On February 8, AltsDb co-founder Jimmy Atkinson hosted Jay Hatfield, founder and CEO at InfraCap, for a comprehensive one-hour webinar tailored for financial advisors. The live event delved into nuanced income investing strategies designed to navigate the complexities of the current macroeconomic landscape. The discussion provided actionable insights for advisors seeking to optimize their clients’ portfolios in an environment marked by persistent uncertainty and evolving economic indicators. An audio version of this informative webinar, including a brief introduction by Andy Hagans, is now available.
The Enduring Appeal of Income Investing
The webinar commenced with an exploration of why income investing has garnered such significant attention, particularly among high-net-worth and ultra-high-net-worth individuals and their advisors. Jay Hatfield articulated that income generation forms the bedrock of a robust and high-quality portfolio, especially for those nearing or in retirement. He shared an anecdote about assisting a high school friend who had recently parted ways with his previous advisor. Upon reviewing the friend’s portfolio, Hatfield noted a substantial lack of yield, exacerbated by high fees. By constructing a diversified portfolio with a target yield of 4% to 5%, comprising both bonds and equities, the friend gained the financial confidence to retire. This illustrates how a strategic focus on income can provide essential financial security, enabling individuals to meet their expenses without the pressure of continuous work.
Hatfield emphasized that for more conservative investors, a consistent income stream is not merely a desirable feature but a crucial component for maintaining financial sanity, particularly during periods of market volatility. Knowing that income is being generated, even when market headlines appear bleak, allows for strategic reinvestment at lower prices and potentially higher yields. Furthermore, he highlighted that income streams tend to be less volatile than stock prices, often demonstrating growth even amidst market downturns. This fundamental principle, he stated, guides InfraCap’s own investment philosophy and is applied to their personal portfolios, underscoring their conviction in these strategies for a broad range of investors.
Economic Outlook and the Year Ahead for Income Investors
Reflecting on the challenging market conditions of 2022, which saw significant declines in both the bond and public equity markets, and a comparatively stronger performance from alternative investments, Hatfield offered his perspective on the economic outlook for the coming year. He noted that InfraCap had correctly anticipated the market’s downturn in 2022, particularly concerning tech stocks and speculative assets like cryptocurrencies and meme stocks. The rationale behind this negative outlook was rooted in the Federal Reserve’s aggressive monetary tightening, which involved a substantial reduction in the money supply. Hatfield pointed out that the Fed’s reduction of the money supply by nearly 20% last year, primarily through open market operations rather than solely interest rate hikes, was a key driver of the pain felt across capital markets, impacting both bond and stock prices.
Conversely, for the current year, InfraCap projected a top-decile target for the S&P 500 at 4,500. This optimistic outlook is attributed to the expectation that the bulk of the Fed’s monetary tightening is now behind us. Hatfield elaborated on a complex mechanism known as reverse repo operations, through which the Fed managed to withdraw approximately $2.5 trillion from the financial system. He expressed surprise that this aspect of monetary policy was not more widely understood, as it played a critical role in liquidity reduction.
He anticipates that the Federal Reserve will implement two more rate hikes, as previously indicated, but will refrain from further cuts. Despite the usual correlation between Fed rate hikes, cooling housing markets, and potential recessions, Hatfield identified post-pandemic tailwinds—specifically, shortages in housing and automobiles, coupled with a robust labor market—as mitigating factors against a severe economic downturn. The resilience of the labor market is particularly noteworthy, as it is rarely strong during periods of Fed tightening. The core bullish argument rests on the Fed’s anticipated halt in rate hikes, signaling a more favorable environment for investors.
Navigating Inflationary Pressures and Deflationary Forces
A significant point of discussion revolved around the Federal Reserve’s approach to inflation. Hatfield expressed a strong conviction that the Fed is "completely out to lunch on inflation," suggesting they are not utilizing the most effective indicators. He posited that high inflation is primarily driven by two factors: loose monetary policy, which fuels housing inflation, and energy price shocks. He drew parallels to the 1970s, a period characterized by similar shelter inflation and significant energy price surges. In contrast, he argued that the labor market, while influential, is not the primary driver of high inflation, citing the Phillips Curve as a potentially misleading indicator in this context.
Hatfield introduced his firm’s proprietary index, CPI-R (Consumer Price Index-Real), which he claims has turned negative over the past four months, indicating deflationary pressures at an annualized rate exceeding 4%. This index differs from the Bureau of Labor Statistics’ (BLS) methodology by incorporating housing prices rather than relying on the lagged estimate of owner’s equivalent rent. He asserted that housing prices have historically predicted the shelter component of CPI with a 70% correlation, albeit with a 12-month lead. This forward-looking indicator, he believes, makes CPI-R a more relevant gauge of inflation.
He detailed how goods prices, including shelter, and energy price shocks contribute to inflation. When goods prices rise, workers demand higher nominal wages to maintain their standard of living. Conversely, as inflation plummets, real wages rise, leading to a slackening demand for nominal wage increases. The Fed, in his view, overlooks these dynamics. While acknowledging the Fed’s intention to raise rates twice more and maintain them, Hatfield maintained that this policy, while potentially not optimal, would not cripple the economy.
The S&P 500 Target and Market Dynamics
InfraCap’s target of 4,500 for the S&P 500 is based on a projected price-to-earnings multiple of 18.5 times 2024 earnings estimates. This multiple is derived from an anticipated 3% yield on the 10-year Treasury note. Hatfield cautioned against investing solely in the riskiest stocks, such as those in the NASDAQ or Bitcoin, until the Fed’s policy stance is fully resolved. He anticipates a range-bound market, with 4,200 serving as a significant barrier. However, he also noted that the risk leans towards the upside, as the market appears to be aligning with the view that inflation is declining and that the Fed’s response is misaligned.
He reiterated that a major recession is not anticipated, which he believes sets the stage for a substantial rally as the uncertainty surrounding Fed policy diminishes. While advocating for following the Fed’s cues, as demonstrated by their negative stance in 2022, Hatfield sees a potential halt in rate hikes as a significant bullish signal.
The Role of Bonds and Fixed Income Alternatives
The conversation then shifted to fixed income and its role in a diversified portfolio. Hatfield projected that the 10-year Treasury yield would settle around 3%, a scenario he considers very bullish for bonds. This forecast is supported by several factors, including the aging global population and the resulting increase in demand for fixed-income assets from well-funded pension plans. With approximately $52 trillion in global pension assets, a substantial portion of which is in the U.S. (150% of GDP), these plans represent significant potential buyers of bonds.
Furthermore, he highlighted the attractiveness of U.S. bonds on a global scale, noting that U.S. yields are considerably higher than those in Canada, Germany, France, and Portugal. This global perspective underscores the value proposition of U.S. fixed income.
Within the fixed-income alternatives space, Hatfield discussed several asset classes:
- Treasuries: Currently offering decent yields, they remain a foundational element.
- Municipal Bonds: Offering slightly lower yields than Treasuries but with reduced interest rate risk.
- Corporate Bonds: Becoming increasingly attractive with yields around 5.4%.
- Preferred Stocks: A key focus for InfraCap, offering average yields around 6%. Hatfield noted that by diversifying beyond the financials sector, which dominates cap-weighted indices, investors can achieve significantly higher yields, with InfraCap’s own REIT preferred fund yielding over 7% and another fund approaching double digits. These securities are presented as having modest stock market risk, typically around half that of common equities.
- High-Yield Bonds: Attractive at current yields of around 9%, offering lower correlation to the stock market than preferreds.
- Senior Loans: While not directly managed by InfraCap, they are acknowledged as an asset class with lower beta to the stock market and decent yields, though not as compelling as other alternatives.
Hatfield recommended a diversified approach across these asset classes to construct a robust bond portfolio, emphasizing that adding preferred stocks and high-yield bonds can significantly enhance overall portfolio yield.
Equity Income Strategies and Asset Allocation
On the equity side, Hatfield discussed strategies for generating income, with a focus on large-cap dividend stocks. He highlighted that these stocks, historically known as "dividend aristocrats," have delivered nearly the same returns as the NASDAQ since 1991, but with significantly lower volatility and superior income generation. This makes them particularly appealing for conservative investors.
InfraCap’s own large-cap dividend fund, ICAP, employs a strategy that leverages low leverage and preferred stock investments to achieve yields well above the index it tracks. With a current SEC yield of 9.54%, the fund aims to provide well-covered dividends that are largely qualified, offering favorable tax characteristics.
Preferred stocks, in general, are strongly recommended by Hatfield, especially for clients lacking exposure to them. He noted that they are currently trading at attractive discounts to their call price, offering the potential for equity-like returns when they revert to par. While waiting for this potential appreciation, investors receive good dividends, with InfraCap’s flagship preferred stock fund, PFFA, yielding over 9%. The safety of preferred dividends is enhanced by the fact that companies often prioritize them over common dividends to maintain investment-grade credit ratings.
Master Limited Partnerships (MLPs) were also discussed, with Hatfield acknowledging past investor concerns stemming from their previous structure as growth stocks with high leverage. However, he emphasized that large-cap MLPs have since restructured, improving dividend coverage, retaining earnings for growth, and reducing leverage. This has made them a more stable and attractive investment, despite the potential complexity of K-1 filings for individual investors (InfraCap’s corporate structure avoids this).
Regarding asset allocation, Hatfield suggested that even younger investors should incorporate a fixed-income component for rebalancing purposes. For a hypothetical 30/70 portfolio (30% fixed income, 70% equity), yields could reach 4.67%, increasing to 6% with a higher fixed-income allocation. He stressed the importance of equity income, as achieving desired yields necessitates income from the equity portion of the portfolio, not just the traditional low yields of broad market indices.
Yield Metrics and Market Valuations
A technical question arose regarding the distinction between various yield metrics, such as SEC yield and distribution yield. Hatfield explained that SEC yield is an estimate mandated by the SEC, intended to reflect the income generated by a portfolio based on dividend yields, minus expenses, at a specific point in time. Distribution yield, conversely, represents the actual payout to investors. He advised advisors to look for funds where the SEC yield is at or above the distribution yield to avoid returns of capital and ensure that the dividend is adequately covered by income.
Addressing the valuation of publicly traded funds compared to private funds, Hatfield acknowledged that public market securities, such as preferred stocks, are currently trading at significant discounts to their intrinsic value, citing preferreds trading at 21 when their call price is 25. This contrasts with private market valuations, which he suggested might be artificially inflated. He argued that this discount in the public market represents an opportunity for investors to acquire assets at attractive prices, particularly within ETFs that trade close to Net Asset Value (NAV), mitigating the risk of premiums often associated with closed-end funds.
Conclusion and Future Outlook
In conclusion, the webinar provided a comprehensive overview of income investing strategies tailored for the current economic climate. Jay Hatfield of InfraCap offered a balanced perspective, acknowledging potential market volatility while presenting a case for strategic opportunities in fixed income, preferred stocks, dividend-paying equities, and revitalized MLPs. The discussion underscored the importance of a well-diversified portfolio, sound economic analysis, and a nuanced understanding of monetary policy to achieve robust income generation and capital appreciation. The availability of the webinar recording and presentation materials offers financial advisors a valuable resource for refining their income-focused investment strategies.
