2 August 213 Can the dividend d theme thrive in a rising rates environment? Grace Tam Vice President Global Market Strategist J.P. Morgan Funds Ben Luk Market Analyst Global Market Strategy Team J.P. Morgan Funds The search for income from high-yielding fixed income products and high dividend- popular investment theme over the past several years paying stocks has been a very post the Global Financial Crisis amid the very low interest rate environment. However, after Fed Chairman Ben Bern nanke stated in his testimony before Congress in May that the Fed may taper the bond-buyinand high dividend stocks have seen a major correction. Investors understand the program in the coming months, high-yielding bonds negative impact on bond prices when interest rates are rising. Nevertheless, is it true that rising rates would also derail dividend stocks? In this paper, we look at the historical performance of global high dividend stocks when US Treasury bond yields were rising and explain why rising rates do not necessarily mean underperformance from high dividend stocks. Resilient dividend stocks performance despite rising US yields Investors often have a perception that rising rates are negative for high dividend stocks, particularly after they saw a sell off in the May/June correction triggered by the Fed s tapering concerns. But given the very strong inflows into dividend income products over the past couple of years, som me profit-takingtaking in the asset class was very reasonable in response to the potential transition of US monetary policy. However, does this now mean that the dividend income theme is effectively over for investors? Our analysis using historical data from January 1995 to July 213 in Chart 1 shows that the dividend income theme is not over, as high dividend stocks held up quite well in a rising rates environment. During periods of rising US yields (which we define as rolling 3-month periods with over 25 5bps increase in US 1-year Treasury yields), the average 3- month total return of global high dividend stocks* is +4.5%, slightly outperforming the broad MSCI AC World (USD) Index. We use the same method to look at the performance of high dividend stocks during a falling rates environment (which we define as rolling 3-month periods with over 25bps decrease in US 1-year Treasury yields). The results show that high dividend stocks on a 3-month total return basis ou utperformed the broad index by 1.7%, resulting in a cumulative outperformance of +328% since 1995. With significant outperformance during market downturns, while remaining relatively resilient during rising rates, global high dividend stocks were able to maintain long-term outperformance. *The global high dividend universe is a monthly rebalanced portfolio based on the top two quintiles (top 4% of stocks) ranked by dividend yields in the MSCI AC World (USD) Index (i.e. our model updates each stock s dividend yield in the index on a monthly basis and selects the top 4% of stocks by dividend yield to be included in the high dividend universe).
Performance of high dividend stocks in line with the broad index when US yields are rising and much stronger when US yields are falling Chart 1: Rolling 3-month average total return from January 1995 to July 213 Rising Rates Environment Falling Rates Environment All 4% 4.5% 4.3% 3.% 2% 1.8% 2.2% % High Dividend Universe AC World High Dividend Universe AC World High Dividend Universe AC World.1% August 213. Note: Periods of rising/falling US yields are defined as rolling 3-month periods when the US 1-year Treasury yields increased/decreased over 25bps from January 1995 to July 213. Refer to page 1 for the definition of high dividend universe. High dividend stocks are not just about defensives In many investors minds, high dividend-paying stocks mainly consist of defensives (utilities, health care, consumer staples and telecom). During a rising rates environment when the US economic recovery is getting stronger, cyclicals (materials, energy, industrials and technology), which are strongly tied to the economic cycle, naturally tend to outperform defensives. In fact, Chart 2 shows that within the high dividend stocks universe, global non-defensives (financials and cyclicals) l outperformed the MSCI AC World (USD) Index, while g lobal l defensives underperformed d during periods of rising i US yields over the past 18 years. Within the high dividend universe, non-defensives have outperformed defensives in a rising rates environment Chart 2: Rolling 3-month average total return during periods of rising US yields from January 1995 to July 213 7. 4.3% 5. 6.3% 6.2% 5.8% 5.1% 4. 3% 2.3% 2.8% 2.4% 2.3% 1. % August 213. Note: Periods of rising US yields are defined as rolling 3-month periods when the US 1-year Treasury yields increased over 25bps from January 1995 to July 213. Defensives include Telecom, Utilities, Health Care and Consumer Staples. Non-defensives include Energy, Industrials, Materials, Technology, Consumer Discretionary and Financials. Refer to page 1 for the definition of high dividend universe. 2
When we take a look at the breakdown of the high dividend stocks universe in the MSCI AC World (USD) Index, defensives make up only 34%, while financials and cyclicals weightings are 24% and 42%, respectively (Chart 3). Therefore, it is actually the non-defensive sectors that account for 2/3 of the high dividend stocks in the world index. This also explains why the performance of global high dividend stocks managed to largely match that of the broad index during periods of rising US yields. Non-defensives make up 2/3 of the high dividend stock universe in the MSCI AC World Index Chart 3: Composition of the high dividend universe of the MSCI AC World (USD) Index Industrials Financials 24% Energy 13% In fact, Chart 4 shows that annualized earnings per share (EPS) growth over the last decade was much stronger for high dividend non-defensive stocks (+8.1%), relative to high dividend defensive stocks (+5.4%). Earnings growth for technology (+12.4%), industrial (+25.%) and material (+1.5%) stocks were particularly stronger than the universe over the past 1 years. As we believe the global macro environment will continue to improve in what remains of 213 and into 214 due to a pickup in US and European economic growth, non-defensive stocks would be in the right position to potentially outperform the broad market. Non-defensives have a stronger EPS growth than defensives in the high dividend universe Chart 4: Earnings per Share Index, rebased 23 = 1 5 4 Utilities Telecom 7% Health Care 1% Materials 7% Con. Stap. 11% Con. Disc. Disc. 4% Tech. I.T. 3 2 1 Attractive opportunities in high dividendidend non-defensives es While defensive stocks (+4.%) on average have tended to pay higher dividend yields relative to non-defensive stocks (+3.8%) within the global high dividend universe over the past 18 years, investors should also focus on other factors that could drive total returns besides higher dividend yields, such as the ability of a company to generate and sustain its earnings and dividends over time. '3 '5 '7 '9 '11 '13 In terms of dividend per share (DPS) growth within the global high dividend universe, Chart 5 shows that annualized dividend growth was largely the same between defensives (+6.) and non-defensives (+6.5%) over the past decade. If we break down the non-defensive segment, it was mainly financials that dragged down the DPS growth of the overall non-defensive segment with an annualized dividend growth of only +3.%, while other cyclical sectors including technology (+17.3%), industrials (+2.1%) and materials (+8.4%) had relatively stronger DPS growth. 3
Both high dividend defensives and non-defensives have a similar pace of DPS growth Chart 5: Dividends per Share Index, rebased 23 = 1 25 High dividend non-defensives are trading at a discount to the broad world index Chart 6: Weighted average 12-month forward P/E Relative to MSCI AC World 1.4x 2 1.2x 15 1 5 '3 '5 '7 '9 '11 '13 Compelling valuations for high dividend non-defensives As chasing for income has become a fashionable investment theme, it is reasonable to question whether the valuations of high dividend stocks have become expensive after a few years of re-rating. Traditional high dividend defensive stocks are currently trading at a 12-month forward P/E ratio of 14.9x, a premium of 1.12x relative to the MSCI AC World Index. However, what investors may not realize is that high dividend non-defensive stocks are trading at 11.7x, a discount of.88x relative to the broad index, with technology, financials and energy stocks trading at a discount of.93x,.87x and.74x, respectively (Chart 6). 1.x.8x.6x '3 '5 '7 '9 '11 '13 Note: Ratio above 1 indicates more expensive relative to the MSCI AC World index. An investment theme for all seasons Chart 7: MSCI AC World (USD) Cumulative Total Return by Quintiles (ranked by Dividend Yield) with Monthly Rebalancing Index, rebased 1995 = 1 1, 8 6 Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5 AC World 4 2 '95 '97 '99 '1 '3 '5 '7 '9 '11 '13 August 213. 4
Investment implications As history suggests that high dividend equities do not necessarily underperform when US bonds yields are rising, we believe investing in this asset class is more than a purely defensive strategy. It is actually a long-term investment theme for all seasons, as high dividend defensive stocks tend to outperform during the downturn, while high dividend financials and cyclicals tend to outperform when the economic outlook is improving. Thus a portfolio combining both types of high dividend stocks effectively pushes the risk-reward ratio in a favourable direction. This also explains why global high dividend stocks have delivered consistent outperformance over the past two decades (Chart 7). In fact, since a large portion of the global high dividend universe consists of financials and cyclicals, investors were able to benefit from the non-defensives high income and earnings growth opportunities even in a rising rates environment. We believe investors should be able to continue to benefit in 214 as well. Past performance is not a guarantee of future results. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. Opinions, estimates, forecasts and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without further notice. The information provided herein should not be assumed to be accurate or complete. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategiess described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not interpreted as recommendations or investment, product, accounting, legal or tax advice. J.P. Morgan Chase & Co. group assumes no responsibility or liability whatsoever to any person in respect of such matters. The views expressed are those of J.P. Morgan Asset Management. These views do not necessarily reflect the opinions of any other firm or other division of the JPMorgan Chase & Co. group. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued by the following entities: in Hong Kong by JF Asset Management Limited, it JPMorgan Funds (Asia) Limited it or JPMorgan Asset Management Real Assets (Asia) Limited, all of which are regulated by the Securities and Futures Commission; in India by JPMorgan Asset Management India Private Limited, which is regulated by the Securities & Exchange Board of India; in Singapore by JPMorgan Asset Management (Singapore) Limited or JPMorgan Asset Management Real Assets (Singapore) Pte. Ltd., both are regulated by the Monetary Authority of Singapore; in Taiwan by JPMorgan Asset Management (Taiwan) Limited or JPMorgan Funds (Taiwan) Limited, both are regulated by the Financial Supervisory Commission; in Japan by JPMorgan Asset Management (Japan) Limited, which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Japan Securities Dealers Association, and is regulated by the Financial Services Agency (registration number Kanto Local Finance Bureau (Financial Instruments Firm) No. 33 ); in Korea by JPMorgan Asset Management (Korea) Company Limited, which is regulated by the Financial Services Commission (without insurance by Korea Deposit Insurance Corporation) and in Australia to wholesale clients only as defined in section 761A and 761G of the Corporations Act 21 (Cth) by JPMorgan Asset Management (Australia) Limited (ABN 551438328) (AFSL 376919), which is regulated by the Australian Securities and Investments Commission. This communication is for intended recipients only and may only be forwarded or presented to other persons in compliance with local law and regulations which shall be the intended recipients sole responsibility. Investment involves risks. The value of investments and the income from them may fall as well as rise and investors may not get back the full or any of the amount invested. Recipients of this communication should make their own investigation or evaluation or seek independent advice prior to making any investment. It shall be the recipient s sole responsibility to verify his / her eligibility and to co mply with all requirements under applicable legal and regulatory regimes in receiving this communication and in making any investment. 213 JPMorgan Chase & Co. 5