Income stocks: economic recovery pays dividends

We discuss the outlook for income stocks.

Key points

• Dividends have rebounded strongly and much faster than normal following a recession.
• In the US and Europe, payout ratios are below pre-Covid levels, creating room for further dividend growth if economies continue to do well and providing a buffer if growth doesn’t come through.
• Income stocks are attractively valued versus the broader market.

Dividends have rebounded strongly and much faster than normal following a recession. While the dividend recovery of individual companies varies, most regions, with the exception of the UK, should see 2021 dividends exceed pre-pandemic levels. The recovery has been especially strong in cyclical sectors or sectors that have seen the biggest impact from the lockdown of economies. Sectors like health care and technology, which benefit from strong secular growth trends, have also continued to grow. Profit margins are expected to hit new all-time highs in the coming year – not only in the US, where the technology sector has led to continued margin expansion in the past, but also in the rest of the world.

As long as the economic recovery continues, we expect dividends to benefit from the tailwind created by the strong positive improvement in company earnings that goes hand in hand with the economic upturn. Indeed, thus far, the earnings recovery has been ahead of the dividend recovery. As a result, dividend cover has increased, suggesting that there is scope for further upside in distributions and certainly implying that current dividend levels are sustainable. What is more, it means that there is a larger buffer in place than there was pre-Covid in the event that economic recovery stalls. We believe that 2020 should be seen as a hiatus in the income generation from equities, rather than a permanent structural change. For those reasons, we believe investors that need income should keep faith in equities.

Inflationary pressures, which have been building as a result of increased state intervention and the unification of monetary and fiscal policy, have been exacerbated by Covid-related lockdowns, leading to supply shortages. We expect some of this rise in inflation to be temporary, as price pressures in commodity, raw-materials and goods sectors diminish as supply shortages ease. However, others may be permanent – for example, with regard to wages – and we therefore expect inflation to settle at a higher rate than we have become used to. This is likely to lead to higher bond yields, and the US Federal Reserve has been clear that it will look to taper its bond purchases and ultimately to raise interest rates. This might be thought of as a negative backdrop for income stocks, but we would note that dividends tend to grow with inflation, providing a degree of protection; our Global Equity Income strategy, for example, has increased its exposure to the financial sector considerably over the last 12 months, as this area appears set to benefit from higher bond yields. Finally, so far this year periods of rising bond yields have been positive for income stocks on a relative basis as investors rotated out of growth stocks.

While income stocks recovered at the beginning of the year, from mid-May onwards technology stocks have reasserted themselves and income stocks have lagged once again as the Covid-19 Delta variant has taken hold and bond yields have fallen once more. We expect the pattern of rotations in leadership between income/value and growth to continue, but we are very positive on the longer-term prospects for income stocks, as we believe valuations remain attractive versus the broader market. With dividends recovering and offering an attractive spread over fixed-income assets like government, corporate and high-yield bonds, we see their attractions as being only enhanced.

Authors

Jon Bell

Portfolio manager, Equity Income team