Bedevilled by soaring inflation, rising interest rates, possible recession and major disruption to global supply chains, global stock markets have fallen hard this year. A consequence of falling share prices is ballooning dividend yields, pushing double-digits in some cases in the UK.

Is this a once in a lifetime opportunity to secure inflated income yields for the long haul, or a value trap for investors if shareholder payouts are pared back from current expectations?

At the beginning of 2022, investors were worried mainly about inflation. Now, as we move into the second half, concerns are focused on inflation and recession.

Latest data show both the US and UK economies shrinking in the second quarter to 30 June, while the IMF has recently made another gloomy prognosis in its World Economic Outlook report as consumers reel in spending as pressure mounts on household budgets.

By one well-used measure, the US has already fallen into recession after GDP – a broad measure of the price of goods and services – decreased at an annualised rate of 0.9% in the second quarter, having declined 1.6% in the first three months.

Two quarters of negative GDP growth are widely regarded as a signal that the economy has gone into recession. But the US’s National Bureau of Economic Research is the official arbiter of when recessions begin and end, so while the GDP figures will play into the NBER’s final verdict, it also looks at a wider range of economic factors, including the jobs market, and is unlikely to give its decision soon.

A SLOWDOWN COULD HURT DIVIDENDS

While many dividend-paying stocks come from defensive and less growth-focused sectors of the economy, a wider slowdown will inevitably have an impact on earnings and the ability of some companies to pay dividends.

Pessimists will say that firms slashed payouts in 2020 as the impact of the pandemic became apparent, and they will do so again under pressure in recession.

Optimists would argue that 2023 can’t be as bad as 2020, and that the risk of recession is already being priced into many of the more economically sensitive sectors, often called cyclicals.

‘Nothing can be taken for granted, especially if recession hits,’ argues AJ Bell investment director Russ Mould.

In July, we witnessed a major turnaround in the stock market despite aggressive rate hikes and mounting evidence of a recession.

Stock markets around the world bounced back, posting the best month since 2020, led by cyclicals, like consumer discretionary, technology and industrials. In contrast, sectors that usually fare better in recessions (referred to as defensives), such as consumer staples and healthcare, lagged the overall market.

‘High-dividend-paying stocks have been outpacing the overall stock market this year in the US, Europe, and Japan, except during July,’ said Jeffrey Kleintop, managing director and chief global investment strategist at broker Charles Schwab.

‘Both the S&P 500 High Dividend index and MSCI Europe High Dividend index have delivered positive total returns for the year through the end of July, while the S&P 500 is down 13% (as at the start of August 2022) and MSCI Europe index is down 7% (as measured in euros).

‘In Japan, the MSCI Japan High Dividend index is up 13% this year compared with losses for the MSCI Japan index (as measured in yen).’

CAN IT LAST?

It’s not clear that stock markets can sustain July’s upward momentum and may rotate back to the leadership we had seen in the first half of the year.

Support for this view includes concerns over an ongoing slide in economic activity while central banks continue to tighten monetary policy in response to inflation.

‘If that is the case, there may be grounds for renewed focus on dividend payers, which have often offered investors some refuge during recessionary bear markets of the past,’ said Kleintop.

DIVIDEND FORECASTS

Link’s latest quarterly Dividend Monitor, released on 27 July, forecasts a decent year for UK dividends in 2022 but looks ahead to a more challenging environment next year.

‘As we move into 2023, headwinds will strengthen,’ said Link’s Ian Stokes, managing director, corporate markets UK and Europe.

The headline total for Q2 2022 jumped 38.6% year-on-year to £37 billion bolstered by large one-off special payments, but the underlying picture was also good, according to the Link data.

‘Underlying dividends, which exclude these volatile specials, jumped 27% to £32 billion, boosted by the weak pound. This was the second-largest quarterly total on record, for both headline and underlying figures, just shy of the record reached in Q2 2019,’ said Stokes.

HIGH YIELDING SECTORS

One of the risks of dividend investing is sector concentration, an issue that has dogged UK income seekers for years. Companies in the utilities, consumer staples and resources sectors tend to pay much higher dividends than companies in other sectors.

Seeking high-dividend payers without considering sector allocation can result in a lack of diversification, potentially making a portfolio more vulnerable during periods of high volatility.

FTSE Russell data tells us that the FTSE 350 is currently on a yield of 3.4%, or 3.5% if we strip out investment companies. That’s in line with an average of 3.4% in the 25-year period between 1993 and 2018.

HIGHEST DIVIDENDS COME FROM A SMALL GROUP

One third (120) of the companies that make up the FTSE 350 index (which is made up of the FTSE 100 and FTSE 250 indices combined) are forecast to pay income yield above the average, yet most of UK’s forecast dividend payments this year come from a worryingly small band of stocks.

According to AJ Bell’s second quarter Dividend Dashboard data, just 10 companies are forecast to pay dividends worth £47.7 billion, or 56% of the forecast total for 2022. The top 20 payers are expected to generate 74% of the index’s payout at £62.5 billion.

‘Anyone who believes the UK stock market is attractive on a yield basis, and looking to buy individual stocks, glean access via a passive index tracker or buy a UK equity income fund needs to have a good understanding of, and strong view on, those 20 names in particular,’ says AJ Bell.

HAVE MINING DIVIDENDS PEAKED?

Mining companies have been the engine of the post-pandemic recovery, paying generous ordinary and special dividends as commodity prices have soared. That boom is likely to have peaked, Link says, and will lead to a slowdown in UK dividend growth going forward – although banks are likely to make up some of that shortfall.

Mining payouts are closely linked to the cyclical fluctuations in mining profits. They tend to rise and fall much more over that cycle than dividends from other industries. Concerns over global growth have pushed commodity prices sharply lower in recent weeks, though they remain high in historic terms.

‘The sector has confounded expectations more than once before, bending their stated dividend policies at important moments, but if mining dividends have peaked, they will act as a brake on UK dividend growth in the next 12 months having provided the main engine over the last 24,’ said Link’s Stokes.

The weakness of the pound is also proving a key swing factor this year. If it maintains its current level for the rest of 2022, sterling is set to have its worst ever year against the dollar, according to Link, with the translated value of dollar dividends getting a very big boost.

‘The easy post-pandemic catch-up effects are soon to wash entirely out of the figures, and an economic recession will crimp the ability and willingness of many companies to grow dividends.’

DISCLAIMER: AJ Bell owns Shares magazine. The author (Steven Frazer) and editor (Daniel Coatsworth) own shares in AJ Bell.

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