Shelter from Storms: Dividends Demand Attention

This is a tumultuous time for clients. As of June 10, the Bloomberg US Aggregate Bond Index and the S&P 500 are down 10.5% and 17.7%, respectively, year-to-date.

As is being widely noted, not much is working among traditional asset classes and that unpleasant situation could be around for some time. The May reading of the Consumer Price Index (CPI) checked in at a staggering 8.6% increase, which was far worse than expected and keeps the gauge at 40-year highs.

An obvious result of continually dour inflation numbers and essentially no progress on that front is the Federal Reserve must continue raising interest rates. Alright, so advisors and clients already knew that rate tightening  is likely to carry into next year. That’s the result of the Fed being tardy to the inflation-fighting party. What wasn’t known a few months ago was the intensity at which the central bank could hike rates. Following the aforementioned CPI reading, there’s speculation the Fed’s next rate hike could be 75 basis points.

All of that is to say, these are trying times for income investors. Rising rates ensure Treasuries are anything but risk-free and inflation is eroding purchasing power, potentially compelling some investors to go it alone and embrace risky high-yield fare. Fortunately, a familiar concept – dividend stocks and funds – could be the elixir to get clients through this less-than-hospitable climate.

Better Than Bonds? Perhaps.

Advisors that have been in business awhile, say multiple decades, know that from around the time Paul Volcker took the lead at the Federal Reserve in the 1980s until about 2010, Treasuries were an income investor’s delight. However, nothing lasts forever.

Starting around 2010, the real returns on 10-year Treasuries that were bought at inception and held to maturity actually turned negative,” according to S&P Dow Jones Indices. “The prospects haven’t improved much by now either: based on the relative prices of inflation-protected and standard Treasury bonds, real returns for 10-year Treasury bonds bought today are expected to be around 0.”

Not long after that, domestic dividend growth started taking off in notable fashion. For several years, that growth was hindered by the inability of banks – once a reliable source of payout growth – to boost dividends in the wake of the global financial crisis. Other sectors picked up the slack and even with rampant cutting during the coronavirus bear market of 2020, dividends hit records in 2021, continuing to do so in the first quarter of this year.

As such, dividends are becoming a more significant part of the income investing equation and data suggest the same is true as a percentage of household income. Add to that, there’s room for this trend to continue in favor of dividends, potentially at the expense of government bonds.

“According to data from the Bureau of Economic Analysis, dividends as a share of Personal Income have climbed from 3.2% in Q1 1980 to 7.3% in Q1 2022, whereas interest income has declined in share from 16.2% to 9.2% over the same period,” adds S&P Dow Jones. “In other words, dividends are indeed becoming more important, in both absolute and relative terms, to the average U.S. household’s ‘income statement.’”

Inflation Situation

Historically, dividends and, more importantly, payout growth, have been important parts of the inflation-fighting equation. Today, advisors need to help clients keep their eyes on that ball because it’s not reasonable to expect payouts to grow at a rate of 8%-plus.

However, the dividend/inflation data favor clients if they’re patient, which they should be when investing for equity income.

“Taking a closer look at the S&P 500®, dividends paid out by index constituents rose from USD 140.1 billion in 2000 to USD 511.5 billion in 2021, corresponding to an increase by a factor of 3.7x and a compound annual growth rate of 6.4%,” concludes S&P Dow Jones. “The rise in consumer prices, on the other hand, averaged just 2.3% over the same period. “The significant spread between the dividend growth rate and the inflation rate over the past two decades, which translated to an increase of over 130% in the purchasing power of dividends paid out by S&P 500 constituents.”

Related: It Could Pay to Be Mindful of Mid Caps