By Ben Lofthouse
Dividend-paying stocks were hit hard in the opening months of 2018. Is this a result of rising interest rates?
Historically, higher rate expectations can cause defensive sectors to underperform the market, alongside sectors with elevated debt levels. But it is important to note that not all dividend-paying stocks will consistently underperform in a rising bond yield environment. Many financial services companies' earnings actually benefit from interest rate increases, and commodity sectors, including oil and mining, are positively correlated to rising rates at some stages of the economic cycle. It is unclear whether the energy sector's sharp fall during the first quarter this year - a sector with some of the highest dividend yields in the market - can be attributed to rising rates, and it was good to see the sector recover in response to improving fundamentals.
As ever in equities, the starting point is important: We have long viewed some U.S.-yielding sectors as relatively expensive. These sectors, including consumer staples and utilities, have turned out to be some of the most negatively impacted this year.
Global dividends recently hit a record high. What factors could drive dividend growth in 2018?
After faltering in 2016, economic growth recovered last year, and many companies' earnings are growing again. Dividends tend to lag earnings growth - management and company boards like to see improving profits before committing to dividend increases - so we believe 2018 should see good dividend growth, thanks to a still relatively benign macroeconomic environment.
In addition, there are a few sector-specific factors that might impact dividend growth in 2018. The first is U.S. tax reform, which reduced the corporate tax rate and barriers to repatriation. A lower tax rate will likely improve the cash-flow cover of dividends, which might encourage management teams to make bolder dividend decisions. Meanwhile, the change to repatriation could free up significant amounts of capital, some of which may be returned to shareholders. Companies to watch include those with a high level of domestic U.S. profits, as well as technology and pharmaceutical companies, which tend to have significant overseas cash.
The other driver of improved dividend trends is the recovery in many commodity prices. This recovery is improving the free cash flow of many natural resource companies and, subsequently, their dividend-paying potential.
Where are you finding the best opportunities for dividend growth now?
There is a wide range of opportunities for dividend investors, in our opinion. For one, we think energy is well-positioned on the basis that the sector's improved cash generation is being underappreciated by the market. Investors may also want to consider European equities, which we believe look attractively valued. Additionally, many companies in Europe have yet to fully take advantage of the region's persistently low interest rates. And firms are increasing share buybacks, maintaining low debt levels and undertaking positive restructuring activities, the extent of which continues to positively surprise us.
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