Repositioning Your Portfolio to Dividends Stocks in This Inflationary Environment

The recent extreme volatility in growth equities has brought dividends back into focus. Dividend-paying equities have outpaced their growth counterparts by a substantial margin year-to-date. However, fears of rising interest rates and concern about slowing economic growth in the United States and China have raised valid concerns over the elevated valuations of many previously high-flying growth equities.

Investors saw a similar market rotation in Q1 of 2021, as growth equities made a robust comeback. But this year, the macro-economic backdrop is very different. Inflation is at a multi-decade high, so the Federal Reserve plans to raise interest rates and wind down its quantitative easing program. Earnings reports from some larger market cap growth companies, like Meta and Netflix, have disappointing results. As a result, the value of distant cash flows of growth companies makes them more vulnerable to rising interest rates.

1. Positive correlation between bond yields and dividend yields

For the majority of the past 35 years, the relative returns of high dividend-yielding equities and changes in U.S. Treasury yields had an inverse relationship. That inverse relationship reversed in the past two years, and high-yielding equities positively correlated to bond yields. If this trend continues, an increase in interest rates may not dampen the prospects of dividend equities as they have in the past.

Notably, interest rates are rising, but from a historically low base. Even as the Fed begins to increase policy rates, our fixed-income experts expect the 10-year Treasury yield to remain within a narrow range of 2.5% - 3.26%, with additional flattening of the yield curve led by an increase in short-term rates. In 2018, the 10-year Treasury yield rate peaked at 3.26%, which led to a market sell-off, so the 3.26% level should provide significant resistance. Against this backdrop, dividend-paying stocks enable a combination of income and the possibility for capital appreciation, primarily since the valuations of many of these stocks appear reasonable. It’s crucial to distinguish companies with heavy debt loads or extreme leverage on their balance sheets in a rising rate environment.

2. Dividends are making a comeback

Global dividends are expected to increase but at a deliberately measured pace. As a result, many companies are taking a more intentional approach after their experience in the depths of the global pandemic, when they were forced to cut or eliminate their payouts substantially. However, with a deceleration in global economic growth, some companies want to preserve cash because of the increased risk of a greater-than-expected market downturn.

Of the 241 companies that either suspended or cut their dividend in 2020, 101 have reinstated payments, and only four companies cut their dividend in 2021.

Companies with outsized pricing power are likely to be better positioned to increase dividend payments. For example, household products giant Procter & Gamble has already increased prices across multiple product lines to help hedge against inflation. Consumer staples companies are often hurt when inflation begins to grow, and raw materials go up; however, these companies often seek to reprice contracts with retailers and grocers after three to six months. This price increase ultimately puts them in a better position to recoup those rising raw material costs, grow their earnings, and potentially boost their dividend at a commensurate rate.

Acceleration in dividends is also anticipated in Europe, where governments have eased pressures on dividend payments. For example, governments and regulators had pressed some companies to refrain from making payments as part of a social solidarity movement during the pandemic.

3. Highly cyclical firms take innovative approaches with variable dividends

Some companies, especially those in cyclical industries, adopt innovative approaches to balance their business needs and a commitment to dividend payouts. For example, take the mining sector, which had a boom in dividend payouts. Over the past three years, many large mining companies, such as Vale and Rio Tinto, have converted from progressive dividend policies to a payout ratio. In these arrangements, dividend payouts are calculated by a formula tied to specific operating metrics, resulting in a variable dividend yield over a more extended time. Still, it also gives these companies an increased ability to sustainably manage their balance sheet and cash flows during multiple commodities cycles.

Previously, miners often struggled to maintain a regular dividend during market downturns; instead, they would either cut their dividend or be required to raise debt to cover the payout.

Many Exploration and Production (E&P) companies are also changing their dividend payout strategies. Previously, E&P companies have not been dividend payers, choosing alternatively to reinvest in the business to pursue more production growth. Still, growth backfired at times when changing energy prices decreased investment returns on projects and led to financial hardship.

Companies have become more disciplined. For example, companies have begun to establish a regular dividend at a low base, strengthening them with special dividends or variable dividends depending on the prices of commodities and the strength of cash flows.

Companies hope this more disciplined approach can lead investors to adopt a more favorable valuation framework to value them.

4. Financials, energy, and health care are areas of dividend opportunity

Financials, energy, and health care represent a substantial chunk of the dividend-paying universe. A confluence of factors appears to support the case of rising dividends from each of these areas.

Financials: Rising rates should help the more rate-sensitive banks in the U.S. and Europe expand their net interest margins, which have been suppressed for many years by persistently low-interest rates. This increase in rates could result in more robust earnings, improved dividend streams, and higher valuation multiples.

Since the Great Financial Crisis, banks have built excess capital on their balance sheets. Most are now well-capitalized, having undergone several regulatory stress tests. And some banks in the U.S. and Europe are poised to redeploy surplus capital in the form of regular and catch-up dividends after facing regulatory limitations during the pandemic.

For example, Dutch banking giant ING has committed to a minimum 50% dividend payout ratio of earnings. CaixaBank, one of Spain’s largest banks, stated it would boost its payout ratio to as much as 60% from 50% previously. It’s possible that other European banks could follow a similar course of action as regulatory pressures ease, making this sector a potential source of more consistent dividend income.

Energy: Large integrated oil companies have long been good sources of consistent dividends for income-oriented investors. They’ve also become more disciplined on supply, having curtailed investment in existing reserves and pursuing new sources of oil.

U.S. oil giants Chevron and Exxon Mobil have demonstrated a steadfast commitment to paying dividends despite some dramatic oil price swings over the past decade. Chevron recently increased its dividend for the 35th consecutive year.

But dividend policies have diverged in the oil sector, and calibrating the dividend streams of oil companies has become more challenging. Over the past couple of years, European oil majors BP and Royal Dutch Shell have cut their dividends amid their transition to investing in renewable energies that are capital intensive and where the return on invested capital is still uncertain. Having reset their dividends to lower payout ratios, the European oil majors have left sufficient room to increase dividends over time.

Health care: Health care companies could be a source of earnings and dividend growth in the current inflationary environment. Pharmaceutical companies historically have exhibited relatively strong pricing power. While the industry has faced political pressures on drug prices, the more innovative pharmaceutical companies will likely be positioned to raise prices at modest levels.

Like the energy companies, the major pharmaceutical companies recognize that a sizeable portion of their value proposition with the investor base is the dividend payout. That, combined with the potentially robust pipeline over the next several years at several major pharmaceutical companies across all geographies, gives us confidence that this will be another area that can be a well-diversified source of equity income.

Bottom line

During the past decade, many growth stocks have been rewarded in an environment of moderate global economic growth, low inflation, and ultra-low interest rates. As a result, we appear to be in the beginning stages of an equity market cycle that shows some breadth after a heavy focus on technology-related growth equities, especially those in the United States.

As market volatility increases due to monetary policy tightening and elevated inflation levels, the dividend-income investment could play a more critical role in the total return of a portfolio. As a result, investors are likely to pay greater attention to dividend payers as companies reinstate or continue to raise their dividends, albeit gradually. Furthermore, long-term investors have a fantastic opportunity to get in early during this changing economic landscape; many companies currently trade at extremely attractive valuations that may not fully reflect their upside potential as economies recover.

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Investment Disclosures

​This material is not meant to provide investment advice and should not be considered a recommendation to purchase or sell securities.

The views expressed are the views of Infinitus Wealth Management, LLC. These views are subject to change at any time and may not represent the views of all portfolio management teams, Wealth Advisors, or other Investment Professionals. These views should not be interpreted as a guarantee of the future performance of the markets, any security, or any funds managed by Infinitus Wealth Management, LLC. These views are not meant to provide investment advice and should not be considered a recommendation to purchase or sell securities. Investment Advice will be given to individual clients based on risk tolerance, time horizon, investment objectives, and other considerations.

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