A new normal awaits us as we head into 2023. Inflation is expected to be higher than it had been in the decade before COVID-19, as major pandemic-related changes have been established. As a result, the era of “free money” is over and international tensions are at an all-time high. In light of this, it is critical to be flexible and proactive in making investment decisions.
Dividend-paying companies provide strong protection against inflation and higher long-term returns because dividends from well managed companies tend to increase faster than inflation, over the long-term, preserving the real purchasing power.
Commodities or precious metals can serve as inflation hedges but are not a reliable source of long-term return. Conversely, over time, dividend equities have produced better risk adjusted returns.
This uncomfortably high level of inflation was last seen more than 40 years ago, and analysing historical evidence, when inflation rises above 5%, it might take up to 10 years before it returns to the 2% target rate. The University of Michigan expected inflation rate over the next 5-10 years is now 3%.
Number of years before inflation reverted to 2%. Source: The Ruffer Review 2022
Dividend payers are frequently thought of as static, old businesses with little room for expansion, especially in the last decade, but when we looked at the data with a broader lens, we noticed that dividend-paying equities had produced significant returns over the last 30 years. By their very nature, dividend strategies invest in more established businesses that generate a significant free cash flows and typically do better in slowing growth, recessionary or inflationary environments than the overall market.
Since 1930, dividends have contributed about 40% of the S&P 500’s overall return. However, during the 1940s, 1970s, and 1980s, when inflation was 5% or greater on average, dividends were responsible for 54% of the overall return.
S&P 500 Returns Explained
Annualized price return and dividend contribution to total return. Source: Bloomberg