An equity allocation that literally pays dividends

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“Recession? What recession?” That’s what U.S. equity markets seemed to be asking for much of July. Despite still being in the midst of a historic monetary tightening cycle that may send the economy into a recession, the Dow Jones Industrial Average logged a 13-day winning streak (its longest since 1987) and the S&P 500 Index came close to its all-time high before falling in the middle of last week. To some extent, the market’s recent buoyancy isn’t surprising: Recent data have painted a portrait of a thriving U.S. economy, showing resilient labor markets, improving consumer sentiment, moderating inflation (Figure 1) and strong annualized GDP growth (+2.4%) in the second quarter of 2023.?

A Catch-22 could deep-six further exuberance in the near-to medium term. Last week’s market reversal happened the day after the Fed’s widely anticipated 25 basis points (bps) rate hike, which pushed the fed funds rate to its highest level in more than two decades. Fed Chair Jerome Powell left the door open to another possible rate increase later this year, as inflation remains elevated. But even if the Fed were to pause (again), an upbeat market response is by no means assured. Having long hoped the Fed would stop raising rates because continued tightening might slow the economy to the point of recession, some investors now fear that failing to raise rates would signal the Fed’s belief that the economy is slowing, potentially to the point of recession. The tug of war between those contradictory ideas highlights the uncertainty markets are now experiencing.

It pays to be prudent. As investors grapple with how best to allocate portfolio assets in this unique economic, market and policy environment, we continue to believe that staying invested is the soundest approach — and that some ways are better than others to increase equity exposure while mitigating risks.?

Portfolio considerations

Market breadth has been improving. Following the dominance of mega-cap growth stocks this year, the U.S. equity market rally has broadened, with more sector, style and capitalization segments participating. We expect this trend to continue, enhancing opportunities for investors to benefit from a flexible investment approach supported by rigorous, bottom-up research and careful stock selection.?

Companies that pay (and grow) dividends stand to benefit. Dividend growth-oriented equities deserve particular consideration both in the current environment of continuing, albeit slowing, economic growth, and as a long-term portfolio allocation. We believe these companies — supported by positive fundamentals, sustainable growth potential, healthy balance sheets, ample free cash flow, stable profit margins and management teams committed to returning capital to shareholders — offer several compelling potential advantages:

A hedge against persistent inflation: The combination of capital flexibility, balance sheet strength and growing dividend payments may help mitigate inflationary pressures and the impact of higher interest rates.

Downside management: Our research shows that dividend growth companies have historically performed relatively well during periods of heightened volatility and market drawdowns, and also during periods following interest rate hikes (Figure 2). We expect this area of the market may be able to maintain and expand margins amid inflation and higher interest rates while also providing a cushion against market volatility.?

The potential for income growth: While dividend growth has decelerated from 2022 levels, more than 200 S&P 500 companies have declared a dividend increase in 2023 so far, according to S&P Dow Jones. This continued strong dividend activity signals that company management teams are confident in their business prospects despite cost pressures.

Not all dividend-paying companies offer the same advantages. We see key differences between dividend growth companies and high dividend yielding companies. In our view, dividend growers offer stronger earnings growth potential, better dividend payout ratios, higher profitability metrics and less reliance on the debt market.

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