Economists and strategists continue to argue vehemently about inflation risks – whether the combination of fiscal and monetary stimulus and a postpandemic business recovery will push prices and wages sustainably higher. The stakes are high for dividend investors because income-generating sectors have historically underperformed significantly in inflationary environments.
I’m not about to arbitrate the “will there/won’t there be inflation” argument. But, using real estate investment trusts as an example, we can estimate when it’s time for dividend investors to worry about inflation’s negative effects on income-paying stocks.
The rising bond yields that come with inflation are the biggest problem for dividend stocks. As the yield on risk-free government bonds approaches the yield on dividend stocks, investment assets shift from income-oriented equities into bonds, and dividend stocks underperform.
The first accompanying chart shows how this works, using REITs as a proxy for income sectors. Each dot represents the yield advantage for REITs versus 10-year Government of Canada bonds (the REIT index yield minus the bond yield) and the performance of the S&P/TSX REIT Total Return Index in the following two years.
For example, the red dot (it’s from November, 2008, but dates aren’t relevant for this type of chart) shows that when the REIT index yielded 7.7 percentage points more than the 10-year bond (X-axis), the cumulative return for the REIT index in the next two years was 59 per cent. The chart covers all months since December, 2005, as far back as the data allow.
The upward sloping trend line shows clearly that future returns on REITs rise with the difference between REIT yields and bond yields. Importantly, the trend line cuts the X-axis at around 3 per cent – when average REIT yields are three percentage points more than 10-year bonds. This means that when the yield difference on the REIT index is three percentage points or less than the bond yield, investors can expect flat or negative returns in the following 24 months.
Currently, the indicated yield on the REIT index is 4.7 per cent and the yield on the 10-year bond is 0.87 per cent, for a difference of about 3.8 percentage points. So if inflation drives the bond yield 0.8 of a percentage point (or 80 basis points) higher, this would drop the yield advantage of the REIT index down to three percentage points, indicating flat future returns.
The second chart is reproduced from the work of Bank of Nova Scotia strategist Hugo Ste-Marie, whose thesis is that REITs underperform as the domestic yield curve steepens (that is, the difference between two-year and 10-year Government of Canada bond yields increases). Steeper yield curves are also a function of rising inflation expectations.
REITs underperform as the domestic
yield curve steepens
S&P/TSX Composite Index divided by
S&P/TSX REIT Index (left scale)
Yield curve steepness: 10Y Gov’t of Canada
bond yield minus 2Y bond yield
(right scale, basis points)
300
35
250
30
200
25
150
100
20
50
15
0
-50
10
2017
2009
2021
2013
THE GLOBE AND MAIL, SOURCE: BLOOMBERG
REITs underperform as the domestic
yield curve steepens
S&P/TSX Composite Index divided by
S&P/TSX REIT Index (left scale)
Yield curve steepness: 10Y Gov’t of Canada bond yield
minus 2Y bond yield (right scale, basis points)
300
35
250
30
200
25
150
100
20
50
15
0
-50
10
2007
2017
2009
2019
2021
2011
2013
2015
THE GLOBE AND MAIL, SOURCE: BLOOMBERG
REITs underperform as the domestic yield curve steepens
S&P/TSX Composite Index divided by S&P/TSX REIT Index (left scale)
Yield curve steepness: 10Y Gov’t of Canada bond yield minus 2Y bond yield
(right scale, basis points)
300
35
250
30
200
25
150
100
20
50
15
0
-50
10
2007
2017
2009
2019
2021
2011
2013
2015
THE GLOBE AND MAIL, SOURCE: BLOOMBERG
The purple line on the chart measures the relative performance of the S&P/TSX Composite Index and the S&P/TSX REIT Index by simply dividing the main benchmark’s level by the REIT index. A rising line indicates that the S&P/TSX Composite is outperforming the REIT index.
The period between March, 2009, and July, 2012, is the clearest example of the historical pattern. The falling purple line indicates that REITs are outperforming the broader benchmark while the yield curve (blue line) flattens. Historically, REIT performance moves inversely to the yield curve – outperforming the TSX as the yield curve flattens and underperforming as the curve steepens.
Since February, 2020, the yield curve has been steepening – from minus 0.16 per cent to 0.65 per cent – and true to form, REITs have been underperforming. The S&P/TSX Composite has generated a 3.5-per-cent total return since February of last year while the REITs benchmark is down 19.2 per cent.
The takeaway here is that inflation is bad for dividend stocks but it’s important for investors to recognize that rising inflation pressure is not a foregone conclusion. Morgan Stanley chief U.S. economist Ellen Zentner forecasts that U.S. inflation will hit 2 per cent in 2021 and will “overshoot 2 per cent [annually] on a sustained basis from 2022 onwards.” But, there are others, such as CIBC economist Royce Mendes, who believe that price pressure will recede after a brief spike higher in the latter half of 2021.
Investors don’t need to take a side on this debate, but should be watching bond yields and the yield curve carefully for signals that portfolio changes are necessary.
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Scott Barlow