In mid-2020, when we were modelling income stock performance through to 2022, we predicted a peak-to-tough decline in the realms of 40%, and a two to three-year timeframe to full recovery.1 While the initial decline came close to matching those expectations (falling around 30% below pre-COVID levels2), the recovery has come about much more quickly.
Mining dividends have roared back, thanks to rising iron ore prices, and banking stocks - the other major source of Australian dividend yield in recent times, have bounced back strongly as well. Broker consensus for ASX dividends across the next 12 months is for dividends to be only 8% below their pre-pandemic levels3, which represents an incredibly fast turnaround given the circumstances.
We believe there are two immediate takeaways from this rapid recovery:
The first is that dividends are a very consistent form of income, even through periods of volatility such as 2020. With few exceptions, net dividend yield for the ASX has been consistently between the bounds of 3 and 5% per annum since 1993. The figure for 2009 was modestly above this band, and in 2020 modestly below.4
The second lesson is that one of the worst investing decisions can be to sell stock after a company has lowered its dividends. Some investors seem to react to dividend cuts as being a sign of falling cash flows into the future, when they often come towards the end of a difficult financial period, not at the beginning. Under pressure from shareholders, companies tend to hold onto dividends for longer than they should through periods of declining earnings, preferring instead to increase the payout ratio. It is only when companies can’t sustain this practice that they turn to reducing dividends, and once that occurs the business is able to access additional cash to reinvest in their operations.
This maxim won’t always be true, but it certainly applied in 2020. Investors who realised that the medium-term outlook for many affected companies was unchanged and who held their positions - or even bought - following dividend cuts reaped the benefit of stock rerating right through to the payoff of February’s strong reporting season.
And February will be remembered as one of the strongest reporting seasons on record. EPS revisions and dividend beats were at near or record levels, thanks to the triple boom in company profits, house prices and expansion in the mining sector.
Higher interest rates pose difficult questions for growth
The reaction to February’s results wasn’t evenly shared across the market - value stocks outperformed growth stocks significantly since the start of that month, marking a reversal of fortunes for the two strategy indices. By November 2020, the valuation discrepancy in favour of growth stocks was at an all-time high, and it has been slowly correcting since that time, despite standout performances from individual stocks within the technology sector. Strong dividend yields have hastened this dynamic in recent months.
The question is whether the trend to value will continue, and the answer will depend in large part on where the turning point is for the interest rate cycle.
Declining interest rates have been a defining feature of the past 30 years, supportive for almost every asset class but especially so for growth stocks, given that the effect of low discount rates in increasing the attractiveness of future cash flows.
What many have taken to be a natural state of affairs over three decades was sparked by concerted action from central banks to bring inflation under control through the 1980s. What we’re seeing today feels like the same, but in reverse.
Today, many central banks are fixated on dragging their economies out of a deflationary trap, anchoring rates to zero and changing their inflationary targeting to effectively be retrospective, in that they intend to only raise rates once inflation is experienced, not forecast (as was previously the case). In effect, monetary policy will lag the real economy.
Coupled with unprecedented fiscal stimulus, the result is rising inflationary expectations, which our Reserve Bank hopes will drive wage growth.
For markets, it means a completely changed investment paradigm from the last 30 years, and there are many people who won’t recognise what investing looks like in a higher-interest rate environment. We expect that strategies that worked in the past aren’t necessarily going to work going forward.
For growth stocks, one of the key attractions that helped justify their multiples has been that growth elsewhere in the economy has, for the most part, been scarce. With rising interest rates and an improving economy this is not necessarily going to be the case forever. In some cases, growth on offer from cyclical companies may outpace that of growth stocks, at a much cheaper multiple.
The good news is that with central banks committing to keep interest rates low in the near term and the economy growing, the outlook for shares, in our opinion, is as positive as it has been for some years.
1 AMP Capital. Forecast as at July 2020.
2, 3 FactSet. As at 26 February 2021
4 ASX 200 Index, FactSet. As at 26 February 2021
Subscribe to Institutional Edition using the form below to receive all of my articlesTom Young, Co-Portfolio Manager (Income)
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