The Income Conundrum

The combination of rising global interest rates and rising recession fears has complicated the current investing environment. The traditional “safe haven” of fixed income has seen volatility spike at a faster rate than equities.[1] For those who require consistent cash flow, this creates a new level of uncertainty. To produce enough income to offset persistently higher levels of inflation, more risk seemingly needs to be accepted within a portfolio.

This plants the seed of the idea that investors must be more creative to generate adequate income. This seed germinates into allocation shifts that require either strategies or asset classes that were previously unfamiliar to the average investor. For example, the role of private real estate or infrastructure, with their built-in inflation protection, may become a logical destination for many investors who can accept illiquidity. Leveraged loans have floating rates that could protect the portfolio against rising interest rates. Other hybrid payout structures—such as structured notes and convertibles—may also be an attractive income option for some.

While these are reasonable places to search for steady income, what has happened in the first half of 2022 may have also provided a roadmap toward achieving income goals by following a more traditional path.

Volatility leads to opportunity

Looking at the global fixed income markets, the sharp selloff in bonds has opened an interesting opportunity to invest in various fixed income asset classes at meaningfully higher starting yields compared to recent history. As of end April this year, about 42% of the bonds in the Bloomberg Multiverse Index—a gauge of the global bond market—yielded more than 3% in nominal terms (Exhibit 1). Only 10.8% of bonds in the index were above 3% at the beginning of the year.[2]

Exhibit 1: Bloomberg Multiverse Index, Index Weight by Yield-to-Worst Close to 42% of the constituent bonds in the index yield more than 3% in nominal terms, a meaningful increase from just 11% of the index as of the end of 2021.

Source: Analysis by Franklin Templeton, Bloomberg. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.

Looking across asset classes in the United States, mostly because of appreciation, the S&P 500 Index’s dividend yield declined since the start of the pandemic from levels of 2% to 1.5%.[3] In contrast, the 10-year US Treasury yield has increased from 1.5% to 3% during the same period.[4] With historical volatility of equities 3.6 times higher than fixed income,[5] this created a difficult decision for an investor looking for steady income and lower volatility from their portfolio.??

Higher quality becoming more attractive

Today, despite the decline in the broad equity market, bond yields at every maturity have risen to levels back in excess of dividend yields. In addition, higher-quality corporate bonds, which tend to have longer duration than high-yield issues, have seen some of the biggest price declines in a generation. This seems to imply that markets are pricing in further rise in rates and elevated inflation.

Similarly, within equities, sectors that are typically considered inflation-sensitive, like utilities, communications, materials and energy, have performed well year to date, while the broad market has declined. In other words, the expectations built into current equity prices are creating bifurcations where valuations in some sectors are at levels not seen since before the pandemic.

However, a broad array of indicators and surveys expect inflation to moderate toward pre-pandemic levels. In other words, market participants within fixed income and equities seem to have a more pessimistic inflation outlook than corporations or individuals, which is creating pockets of valuation opportunities in both investment-grade credit and higher-quality equities that have not been seen since prior to the pandemic.

Inflation peaking?

Consumer surveys of inflation expectations have indicated that inflation will be in a higher trend than recent years, but not near the current extreme levels. This difference in expectations will be an important determinant as to optimal portfolio positioning relative to inflation.??

?Exhibit 2: Long-term Inflation Outlook: Consumers’ Expectations

Sources: Analysis by Franklin Templeton Institute, University of Michigan, Bloomberg. As of June 9, 2022. Important data provider notices and terms available at www.franklintempletondatasources.com. There is no assurance that any estimate, forecast or projection will be realized.

?Additionally, there is another concept that is important in understanding inflation: the velocity of money. It is defined as the ratio of gross domestic product to the total money supply in circulation. With the massive amounts of stimulus that have been pushed into the economy, this ratio has declined significantly since the 1990s, coinciding with lower inflation. Looking at this measure a bit more deeply (Exhibit 3), the annual change in the velocity of money has been a good indicator of future inflation with a lag of about a year. This measure seems to be rolling over.

?Exhibit 3: Velocity of Money The number of times a unit of currency is used to purchase goods and services has fallen since the mid-1990s

Sources: Analysis by Franklin Templeton Institute, Federal Reserve, Bloomberg. As of June 2022. Important data provider notices and terms available at www.franklintempletondatasources.com.

?Exhibit 4: Inflation Follows Change in Velocity of Money with a One-Year Lag

Sources: Analysis by Franklin Templeton Institute, Federal Reserve, University of Michigan, Bloomberg. As of June 2022. Important data provider notices and terms available at www.franklintempletondatasources.com.

?What does this all mean for an investor? The inflation and growth pictures are not clear cut, but the markets have priced in a high inflation economic outcome. This creates a dislocation that provides wider dispersion of investment opportunities across traditional fixed income and equity markets. While some alternative investments may be attractive regardless of how the economic landscape plays out, the current valuations of traditional assets may provide an opportunity to re-balance portfolios toward income goals using stocks and bonds.

For additional views, read:

US Readers: Seeking income in a rising rate world

International Readers: Seeking income in a rising rate world

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WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.?Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. ?Investments in lower-rated bonds include higher risk of default and loss of principal. Floating-rate loans and debt securities tend to be rated below investment grade. Investing in higher-yielding, lower-rated, floating-rate loans and debt securities involves greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy. Interest earned on floating-rate loans varies with changes in prevailing interest rates. Therefore, while floating-rate loans offer higher interest income when interest rates rise, they will also generate less income when interest rates decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. The risks associated with a real estate strategy include, but are not limited to various risks inherent in the ownership of real estate property, such as fluctuations in lease occupancy rates and operating expenses, variations in rental schedules, which in turn may be adversely affected by general and local economic conditions, the supply and demand for real estate properties, zoning laws, rent control laws, real property taxes, the availability and costs of financing, environmental laws, and uninsured losses (generally from catastrophic events such as earthquakes, floods and wars).

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[1] Analysis by Franklin Templeton, Bloomberg.

[2] Source: Bloomberg. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator a guarantee of future results.?

[3] Source: Bloomberg. As of June 9, 2022.

[4] Source: Bloomberg. As of June 9, 2022.

[5] Calculations based on standard deviation of the returns of S&P 500 Total Return Index and the Bloomberg US Aggregate Total Return Value Unhedged USD Index over the period 1988 to 2019. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.?