Fidelity: A new world for equity income

Key Points

• Contrary to common belief, most companies are still paying dividends and the majority of the companies represented in major equity indices have kept dividend flats or even increased them.
• Relative to government bonds, where yields troughed as a result of central bank action, dividend yields are in line or slightly below their long-term averages.
• Changes in government spending plans and the need to provide for longer retirement periods could see investors increasingly turn to equities to satisfy growth and income requirements.

A good deal of commentary has been written about companies cutting dividends in the past few months - so much so that it might be worth stating the simple fact that a majority of companies are still paying dividends to shareholders, and many companies have continued to grow dividends in 2020. Even in Europe and the UK, the markets where cuts have been most common, around half of companies have delivered dividend growth in 2020.

Percentage of companies by 2020 dividend action

Source: SG Cross Asset Research/Equity Quant, Bloomberg. 6 July 2020

While there have many been many reasons for companies cutting dividends in 2020, a clear pattern has emerged: companies with more sensitivity to economic activity and with more debt on their balance sheets have been at greatest risk of cutting dividends. Companies with more defensive business models and stronger balance sheets have been at significantly lower risk of cutting dividends, both in the current crisis and in more normal market environments.

There is also a regional pattern. European and UK businesses tend to pay out a larger proportion of earnings than in other markets, and so dividends are more vulnerable to declining earnings. Additionally, financial regulators in Europe were quick to enforce dividend suspensions on banks and some insurers across Europe.

We have also seen a higher propensity for ‘high yield’ shares to cut dividends. A company trading at a high dividend yield may be doing so because the market questions its financial strength or cashflow resilience. Recent events demonstrate a point we have made consistently: the highest yielding stocks do not always produce the best long-term outcomes for income investors.

Despite an undeniably challenging environment for dividend-based investors, the good news is that there are a wide selection of businesses operating profitably and continuing to pay dividends. Even in companies which are currently not paying dividends, attractive longer-term opportunities could arise.

Dividend yields are attractive relative to other asset classes

Average dividend yields are not high in absolute terms. Historic yields for global equities, which have now been impacted by the cuts mentioned above, are roughly in line or slightly below long-term averages. While we can expect a recovery in dividends as the economy ‘normalises,’ the time this will take remains unclear - an immediate recovery is not guaranteed.

However, on a relative basis, the attractiveness of equities to income-seeking investors is much clearer. Central banks have responded to the economic challenges of coronavirus by slashing interest rates and in some cases restarting quantitative easing programmes. This has pushed down yields on government and investment grade bonds to historically low levels. While yields of lower quality bonds may be higher, this is often because solvency risks are greater.

Current guidance from central banks suggests that interest rates are unlikely to rise in the near-term, and so income-seeking investors may be required to venture out of fixed income markets into equities to satisfy their yield requirements. While these comments refer to the yield of the ‘market’, as active investors, we are not in the business of buying the market average but seeking out stocks which trade at more attractive valuations and have more resilient business models and dividend prospects.

Longer-term drivers remain intact

Many of the largest economies in the world have aging populations, and retirement funding has become a major long-term problem for some governments. Even before the current crisis, it seems inevitable that more financial responsibility for retirement provision would pass from the state to the individual. Now, with fiscal deficits blowing out as a result of enormous stimulus packages, governments will be forced to re-assess their spending priorities and the task of reducing the enormous costs of state pensions may take on an extra urgency.

If individuals are required to save more for their retirement, what kind of investment choices will they make? A diversified portfolio of sustainable dividend-paying companies could be a good solution. Dividends can be used as a source of income for those in retirement or reinvested for those in the ‘accumulation’ phase of their saving. Growth of capital and income may be required to support the longer retirement periods associated with aging populations, adding to the structural argument for equities as a source of income.

Important information

This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. Investments in emerging markets can be more volatile than in more developed markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is included for illustration purposes only.