The Return of Dividends

by Jeffrey Kleintop, CFA®, Managing Director, Chief Global Investment Strategist, Charles Schwab & Co., Inc.

Although the 10-year U.S. Treasury yield climbed above stocks' dividend yields earlier this year, dividend payers may continue to reward should the economy continue to slow.

In July, we witnessed a major turnaround in the stock market despite aggressive rate hikes and mounting evidence of a recession. Stock markets around the world bounced back, posting the best month since 2020, led by economically sensitive sectors (often called cyclicals) like Consumer Discretionary, Information Technology and Industrials. In contrast, sectors that usually fare better in recessions (referred to as defensives), such as Consumer Staples and Health Care, lagged the overall market. While July was a nice break from the downtrend, if markets return to favoring stocks that tend to outperform during recessionary bear markets, investors may want to consider high-dividend-paying stocks.

High-dividend payers

High-dividend-paying stocks have been outpacing the overall stock market this year in the U.S., Europe, and Japan, except during July. Both the S&P 500 High Dividend Index and MSCI Europe High Dividend Index have delivered positive total returns for the year through the end of July, while the S&P 500 is down 13% and MSCI Europe Index is down 7% (as measured in euros). In Japan, the MSCI Japan High Dividend Index is up 13% this year compared with losses for the MSCI Japan Index (as measured in yen).

United States

Line chart showing total return of S&P High Dividend Index in blue and total return of S&P 500 Index in orange since January 2022.

Source: Charles Schwab, Bloomberg data as of 7/29/2022.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.

Europe

Line chart showing total return of MSCI Europe High Dividend Yield Index in blue and total return of MSCI Europe Index in orange since January 2022.

Source: Charles Schwab, Bloomberg data as of 7/29/2022.

Indexes both measured in euros. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.

Japan

Line chart showing total return of MSCI Japan High Dividend Yield Index in blue and total return of MSCI Japan Index in orange since January 2022.

Source: Charles Schwab, Bloomberg data as of 7/29/2022.

Indexes both measured in yen. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.

It's not clear that stock markets can sustain July's upward momentum and may rotate back to the leadership we had seen in the first half of the year. Support for this view includes concerns over an ongoing slide in economic activity while central banks continue to tighten monetary policy in response to inflation. If that is the case, there may be grounds for renewed focus on dividend payers, which have often offered investors some refuge during recessionary bear markets of the past.

Risks

One of the risks of dividend investing is sector concentration. Companies in the Utilities and Consumer Staples sectors tend to pay much higher dividends than companies in other sectors. Seeking high-dividend payers without considering sector allocation can result in a lack of diversification, potentially making a portfolio more vulnerable during periods of high volatility.

Fortunately, a focus on high-dividend-paying stocks doesn't have to mean abandoning sector diversification. High-dividend payers can be found in all sectors and have been outpacing the market in nearly all of them. The table below shows the performance so far this year for the MSCI World Index sectors ranked by dividend yield. The stocks with the highest dividend yields are the best performers in every sector, except Energy and Utilities.

High-dividend payers outperforming in nearly every sector

Table illustrating sector returns of the MSCI World, divided by quintiles.  Worst performing quintile shaded in red, best performing quintile shaded in green.

Source: Charles Schwab, FactSet data, year-to-date performance through 7/30/2022.

Performance of the MSCI World, by sector. Green signifies best-performing dividend yield quintile in sector, red signifies the worst. Past performance is no guarantee of future results.

Another risk of high-dividend investing is the risk of those dividends being cut. That scenario specifically contributed to high-dividend-paying stocks underperforming during the 2008-09 recessionary bear market. Investors can monitor this risk through reviewing the four most popular ratios for measuring a company's ability to pay its dividend. Those more vulnerable to a dividend cut have a high dividend-payout ratio, low dividend-coverage ratio, low free-cash-flow-to-equity, and high net-debt-to-EBITDA. While the vast majority of high-dividend payers pass these tests, they are backward-looking assessments. Fortunately, despite the ongoing economic downturn, companies are relatively cash-rich right now, likely making dividend cuts less of a risk than in past recessions.

History shows us the benefits of a focus on high-dividend payers during recessionary bear markets, as you can see in the chart below. In every recessionary bear market of the past 50 years high-dividend-paying stocks have outperformed the overall market, except for the Global Financial Crisis in 2008-09, when financials were forced to eliminate their dividends.

Dividend payers and recessionary bear markets

Bar Chart illustrating performance of the MSCI World High Dividend Yield Index and the MSCI World Index during recessionary periods since 1978 in blue.  Second bar chart in yellow documents outperformance margin of the high dividend index during those periods.

Source: Charles Schwab, Bloomberg data as of 7/28/2022.

MSCI World Index total return measured in US dollars. MSCI World High Dividend Yield Index performance minus MSCI World Index performance over the same period. Past performance is no guarantee of future results.

Owning high-dividend-paying stocks doesn't mean losses have been avoided during most of these periods, but it can make a sizable difference in downside protection—as it has this year.

July bounce

In June, we pointed out that the risk of a deep recession seemed to be priced into market internals, so a significant rebound in cyclicals for July (as economic data reflected only a mild downturn) is not that surprising.

We can find evidence of this in relative performance of cyclicals in Europe and the widely watched manufacturing Purchasing Managers' Index (PMI). The performance of cyclicals relative to defensives seemed to price in the expectation for a sudden, deep drop in the PMI to below 40, not far from the low point during the pandemic recession of 2020 when manufacturing activity was sharply cut off. Yet, the preliminary reading for July came in at 49.8—a reading consistent with a stall in manufacturing, but not a contraction. The mispricing, combined with some evidence inflation pressures are beginning to ease, has helped cyclicals to bounce and lead the market higher in July.

Cyclicals bounce in July as data not as bad as feared

Line chart with Eurozone Manufacturing PMI in orange and ratio of STOXX 600 Optimised Cyclicals Index and the STOXX 600 Optimised Defensives Index in blue, illustrating the correlation since November 2016.

Source: Charles Schwab. S&P Global, Bloomberg data as of 7/30/2022.

Past performance is no guarantee of future results.

While there is still a gap between the relative performance of cyclicals and the current level of the PMI, there is still the likelihood of a further slide in the PMI over the coming months. The building of excess inventories at retailers (Shortages Have Led to Gluts) and at manufacturers (chart below) to the highest levels in decades suggests a further slowdown in orders, production, and jobs.

Inventory glut

Line chart of the Eurozone Manufacturing PMI Inventory of Finished goods in blue from June 1997 to the present.

Source: Charles Schwab, Bloomberg data as of 7/30/2022.

Index readings above 50 indicate expansion, readings below 50 indicate contraction.

Dividends make a comeback

As the yield on the 10-year Treasury bond climbed above the dividend yield for most stocks early this year, many investors wrote off the idea of focusing on stocks' yields. But dividend payers have deserved attention this year and may continue to reward investors looking for some defense should the economy continue to slow.

Michelle Gibley, CFA®, Director of International Research, and Heather O'Leary, Senior Global Investment Research Analyst, contributed to this report.

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