Bank deposit rates recently climbed to approximately 4%, breaking a prolonged period of low interest rates. Although this comes as a welcome relief for income investors, whether returns from cash deposits can catch up with inflation remains a crucial question.
Returns from cash deposit unlikely to beat inflation
When interest rates are high, some investors may rely on cash deposits to generate income. However, there is no guarantee that interest gains can outrun inflation so how can yield-focused investors better align their portfolios during periods of high inflation?
The answer is actually quite simple, that is to capture both dividends and bond yields, which has long been an optimal strategy for income investing. Nevertheless, one should look beyond dividends and strive to find a balance between income and capital appreciation. By doing so, investors will stand a better chance of capturing capital gain opportunities while meeting their income objectives, and thereby potential realising higher real returns.
Stay invested to avoid missing the upswing
Following a 25 basis point (bp)- interest rate hike by the US Federal Reserve (Fed) in July 2023, interest rates have reached their highest levels since 2001. This comes at a time when the previously robust US housing and labour markets are showing signs of moderating. Clearly, the Fed remains determined to curb inflation, as it prioritises this objective above all else.
We believe that this tightening cycle is about to end, with only one more 25 bp hike on the horizon. Historically, the Fed typically initiates rate cuts approximately 6-9 months after halting rate hikes. Based on this pattern, the US may start to lower interest rates in 2024, potentially triggering a rally in risk assets. In light of this, remaining invested will be a sensible approach for investors to avoid missing out on a sudden rebound in such assets.
Within the Asian tech universe, we see some interesting investment opportunities that offer a combination of stable income and growth potential. For example, certain semiconductor firms in Taiwan and South Korea which are supported by stable cash flows, have also recently increased their dividend payouts. In addition, this sector benefits from the adoption of artificial intelligence (AI) and rising demand for semiconductors, which we believe indicates further upside potential in related share prices.
Meanwhile, we are positive on the outlook for the banking sector as it is well positioned to benefit disproportionately from higher rates. Besides, a rise in loan interest rates will widen margins and support profitability. On the other hand, traditional utilities stocks are usually known for their high dividend yields among sectors that typically show more stable business models. Even though their growth may not be exponential, their sustainable characteristics can provide investors with a steady income stream.
Short-term bonds can act as a shield against capital losses
Taking the recent macroeconomic environment into consideration, we are leaning towards a more neutral view on Real Estate Investment Trusts (REITs). Their attractiveness as an income strategy has consequently decreased, owing to the fact that the Mainland China and Hong Kong property markets have shifted to a new normal where growth is now slower compared to pre-pandemic levels.
In terms of bonds, our preference is for short-term issuances with the yield curve currently being inverted. Under these circumstances, yields for short-term bonds are higher than that for longer-term bonds, meaning that negative carry will cause higher capital losses for longer-term bonds as they approach maturity. In that sense, choosing short-term bonds is a way to avoid this situation.
All in all, we believe maintaining a diversified asset allocation approach that spans across multiple asset classes can help income-focused investors in Asia enhance their overall returns. In our view, have rather similar weighting between stocks and bonds in income portfolios make good sense in the current environment. Asian equities, especially those from the Mainland China and Hong Kong markets, appear to be relatively more attractive than their global peers. Once market sentiment improves, and when further supportive measures are introduced, these types of portfolios will likely offer considerable capital gains, while at the same time provide a stable source of dividend income.