Is it time to turn to cyclicals for income?

With inflation moving back up to 2.9% in August, obtaining a real return may become more difficult for investors. Certainly, there are a number of popular income shares which are likely to offer income returns in excess of inflation. However, they may become more in-demand if inflation keeps rising, and this may cause their yields to compress.

One solution could be to buy cyclical stocks with above-inflation dividend yields. They may lack the track record of dividend stability of more obvious choices, and their financial performance may not be as robust or predictable as defensive income stocks found in sectors such as utilities and tobacco. However, they may provide a real income return as well as capital growth in the long run.

Higher inflation

An inflation rate of 2.9% is hardly surprising given the political and economic risks facing the UK. Within two years, Brexit will have taken place. Prior to that date, uncertainty surrounding the economic outlook could increase. After Brexit, it could rise to even higher levels. This may weaken sterling even further versus a basket of major currencies and higher inflation than today may be the end result.


Under more normal circumstances, the Bank of England would be expected to tighten monetary policy in response to higher inflation. However, in the case of Brexit-induced inflation, this may not be possible. Concerns about GDP growth and unemployment may overshadow the potential problems brought about by higher inflation. Therefore, a ‘new normal’ of 3%+ inflation may be the cost of Brexit in the medium term.

Cyclical appeal

Given the prospect of higher inflation, stocks which have not been particularly popular for their income appeal may become increasingly in-demand among income investors. They may lack the defensive characteristics of companies such as National Grid (LON:NG.) and Imperial Tobacco (LON:IMB), but their long term earnings outlook may in fact be superior. When combined with a sufficiently high dividend coverage ratio, this may make them relatively appealing.

For example, stocks such as WPP (LON:WPP) and easyJet (LON:EZJ) may face an uncertain outlook, but their prospective dividend yields of 4.5% and 3.5% respectively are expected to be well covered by profit at 2 times apiece.

Further, they are forecast to grow their bottom lines next year and this may create scope for a rise in dividends which is ahead of the rate of inflation. With both companies having well-proven business models and being dominant players in their respective industries, they could deliver sustained profit growth in the long run.

Risks

Undoubtedly, WPP and easyJet face riskier outlooks than more defensive high-yield shares. WPP recently downgraded its guidance for the near term, citing a weak trading environment. Similarly, easyJet may be impacted by a slowdown caused by Brexit, with a possible tapering of QE in the medium term having the potential to cause its sales to come under pressure.


However, the two companies have high yields which are well covered. Their long term earnings growth potential remains high. So, for investors who can cope with a degree of volatility and uncertainty, they could be a sound means of beating higher inflation.

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