Why dividends matter in a low growth, high inflation environment

Sam Slator 19/07/2023 in Equities, Multi-Asset

With interest rates at 5% and likely to rise higher, investors could be forgiven for thinking cash is currently a better home for their savings and investments than equities.

And for some lower risk investors or those that need to access their money in the short term, this will indeed be the case.

However, with inflation remaining stubbornly in the high single digits, the real value of cash will erode quite quickly over longer periods. So, for longer-term investors, equities – and particularly those that produce an income – are still very relevant.

A decade for dividends?

“Dividend stocks have typically outpaced the broader market index during periods of inflation,” commented Julie Dickson, Investment Director, Capital Group. “In an equity market where growth is slowing and fears of a global recession are mounting, we believe it is important to focus on companies with stronger balance sheets and cash flows,” she continued. “Sustainable dividends don’t lie, and dividends could become a much bigger part of the total return equation compared to the past 20 years.”

The managers of the Guinness Global Equity Income fund have the stats to back up this sentiment. “From 1940 to 2020, dividends accounted for, on average, 48.9% of the total return from the S&P500 Index,” they said. “However, when we look at the two lower-growth decades – the 1940s and 1970s – we see dividends played an even greater role, on average contributing over 75% of total returns. Even in high-growth decades such as the 1990s or 2010s dividends still accounted for over 25% of the overall total return. The driving force behind this is the relative stability of dividend payments compared to earnings.”

Mark Peden, global equity income strategy co-manager at Aegon, believes we are entering a “decade for dividends”.

“I’m predicting a record high for dividends this year and there is a cushion if earnings fall or there is disappointment in the next couple of quarters, because pay out ratios are below average,” he said. “Regime change in markets means it is now highly supportive of dividends. The split of S&P 500 returns over time shows that dividends play a much greater role in inflationary environments for total returns.  Stocks with high dividend yields in particular have outperformed the market during periods of high inflation since 1970.”

This is a view echoed by his colleague, Vincent McEntegart, manager of Aegon Diversified Monthly Income, “The 2020s could be a decade for dividends and one that delivers attractive returns for equity income investors,” he said.

Explaining the power of dividends in an inflationary backdrop

“The two main characteristics of an inflationary backdrop are the challenge to real returns and the volatility that it brings to asset class return profiles,” explains Nick Clay, manager of the TM Redwheel Global Equity Income fund.

“The chart below shows how 1970s inflation waxed and waned, as central banks failed to keep monetary conditions tight long enough to defeat inflation. Hence, causing waves of inflation and volatility in equity returns – as demonstrated in the S&P500 returns over that period.

Source:Bloomberg as at 15th May 2023

Past performance is not a guide to future results. The information shown above is for illustrative purposes.

How can equity income help in such an environment?

“Companies can grow dividends over time to compensate investors for inflation,” Nick said. “The chart below demonstrates how during the 1970s, the 12 month dividend growth of the S&P500 was able to keep up with the Consumer Price Index.”

Source: Bloomberg as at 15th May 2023

Past performance is not a guide to future results. The information shown above is for illustrative purposes.

“When a strategy actively generates the greater part of its total return from compounding a dividend over time, this, by virtue of compounded income being less volatile than capital returns, should help reduce the overall volatility of the return stream.

“We believe the importance of an approach that requires an active selection of quality companies with a decent dividend yield at the right valuation to survive an inflationary backdrop. Managed with discipline, this approach has a chance of growing the investors real wealth slowly over time.

Adrian Gosden, GAM UK Equity Income

“Equities in general are a very good tool when you’re investing in an inflationary environment,” agrees Adrian Gosden, manager of the GAM UK Equity Income fund.

“But the real importance about UK equities is they come with a good dividend.

“If you think about inflation out there in the region of 10%, how are you going to do better than that? The answer is to start with a 5% dividend and grow that through the period of the year; things like cash or bonds don’t have that growth element. And, as a result of that they will struggle in an inflationary environment, whereas UK equities should do really quite well.”


Photo by Juliane Liebermann on Unsplash

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