

Equity and fixed income markets may have begun healing from their March panic, but they continue to face headwinds.

Equity markets are currently looking through the shorter-term disruption to a potential recovery in 2021, following an unprecedented monetary and fiscal response. But as parlous macro data continues to emerge over the coming weeks and months, we expect markets to reassess the scale of the economic damage.

Much depends on how long it takes to end lockdowns, lift restrictions and restore confidence. For economies to emerge fully from this crisis, businesses need to believe they can operate without the threat of further infection waves and new lockdowns.

Equity valuations are also likely to come under pressure as more companies reduce dividends and suspend share buybacks. While this may be a temporary phenomenon, it could take a number of years for equity income to return to pre-crisis levels - especially where companies have received state support with conditions attached or corporate debt levels have increased dramatically.

Parts of the fixed income markets could also see income reduce. As countries borrow heavily to mitigate the impact of the crisis, fiscal deficits balloon and monetary policy remains loose, government bond yields are likely to be even lower and carry higher risk than in the past. This creates an income conundrum for investors that may have to be addressed in other ways.

Government bonds no longer offer the diversification they once did

Investors too will need to think about how they allocate to government bonds. Depending on their balance sheet size and rating, sovereigns may now offer less protection for investors wishing to offset overall portfolio risk.

This raises questions as to the effectiveness of a seemingly diversified equity/bond portfolio during a period in which correlations between asset classes may not be operating ‘normally’ due to the exogenous Covid shock. For example, if over the medium to longer-term inflation re-emerges, defensive and growth assets may not have the same correlation as they have historically.

In such circumstances, longer-term investors who can deal with illiquidity may wish to consider strategic alternatives that offer diversification and capital return benefits, where they have access to these. In the short-term, areas such as real estate and infrastructure face challenges around income, tenant viability and counterparty risk. Longer-term, however, high quality real assets should provide both income and elements of diversification away from public markets.

For investors looking to retain liquidity, moving up the capital structure into investment grade credit remains a good option. There may also be select opportunities among high yield names as the size and nature of the central bank support evolves to support parts of this market.

Winners and losers as supply chains shift

More generally, opportunities are also emerging in certain industries that could benefit from the Covid crisis. Beneath the wider trend of moving from offline to online, the acceleration in digitisation within companies should boost software providers.

And, perhaps counter-intuitively, there could be opportunities in autos. While recent demand has fallen off a cliff, semiconductor players in the electric vehicle market should continue to grow strongly over the longer-term. Car dealers with the best value chains are benefiting from social distancing measures that make cars more appealing than public transport. Finally, those companies that are more visibly contributing to society and taking better care of their employees should also outperform.

Among the losers will inevitably be more labour-intensive companies with less capacity for social distancing, as well as airlines, leisure and parts of the retail sector. While some companies are obvious winners or losers, others exist in greyer areas where in-depth analysis is required to understand the multi-year slope of recovery for each firm, their liquidity and solvency characteristics, their income profiles and how easy it might be to restart or modify supply chains.