Being an investor prioritizing current yield simplifies the process of portfolio management by encouraging rotation out of assets that are currently favored in favor of less favored assets. Two of the names we own(ed) are driven by factors related to infrastructure assets and hospitality, both yielding about 4% based on current stock prices. I have liked and held both of these names for years.
Distinct from the above mentioned factors, two factors (among many) that investors dislike today are sensitivity to equity prices and unemployment. Based on the economic commentary I’ve recently encountered, the consensus thoughts revolve around the stock market being overly optimistic given the potential “higher for longer” rate environment. Many people on TV or in print suggest that the Fed will follow through with higher rates through ’23, contrary to futures predicting rate cuts later this year. Additionally, they argue that in light of higher rates persisting, equity prices must decline – “it’s just math.” I find it hard to disagree with this reasonably simple and logical analysis.
However, it also strikes me that all the chips have been placed in the bet that equity prices will decrease significantly on this basis, with few being placed in the concept that prices might not decline dramatically or might even go up. Personally, I tend to favor situations where the reasons for such outcomes are unclear, but because everyone has invested heavily in one side, you can earn modest returns if the high probability scenario materializes, but substantial gains if it doesn’t. We have purchased a modest position in a business that will generate modest earnings if equity markets remain stagnant, while having the potential for elevated capital generation if markets rise or fall. Furthermore, it yields well above 4% and is a qualified dividend to boot.
Moving on to unemployment, names that are sensitive to consumer credit are trading at levels that anticipate a significant increase in unemployment. There is a strong correlation between unemployment and losses in consumer credit because when individuals lose their jobs, they often struggle to service their credit. However, to paraphrase Jeffries analyst John Hecht, we have likely already experienced the steep climb of an interest rate cycle, inflation, rapid capital market disruption, and the delinquency cycle. The only cycle that has yet to experience a significant climb is unemployment. And as previously mentioned, the relationship between unemployment and losses is well known and predictable.
Therefore, consumer credit names, both bank and non-bank, that are underwriting to 5-6% unemployment today and have already reserved (due to CECL) for those figures on the back book, may have less to worry about regarding credit losses compared to the market’s projections. The positive aspect of this situation is that these names have been priced accordingly, at least until the market’s recent jump in early June, meaning you don’t have to bet against things getting worse. You can still do well if things do indeed get worse, and you can thrive if things don’t turn out to be as bad as feared.
While I may have digressed a bit, the original thought behind this article was that in the search for yield, I naturally am encouraged to shift away from factors where there is an explainable positive outlook and move toward factors with less clear positive outlooks, as of today. And while it is an unoriginal thought, yield prioritization makes the old adage “buy low, sell high” a much more simple exercise versus assets that don’t pay you.