Rates Rising? Inflation? … A Case For Dividend Growth
Published: November 25, 2016
After the longest bull run for bonds in history, does the election of Donald Trump as president of the U.S. signal looming inflation and an inflection point for markets? Should investors sell bonds and other interest rate sensitive securities to embrace a Trump inspired, pro-growth economy in the United States? Will fiscal policy and monetary policy in the U.S. finally lead to higher interest rates?
These are questions portfolio managers are asking themselves and their advisors following the U.S. election. It seems clear to market watchers that some ‘smart money’ is voting with their portfolios and asset allocators are moving to equity sectors that will most benefit from the expected policies and many promises that President-elect Trump campaigned on.
For money managers like legendary Bill Miller, who admitted recently that he positioned portfolios to be short treasuries and long financials, the ‘Trump rally’ has paid off. For others who shorted the market in anticipation of a flight to quality based on the uncertainties of a Trump presidency, they have suffered badly and part of the post-election rally was likely short covering.
Is it as simple as investing in banks because of expectations of less regulation and interest rates moving higher that has prompted this stock market bullishness? Have investors finally raised the white flag and sold bonds in anticipation of higher rates or is this just a normal rotation into equities because of a greater potential for earnings growth going forward?
Let’s consider current asset allocation theories.
Many investors are overweight equities with portfolios that hold high dividend paying stocks. Interest rates have been so low for so long that the traditional reasons for holding bonds make no sense. Bond coupons do not meet the income requirements for many so they turn to stocks with attractive dividend yields to compensate. The decisions to hold dividend stocks are often made with little or no fundamental analysis of the companies including the ability for these companies to maintain their dividends. When oil prices declined by more than 50 per cent some of the mighty high yielding energy stocks actually cut dividends because fundamentals for these companies deteriorated. If investors did not anticipate this through good fundamental research, then they failed to position their yield seeking portfolios appropriately.
There is considerable agreement now that interest rates will rise because of Federal Reserve policy combined with the added pressures from a Trump plan to increase spending on infrastructure and give tax cuts to business. Both are inflationary. In fact, there is a new market moniker called ‘Trumpflation.’ We have not seen pressure like this for years even though the Fed tried to manufacture inflation through a low rate policy.
For investors who sought yield by investing in fixed income alternatives such as mortgage funds and high yielding equities, it is now time to consider the impact of rising rates on these vehicles. Credit quality may deteriorate if companies have leveraged their balance sheets with cheap money. This will surely change fundamentals over time. Investing is about forward looking analysis and ultimately de-risking portfolios. Rising interest rates are the biggest and most significant market risk right now. Those managing portfolios should approach asset allocation with this scenario in mind.
Consider an equity investment thesis that has been proven over decades and especially worthy of consideration at this critical inflection point. It is simply called dividend growth investing. It has proved consistent through all market cycles generating both rising income and capital appreciation over time. This strategy is embraced by many institutional investors in the ‘return seeking’ bucket or core component of pension fund portfolios with longer investment horizons. Dividend growth investing focuses on companies that regularly increase dividends. For large institutions such as pension funds, endowments, and foundations investing in a dividend growth strategy not only provide rising incomes to pay benefits and obligations, it also has a lower volatility than the market itself. A good dividend growth manager will ultimately be a stock picker focusing on fundamentals and avoiding those companies that do not have strong records of consistent dividend increases. This usually means eliminating a large number of companies right upfront then picking the very best companies after meeting stringent dividend increase tests.
Stocks that continually raise dividends by 20 per cent a year consistently provide an ever-increasing return on investment. Consider the ‘power of compounding’ in this example. Look at a $20 stock paying a 40¢ annual dividend – a two per cent yield. If that company grows its dividend at just 10 per cent annually, the dividend will grow to $2.69 after 20 years. The annual yield on the original cost of the investment will rise from two per cent to over 13 per cent. Growing dividends provide more than an attractive income stream. They also produce capital appreciation, based on the capitalized value of the growing income stream. If the stock’s yield remains constant at two per cent, the $2.69 dividend should drive the stock price from $20 to over $130 over a 20-year time horizon (see Exhibit 1).
Over the last several years of low interest rates, monetary policies did not have to deal with inflation growth within their economies. This may change with pro-growth fiscal policies. For investors, recent muted inflation has not impacted portfolios, but even a three per cent inflation rate can erode half the value of a retirement portfolio over 25 years. Dividend-paying stocks have outpaced inflation generally but significantly over long time horizons (see Exhibit 2).
NB – This text goes under Exhibit 2:
The Barclays Capital Equity Gilt Study2010 cited in Kleinwort Benson, ‘Dividend Growth: The Key to ‘Real’ Investment Success’ (December 2013)
When inflation does reappear and monetary policy shifts to a rising rate stance, it will change investor behaviour. In an equity example, rising interest rates will likely force investors to sell dividend yielding stocks and consider replacing them with strategies not materially impacted by interest rates. Dividend growth is a realistic option because historically the companies paying increased dividends over time are solid companies that will generate earnings growth that support consistent dividend growth. A dividend growth portfolio has lower current yields and, therefore, is not impacted by rising rates.
It is important to de-risk an investment portfolio by selecting appropriate strategies before major events occur. Investors who understand economic cycles and reversions to the mean know that higher interest rates and inflation may be just around the corner.
Jamie Colliver is with Bristol Gate Capital Partners.