(AP Photo/Susan Walsh, File)
It is no secret that we are entering a potential cycle shift to rising interest rates. The shift is generally considered a good sign by most, indicating an improving economy and stable inflation. Now though, investors are keeping a watchful eye over the tone of the Fed, which determines how quickly interest rates will rise and how much longer the market can rally. As interest rates continue to normalize, new implications will emerge for equities. With each new interest rate hike it presents the question of how dividend-paying stocks may be affected by its ripple-effect?
Rising Rates, Good News
The U.S. Fed funds rate has increased once so far this year, reaching 1.0%. To better assess the current interest rate environment history serves as a useful guide. Since 1980, there have been at least seven periods of rising rates, each designed to solve a different economic puzzle. During the 1980’s, rates hiked quickly to combat runaway inflation, and cool down the economy. Conversely, interest rates were brought down to zero early in the Great Recession, to stimulate the economy and avoid deflation.
Now, the U.S. economy is characterized as “not too hot, and not too cold”. This mix of moderate growth and stable inflation has caused the Fed to call for two additional quarter-point increases for the remainder of 2017. Considering that, the current conditions don’t appear to indicate a rapid rise in rates, and measured incremental increases shouldn’t upset quality positions much. Combined with a nine-year low in unemployment, many investors believe the current bull market will continue in go-forward economic environment. Let’s take a look at what that means for dividend stocks.
Not All Dividends Are Treated Equally
When approaching dividend payers, remember that not all dividend stocks are the same. Investors hungry for high income sometimes gravitate to high-yielders, lured by yields in the mid-single digits on occasion. But, chasing high-yield alone has many pitfalls.
Typically, high-yielding stocks belong to sectors that require a great deal of borrowing costs within operations. These heavily levered companies can be sensitive to interest rate change, as they have more exposure due to higher borrowing costs. Sectors such as real estate and utilities also may bear the brunt of fed action, and may experience weakness in their price performance. Lastly, overall economic improvement can hurt defensive sectors, which showed relatively slower growth while the U.S economy recovered from the last financial crisis.
Source: FactSet, 12/31/06 – 12/31/16. Past performance is no guarantee of future results. You cannot invest directly in an index.
Identify Quality Stocks Via Dividend Activity
Since 2009, the zero-percent interest rate environment compelled many investors to pile into stocks with above-average yields, effectively turning them into bond replacements. For a time, high-dividend payers offered the income and low volatility investors needed. But now, rising rates threaten to erode the value of high-yield stocks and traditional bonds, leaving investors in flux as these issues tend to be a lot more interest rate sensitive.
Given these considerations, a better approach may be to identify quality in the form of a stock’s dividend activity as a hallmark for investment consideration, over yield. With dividend growth occurring in 41 of the last 44 years many investors find comfort in knowing that dividend-growth can be a foundational element in the economy and possibly a more reliable factor upon which to assess overall strength of a stock’s future return potential
Dividend Growers, Unsung Heros
Virtually all stocks feel the effects of changing rates. But, dividend growers historically show resiliency throughout most market cycles, including periods of tightening monetary policy. Because dividends are a function of a stock’s earnings, dividend growth mirrors earnings growth and coincides with healthy fundamentals. History indicates that stocks with consistent dividend growth perform better than stocks with high yields, offering stronger total return potential. According to Ned Davis, dividend growers have outperformed all other categories of the S&P 500 during rising rates periods since 1972.
Source: Ned Davis Research, Inc. Past Performance is no guarantee of future results. Data shown is based on the average performance after all rate hikes since 1972 which occurred on the following dates: 1/15/73, 8/31/80, 4/9/84, 9/4/87,2/4/94, 3/25/97, 6/30/99, 6/30/99, 6/30/04
Cash Is Still King
To declare a dividend, a stock must possess the cash to make payouts to investors. To increase a dividend, a stock’s cash flow must also be increasing to fulfill its obligation to investors. Therefore, stocks with a growing dividend—even during periods of rising rates—show improving free cash flow and earnings health.
In December, corporate cash reached $1.54 trillion, a one-year increase of 7.6% and a 10-year high. Buyback activity fell 20% last year alongside the increase in corporate cash, setting the stage for strong future dividend growth. In fact, dividend growth is already occurring; Apple recently raised its quarterly payout by 10% to become the biggest dividend payer in the world. So again, an investment strategy for higher rate periods is to seek quality, as indicated by earnings, cash flow, and dividend growth.
Keep A Strong Grip On Your Portfolio When Rates Tighten
As interest rates tighten, investors can still engage the markets, seeking income and growth potential for an effective total return. The key for any period of significant market change is a watchful eye for investment quality. One of the best reflections of quality is dividend growth, which is driven by positive fundamentals. A smart approach therefore is to use dividend growth to confidently invest when rates change, and thereafter.
