Look at alternatives to seek income goals

Both stocks and bonds have been on a tremendous run over the last three years. After such a stretch of strong performance, a period of more modest returns would not be unexpected or unhealthy for the markets. It could, however, challenge many investors who have grown accustomed to double-digit returns from their traditional 60% equity/40% bond balanced or moderate growth portfolios.

Financial professionals understand the scope of these challenges, in an investing climate where the risks from inflation, interest rates, high valuations and market volatility are increasing. A recent survey by ETF Trends, conducted on behalf of Nationwide Financial, found that nearly nine out 10 financial professionals are at least somewhat concerned about achieving their clients’ income needs over the next three years. More than one-quarter of those surveyed said they were “very concerned” about these income goals.

With the prospect of more modest returns for stocks and bonds, financial professionals are seeking opportunities in other asset classes to help clients meet their income goals. According to the ETF Trends survey, nearly eight in 10 financial professionals are comfortable with using non-traditional income strategies for their clients. About half (46%) currently use non-traditional income strategies with clients. Another 35% would consider doing so.

Change in the Weather

Last month, I wrote about the about the shift in the weather for equities, as the many tailwinds that lifted the stock market to record levels are changing to headwinds. Stocks have demonstrated impressive resilience over the last three years, with the S&P 500® Index averaging an annualized return of 25% since the end of 2018, thanks to solid corporate earnings growth and expanding valuations. Earnings growth over this time averaged around 8% per year, so the remainder of the S&P 500® Index’s return can be explained by multiple expansion, primarily from the high-flying tech stocks that comprise the largest stocks in the Index.

As of this writing, the S&P 500 Index trades at a price/earnings multiple of 21.4-times estimated forward earnings for the next 12 months (NTM). For comparison, over the last 25 years the NTM price/earnings multiple has averaged 16.3-times forward earnings. P/E valuations at these present levels have not been common; it’s only occurred 15% of the time since the 1990s, mainly during in the dot-com bubble days of the late 1990s and the pre-pandemic days of 2020.

Some explanations for the current lofty valuations are reasonable; interest rates are low, earnings revisions have been strong and the performance of the tech heavyweights have had an outsized influence on the Index as a whole. But more recently, earnings revisions have slowed from the rapid pace of recent quarters. Moreover, a potential increase in the corporate tax rate, if enacted as part of the next federal spending bill, is estimated to knock around 2 percentage-points off of future earnings growth.

If earnings slow down over the next three years (admittedly, a big “if”) and the valuations contract from their high level (which we consider a good possibility), then average returns for the S&P 500 are likely to drop into the single digits. That’s not terrible in the long-term view, but also it’s not what many investors have come to expect in recent years from the equity holdings in their 60/40 portfolios.

What About Bonds?

In traditional 60/40 portfolios, bonds typically serve as a counterweight to stocks and their higher volatility. For investors planning their drawdown strategies and taking income from their portfolios, bonds may also offer an important source of yield.

Bond investors have also enjoyed mainly good times in the last three years, benefitting from falling rates and narrowing credit spreads. Bonds’ positive returns helped a balanced 60/40 portfolio (60% S&P 500; 40% Bloomberg U.S. Aggregate Bond Index) average a 12% annualized return since the end of 2018 and an 11% annualized return over the past 10 years. But similar to stocks, there are rising risks on the fixed income side of the traditional 60/40 portfolio that could challenge clients’ income goals.

If stock investors appear optimistic given the continued rise in equity markets, bond investors are a more skeptical bunch. The next step for interest rates is likely higher, as the Federal Reserve begins to back off monetary policy accommodation by tapering asset purchases first, followed by incremental hikes in the Fed funds target rate. Reading the tea leaves in Fed fund futures market, the bond market seems to expect the Fed to get more aggressive with rate hikes than what Fed Chair Powell has thus far indicated (although it should be stated that Fed futures have historically been a poor barometer for the direction of Fed policy changes.)

The current yield of the benchmark Bloomberg U.S. Aggregate Bond Index is presently at 1.7% with a duration of 6.8. If interest rates increase modestly over the next three years, returns for the bond index would be roughly 1% annualized. That doesn’t provide much of a buffer to stocks in a 60/40 portfolio, especially if equity returns also moderate to the single digits. Rising inflation poses a threat to bond investors’ ability to generate adequate income and maintain the purchasing power of their returns. If rising prices prove to be more lasting than transitory and outpace interest rates, real yields on fixed income investments could turn negative.

The Alternative View

Facing the prospect for more modest returns for both stocks and bonds, investors may want to consider broadening their balanced portfolios beyond the traditional 60/40 allocation to seek returns that help meet their income goals. With large-cap stocks hovering at valuations higher than historical averages, asset classes that are priced at lower premiums, such as value, small-cap and international stocks, may offer opportunities for return at more reasonable valuations. Moreover, with stock indexes dominated by the tech behemoths (at present, the 5 biggest stocks comprise nearly one-quarter of the S&P 500’s market capitalization,) actively managed equity strategies may offer the potential for lower risk over the overly-concentrated passive index funds.

For the bond side of the portfolio, other income-producing investments such as credit-sensitive bonds, dividend-focused equities and alternative income strategies may provide adequate yields to help investors satisfy their income needs.