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Inflation has been a recurring theme. For a year, I’ve argued that higher inflation was more than a transitory response to Covid and supply-chain bottlenecks.
I’ve written that loss of purchasing power will be the big investment risk for many investors over the next few years. Maintaining real returns (inflation) will be hard as annual inflation rises from the current 3.5%.
To be clear, I don’t believe Australia is on the cusp of a 1970s-style inflation breakout, although the risks of higher-than-expected inflation are rising. Nor do I agree with predictions of looming stagflation: high inflation and low growth.
But it would not surprise to see inflation at 4-5% within 12-24 months as pressure on wages, energy and other input costs intensifies. That’s a huge impost on investors.
Consider what this means for retirees who live off portfolio income. Their cash and government bond investments provide almost no return with rates near zero. On Australian equities, they face lower returns this year after a few years of outsized returns following the Covid low.
Many retirees are struggling to live on single-digit portfolio returns as it is (unless they have millions stacked away). If inflation climbs to 4-5%, the real return on that portfolio will be even less attractive as the retiree’s purchasing power is eroded.
Were we to follow the US experience – it had 7.9% annual inflation in February – the real return on Australian equities could be closer to zero, assuming our equities market delivers a single-digit return this year.
What should income investors do? The starting point is having a higher equities allocation in portfolios. The old 60/40 split (growth and defensive assets) will not provide a sufficient total return with rates near zero. Many investors will need at least a 70/30 split but holding more growth assets exposes the portfolio to higher risk.
The next step is focusing on equities with an attractive, sustainable dividend yield. This thinking has informed my positive view on bank stocks over the past few years. In April 2020, I argued that Australian banks offered the best value in a decade. They were horribly oversold at the time and will benefit now as interest rates rise.
Of course, there are more moving parts to investing in banks than the interest-rate outlook. A slowing economy would dampen credit growth and increase the risk of bad debts. Moreover, competition from non-bank lenders is rising, off a low base.
But I still believe banks can outperform in this market. European banks and, to a lesser extent, US banks, look undervalued compared to their Australian peers.
Australian bank shares are a mainstay for many income investors. But after share-price gains this year, bank yields have eased. The Commonwealth Bank has a forward dividend yield of 3.6% in FY22, according to consensus analyst estimates. National Australia Bank is expected to yield 4.5%; ANZ and Westpac should yield a bit above 5%.
Again, if Australian inflation is 4-5%, the real return on bank-share yields would be almost zero (that’s before franking credits and any capital gains).
Parts of the resource sector will deliver better yield. I’ve always avoided buying mining stocks for yield because commodity prices can be volatile and hard to predict. Investors are better off owning banks, utilities, property trusts or infrastructure for income.
But as inflation rises and purchasing power falls, investors will look further afield for yield. The resource sector stands out for two reasons. First, as I wrote last week, commodities and banks are the best sectors to own when inflation expectations rise.
Second, commodities generally have reasonable medium-term prospects due to supply challenges. Claims that commodities are on the cusp of the next great ‘supercycle’ look overstated, but rising resource-sector earnings in the next few years should underpin higher dividends.
However, Australia’s big mining stocks look fully valued at the current price, after outperforming the market. When choosing resource stocks for yield, stick to the biggest and the best: there’s enough risk in mining without chasing small miners for yield.
Here are three mining stocks with attractive yields:
Stock price chart of BHP Group (BHP).
On Morningstar’s numbers, BHP will yield 8.9% in FY22 and 8.4% in FY23 at the current $51.41 (before franking).
That yield is attractive for income investors and BHP should meet or exceed market forecasts for dividend growth, given recent gains in commodity prices. This is ideal timing for BHP and other miners to return more cash to shareholders.
The issue is valuation. BHP is slightly overvalued based on a consensus price target of $49.56. That might not worry long-term income investors who are more interested in achieving a double-digit yield (after franking) for at least the next two years from one of this market’s highest-quality companies.
Stock price chart of Woodside Petroleum Limited (WPL).
Like other large energy stocks, Woodside has rallied this year, amid surging oil prices after Russia’s invasion of Ukraine. Woodside’s total return over 12 months is 58%.
The consensus analyst forecast has Woodside yielding a bit over 6% in FY22 at the current $33.74 (before franking). The consensus target share price is $30.55.
The market view on Woodside is too bearish. Some research houses believe Woodside’s earnings-per-share will almost double in FY22 due to soaring oil and gas prices. Energy prices won’t stay sky-high forever, but if Woodside’s earnings take off as expected, it will trade on a single-digit Price Earnings (PE) multiple in FY22 and FY23.
Surging earnings could see Woodside surpass market expectations on the dividend, as it returns more cash to shareholders in a boom year.
Longer-term, the expected merger of Woodside and BHP Group’s oil-and-gas portfolio has strong strategic rationale. After years of underperformance in the energy sector, the timing could not be better to create a top-10 energy company globally.
Stock price chart of Rio Tinto Limited (RIO)
I considered Fortescue Metals Group (FMG) for the third spot on this list. Fortescue has an expected yield of almost 10% (before franking credits) based on the consensus forecast. Who thought Fortescue would become one of the great yield stocks?
However, I prefer Rio Tinto over Fortescue (for income investors) for a few reasons. The first is valuation. Even though Fortescue is well off its 52-week high ($26.58), the stock looks a touch pricey at $21.66. The consensus target is $17.45 and most brokers have ‘hold’ or ‘sell’ recommendations.
That said, Fortescue has looked overvalued for a long time, yet kept rising because brokers underestimated its earnings growth. In contrast, Rio Tinto is trading slightly below the consensus target and in my view has less valuation risk.
The second reason is China. I’m concerned about a faster spread of Covid in China and what that will do to the country’s economic growth and metals demand. A slowing China is bad for commodity demand generally, but particularly so for Fortescue, given its reliance on iron ore. Rio Tinto, too, relies heavily on China and iron ore. However, Rio’s greater diversification gives it an edge over Fortescue for income investors.
At $118.55, Rio is expected to yield about 10% in FY22 (before franking). The company has had its problems with management and board changes after its destruction of two ancient Aboriginal caves in the Juukan Gorge in Western Australia in 2020. But Rio has a strong balance sheet and seems intent on returning more funds to shareholders.
The consensus price target for Rio is $121.35.
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. All prices and analysis at 7 April 2022. This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.