Investors starved for yield have flocked to stocks offering dividend income. We see rising interest rates ahead, but this headwind for income equities doesn’t weaken the case for all dividend-paying stocks, we believe. This week’s chart helps explain why.
Equities now provide roughly 75% of the income in a typical 60-40 portfolio of global equities and bonds, as evident in the chart above. They became the key income source as low growth and excess global savings helped push bond yields to record lows. We see equities as the dominant source of income going forward, as we expect only moderately rising rates and ongoing high demand for income from aging populations.
A preference for dividend growers
Dividend income is poised to become a larger component of lower overall portfolio returns over the next five years, BlackRock analysis suggests. Bond yields have likely bottomed out, and we don’t see scope for big rises in already elevated stock market valuations amid tepid earnings growth.
High-yielding dividend stocks typically suffer more when rates rise than dividend growers — quality companies with enough free cash flow to sustain dividend increases over time. Yet even many of these stocks could generate positive returns in a gradually rising yield environment. Thanks to the power of compounding dividends and earnings growth, valuations of global developed stocks would need to fall by roughly 30% over the next five years to generate negative returns for investors, our return assumptions suggest. We view this as unlikely.
We see higher inflation expectations, rather than rising real yields, driving rises in nominal bond yields. This bodes well for dividend growers and strengthens our preference for these stocks. They tend to be more resilient amid rising rates and outperform when rising rates are driven by higher inflation, our analysis finds. Dividend growers are typically able to raise prices, and dividends, in reflationary environments.
The key risk? A sharp rise in real (inflation-adjusted) interest rates. This would make bonds more attractive and diminish appetite for dividend stocks overall. For now, we see dividend growth opportunities globally within the technology, consumer discretionary and financials sectors. Read more market insights in my Weekly Commentary.