The case for dividends in volatile times

In March 2017, approximately one fourth of all government bonds of advanced economies in circulation sported negative yields. The situation is particularly dramatic in Japan and Europe. However, by the time investors factor in the effect of inflation it becomes clear that nominal yields in other parts of the fixed-income universe are not sufficient to preserve real purchasing power, either. Although current yields may well be positive in the United States, for example, real yields (nominal yields minus the inflation rate) are negative and even apply to maturities of up to ten years. Thus, it is understandable that dividends are increasingly viewed as the new “interest on equities", despite volatility being a fact of life with equity investments.

For investors, there are two key questions that are important to consider before any assertions can be made about the future success of dividend strategies:

• What advantages can dividend strategies offer the long-term investor?
• Taking the current market environment as a starting point, what can be expected in terms of the future performance of dividend yields?

European companies, in particular, have an investor-friendly dividend policy compared to their international peers. Their average dividend yield across all market segments was around 3.0% (basis: MSCI Europe). Focusing on high-dividend stocks meant that the expected dividend yield in the portfolio rose even further.

Dividends - stability for the portfolio

At the same time, what is noticeable is that dividends can potentially help achieve additional stability in the portfolio. In the past, investors in European equities were the main beneficiaries of high dividend payouts that also helped in stabilising the overall performance in years of declining stock prices.

Dividends were able to partially or even totally compensate for any price losses. Over the entire period (1971 - 2016), the performance contribution of dividends to the annualised total portfolio return for the MSCI Europe was approximately 38%. But in other regions, such as North America (MSCI North America) or Asia/Pacific (MSCI Pacific), around a third of overall performance was determined by dividends, albeit the absolute dividend yield was lower here.

High-dividend equities seem to have a less volatile performance than those of companies with lower dividend payouts. This is demonstrated by analysing the past performance of US stocks, for which the longest time series are available.

This analysis shows that the volatility of US equities (measured in terms of a 36-month rolling standard deviation as a gauge of price fluctuation) has been lower since 1972 among companies paying out a dividend than among stock corporations that did not distribute any profits. Analogous behaviour is also discernible for European dividend stocks since the 1990s.

Looking ahead: How sustainable are dividends?

The lessons of the past, however, must be put into the perspective of expected future performance. Current dividend yields only describe the status quo but not what an investment in equities can actually achieve.

Factors suggesting stable or even rising dividend yields in the current market environment are:

• While the ratio of dividend payout to earnings per share, at around 80 %, is considerably above its pre-crisis level in Europe at the moment, the distribution ratio in the United States and Asia, at approximately 50% and about 45% respectively, is more modest. Therefore, there is still scope for companies in these markets to boost dividends in the future.
• Currently, companies have a large amount of free cash flow at their disposal. For example, the net cash flow of US companies in relation to US gross domestic product (GDP) is 12% and may be approaching the record level seen in 2011.
• Our global market outlook suggests that capital markets are gearing up for “reflation": Economic indicators are improving, not least thanks to an expected fiscal stimulus in the United States. Both of these mean better prospects for corporate profits. At the same time, additional interest rate hikes can be expected from the US central bank, the Federal Reserve. The latter coupled with inflation rates, which are once again on the rise, underpin expectations of weaker bond markets and stronger equity markets.
• Solid yet low global economic growth as well as the prevailing valuation data for the world’s major equity markets suggest that dividends will contribute a significant share towards the overall performance of equities.
• In respect of the profit outlook, supportive factors outweigh negative ones. In the United States, a recovery in the energy sector, expected tax cuts and spending programmes, among other things, should leave their mark on profits. On the other hand, the appreciation of the US Dollar and pressure on margins as a consequence of higher unit labour costs will have an adverse effect. Companies in the European Union should also benefit from the US fiscal stimulus, albeit only indirectly through higher economic growth, as well as from a recovery in the energy and - most likely - the banking sector. Political uncertainty should have a negative impact. It is unlikely that the consensus estimates of analysts in relation to profit increases will be fully met.
• Since increased volatility can be expected in the context of monetary policy and the global geopolitical situation, dividends could potentially play their part as an anchor of stability.
• As dividend strategies overall are part of a value based investment style they are not necessarily in contradiction to a growth oriented investment - it depends on how “growth" is defined. If one defines growth not only by typical multipliers (Price to Earnings, Price Earnings to Growth) but by the typical growth outlook a company has irrespectively of the economic growth outlook, then the advantages of both investment styles could be combined.

By Hans-Joerg Naumer, Global Head of Capital Markets & Thematic Research, Allianz Global Investors

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