When the downward march of bond yields accelerated during the pandemic, many yield-hungry investors turned to high dividend-paying stocks and equity income strategies in particular. However, the era of near-zero interest rates and moderate inflation is over, and we believe the current market environment is fundamentally different than the one that preceded it. Going forward, it’s fair to assume that rates could be higher than they were during the pre-COVID-19 era, as we believe that inflationary pressures are likely to remain elevated for several reasons:
· Increased deficit spending by governments—Postpandemic debt levels remain high as governments spend more freely to tackle issues such as climate change mitigation without raising taxes, a dynamic that could lead to bouts of inflation.
· Deglobalization—Trade disputes, COVID-19, and other factors have fueled policies that have reversed the post-World War II trend of globalization, with many nations and regions turning to neighbors and their own domestic capacity to bolster supply chains. Critics of deglobalization argue that this trend has increased costs of goods and services, stoking inflation and putting upward pressure on rates.
· Aging populations—The United States and many other developed nations are getting older, leading to worker shortages, which push labor costs higher and fuel inflation.
The new era of high rates won’t be without some downward adjustments. Policy projections that the U.S. Federal Reserve (Fed) released at its December 13, 2023, meeting suggest the potential for three rate cuts in 2024 from the current benchmark range of 5.25% to 5.50%.
However, other factors bolster the case for a higher-for-longer long-term outlook. Policymakers’ consensus forecast for a year-end 2024 rate of around 4.60% remains high relative to recent history, and Fed officials worry that any swift reversion to rate-cutting mode could reignite inflation. Moreover, the Fed has acknowledged that the latter stages of its drive to reduce inflation closer to its 2% long-term target rate are likely to progress more slowly than the earlier stages that followed June 2022, when the Consumer Price Index peaked at 9.1%—the highest since November 1981. In addition, the Fed remains under pressure from critics to abandon its target rate as being too low to sustainably achieve over the long term.
With elevated rates likely to persist, costs of capital are variable, and those companies that are trading at attractive valuations while possessing strong fundamentals and positive business momentum are likely to stand out from peers that lack those strengths, in our view. Increased capital cost variability may result in greater differentiation among companies’ overall costs and cash flows, and we believe that this shift has created an unusually fertile environment for an active approach to security selection.
Why equity income strategies may now be at a disadvantage
Our core value approach contrasts with equity income investing, a category that seeks to generate income from dividend-generating stocks. Portfolio managers of equity income strategies typically focus security selection on established companies with histories of consistently increasing their dividend payments.
While such a total return approach may make sense for some income-seeking investors, the appeal of equity income strategies may be diminished in a higher-rate environment like the current one. When rates rise, bond yields adjust upward, and the yields of many bond categories currently exceed those generated by dividend-paying stocks while offering potentially less investment risk. Similarly, yields of bank certificates of deposit have risen as the Fed has lifted rates, creating another current source of yield-generating competition for equity income strategies. In a higher-for-longer environment, we believe it could be a long time before yield-comparison math becomes more favorable for equity income approaches.
As for equity income strategies’ potential to generate capital appreciation, a focus on dividend-paying stocks can come with a price, in our view. Such a constrained approach may involve missing out on stocks that present strong opportunities for capital appreciation but are excluded from an equity income portfolio because they either don’t distribute dividends or pay relatively modest ones.
Core value: incorporating a wide range of factors alongside a price-conscious approach
In our view, a core value strategy may offer a more flexible and holistic approach than its equity income counterparts. Using our firm’s three-circle stock-selection process, we look beyond a stock’s dividend yield and price metrics; in addition to attractive valuations, we seek to identify those stocks that offer strong business fundamentals and positive business momentum. Fundamental measures can include metrics such as a company’s operating returns on operating assets, free cash flow, underlying costs, and balance sheet strength. Business momentum can include factors such as earnings surprises, sales trends, revisions to analysts’ net income projections, and catalysts that may offer an indication of whether the company’s overall business may be improving or deteriorating. We tend to view stocks favorably when we see strengths across all three of these elements in combination; in our experience, portfolios with all three characteristics tilt the probability of outperforming in an investor’s favor over time.
How a core value approach offers potential to add value in today’s markets
We believe the transition to a higher-for-longer rate environment is both entrenched and favorable to the value equity style relative to growth equities, which generally trade at higher multiples. Rate hikes helped to fuel a performance rotation away from the growth style in 2022—which saw sharp declines for many stocks trading at high equity multiples—and we believe that 2024 could bring another stretch of strong relative performance for value.
While valuations don’t always drive markets over the short term, we believe that prices do tend to matter over the long haul, especially when valuation and fundamentals grow in importance following a period of elevated multiples and accommodative monetary policies. We believe that we’re at such a point now and that we’re in the early innings of multiple compression across a wide swath of the U.S. equity market. With high rates likely here to stay, we believe those companies that possess strong balance sheets and are capable of self-financing their operations offer greater potential to outperform than peers facing high debt burdens and elevated costs of capital.
It’s an environment that we believe enhances the potential of active investment management and adherence to a disciplined approach to identify overlooked stocks possessing attractive valuations, strong fundamentals, and positive business momentum. While dividend considerations may also play a role in our process, we believe a core approach opens up a wider opportunity set to leverage the full potential of value equities today.
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The views presented are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index.
Dividend yield is a dividend expressed as a percentage of a current share price. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Investing involves risks, including the potential loss of principal. Value stocks may decline in price. Large company stocks could fall out of favor, and illiquid securities may be difficult to sell at a price approximating their value. Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability. Growth stocks may be more susceptible to earnings disappointments. Hedging and other strategic transactions may increase volatility and result in losses if not successful. These products carry many individual risks, including some that are unique to each fund. Please see each fund’s prospectus to learn all of the risks associated with each investment. Diversification does not guarantee a profit or eliminate the risk of a loss.