When inflation is on the rise: Equity Income becomes “safer” than Fixed Income

When inflation is on the rise, nominal assets such as Cash and traditional Bonds (Gilts and Corporate Bonds), lose their real (inflation-adjusted) value.
The face value of the coupon they pay every 6 months, and the promise to repay the holder a face value of £100 in 10, 20 or 30 years time, looks increasingly less valuable than the paper its written on.
Bonds and Cash cannot adjust for inflation.  That’s why a £5 note buys you less than it did 10 or twenty years ago.

Equity Income Funds: Inflation Resilient

The risk profiling industry has oversimplified risk

There is a systematic problem in the UK financial planning software world that “risk” has become synonymous with volatility.  It’s not.  Even the regulator emphasises that risk should be considered as a risk to “client outcomes.”  But unfortunately there’s no simple mathematical formula for that, so the risk profiling industry continues to be dominated by volatility metrics and numbering scales that convert long-term volatility scores so simple labels.  “He’s a 4 out 5”.  “She’s an adventurous 8 out of 10”.  Risk clients are willing to tolerate is different to the risks clients require to achieve their outcomes.
That’s why we think advisers embracing cashflow modelling are doing better by their clients, than a painting-by-numbers approach.

Bonds are low risk, equities are high risk?

Well yes, if the only metric we are looking at is volatility.  And in normal (low inflation) regimes, this is true.
But in higher inflation regimes, the OPPOSITE is true.
Bonds (and related FIXED income streams) are high risk to client outcomes (they are still low volatility, but their fixed nominal value means they lose their real value after adjusting for inflation).
Equity Income (and related VARIABLE dividend income streams) are low risk to client outcomes (they are still high volatility, but their variable, progressive dividend income stream and fluctuating capital value means they have POTENTIAL to preserve real value after adjusting for inflation).
Naturally, there’s no promise that equities will do that (and hence the equity selection methodology is key).  But there’s precedent that it does.
By contrast, bonds represent a promise that they will definitely lose money in a high inflation regime.  And there’s a precedent.  Just think 2022 (or the 1970s).

Why we like UK Equity Income in a high inflation regime

​The chart below shows the breakdown of Total Return for a Gilts Index fund and for the VT Munro UK Equity Income fund (which is benchmarked to our Elston UK Equity Income index) for the last 5 years.
The UK Equity Income strategy delivered an income return of 5.5%pa (from the UK’s largest dividend payers), and a capital return of +8.5%pa for a total return of +14.0% pa.
The UK Gilts index strategy delivered an income return of 2.5%pa (reflecting the average yield over that period), and capital return of negative -7.8%pa for a total return of -5.3%pa.

So which is the riskier strategy?

If we define risk as volatility, UK Equity Income was naturally higher risk than Gilts.
If we define risk as inflation, then UK Equity Income was lower risk than Gilts.
So financial advisers need to think which risk they are worried about, and invest accordingly.

Why is UK Equity Income inflation resilient

UK Equity Income is inflation resilient for three reasons:

1. The composition of the UK equity market: The UK’s largest dividend payers include Oil and Mining companies (who benefit from rising commodity prices that drive inflation upwards), Financials (who benefit from rising interest rates to fight inflation), and Consumer Staples and Healthcare companies (who can pass through the impact of inflation to their essential goods and services).
2. Progressive dividend policies: The UK’s largest dividend payers have progressive dividend policies that aim to steadily increase their dividend per share.
3. Dividends are the main driver of total returns: reinvested dividends are the main driver of UK equity market total returns providing an underpin to the market.

How did UK Equity Income fare in the inflation shock of 2022

In the last inflation shock of 2022 and rapidly rising rates, US Equities declined -9.1%, World Equities declined -8.3, UK Gilts declined -23.7 and UK >15 year Gilts declined -40.7%.  UK large-cap Equities increased +5.0% and UK Equity Income (represented by our UK Equity Income Index) increased +8.2%.  This supported our 2021/22 thesis that a value/yield factor tilt within equities would prove defensive.  Ironically, the disruption to the Gilts market, that the 1 year volatility of Gilts was the SAME as it was for UK Equities.  So much for risk “mapping,”

Another inflation shock in 2026

The crisis in the Gulf means another inflation shock is potentially on the way.  As in 2022, this means that nominal assets, such as Gilts and Corporate Bonds are once again at risk.
For advisers seeking to build portfolio resilience, accepting some volatility risk with UK Equity Income is a proven way to mitigate inflation risk.
Advisers should discuss with their client which risk they are concerned about – the level of fluctuation of an asset class, or the preservation of capital in real terms.