Many of the world's central banks have been holding interest rates below the level of inflation, a policy they appear to be in no rush to change. While this may help cushion the impact of a global deleveraging, it is creating a long-term dilemma for saver
In a world in which yield is scarce, investors have increasingly been turning to dividend paying stocks as an alternative source of income. However, with more investors piling into the trade, certain segments of the high dividend space have become expensive, particularly in the United States. However, outside the United States most dividend paying stocks still appear cheap, trading at a significant discount to the broader equity market. In addition, non-U.S. dividend stocks are offering yields that are often twice as high as those in the United States. And in an environment likely to be characterized by below-trend growth, dividend payers are more likely to outperform.
Getting a Bit Crowded
Back in late January, Federal Reserve Chairman Ben Bernanke extended his promise to keep short-term rates low through 2014. While this may mitigate the headwind of an unprecedented consumer deleveraging, it comes with at least one serious side effect: Leaving income-dependent investors even more desperate to find a reasonable source of income. With the short-end of the curve held at zero and the Fed keeping the long-end of the curve down through asset purchases, fixed-income investors must either take on more credit or significant duration risk to generate income. Faced with this Hobbesian choice, many investors are instead reasonably electing to increase their exposure to dividend paying stocks.
Unfortunately, this rush for income has left a few segments of the dividend corner of the equity market expensive. We have written extensively about the excessive valuation in the U.S. utilities sector, last year's big beneficiary of the rush for yield. By the end of 2011, utility stocks were trading at a 5% premium to the broader market. Since then, investors have started to reconsider the wisdom of paying a premium for a slow growing, regulated industry. Year-to-date, the sector is down despite a 10% gain in global equities.
However, the utilities sector still sports a historically high valuation and is vulnerable to further losses - particularly given that this sector re-priced the most following the dividend tax cut in 2003 and is perhaps in the most danger should the dividend tax cut be reversed in 2013.
Other parts of the dividend space look less stretched. Telecom stocks currently still yield over 5%, but at the cost of a premium valuation. While the U.S. stock market generally appears cheap, it is hard to argue with the fact that dividend oriented stocks are now trading at a significant premium.
Outside of the U.S. the Story is Different
Outside of the United States, the premium for dividend stocks is less obvious or totally absent. For example, the Dow Jones EPAC Select Dividend Index - primarily composed of companies domiciled in Europe and Asia - is currently trading a bit below 12x trailing earnings. In comparison, the MSCI World Index of developed countries is trading at over 14x earnings.
Non-U.S. dividend companies are also offering more enticing yields. Currently the Dow Industrials yields 2.50% and the broader S&P 500 provides a dividend yield of 2.0%. Meanwhile, European stocks are yielding roughly 4.5%, based on the Euro Stoxx 50. Nor do investors need to buy the problem children in Europe to access that yield. Many of the more stable, northern European countries are offering yields well in excess of those found in the United States. Currently, Germany and the Netherlands both yield approximately 3.5% while Norway, a country with no net debt, yields roughly 4.5%.
Other parts of the world also offer an opportunity for higher income. For example, developed markets in Asia currently offer particularly rich yields: Australia at 5%, New Zealand 4.5%, and Singapore and Hong Kong both over 3%. Even in emerging markets, many countries offer substantial dividend yield, including Brazil at 3.5%.
Source: Bloomberg, as of 2/29/12
Dividends for the Slow Lane
There is another factor supporting the dividend theme: High dividend paying stocks tend to outperform during periods of slow growth. Our expectation continues to be another recession can be avoided, but we don't believe that the U.S. or global economy will return to trend growth until the global deleveraging is further along, a process that is likely to take several more years.
As Chart 1 demonstrates, international dividend paying stocks have generally outperformed a broader global benchmark since 1999. But in years in which global growth was below average, the median outperformance of the dividend index was over 18%. In years when global growth was above average, relative outperformance fell to around 3.5%.
The current environment, characterized by zero nominal and negative real rates, has created many distortions, not the least of which is that investors have occasionally ignored price in an effort to generate income. While understandable, this is counter productive. If an asset is significantly overvalued then a modest income stream is unlikely to compensate for a significant capital loss.
Today, we do see pockets of excess in the dividend space, most notably U.S. utilities. Outside of the United States, things appear more reasonable. International high dividend paying stocks are trading at a significant discount to the broader market, while still offering yields in excess of U.S. equities and in many cases bonds. As such, we would continue to emphasize a tilt toward equity income, but would advocate casting a wider net to avoid over paying.
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