Despite A Slowing Economy, Dividend Growth Remain Confident

Key takeaways

• While 2022 was a challenging environment for the capital markets, it highlighted many of the strengths of dividend equities, which outperformed non-dividend equities and bonds year-to-date.
• Despite a slowing economy, we remain confident in dividend growth: conservative payout ratios mean companies have plenty of cushion to continue raising dividends despite slowing, or even negative, earnings growth.
• As patient and conservative dividend investors, we will continue to focus on companies with pricing power that can raise prices to offset inflationary pressures and protect their profitability.

Rising dividends can help offset the ravages of inflation, protect purchasing power

While 2022 was a challenging environment for the capital markets, it highlighted many of the strengths of dividend equities, which outperformed non-dividend equities as well as bonds (Exhibit 1). Many of the forces that buoyed companies with growing dividends in 2022 remain intact for 2023. First, in volatile and uncertain markets, dividend payers tend to stay afloat as their current income gives investors something to hold onto in choppy waters. Second, inflationary concerns remain front and center. Dividend growers can thrive in an inflationary environment because, unlike bonds, which have fixed coupons, rising dividends can help offset the ravages of inflation and protect purchasing power.

Exhibit 1: Dividend Payers Were Defensive in 2022

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Sources: FactSet, ClearBridge Investments, as of November 30, 2022. Measures performance of dividend-paying stocks and non-dividend-paying stocks in the S&P 500 Index as well as corporate bonds, as represented by the Bloomberg US Aggregate Bond Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is no guarantee of future results.

With rising interest rates and a slowing economy, many wonder if we are headed for a recession. Earnings comparisons are getting tougher, monetary policy works with a lag (we still have not seen the full impact of previous hikes by the US Federal Reserve) and interest rates may go even higher than expected.

In these turbulent and uncertain times, when crystal balls can be especially cloudy, we believe dividend growers are particularly attractive. They offer current income as well as the potential for downside support, inflation protection and capital appreciation if things go better than expected. Either way, volatility is not going away.

Despite a slowing economy, we remain confident in dividend growth. Payout ratios, broadly speaking, are conservative (Exhibit 2), meaning companies have plenty of cushion to continue raising dividends despite slowing or even negative earnings growth.

Exhibit 2: Dividend Payer Payout Ratios Are Conservative

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Sources: FactSet, ClearBridge Investments, as of September 30, 2022. Past performance is no guarantee of future results.

We tend to target companies with payout ratios of 40%–50%, a level that tells us that even with healthy payouts to shareholders, these companies also retain significant amounts of their earnings to fund growth and, importantly, to provide a margin of safety in challenging times.

While we observe the increasing headwinds to the economy and expect continued deceleration, our base case for 2023 is slow but positive growth. Inflation in goods such as used cars and furniture is declining, supply chain snarls of the past 18 months are being resolved, and loosening COVID-19 restrictions in China could help both global supply and demand.

From our perspective, as patient and conservative dividend investors, the dividend playbook should be similar: we will focus on companies with pricing power that can raise prices to offset inflationary pressures and protect their profitability. We still like financials, which benefit from higher interest rates, and where a strong labor market is keeping credit quality high. We continue to expect energy to be a strong contributor to dividend returns given just how robust the energy sector is and the financial strength that some of those companies display.

Dividend equities were timely in 2022, and as 2023 presents similar uncertainty and challenges—elevated inflation, higher interest rates, pressure to earnings—the timelessness of dividend stocks should offer value, in our analysis. We view dividend investing as an evergreen strategy. We believe it is the core of investing: buying good companies that have consistent, meaningful and growing cash flows, valued using present free cash flow rather than some pie-in-the-sky forecast of where they will be five or seven years from now. We like to stay patient, disciplined and conservative and compound returns over the long term.

While any given year in the market is hard to predict, dividend investing is a sound strategy for the long term, in our opinion. If 2023 proves a repeat of 2022, with a recession added in, dividend stocks should offer similar support amid volatility; if markets perform better than expected, dividend stocks should participate nicely in a recovery.