Morningstar's "Perspectives" series features investment insights from third-party contributors. We hear from JP Morgan Asset Management Chief Global Strategist David Kelly and JP Morgan Asset Management US Equities Client Portfolio Manager Christian Preussner.
Global stock markets may be stuck in the doldrums, but collecting dividends from equity holdings looks like a far better strategy than relying on the barren fields of cash and fixed income. In particular, an optimistic outlook for dividend growth in US equities could make them an interesting alternative for UK equity income investors fatigued by slumping dividends.
UK dividends fell by 5% in the first three months of the year, dividends are actually growing in the US
US equities are only up a modest 1.8% in the last 18 months whereas UK and European indices are in negative territory or treading water. However, the average investor in large-cap U.S. stocks could have picked up a further 3.3% via dividends over the same period. While 4.6% over 18 months doesn’t sound overwhelming, it beats inflation and cash returns over the same period of time.
Stocks are still struggling to find direction, but argues a solid economic foundation and a brighter outlook for earnings make equities an interesting spot for investors to collect income as they await the next leg in the markets. The fact that absolute stock valuations in the US are at close-to-average levels – meaning equities are neither cheap nor expensive on a historical basis – is another reason to consider their relative income advantages.
Most US companies are actually growing, generating a huge amount of cash, and are focused on shareholder returns, with the ever growing band of activists snapping at the heels of any that disappoint. Even in a world of modest growth, investing in US equities still looks sensible.
Corporate America Sits on a Lot of Cash
Corporate America is in good financial shape, with reasonably strong fundamentals. As shown in the chart below, they are sitting on record high cash levels with plenty of ways to reward investors through dividends, buy backs or to make acquisitions.
In the US, the dividend yield on the S&P 500 is roughly 0.3% above the 10-year Treasury yield. While that is not unusual relative to recent history, it never happened once in the 50 years between 1958 and 2008. In fact, since 1957, 10-year Treasury yields have averaged 3.2% above S&P 500 dividend yields, as investors have gladly accepted lower quarterly checks in return for potential price appreciation.
US Beats UK on Dividend Outlook
Whilst Britain is falling behind on dividend generosity, dividends are actually growing in the US. UK dividends fell by 5% in the first three months of the year, against global growth of 2.2% to $218 billion, according to Henderson Global Investors. Despite the drag from struggling energy and basic materials companies cutting their pay-outs in response to plunging earnings, average US dividends are up 4.6% year-over-year in the first quarter.
A recovering oil price and stabilising US dollar bode well for future dividends growth, noting that overall S&P 500 earnings should rebound in the second half of this year and into 2017. Econometric analysis suggests that, if S&P500 operating EPS grows by 9% this year and 15% in 2017 – which, following an 11% decline last year is not a stretch – dividends per share could be up 7% this year and 10% next year.
Rising Rates Bad News for High-Yielding Stocks
That’s not to say that high-yielding stocks will do better than low-yielding ones. In fact, even if rates rise very slowly, a rising rate environment should be more difficult for high-dividend payers that are primarily being bought for income. However, it does help to make the case that US equities can be a fertile ground for gathering income in a continued low yield environment, where interest payments from bonds or cash are delivering virtually nothing.
UK investors might be surprised to hear that dividends have accounted for 40% of total returns from the S&P 500 index in the last 90 years, as shown in the chart below, making them almost as important as capital appreciation in terms of delivering gains.
Earnings Should Pick Up in Future
We expect US corporate profits and thus S&P 500 earnings to reaccelerate in the second half of 2016. The rapid pace of US dollar appreciation may be behind us; this may indicate the potential for upside earnings surprises as early as next quarter resulting from a weaker US dollar.
With a modestly more positive outlook for economic growth likely to boost earnings for cash rich corporates and a positive direction of travel for dividend growth, US equities could provide a fruitful home for UK equity income investors, even if stock markets can’t be expected to shoot the lights out on a total return basis anytime soon.
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