Higher Interest Rates after a very long time will turn Investor attention to Dividend Growth

Higher Interest Rates after a very long time will turn Investor attention to Dividend Growth

The US Federal Reserve will meet in a couple of days  and I  expect it to  increase interest rates. This would mark its only hike in 2016, despite early year indications of many more. The path thereafter is less clear, though growing reflationary forces, reinforced by a probable fiscal expansion under US president elect Donald Trump and new appointments to the Fed board, could imply a more hawkish central bank down the road.

In any case, I believe government bond yields have seen their lows. The 35-year bull market in bond prices is facing sunset; higher yields and steeper yield curves are on the horizon. Income seekers, for years tormented by low bond yields, may welcome the prospect of rising rates.

Yet structural changes to the global economy, ageing populations, weak productivity and the debt overhang following the financial crisis are a notable offset. These should limit growth and, with a glut of savings in emerging markets, put a cap on how high rates go. As such, yields are likely to reside in a lower range than they have historically.

That means investors should not turn away from equities for income. I believe dividend growth stocks remain one of the most fertile fields for income seekers. Equities become the key income source as low economic growth and excess global savings helped push bond yields to record lows. Equities today provide more than 70 per cent of the income in a global 60 per cent to 40 per cent stock-bond portfolio, my analysis shows, even after the recent rise in bond yields. This compares with an average of just 46 per cent since 1990.  I expect equities to remain the key source of income for investors even as bond yields rise.

A rise in rates could hurt high yielding dividend stocks with premium valuations and low growth rates, so-called bond proxies. Yet it does not weaken the case for all dividend paying equities. In fact, it reinforces our preference for dividend growers.

As overall portfolio returns are likely to be lower over the next five years, dividend income is likely to become a larger component of return. This is particularly true when you consider that bond yields have bottomed and stocks have little room to run amid high valuations and tepid earnings growth.

I see dividend growth stocks, quality companies with enough free cash flow to sustain dividend increases over time, having an upper hand in this environment. They are less susceptible to rising rates than high yielders.

Dividend growers also have a clear return advantage relative to bonds. As rates rise and bond prices fall, many of these stocks could generate positive returns thanks to the power of compounding dividends and earnings growth. My analysis shows valuations of global developed stocks would need to fall some 30 per cent over the next five years to generate negative returns, a very unlikely scenario.

Part of the reason bond yields are rising is that growth and inflation expectations are rising. Higher inflation expectations also favor dividend growth companies, which are typically able to raise prices, and payouts, in reflationary environments.

Both the search for income and the strong case for dividend growers are global trends. Yield opportunities are scarce throughout the world, and the need for equity income remains high as retired populations increase and investment income is challenged to supplant pay cheques.

But dividend growth opportunities exist across sectors and regions. US financials, for one, may have appreciation potential given the steepening yield curve, the prospect of looser regulation and investors filling long-held sector underweights. In addition, I can see US bank revenues benefit more than in past rate-hiking cycles as the Fed raises rates slowly. With little competition for deposits in this cycle, banks should be able to earn more on loans without a commensurate increase in deposit rates.

One tailwind for US investors may be tax reform. If a repatriation tax on US earnings held overseas were enacted, US companies’ cash flows would enjoy the windfall, a potential positive for dividend growth. Technology stands out in this regard.

Rising bond yields are a headwind for income stocks. But I believe a focus on dividend growth is still likely to offer both income and potential for attractive relative returns.

-Farzan Ghadially