How can equity income funds help you fight back against inflation?

Why might investors usefully consider equity income funds to help combat the effects of inflation?

The challenge of inflation, and how to preserve real incomes, is an issue that has received little attention for decades. But strain on real incomes is now, once more, a very live issue that has the potential to remain with us for some time to come.

Whilst index linked bonds would in theory provide some defence against inflation, there is a shortage of available products in the bond market. Meanwhile, the price of those bonds that do exist is unattractive for many investors.

All of which serves to underline the important role that a thoughtfully managed equity income fund can play in portfolios. That’s why investors who have spent recent years in pursuit of growth may now want to consider the need for balance to maintain real levels of income.
 

Dividends have historically provided an attractive real income stream?

At the heart of the case for income funds is a reminder that dividends are paid out of company earnings. Whilst costs may also be increasing in periods of high inflation, companies have the opportunity to try to increase prices. If successful, this can see the earnings which support the dividends keep pace with inflation.

The 50-year chart below shows the actual level of income paid out in dividends by companies in the FTSE All-share index, and the value of the FTSE All-share index itself, compared to inflation in a notional basket of goods. This is indexed to 31 December 1971.

It should be noted that this assumes that dividends paid out by companies are drawn as income. It ignores any returns from reinvestment of dividends which in practice is a powerful driver of total return.

The analysis shows that an investor in December 1971, who held sufficient funds in the FTSE All-share to receive a dividend of £100, would have seen their income (and also the capital) grow at a compound rate of 6.3% per annum by end of April 2022.

This is significantly above the 5.1% rate of inflation over the period. Put another way, the real income (income adjusted for inflation) was, at the end of April 2022, 75% higher than it was in December 1971.

And this is not a particularly advantageous point to do the calculation. Firstly, dividends have not yet fully recovered from the marked cuts that occurred during the pandemic. Secondly, inflation has spiked in response to energy and supply chain pressures arising from the pandemic and the war in Ukraine.
 

How resilient is dividend growth during periods of inflation?

Of course, this stream of equity income is not without risks (set out at the end of this note!). The second chart shows the progression of real dividends over the past 50 years through to April 2022, with all its peaks and troughs. The actual volatility of incomes from dividends over the period (based on a 1 standard deviation measure) has been 9.2%. 

There are a number of points that are striking from further analysis of the data behind the chart:

• There has been real growth in dividends (dividend growth in excess of inflation) for 63% of the time. The periods when dividends have been cut typically followed periods of economic recession (shaded areas on the chart). Most recently, a particularly marked dividend cut has resulted from the desire by companies following the pandemic to preserve capital.  In our view all this is understandable – in a recession, corporate profits would usually fall and so it is to be expected that the dividends paid also decline.
• Inflation over the past 50 years has been higher and more persistent than people might remember based on our experiences of the past 10 years. Not only has the average rate of inflation over the past 50 years been above 5%, it has been above the current target of 2% (set by the UK Government for the Bank of England) some 71% of the time.
• As well as economic factors that affect the market as a whole, volatility in dividend from the Index has been partly driven by company specific factors. For example, currently the largest single dividend payer in the FTSE All-Share Index, mining company Rio Tinto’s dividend policy is to pay out a percentage of its earnings, within a range. This means that when industrial metal prices next fall and its earnings fall, the dividend it pays may be at risk. Rio Tinto has cut its dividend on 6 occasions since 1986. On three occasions this has been by more than 50%.

But the role of equity income as defence against inflation is that it must be effective when inflation matters most.

The chart below focuses on a period during the 1970s and early 1980s when UK inflation was last in double digits. The UK economy had been in recession during 1973, 74 and 75. Readers of a certain age will remember the miners’ strike of 1972, petrol coupons being issued in 1973 during a crisis in supply, and the three-day week imposed by the Heath government in 1973 and 1974 following industrial action by coal miners and railway workers. Inflation then peaked at 27% in August 1975.

The chart shows that during a two-year period to mid-1975, real dividends fell by around 20% in the face of recession and as inflation climbed to record peak levels. But, encouragingly, real dividends then stabilised. They then fully recovered back to 1972 levels by 1982, before subsequently delivering above inflation growth over the following four decades.

The decline and recovery in equity income in real terms over the cycle from 1972 to 1985 compared very favourably with the experience of bond holders. Over the same period bond holders saw their fixed coupon decline in real terms by 78%.

An active approach can help reduce the volatility of income

An active income manager can potentially mitigate the effects of equity income volatility. This might be achieved through thoughtful diversification and balance within a portfolio, as well as careful stock selection with due consideration of dividend cover, instead of simply targeting high headline yields.

An individual investor might also look to draw the income but reinvest the growth in income (via income accumulation units) during the many periods when it is above inflation. This could then be drawn down during the less frequent periods of below-inflation dividend growth to maintain the income stream in real terms.

We are not making a forecast that this decade will look like the 1970s. However, this is the first time in a generation that persistently high inflation is a possibility and so it is understandable that it is on the minds of investors. Should high inflation become entrenched, history suggests that an active approach to equity income investing could offer an effective defence mechanism.