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Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.
There was a significant change in the income landscape in 2022. Higher interest rates meant that for the first time in a decade, bonds now pay an income comparable to that available from company dividends. This creates a greater hurdle for equity income investors, but we still see real value in choosing stock markets for income.
Inflation has been the big story of 2022. For much of the year, inflation surprised financial markets with its depth and breadth, outpacing the expectations of central banks.1 It has been fuelled by rising commodities prices, resilient demand, supply chain constraints and, increasingly, rising wages.
For those investors who rely on the income they receive from their investments, this presents a dilemma. Their income may be the same, but it is less valuable. While it is easy to dismiss this as a temporary phenomenon, it seems increasingly clear that inflation may settle at a higher level. The BlackRock Investment Institute says: “We expect inflation to cool but stay persistently higher than central bank targets of 2%...We see long-term drivers of the new regime such as aging workforces keeping inflation above pre-pandemic levels.”2
Holding dividend-paying equities can help protect an investor’s income against the damage caused by inflation. With bonds, the income is usually fixed. It will stay static over the lifespan of the bond. This means bonds are likely to become less valuable at a time of rising inflation.
Fixed income risk: Two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to repay the principal and make interest payments.
In contrast, companies may be able to pass on cost increases to their customers during periods of rising prices. This can help dividends keep pace with inflation. In the fourth quarter of 2022, UK dividends rose 8% to £94.3bn on a headline basis, 3 according to the Link UK Dividend Monitor Q4 2022, and the group expects dividends to grow again in 2023.
It is possible to underestimate the power of this growing income at times when inflation is benign, but as the world enters a period of structurally higher inflation, it may prove more important.
Investment trusts have a particular advantage in protecting dividends in line with inflation. They can reserve income during buoyant periods and pay it out during more difficult periods. The BlackRock Income & Growth Investment Trust currently has revenue reserves, which allowed it to maintain its dividends to investors during Covid and pay a rising income over time.4
The long-term growth of stock markets
Building long-term wealth is difficult. It is an uncomfortable truth that many people don’t save enough to ensure they have financial security. Historically, returns from the stock market have outpaced those from bonds or cash, albeit with greater volatility in between.
The periodic drawdowns in equity markets can be a deterrent and may add to the appeal of fixed income investments. However, 2022 proved that even ‘safe’ bond markets are not immune to falls in capital. Equally, by focusing on high quality companies – I,e, those companies that are cash generative, with strong balance sheets and experienced management teams, it may be possible to manage some of the volatility associated with stock markets. There are companies that can thrive, even in tough environments.
Equity risk: The value of equities and equity-related securities can be affected by daily stock market movements. Other influential factors include political, economic news, company earnings and significant corporate events.
2022 has thrown up a lot of challenges. The world has entered a phase of more volatile geopolitics, while the UK has had to contend with its own domestic instability. The BlackRock Income & Growth Investment Trust maintains a flexible style avoiding a particular sector or style bias: over the year, we increased our exposure to the resources and power sectors in the trust in response to rising energy costs, we also increased our weighting in non-UK companies, providing a degree of diversification and additional sources of income.
Diversification risk: Diversification and asset allocation may not fully protect you from market risk.
Dividends are not bonds, and will change in response to rising or falling profitability, but by finding those companies with sound cash flows, a strong market position, pricing power and robust earnings, it may be possible to sustain a growing income over time.
2 https://www.blackrock.com/corporate/literature/whitepaper/bii-global-outlook-2023.pdf - BlackRock 2023 Outlook
3 https://www.linkgroup.eu/insights/publications/uk-dividend-monitor-q4-2022/ - LINKGroup: UK Dividend Monitor Q4 2022, Q4 2022
4 https://www.blackrock.com/uk/literature/annual-report/blackrock-income-and-growth-investment-trust-plc-annual-report.pdf - BlackRock 31 October 2022
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