By Satyajit Das
The humorist Will Rogers famously remarked that the return of his capital was more important than the return on his capital.
Income and capital return are connected. Asset prices reflect future earning streams. Unfortunately, in this coronavirus-plagued world, income is becoming a problem.
Unless assets are sold, investment income comes from interest, rents or dividends, either directly or indirectly via funds or investment structures. Even before the pandemic, interest rates had fallen to near zero and, in Europe and Japan, to negative levels.
This turn of events reflects low inflation, at least as measured. The main cause was a policy of ultra-low rates to boost growth through debt-funded consumption and investment. Low rates were needed to sustain excessive debt levels, which are likely to become even greater as a result of governments’ response to the pandemic. The 2013 “taper tantrum” and the 2018 mini stock-market crash highlighted the inability of financial markets to accommodate even modest interest rate rises.
With returns low, over the past decade, investors were forced into a “dash for trash.” They extended duration or purchased lower credit-quality or illiquid securities. This fueled demand for BBB or non-investment grade corporate debt, CLOs, complex derivative based products and emerging- or frontier market debt. In 2017, for example, investors oversubscribed the 100-year bonds issued by Argentina. The attraction was a coupon of 7.125%. Today, these bonds trade at around 30 cents on the dollar.
Rental properties take a hit
Today, with interest rates likely to remain at zero or lower for the foreseeable future, interest income is a non-sequitur. With financial distress increasing, riskier debt is increasingly less palatable.
Already low from the decade-long search for income, rent from residential and commercial properties will fall due to the economic slowdown. Even when the lockdowns ease, the shift to online retailing, remote working practices and altered social norms will affect commercial returns. The loss of wealth and lower incomes will depress residential property returns. In the empty chair, 90% economy that will evolve, rents may remain low.
In recent years, investors purchased shares for dividend income or distributions via share buybacks. Lower corporate earnings will restrict stock dividends. Even after any recovery, the need to rebuild capital will mean that distributions may not return to pre-crisis levels for an extended period.
Conditions attached to government support or regulatory pressure also will limit dividend payouts. For multinationals, weakness in overseas operations, such as in Europe, China and emerging markets, will affect earning even if U.S. operations improve. Conditions attached to local assistance and capital controls may prevent repatriation of earnings or dividend payments to the parent, reducing the capacity to make distributions.
In each market, the bulk of dividends are paid by a few companies concentrated in certain sectors, primarily banks, oil and resource companies, tobacco, pharmaceutical and retail. Many are badly affected and may not recover for some time.
The lack of income will force changes in investors’ behavior.
The lack of income will force changes in investors’ behavior. It will dictate higher cash reserves. Investors may need to regularly sell assets to finance spending, exposing them to market volatility and price downturns. Regular sales will reduce capital and reduce exposure to markets and ability to generate future returns.
Income shortfalls will affect individuals’ spending, especially retirees who rely on investment income to help cover living expenses. Pension funds and insurance companies will also feel the pinch, as will asset management firms. Lower returns will increase pressure on fees. Withdrawals to fund cash flow needs will affect assets under management and, accordingly, firms’ profits.
The duration and type of investments that investors purchase will also be affected. More conservative choices, such as shorter-duration assets like fixed income, will reduce return but minimize price and liquidity risk. Riskier investments, such as real estate and stocks, may increase return but expose investors to greater risk. Where investors choose risky assets, it would be wise to follow another bit of advice from Will Rogers’ strategy: “Buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.”