Dividends: a friend for tough times

Capital at risk. In the giddy days of low interest rates and abundant liquidity, dividends were an afterthought for many investors. Instead, they were drawn to the long-term growth potential of areas such as technology. However, as the economic environment changes, inflation rises and interest rates move higher, investors may start to rediscover the charms of a dividend strategy.

At a time of higher inflation, returns today become more valuable than returns tomorrow. This means that dividends being paid in the short-term have more appeal than long-term capital growth, which is less certain. We are already starting to see this shift in markets as investors move away from previously fashionable sectors.¹

Equally, at a time of market volatility, dividends may provide some stability in a portfolio. When capital values are moving around, a steady dividend is reassuring. Even though yields on bonds have increased, dividends remain one of the few ways to grow income over time. This is important at a time when inflation is exerting a drag on investor returns.

Selectivity

However, investors cannot afford to take a scattergun approach in the current environment. Recession now appears to be a plausible scenario for 2023² and certain companies will struggle as rising energy prices and interest rates bite. In the BlackRock Income & Growth Investment Trust, we have been moving away from consumer-facing areas, for example, recognising that households will come under increasing pressure in the months ahead.

It remains very difficult to predict the trajectory of inflation. We still do not know whether the current inflationary trends are the temporary impact from the significant Covid stimulus, the unwinding of extreme Covid behaviours, a more structural shift in the cost of labour, the impact on costs from the decarbonisation agenda or a combination of the above. Against this backdrop, it will be incredibly important to focus on companies with strong, competitive positions, at attractive valuations that can deliver in this environment.

Inflation impact

It is notable that for much of 2021, the majority of companies we have spoken to have been able to pass on cost increases. However, as input costs rise and inflation endures longer than expected, that is likely to become more challenging. As such, we continue to concentrate the portfolio on businesses with the ability to pass on price rises to their customers and those that demonstrate sustainable free cash flow. These companies are best-placed to protect margins and returns - and therefore to grow their dividends - over the medium and long-term.

Another significant unknown is wage inflation. High employment levels are already pushing up wage demands and there is a danger that this will accelerate. The companies we speak to are concerned about employee retention as competition for labour intensifies. We believe employee retention will be an important differentiator in the year ahead given the productivity benefits of a stable workforce.

While it has been heartening to see how swiftly and robustly dividends have come back in the wake of the pandemic, we believe it will be tougher from here. Soaring commodity prices have enabled companies such as Rio Tinto and BHP to pay large special dividends, but this may not persist. Carefully assessing a company’s ability to preserve its cash flows in this environment will be vitally important in generating a resilient and growing income for our investors.

Reference to Specific Stocks: Reference to the names of each company mentioned in this communication is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies

The UK remains the highest dividend yielding market in the developed world³ and the fundamental valuation of the UK is attractive relative to its global peers. We believe most companies in the UK have emerged from the Covid crisis with more appropriate and realistic dividend policies. This gives us confidence that there will remain plenty of opportunities for stock-pickers.

Dividends may become a more important part of overall return for investors in the years ahead. They are not a panacea, however, and we are directing our portfolio to those companies most likely to be able to preserve their margins and cash flow in an increasingly tough environment. These companies are likely best placed to sustain and grow dividends into the future.

This material is not intended to be relied upon as a forecast, research or investment advice and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are from BlackRock as of July 2022 and may change as subsequent conditions vary.

For more information on how to access the opportunities presented by the income and growth sector, please visit: www.blackrock.com/uk/brig

¹ https://www.cnbc.com/2022/06/30/tech-stocks-q2-2022-worst-quarter-in-years-for-tsla-amzn-msft-goog.html - 30th June 2022

² https://www.cnbc.com/video/2022/07/25/a-genuine-recession-could-be-coming-to-the-us-in-2023-economist.html - 25 July 2022 https://www.blackrock.com/corporate/literature/market-commentary/weekly-investment-commentary-en-us-20220718-ecb-may-limit-hikes-as-recession-nears.pdf - 18 July 2022

³ Barclays Research, Refinitiv. 10 February 2022

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