Top 5 Questions for Income Investors in 2024

Key Questions

1. Will the US avoid a recession in 2024?
2. Have we seen the peak in interest rates?
3. Why should I own anything other than cash?
4. Should I own investment grade bonds or high yield?
5. Can dividend stocks outperform?

2023 brought a welcome reprieve to investors via improved market returns vs. 2022. Yet, many investors have been absent in the rebound, choosing to sit on the sidelines to wait for more certain times. There is a record USD $5.9T of capital in money market funds today. ¹ We think this is the wrong approach for long-term investors. There continues to be more compelling opportunities for investors that can be accessed through diversified portfolios. Below we seek to uncover these opportunities and address some of the most asked questions by clients.

1. Will the US avoid a recession in 2024?

We believe there are several potential paths to consider for the US economy next year, including upside and downside scenarios. In the end, the key factors to watch will be the labor market and inflation. Without a significant spike in unemployment or reaccelerating inflation, it’s hard to see a US economy that comes to a screeching halt. We believe a modest softening in growth would be welcomed by markets as it will allow the Fed to end their rate hikes and eventually move rates lower. In short, we are positioning for a backdrop that will show a slowdown but no hard landing, moderating inflation, and a Fed that is likely done with its hiking campaign.

So far, the US economy has proven more resilient than most expected. Inflation has subsided without a substantial hit to the labor market that many anticipated. While some tailwinds to growth are fading, there are also reasons to believe growth will continue to hold up well. Notably, consumers remain in healthy shape evidenced by higher net worth, lower debt burdens, and positive real wage growth. A similar story of strength exists for US corporates. Consider that S&P 500 borrowing costs remain close to the lowest level in 48 years and the median S&P 500 stock has an interest coverage ratio of 8x.² We also saw a substantial easing of financial conditions towards the end of the year which cuts in a positive direction for US growth.

Chart 1: U.S. unemployment, inflation and rates

On inflation, prices have clearly inflected lower versus last year’s peak (headline CPI of 3.1% vs. 9.1% in June 2022), hitting the lowest levels in two years. As supply and demand dynamics have come into better balance and consumers normalized spending habits, goods prices have fallen sharply. What’s been “stickier” and likely to keep inflation above central bank targets for longer has been the service side of the economy (e.g., shelter). Encouragingly, service inflation has also shown signs of moderating, and we believe rental inflation has much further room to fall. A similar story of moderating inflation now exists across Europe, although we are more cautious around the growth outlook there. 

We expect China to remain a key source of uncertainty for 2024. Until we see more signs of stabilizing growth and/or a larger government response, we will continue to take a cautious stance.

Our bottom line: Risks remain, yet a hard landing in the US seems unlikely. Being too defensive will likely bring opportunity costs.

2. Have we seen the peak in interest rates?

Closely connected to the recession question is the future path of policy rates in the developed world. Going back to 1974, the average length of time from the last Fed rate hike to the first rate cut has been roughly five months, albeit with a lot of variability.³ It’s already been more than five months since the last Fed hike (July 2023), so clearly cuts will take longer than average this time around.

Although, we are inching closer as the Fed acknowledged in their December meeting.

Despite the Fed’s more dovish tone to end 2023, we believe markets have too aggressively priced in easing in 2024. Markets now reflect more than a 150bps drop in the Federal Funds Rate as shown in Chart 2. While the Fed has now broached the topic of recalibrating policy in 2024, that will require continued progress back towards the Fed’s 2% inflation target. Our base case is that the Fed will begin easing policy in 2024, but we think a later start and lower magnitude of easing are likely relative to what’s reflected in expectations today. A similar story exists across Europe.

Chart 2: Market pricing for Fed policy rates in 2024

For investors, what will matter the most will be the catalysts for rate cuts when they do come. Are the Fed and other central banks cutting because inflation has slowed to more tolerable levels or because growth has fallen off sharply? The latter would likely prove much more challenging to risk assets. This is not our base case, but something investors should consider. 

Ultimately, we believe we are moving to an environment where duration (interest rate sensitivity) will move from being your enemy to being your friend. This is a good thing for multi-asset portfolios. That said, where you own duration will matter. We remain cautious on the long-end due to the elevated level of issuance expected from the US Treasury and the sharp rate rally at the end of the year. 

Our bottom line: We think we’ll stay above the zero-rate world we recently left, barring an unforeseen growth shock. We view this as a good thing for the savers of the world and multi-asset income portfolios. It means more income and diversification opportunities will be available for longer. 

3. Why should I own anything other than cash?

For starters, we expect most asset classes across rates, credit, and equities to outperform cash in 2024 under our base case. It’s true the Fed and other central banks don’t appear to the be on the cusp of drastic rate cuts, but when you extend your horizon, you can clearly see the risk of holding too much cash. To better understand this dynamic, we looked back over the last 30+ years to quantify the relationship between starting yield and future total returns.

The link between cash yields today and future returns is weak. Why? Because there is no guarantee that prevailing yields one or three months out, when that hypothetical cash-like instrument matures, will still be as high as the initial investment rate. In other words, the durability of cash investments’ return stream is unpredictable. As the chart below illustrates, the dispersion of forward returns for cash at various yield levels is quite wide, and a higher starting yield does not necessarily translate to a favorable three-year return experience.

Chart 3: Initial yields vs. subsequent 3-year total returns

In contrast, for a blended multi-asset portfolio comprised of global dividend stocks, investment grade bonds and high yield, starting yields had a much more positive predictive relationship with ensuing three-year returns. This is due to reduced sensitivity to short-term rate policy, brought about by owning fixed-rate investment grade and high yield bonds, which allow investors to “lock-in” higher starting yields for a longer period. This can be a powerful return driver especially when combined with the greater upside potential of equities.

Our bottom line: Investors can achieve attractive income and total return using a multi-asset approach with the added benefit of portfolio diversification again.

4. Should I buy investment grade over high yield bonds?

In hindsight, many investors were too early to this trade. For example, a rotation out of US high yield into US investment grade bonds would have cost investors about 9% in total return going back to the start of 2022. Nonetheless, the question for investors today is should they stick with the higher quality bond theme.

Firstly, we agree the yield available in high quality bond markets is much more attractive today and these areas should represent a larger allocation in portfolios versus years past. For instance, the average yield across short-term investment grade bonds, investment grade collateralized loan obligations (CLOs), and agency mortgage-backed securities (MBS) is 5.2% today vs. 1.8% at the end of 2021.⁴ We have been taking advantage of these higher rates by shifting up in credit quality, most notably in our more conservative strategies. Many of these areas also look particularly attractive versus cash as you can lock in higher quality yields for longer.

That said, longer-term investors that are avoiding high yield entirely may be leaving some income and return on the table. Consider that the current 7.6% yield of the US high yield index is ~0.5% above that of the average annualized return of US equities since 2000.⁴ Said another way, there are pockets of credit markets that we think can provide equity-like returns. Historically, high yield has also had about 60% of the volatility of global stocks.⁵ Another area to consider for US dollar investors is European high yield hedged back to the US dollar. This hedging results in an additional 1.5% in yield today.⁴ European high yield is also a higher quality market on average compared to the US.

Chart 4: Bonds yields from 2021 to 2023

Overall, we are constructive on high yield with one important caveat - owning the lowest quality bonds in a slowing environment requires caution. A higher cost of capital backdrop will likely lead to an uptick in defaults in 2024 with lower quality exposures being most exposed. Thus, we are staying selective and have most of our exposure in BB and B rated bonds. Where we do own lower rated bonds, it is diversified across high conviction names, rather than broad beta exposure. Lastly, we think investors should proceed with caution on more distressed areas like pockets of US commercial real estate, Asian property bonds, and lower rated floating rate bank loans.

Our bottom line: We think investors should have an allocation to both investment grade and high yield bonds due to the attractive yield levels available today and lean more into the latter the longer your time horizon is.

5. Can dividend stocks outperform?

One of the most notable trends of 2023 was the AI led outperformance of the Magnificent 7 versus everything else. As a result, we saw a significant divergence in returns between market cap and equally weighted indices (e.g., +26.3% vs. +13.8% for the S&P 500, respectively). Consequently, US mega cap tech is now one of the most expensive areas of markets.

For example, the Nasdaq index has a forward P/E of 38 which is up from 26 since the middle of 2022, this compares to 18 for S&P Equally Weighted Index which is only up 4 points from last year’s lows.⁶

In a similar vein, dividend stocks significantly lagged broad markets in 2023. For instance, the S&P High Dividend Index returned +3.9% last year. Dividend growth stocks, represented by the Morningstar US Dividend Growth Index, fared better at +9.6%, but still sharply underperformed growth equities. As a result, dividend stocks continue to screen as cheap relative to their own history and relative to broad markets which are increasingly dominated by growth stocks. This means the bar for future gains is lower for dividend stocks and these stocks stand to benefit more should the equity rally broaden out.

We continue to favor those stocks that are higher quality with a history of growing dividends. We think this approach makes sense in a more uncertain macro backdrop like today and has proven effective over time. Take the example of Company A (manufacturer of snacks and beverage products). Looking at just its dividend yield of 2.3% wouldn’t tell the full story of its potential. The stock has an equity beta of 0.72, has doubled in price over the last ten years, and grown its dividend by an annualized rate of 11.7%.⁶ Those are powerful attributes for income investors!

Chart 5: Dividend Stock Example

Importantly, income investors shouldn’t abandon growth stocks altogether just because they trade at higher multiples. Those portfolios that were underexposed to such sectors and themes in 2023 significantly lagged, and the trends around technology have staying power in our view. Rather, one consideration for income investors is to gain some of this growth equity exposure through covered calls. By selling calls on growth stocks investors can diversify their sector exposures beyond traditional dividend sectors like consumer staples, generate additional income in their portfolios, and allow for some equity upside participation.

Our bottom line: Dividend stocks remain cheaply priced and have proven a powerful asset to own over time. A Fed on hold and a soft landing in the US should allow the equity rally to broaden out beyond just mega-cap tech.