Data released by the US Department of Labor last month indicated that consumer prices jumped 6.2% y-o-y in October, the steepest rise since December 1990. Core inflation, which excludes energy and food prices that tend to be more volatile, came in at 4.6% — its highest since 1991.
The data marked another troubling sign that inflation may persist, contradicting the “transitory” label the Federal Reserve (Fed) had used to describe price pressures. For months, price increases had been rationalised as a temporary outcome of surging demand as the economy recovers from the Covid-19 pandemic, supported by the Fed’s multiple stimulus packages.
However, as supply chain disruptions and rising energy and commodity prices compounded inflationary effects in the past months, the narrative of elevated inflation being a temporary issue has been increasingly contested.
In early December, the Fed surprisingly pivoted on its inflation stance. At a congressional hearing on Nov 30, Fed chairman Jerome Powell said it was a good time to retire the term “transitory” when talking about inflation. US Treasury Secretary Janet Yellen echoed his views during an interview later that same week.
Powell also noted that factors pushing inflation are anticipated to “linger well into next year”, prompting fresh speculation on when the Fed will start raising interest rates. This comes as the central bank began tapering the pace of its US$120 billion ($163 billion) bond purchases in November.
For some, Powell’s change in stance reflects an increasing likelihood that the Fed’s pace in winding down purchases may be accelerated, while rate hikes could begin by 2022, rather than in 2023, as many originally anticipated.
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Amidst the backdrop of prolonged inflation and impending rate hikes, equity markets may be in for a bumpy ride in the months ahead. Sam Witherow, portfolio manager of JPMorgan Asset Management’s JPM Global Dividend Fund, believes it is a good time for investors to look at high-yield stocks as a way to cushion against volatility.
Not ‘stagflation’
Witherow does not believe inflation will persist long-term. “The economics of reopening should see both an increase in supply as output in the world’s factories increases and a decrease in demand for goods as consumer spending shifts to services,” he tells The Edge Singapore in an email interview. “The bottlenecks in shipping logistics may take longer to rectify but again will slowly ease as Covid-19 restrictions around ports are lifted and backlogs are cleared.”
Still, Witherow stresses that investors need to keep an eye on how the situation develops. “While we do not believe that stagflation (a situation in which the inflation rate is high, the economic growth rate slows and unemployment remains steadily high) will dominate the economic environment, monitoring the path of inflation and growth is crucial to asset allocation.”
He also highlights that while the pace of economic growth is expected to slow as the economy transitions from the early phase of recovery to the middle, it is important for investors not to confuse it with the start of a down-cycle, adding: “While rising energy prices and supply disruptions pose downside risks to growth, this is some way from a recession.”
With inflation, Witherow stresses for investors to take a longer-term view. “Investors should not position for an extended period of low growth and high inflation, but be mindful of the transition from early- to mid-cycle and the likelihood that inflation rates will be relatively higher than they have been used to.”
Dispersion in equity performance
For many investors looking for yield, equities have become preferable over bonds given the low yield environment, especially after interest rates tumbled at the onset of the pandemic. Given the increasing concern over inflation in the last months, Witherow notes that equities offer a hedge against moderately rising inflation as corporate profits usually rise along with prices.
Bond yields have picked up while the economy recovers: 10- year US Treasury yields have hovered around 1.6% this year, compared to the near-zero levels in 2020. While fears over the new Covid-19 Omicron variant have recently caused a pullback, interest rates are expected to continue rising across the board going forward as the economy picks up and as the Fed begins normalising its monetary policy in earnest.
Within this environment, Witherow expects there to be a wide dispersion in performance among equities, adding: “Higher interest rates would put more pressure on equity valuations, especially sectors that are trading on loftier valuations. The yield curve could also steepen if we see growth fears fade.”
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He also believes there is a strong case for investors to have an allocation towards high yield stocks within their equity portfolio. Witherow also argues that adding exposure to cyclical- and value-oriented sectors will benefit investors given that they are cheaper relative to growth stocks, positively correlated with interest rates and poised to benefit from the post-pandemic economic recovery. “Given the high correlation between value and income, a more income-oriented portfolio will likely deliver strong performance in this constructive environment for value,” he adds.
Investing in ‘compounders’
Even for growth-focused investors, which Witherow says characterises many investors in Asia, incorporating high-yield stocks in their portfolios is important as it will allow them to cushion against fluctuations in the stock market. “While we believe that structural growth trends are here to stay, there is also a strong case for those who have a disproportionate bias towards growth to have a more balanced portfolio for less volatile returns and more stable income.”
It is worth noting that despite rising yields, Witherow views dividend stocks currently remain a more attractive source of income compared to bonds. “[High-yield stocks] not only provide [a] higher level of income but also allow investors to participate in capital growth over the long-run,” he says. He also points out that despite the climbing nominal yields, real yields are still “firmly in the negative territory” given the higher inflation expectations, which should continue to support equities on relative valuations.
Witherow is the fund manager for the JPM Global Dividend Fund, which has a fund size of US$612 million as of Oct 31. According to the fund’s fact sheet, it aims to provide long-term capital growth by investing primarily in companies that generate high and rising income.
While the fund focuses on delivering income, Witherow is quick to point out that investors will still reap the benefits of growth. He explains: “We invest across the yield spectrum but with an emphasis on companies we call ‘compounders’. These are stocks that sit in the middle cohort between yield and growth and which historically have offered the best absolute and risk-adjusted returns in our investment universe.”
As of Oct 31, the fund’s top 10 holdings are in Microsoft, Coca-Cola, Apple, McDonalds, CME, logistics and supply chain REIT Prologis, semiconductor firm Analog Devices, Truist Financial, Procter & Gamble and Vinci. Nearly 60% of its portfolio is concentrated in the US, followed by Europe and the Middle East excluding the UK, which make up 23.1% of its portfolio.
Stay on target
In terms of positioning, Witherow says the fund is currently running a very balanced portfolio in terms of aggregate cyclicality, adding: “We believe that the bulk of the post-vaccine gains in cyclicals have now been made and now it’s much more about stock and industry specific trends.”
The fund is however currently overweight on Europe, where Witherow sees the best prospects for dividend growth coming out of the region following the sharpest payout correction. He notes that dividends per share in Europe are anticipated to grow at a compound annual growth rate of around 11% over the next five years.
On the whole, the fund is centred on accessing structural growth themes that have been accelerated by Covid-19. Witherow cites Deutsche Post, which owns the courier company DHL, as an example. “For many years the business-to-consumer (B2C) side of their businesses wasn’t very profitable for them but the jump in e-commerce penetration has led to greater route density and higher ‘normalised’ margins.”
Sectors and industries with strong prospects for normalisation coming out of the pandemic are also another target area. He adds: “For post-Covid-19 normalisation, we would point to areas like US banks, which we believe are well back on the path to making healthy returns on equity and are restarting meaningful distributions back to shareholders given their over-capitalised balance sheets.”
As inflation concerns and the rising yield environment continue to pose uncertainties for equity markets, the key is to focus on “normalised” levels of business profitability. Witherow says: “In a world where people are paying ever higher prices for ‘growth’, we want to have a very healthy valuation margin of safety in our portfolio holdings.”
Cover photo of Sam Witherow: JP Morgan Asset Management
