The Income Investor: time to exploit economic uncertainty

Income seekers can be forgiven for feeling somewhat downbeat about the investment outlook for 2025. After all, following what proved to be a challenging 2024, the prospects for mainstream income-producing assets remain uncertain.

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A flight to cash

Indeed, inflation has ticked higher over recent months. It rose from 1.7% in September to 2.6% in November and, despite a dip to 2.5% in December, the Bank of England expects the cost of living to remain at or around its current level throughout much of this year. This suggests that the central bank’s capacity to cut interest rates may be more limited than many investors had previously anticipated. After all, it is difficult to justify a period of sustained monetary policy easing when prices are rising at a rate that is substantially higher than the Bank of England’s target. It is even more challenging to do so when inflation is not expected to meet the 2% target for the foreseeable future.

A slower pace of interest rate cuts than previously expected could mean that the performance of the UK economy remains subdued. Indeed, its flat performance in the third quarter of 2024 suggests that it continues to be hamstrung by a period of restrictive monetary policy. And while the two rate cuts made last year are unlikely to have yet had their full impact on GDP growth due to the presence of time lags, further monetary policy easing may not offer a growth catalyst for the UK economy until post-2025 for the same reason.

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In such an environment, the default response of income investors may be to retreat to the apparent safety of cash. After all, a flatlining economy is unlikely to provide an operating environment that is conducive to profit or dividend growth, as well as capital returns, in the short run. Income investors may also be concerned that difficult trading conditions for companies could make the prospects for corporate bonds less upbeat. And with ongoing uncertainty surrounding fiscal policy contributing to a recent spike in gilt yields, it would be unsurprising if government bond prices come under further pressure.

Dividend appeal

However, cash is set to offer a falling income return over the coming months. Although monetary policy easing is now likely to take place at a slower pace than previously expected, bank rate is still nevertheless widely anticipated to move lower during 2025. And while inflation is forecast to hover just below 3% this year, it is then set to fall to the central bank’s target over the coming years. This means that the return on cash could fall year on year as interest rate cuts continue, thereby compounding the reduction in income received from savings accounts over the medium term.

Source: Refinitiv as at 15 January 2025. Bond yields are distribution yields of selected Royal London active bond funds (as at 30 November 2024), except global infrastructure bond which is 12-month trailing yield for iShares Global Infras ETF USD Dist as at 13 January. SONIA reflects the average of interest rates that banks pay to borrow sterling overnight from each other (13 Jan). *Data prior to May is based on 3-month GBP LIBOR. Best accounts by moneyfactscompare.co.uk refer to Annual Equivalent Rate (AER) as at 13 January.

Dividend stocks, in contrast, could offer a superior income return to cash not only in 2025, but also over the long run. A wide range of FTSE 350 shares currently have dividend yields that are substantially higher than the 4.5-5% interest rate available on cash savings. And with interest rate cuts set to prompt a gradual improvement in their operating environment, while inflation is due to fall to the Bank of England’s 2% target by the end of 2027, real-terms dividend growth could prove to be far more positive than many investors currently realise. This could prove to be a key differentiator versus bonds, where the income element is, of course, fixed.

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Certainly, dividend stocks could yet experience heightened volatility due to an uncertain outlook for the economy following its 0% growth rate in the third quarter. However, in many cases, higher-yielding dividend stocks offer wide margins of safety. For example, they may trade at only a modest premium to net asset value or have a low price/earnings (PE) ratio. This means that investors may have already factored in tough operating conditions in the short run, thereby providing scope for capital growth to complement their income return over the long term.

A generous dividend yield

For example, FTSE 100-listed real estate investment trust (REIT) British Land Co (LSE:BLND) has a dividend yield of 6.7%. This is almost twice the 3.7% yield of the FTSE 100 and compares favourably to the income returns available on other mainstream assets such as cash and bonds.

A relatively high yield also suggests that the company offers a wide margin of safety. Indeed, its shares currently trade at a 36% discount to net asset value. This indicates that investors have priced in the prospect of a challenging near-term outlook for the commercial property industry amid the economy’s uncertain outlook. As such, the stock could deliver attractive capital growth alongside its generous income return.

An upbeat long-term outlook

Since the trust was first discussed in this column during August 2023, its shares have risen by around 3%. This is lower than the FTSE 100 index’s 9% gain over the same period. However, with the company being firmly focused on the UK, versus the large-cap index’s reliance on the global economy, it has failed to benefit from relatively strong economic performance elsewhere.

Now, though, it is well placed to capitalise on a gradual decline in interest rates over the coming years that should have a positive impact on both the UK economy and the company’s operating environment. For example, lower borrowing costs have the potential to increase demand for commercial property. This could support price rises that prompt the aforementioned discount to net asset value to narrow as investors no longer feel the requirement to factor in future declines in property prices.

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Indeed, the company’s half-year results showed that the value of its portfolio rose by 0.2% in the previous 12 months. This compares with a 2.6% decline in its latest full year and a 12% slump in the 2023 financial year.   

Demand growth

A gradual easing of monetary policy could also have a positive impact on demand across the trust’s portfolio. As part of its overall strategy, it has sought to increase its exposure to retail parks due in part to their popularity among omnichannel retailers. Such locations now account for 32% of its portfolio, versus just 15% in 2021, with lower interest rates likely to prompt renewed demand among consumers.

In turn, this could mean stronger operating conditions for retailers that provides support to rental income growth in what is an increasingly important part of British Land’s portfolio. This could equate to higher profitability and rising dividends over the coming years.

Risk/reward ratio

The company appears to have a relatively solid financial position through which to overcome what remains an uncertain near-term economic outlook. Although its loan-to-value (LTV) ratio rose by 140 basis points to 38.7% in the first half of the year, this figure could moderate if the value of its portfolio continues to rise. And with interest rates due to fall over the coming years, it may be able to reduce debt servicing costs as it refinances existing borrowings.

Clearly, British Land’s share price could experience heightened volatility in the short run if the economic outlook remains challenging. Dividend growth could also prove to be a very gradual process, with shareholder payouts rising by just 1% in the first half of the year, as time lags mean that interest rate cuts are unlikely to have an immediate impact on its operating environment.

However, investors appear to have priced in an uncertain near-term future for the company. With it offering a generous yield, a sound strategy and upbeat long-term prospects, the company appears to have a favourable income investing outlook.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.