Where will most returns likely come from going forward?

Income is always a component of total return, whereas capital growth is not.
Chad Padowitz

Talaria Asset Management

As history shows us, the period after an interest rate rising cycle can be quite difficult for equity prices as higher rates dampen economic activity while at the same time increasing financing costs. Given this, and the fact that equity markets are already starting from very high multiples, their outlook is probably skewed to the downside.

If we look at previous rate hiking cycles since World War II, on every occasion the US manufacturing index has entered a slowdown, and 12/13 times there has been an earnings recession.

Time will tell this time around, but against such a backdrop income as a source of return will likely be more important than ever going forward.

Historical Context

This isn’t a new phenomenon. If we look back at historical returns for the S&P 500, since 1880 there have been three 10-year periods where income comprised all of investors' returns, i.e. capital values were negative for a decade. This was the case in the 1910s, 1930s and as recently as the 2000s.

In fact, income is always a component of total return, whereas capital growth is not.  

Source: S&P, Bloomberg
Source: S&P, Bloomberg

While the data is for the S&P500, the ASX is no different. Between 2007 and 2020, point to point, all of the returns generated by investors were from income. This was in a period that saw one of the largest resource booms, housing booms and low-interest rates.

Not all income is created equal

Typically speaking, the two most obvious sources of income returns for investors are dividends from equity investments and interest income from cash or bonds.

However, as we saw during COVID, dividends can be cut and the risk of this increases as profits start to unravel. Companies begin prioritising liquidity or having cash to seize bottom-of-the-cycle opportunities as we enter a recession with dividends being the first thing cut.

Another risk of relying too much on dividends is you run the risk of creating a portfolio comprised of companies in the same sector or region. Take Australian banks for example. High dividends, but there is little diversification benefit. In short, over-reliance on dividends can lead investors to unwittingly develop a bias towards certain sectors, such as banks, resources and retail particularly in Australia.

What about interest on cash or bonds? In recent months this has no doubt been a good place to store money and earn a decent return, but that isn’t always the case. In August 2008, the RBA cash rate was 7.25%. The following year the number had more than halved to 3.00%. This reflects the volatility of income and how easily and quickly it can be cut.

Again, the issue with interest rates is these tend to fall as the economy stalls with central banks cutting rates to stimulate economic growth.

In both instances when investors need income the most, the risk to dividends and interest income rises. So finding a source of income that diversifies risk, and does not result in markedly higher volatility, is not easy.

A solution – The income engine

Not easy but possible - and in our case achieved through the implementation process, receiving a minimum 15% contracted rate of return per annum as a result of our commitment to buying a share we want to own. This flows through in the form of an income stream that is not dependent on a company’s ability or management’s desire to pay a dividend to shareholders.

The other unique feature of such a strategy, unlike dividends and interest, is that it is priced off volatility. The higher the uncertainty about the future, the higher the premiums we collect to compensate for that higher uncertainty.

In the current economic environment, with historically high starting valuations for equities, high inflation and the lagged impacts of monetary policy starting to take effect, having a consistent and diversified source of income return can be invaluable. 

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The information in this article is general information only and is not based on the objectives, financial situation or needs of any particular investor. In deciding whether to acquire, hold or dispose of the product you should obtain a copy of the current Product Disclosure Statement (PDS) for the Fund and consider whether the product is appropriate for you. Units in the Talaria Global Equity Fund (Managed Fund) (the Fund) are issued by Australian Unity Funds Management Limited ABN 60 071 497 115, AFS Licence No. 234454. Talaria Asset Management Pty Ltd ABN 67 130 534 342, AFS Licence No, 333732 is the investment manager and distributor of the Fund. References to “we” means Talaria Asset Management Pty Ltd, the investment manager. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. In deciding whether to acquire, hold or dispose of the product you should obtain a copy of the current Product Disclosure Statement (PDS) and the target market determination for the Fund and consider whether the product is appropriate for you. A copy of the PDS and the target market determination is available at australianunity.com.au/wealth or by calling Australian Unity Wealth Investor Services team on 1300 997 774. Investment decisions should not be made upon the basis of the Fund’s past performance or distribution rate, or any ratings given by a rating agency, since each of these can vary. In addition, ratings need to be understood in the context of the full report issued by the rating agency itself. The information provided in the document is current at the time of publication.

Chad Padowitz
Co-Chief Investment Officer
Talaria Asset Management

Chad is the Co-Chief Investment Officer and co-founder of Talaria Asset Management. He has more than 21 years of experience in the financial services industry in the UK, South Africa and Australia. Talaria's investment strategy seeks to increase...

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