INSIGHTS

On July 20, 2022

More of the Same

Inflation, the Federal Reserve’s (Fed) actions, and ensuing market responses continued to be top of mind for investors as we enter the back half of 2022. Any uncertainty about the Fed’s path forward was left behind when the May Consumer Price Index (CPI) surprised to the upside at +8.6%, causing the central bank to raise the Federal Funds rate by 0.75% and “strongly commit” itself to lower inflation at its June meeting. Higher rates and inflation continued to pressure both equity and fixed income markets, with the S&P 500 and Bloomberg U.S. Aggregate Bond indices posting their worst first-half performances in over 50 years in 2022. The biggest losers within equities were long duration and non-dividend payers (Exhibit 1), which underperformed for a second quarter in a row, which we view as an opportunity for high-quality and dividend-focused active managers (Exhibit 2).

Exhibit 1: 2Q 2022 total return by S&P 500 dividend tranche

Source: Bahl & Gaynor. FactSet, 2022 | Past performance does not guarantee future results.

Exhibit 2: S&P 500 Dividend Payers Relative to Non-Payers (indexed to 100 on 1/1/2015)

A RECORD NEGATIVE YEAR FOR FIXED INCOME

With U.S. fixed income yields higher, the percentage of S&P 500 companies with a dividend yield greater than the 10-year U.S. Treasury yield has declined to levels not seen in 15 years (Exhibit 3). These higher yields combined with the year-to-date volatility in equities have the market questioning whether the TINA (there is no alternative to equities) playbook has been replaced with TARA (there are reasonable alternatives to equities). While Bahl & Gaynor recognizes the defensive properties fixed income assets can provide to a portfolio amid market volatility, the asset class has not been the ballast it has been in prior S&P 500 down years since 1977 (Exhibit 4). This underperformance is likely due to the negative effects of inflation and higher interest rates, headwinds not often seen in the now-expired four-decades-long bond bull market.

Exhibit 3: Percentage of S&P 500 Stocks with Dividend Yields Greater than the 10-Year US Treasury Yield

Exhibit 4: S&P 500 Down Years (1977–2022)

Source: COMPOUND; Charlie Bilello; Y-Charts, 2022 | Past performance does not guarantee future results.

DIVIDENDS AND DIVIDEND GROWTH TO COMBAT INFLATION

Dividend-growth companies have outperformed broader index returns across all inflationary timeframes going back since 1970, particularly during runaway inflationary periods (Exhibit 5). In addition, growing dividends can act as an inflation hedge — a key advantage that many fixed income products cannot offer. Over the last 150 years, dividends paid by U.S. companies have grown 3.7% per year compared to inflation’s growth at 2.1% per year (Exhibit 6), demonstrating the enhanced long-term purchasing power dividends have provided.

Exhibit 5: Stocks with high dividend growth outperformed the market during periods of high inflation (since 1970)

Exhibit 6: Annualized dividend growth of US stocks vs. inflation, 1871–2022

MULTIPLES AND EARNINGS DRIVE MARKET RETURNS

The expected potential return of any stock is a function of earnings growth per share, dividend yield and a price-to-earnings (P/E) multiple expansion or contraction. Negative year-to-date equity market returns have been driven by P/E multiple compression (Exhibit 7). P/E ratios are typically affected by inflation, which has remained elevated, and liquidity — which is decreasing due to the Fed’s announced quantitative tightening (QT) stance. QT is an effort to normalize monetary policy, decrease the money supply in the economy and ultimately normalize (i.e., raise) interest rates to reduce inflation. This posture is a stark contrast to the last decade of intermittent quantitative easing (QE) and easy monetary policy.

Exhibit 7: Year-to-Date Percent Change in S&P 500 Price, P/E Ratio, & Earnings per Share (EPS)

Earnings growth is another significant component of equity market returns. The market in the second quarter seemed to be grappling with earnings visibility as a result of the potential slowdown in consumer spending and decline in corporate profit margins. Consumer discretionary spending seems likely to slow due to higher energy prices, rising interest rates (and thus a less attractive borrowing outlook) and decreased fiscal stimulus, deflating consumer pocketbooks. These factors, combined with the reality that inflation has crept into sticky corners of the economy such as rent, contributed to the lowest all-time reading of the University of Michigan’s U.S. Consumer Sentiment Indicator in June. Given the abundant inflationary headwinds for corporate America (wages, transport costs, etc.), we believe that optimistic earnings estimates will continue to drift lower (Exhibit 8), presenting further risk to the outlook for equity markets.

Exhibit 8: 2023 S&P 500 EPS Progression

In summation, markets seem to be battling with the duality of two components of equity returns:

1. What valuation multiple is right for the market?
2. How will earnings trend given the multitude of economic headwinds?

We anticipate that those investments with generally lower starting valuations coming into 2022 and greater earnings stability likely have the advantage.

If the market increasingly responds to pressures more definitive of a secular bear market, we believe a strategy focused on high-quality, dividend-paying equities has the potential to provide positive dividend growth for investors, something that remains especially relevant in today’s environment.

CRN: 2022-0714-10178 R

Opinions in this piece are those of Bahl & Gaynor Investment Counsel and are not necessarily that of AAM.