On February 8, AltsDb co-founder Jimmy Atkinson hosted Jay Hatfield, founder and CEO at InfraCap, for a comprehensive one-hour webinar aimed at financial advisors. The session, designed to navigate the complexities of the current economic climate, focused on income investing strategies, offering actionable insights for advisors seeking to build robust portfolios for their clients. The webinar has since been made available as an audio podcast, featuring a brief introduction by Andy Hagans, further extending its reach to a wider audience within the alternative investment community.
The Enduring Appeal of Income Investing
The webinar commenced with an exploration of why income investing continues to be a cornerstone strategy, particularly for high-net-worth and ultra-high-net-worth individuals and their advisors. Jay Hatfield articulated that income generation is fundamentally linked to the core of a high-quality portfolio, especially for those approaching or already in retirement. He shared a compelling anecdote about a high school friend who, after being ill-served by a previous advisor, found financial security through a diversified portfolio yielding 4% to 5%. This income stream, composed of roughly half bonds and half equities, provided the necessary financial cushion to enable early retirement, highlighting the psychological and practical benefits of predictable income.
Hatfield emphasized that for more conservative investors, a reliable income stream is crucial for maintaining financial "sanity," especially during periods of market volatility. Knowing that income continues to be generated, even when asset prices fluctuate, allows for strategic reinvestment at lower prices and potentially higher yields. This stability, he argued, provides confidence, as income streams tend to be less volatile than stock prices and often exhibit growth over time, even amidst downturns. InfraCap’s own investment philosophy, deeply rooted in this principle, sees the firm itself as a significant holder of its exchange-traded funds (ETFs), underscoring their conviction in these income-focused strategies for all investor demographics, not just retirees.
Economic Outlook and the Path Forward for Income Investors
Reflecting on the challenging investment landscape of 2022, which saw significant downturns in both bond and public equity markets, Hatfield offered his perspective on the economic outlook for the year ahead. He acknowledged that 2022 was a difficult year for traditional assets, but noted that alternative investments often perform comparatively well in such environments.
Hatfield recounted InfraCap’s prescient negative stance on the market in 2022, particularly concerning tech stocks and speculative assets like cryptocurrencies and meme stocks. The rationale, he explained, was rooted in the Federal Reserve’s aggressive monetary tightening. The Fed’s reduction of the money supply, primarily through open market operations rather than solely interest rate hikes, was a significant factor draining capital from the financial markets and consequently driving down both bond and stock prices. This contractionary policy, he noted, was a key driver of the pain experienced by investors throughout the year.
For 2023, InfraCap projected a top-decile target for the S&P 500 at 4,500. This bullish outlook was predicated on several factors, chief among them being that the bulk of the Fed’s monetary tightening appeared to be behind us. Hatfield elaborated on the Fed’s use of reverse repo operations, a mechanism to absorb liquidity from the financial system, noting the significant scale of this operation and its impact on the money supply. He posited that the Fed’s balance sheet reduction, coupled with these reverse repo operations, had effectively removed substantial capital from the economy.
Conversely, he anticipated that the Fed would implement two more rate hikes, but stressed that a significant recession was not on the horizon. This optimistic view was supported by several post-pandemic tailwinds, including persistent shortages in housing and automobiles, sectors that would typically experience significant downturns during a typical tightening cycle. Furthermore, the labor market remained robust, a rarity during periods of Fed rate hikes. The core of his bullish sentiment rested on the expectation that the Fed would ultimately halt its rate hikes, creating a more favorable environment for equity markets. He projected that long-term rates would settle around 3%, a development he viewed as highly positive for the bond market.
However, Hatfield cautioned that the market’s rapid ascent early in the year presented its own set of risks, particularly as companies transitioned from earnings season to a period dominated by macro data and hedge fund activity.
A Deep Dive into Inflation and Monetary Policy
A significant portion of the discussion revolved around Hatfield’s strong views on inflation and the Federal Reserve’s approach to managing it. He asserted that the Fed was "completely out to lunch on inflation," contending that they were not utilizing the correct indicators. His firm’s proprietary real-time inflation index, CPI-R, which calculates inflation using housing prices as a leading indicator for the shelter component of the Consumer Price Index (CPI), had turned negative, indicating deflationary forces at play. This index, he explained, mirrored the pre-1982 methodology of the Bureau of Labor Statistics (BLS), offering a more forward-looking perspective than the BLS’s current estimations, particularly concerning the lagged owner’s equivalent rent.
Hatfield identified two primary drivers of high inflation: loose monetary policy, which fuels housing price inflation, and energy price shocks. He drew parallels to the 1970s, a period marked by similar housing inflation and significant energy price surges. He argued that the Fed’s reliance on the Phillips Curve, which links inflation to labor market conditions, was misplaced, as the labor market, barring pandemic-induced disruptions, had historically been stable. The volatile monetary policy, he contended, led to volatile asset and housing prices, exacerbated by energy shocks.
He highlighted the sharp decline in natural gas prices, a significant component of energy costs, as a key deflationary signal. This deflationary pressure, he argued, would eventually lead to a slackening demand for nominal wages, as real wages would rise. The Fed’s failure to fully appreciate these dynamics, he suggested, was leading to an inappropriate monetary policy.
Implementing a Balanced Portfolio for Income and Growth
The webinar then transitioned to practical portfolio construction, emphasizing the benefits of a balanced approach that incorporates both income generation and potential for growth. Hatfield presented asset classes categorized by their correlation to U.S. Treasuries and the broader stock market, providing a framework for advisors to construct diversified portfolios.
Fixed Income Alternatives:
Hatfield discussed various fixed income alternatives, including Treasuries, municipal bonds, corporate bonds, preferred stocks, high-yield bonds, senior loans, and the firm’s own preferred stock ETFs. He highlighted that preferred stocks, when strategically selected beyond the heavily weighted financial sector, could offer yields well over 7%, with some InfraCap funds yielding close to double digits. These instruments, he noted, provided attractive yields with modest stock market risk, typically around half the volatility of common equities.
Equity Income Strategies:
On the equity side, Hatfield discussed utilities, REITs, telecommunications, Master Limited Partnerships (MLPs), and high-dividend yield stocks. He expressed a preference for large-cap, high-dividend stocks, citing their historical performance, which has delivered nearly equivalent returns to the NASDAQ with significantly lower volatility and superior income generation. He also noted the potential for REITs to be depressed, offering an opportunity for attractive returns as cap rates normalize.
Portfolio Construction Examples:
To illustrate the impact of asset allocation on income generation, Hatfield presented hypothetical portfolio yields. A 30% fixed income/70% equity portfolio could yield approximately 4.67%, while increasing the fixed income allocation could push yields to 6% or even 7% for a more conservative 70% fixed income portfolio. He stressed the importance of incorporating equity income to achieve higher overall portfolio yields, especially for investors seeking to avoid drawing down principal.
Key Asset Classes for Income Generation
High Dividend Large-Cap Stocks:
Hatfield championed large-cap dividend-paying stocks as a lower-risk alternative to small-cap equities, offering lower betas, better credit ratings, and a longer track record of dividend payments. He highlighted the performance of InfraCap’s ICAP fund, which leverages modest leverage and preferred stock investments to achieve yields exceeding 7%, significantly outperforming the broader market’s dividend yield.
Preferred Stocks:
Preferred stocks were strongly recommended, particularly given their current trading levels. Hatfield explained that preferreds trading at a discount to their call price offered the potential for equity-like returns upon reaching par, in addition to their attractive dividend yields. He emphasized the importance of active management in this sector to avoid securities trading above par, which carry call risk. InfraCap’s flagship preferred stock fund, PFFA, was noted for its high SEC yield and superior performance relative to other preferred stock ETFs.
Master Limited Partnerships (MLPs):
Hatfield addressed the historical stigma associated with MLPs, explaining that the asset class had undergone significant restructuring. Modern MLPs, he noted, were better capitalized, had lower leverage, and offered well-covered dividends, making them a more stable and attractive investment. He suggested that energy prices were likely to remain strong, providing support for MLP valuations.
Navigating Yield Metrics and Market Valuations
The webinar also delved into the nuances of yield metrics, distinguishing between SEC yield and distribution yield. SEC yield, a mandated calculation by the Securities and Exchange Commission, provides an objective estimate of a fund’s income based on its holdings and expenses. Distribution yield, on the other hand, represents the actual cash payout to investors. Hatfield stressed the importance of ensuring that distribution yields are well-covered by SEC yields to avoid return of capital notices and maintain the integrity of the Net Asset Value (NAV).
Regarding market valuations, Hatfield acknowledged that publicly traded assets, including preferred stocks and REITs, were trading at discounts compared to their privately held counterparts. He attributed this to market inefficiencies and investor sentiment. This disconnect, he argued, presented opportunities for astute investors to acquire undervalued assets through ETFs and closed-end funds, which typically trade at or near Net Asset Value.
Conclusion and Future Outlook
In conclusion, Jay Hatfield reiterated his conviction that income investing strategies remain highly relevant and effective, particularly in the current uncertain macroeconomic environment. He emphasized that a balanced approach, incorporating a diversified mix of income-generating assets, could provide both financial security and opportunities for capital appreciation. The webinar concluded with an interactive Q&A session, addressing specific investor concerns regarding the yield curve, the financial sector, and optimal asset allocation for blended growth and income portfolios. The overarching message was one of cautious optimism, with a focus on strategic asset allocation and a deep understanding of market dynamics to navigate the evolving economic landscape.
