The Purchasing Power Dilemma Rages On

Transcription

1 JUNE 1, 2015 The Purchasing Power Dilemma Rages On By Mark Luschini, Chief Investment Strategist Over the years, we have written extensively about the need for investors to defend their purchasing power. After all, if your investment portfolio isn t producing a return that overcomes the cost of living, it exposes you to the risk of running down, or worse, out of your money. That, too many, is a greater risk than a loss in value caused by a temporary downturn in the financial markets. Unfortunately, the conventional solutions that have been employed historically to satisfy the need for income remain repressed by sub-trend economic conditions and a Federal Reserve ( Fed ) policy that has held interest rates near zero since While inflation has been mostly dormant since the end of the financial crisis six years ago (having reached the Federal Reserve s target of 2% only briefly in early 2012), it seems reasonable to assume, given strengthening economic conditions, that inflation readings should move higher. The chart below depicts the personal consumption expenditures price index (excluding food and energy), a fancy term for a calculation of inflation and the one that the Fed uses for interpreting price movements. Part of the Fed s dual mandate is price stability (the other being maximum employment) which it defines as a consistent rate of inflation at 2%, a level it deems sufficient to keep long-term inflation expectations well anchored while fostering an environment conducive to hosting moderate long-term interest rates. Note that Fed officials are underachieving against that target at the moment (the PCE index is running at just a 1.2% annualized pace). This is not lost on policymakers at the Fed as they discuss various means of promoting faster economic growth. In fact, one of the triggers for raising interest rates expressed by Chairwoman Janet Yellen was her being reasonably confident inflation was at least moving toward the Fed s target rate. The Fed seeks to achieve 2% inflation as its target. Page 1 of 5

2 This paper, however, is not about whether the Fed achieves its price target in the near- or longer- term, rather to reinforce our siren call for investors to recognize that there is inflation (a notion that not everyone considers when applying it to investment considerations), and the instruments that investors often purchase and expect to produce income - bonds and various cash equivalents today simply do not offer yields that cover price increases by that great of a margin, if at all. That is not an acceptable solution for investors seeking to derive income, or generate a total return, that builds a cushion against the inflation of today and in anticipation that it may likely be higher down the road. In fact, it could be much higher if the economy picks up a little steam and Fed officials allow for inflation to run above target while building momentum in the job market to achieve its employment mandate. There is heavy debate amongst monetary officials and market participants alike, as to when the Fed is likely to raise interest rates. Chairwoman Yellen said if job creation and inflation progress as expected a rate hike will occur sometime this year. This would represent the first increase in interest rates in nine years. Subsequent interest rate increases are expected to be gradual and current projections show rates leveling off around % several years out (see graph below). Another way of looking at it is to say what is not expected; that is a return to rates of 4.0 % or more, and some even suspect it unlikely the Fed will be able to raise rates above 3.0 % for many years to come. Waiting several years to earn a couple percent yield on deposit accounts, such as savings, checking and money markets, is untenable because that may only then outdistance inflation if it remains at or below the Fed s target. In the meantime, purchasing power is being eroded as the cost of living keeps climbing. Bond yields will probably improve but even then still offer less than mid-single digit yields in most cases for high quality debt. And since most bonds offer a fixed coupon the payment on bonds already issued doesn t go up even if interest rates or inflation do. Of course any upward bias in yields Page 2 of 5

3 engendered by Fed policy, or otherwise, will impair the value of existing bonds held individually, or through collective instruments like mutual funds and exchange-traded products. So what is an investor to do? While there are several investment instruments available, such as immediate annuities and niche structured products, that may be suitable as part of an income-seeking solution, most fail to deliver a rising income stream that is often critical for maintaining purchasing power parity. Investors with the luxury of only drawing on a small portion of their portfolio, if at all, can focus more on capital appreciation or sacrifice some yield because growth is comparatively important or the withdrawal rate required to meet cost of living needs is fairly de minimis. For others, especially those looking for income or a more stable contribution to the total return expected from the equity market, dividend paying stocks offer tremendous appeal. Our advocacy for dividend-payers is hardly new but the story remains unchanged. Owning shares of dividend paying companies, in proportion to one s risk tolerance, that have an attractive yield but have also demonstrated a propensity to raise their dividend payout regularly, is unequivocally important. After all, current yield is one thing, but getting a raise on top to fend off the ravages of inflation should be the dual mandate of most every investor. How important is a rising income stream? Take the inflation rate portrayed in the opening graph. A loose regression might suggest it averaged about 1.6% a year. Discounting a dollar from the year 2000 at that meager rate erodes its value to less than $0.80 in 2015 spending terms. In other words, a dollar today buys far less of a meal, vacation, a car, utility bills, clothes and health care, than as recent as the year we stopped fretting that our computers were going to shut down because of Y2K. Imagine if inflation was running at the 2.0 % target rate or higher. It should not, however, require rampant inflation to force action. By then it may be too late. Incipient inflation like we have today can quietly destroy an attempt to grow value and increase purchase power unless the right parts are bolted together in a fashion to mute it. At the risk of repeating, investors with a primary objective of growth can alternatively earn that raise through the prospective appreciation of the portfolio and worry less about the income stream to provide it. Investors who draw on most or all of the income produced by a portfolio to subsidize everyday living needs have to think about a means by which that cash flow can increase to insulate them from invading the corpus. Fortunately, there is quite a large selection of stocks that offers these characteristics. Not all are in the U.S. and frankly we encourage a global search initiative to promote a wider amount of choices by country and industry. Having said that, we have included fifteen companies listed in the following table as tangible evidence that such stocks exist and to illustrate the merits of their inclusion in investors portfolios. Our selection set was limited to companies domiciled in the United States but most are multi-national in nature and represent some of the best brands in their respective industries. These companies are a sampling from a list of more than fifty companies known as Aristocrats. Each of them are constituents within the S&P 500 index but their Aristocratic status is earned by virtue of not only Page 3 of 5

4 consistently paying a dividend but having increased it for at least the last 25 years. We whittled the list down a tad and chose just those with a yield above 2.5% along with a valuation (price-to-earnings ratio) approximately equal to or less than that of the S&P 500 index. With the 10-year Treasury bond yielding about 2.2% and the S&P 500 index yielding just shy of 2.0%, a starting point for current income supplied by a diverse group of companies (eight of ten S&P sectors are represented) with a minimum dividend yield of 2.5%, and the track record of seeing that payment increase every year, is extremely attractive from our vantage point. A broader screening process could reveal more companies of similar name recognition and quality that may have missed the cut for inclusion as an Aristocrat but are no less attractive for purposes of building a sound portfolio with the high and rising dividend payout target applied. We know Europe hosts many companies that have attractive valuations and above market yields as well. Economic conditions have turned up in the Euro area and stocks there are responding favorably, yet in our view, have more room to go. Therefore, we would encourage investors to cast the net across the pond for both opportunity and income. LAST PRICE TO DIVIDEND TICKER COMPANY SECTOR PRICE EARNINGS RATIO YIELD CVX Chevron Corp Energy XOM Exxon Mobil Energy T AT&T Telecommunication Services WMT Wal-Mart Stores Consumer Staples EMR Emerson Electric Industrials ED Consolidated Edison Utilities JNJ Johnson & Johnson Health Care TROW T.Rowe Price Group Financials CINF Cincinnati Financial Financials KMB Kimberly-Clark Consumer Staples GPC Genuine Parts Consumer Discretionary KO Coca-Cola Co Consumer Staples PG Procter & Gamble Consumer Staples HCP HCP Inc Financials MCD McDonald's Corp Consumer Discretionary Source: Janney ISG, Standard and Poor's, Bloomberg Prices as of: 6/1/2015 By way of example, we can take a deeper dive into the dividend profile of McDonald s. The company has raised its dividend for 38 consecutive years, but what is astounding is the pace of those dividend increases. Over the last five years, for instance, dividend increases have annualized at slightly more than 9% and if that were to continue it builds on an attractive starting point given today s yield of roundly 3.5%. Contrast that with inflation below 2% and the formula for maintaining purchasing power is solved - in sum, a higher yield than the S&P 500 index and benchmark 10-year Treasury bond, a lengthy history of raising the dividend over various market cycles since the 1970 s, and the prospect of the dividend increase coming at a rate higher than inflation. Page 4 of 5

5 Perhaps our previously written pieces, including Income for the Ages and Investors Need Purchasing Power helped to spark an earlier interest in the power of high and rising dividends and have already been incorporated into balanced portfolios. For those early adopters, this message is reaffirmation that this theme remains intact as the insatiable appetite for yield and income that has persisted for so long is likely to continue a good while longer. For investors newly considering options to solve for the income dilemma, or not yet fully committed to recognizing that the defense of purchasing power is weakening under the unabating repression of interest rates - a global phenomenon by the way - our hope is that the solution we presented is applied in earnest. Disclaimer: Past performance is no guarantee of future performance and future returns are not guaranteed. There are risks associated with investing in stocks such as a loss of original capital or a decrease in the value of your investment. This report is provided for informational purposes only and shall in no event be construed as an offer to sell or a solicitation of an offer to buy any securities. The information described herein is taken from sources which we believe to be reliable, but the accuracy and completeness of such information is not guaranteed by us. The opinions expressed herein may be given only such weight as opinions warrant. This Firm, its officers, directors, employees, or members of their families may have positions in the securities mentioned and may make purchases or sales of such securities from time to time in the open market or otherwise and may sell to or buy from customers such securities on a principal basis. Page 5 of 5