Dividend investors, your time has come. Well, maybe.
The Bank of Canada cut its key interest rate on Wednesday morning by a quarter of a percentage point, marking the first turn in monetary policy in more than two years.
This one cut, which follows 10 consecutive rate hikes since early 2022, might not be enough to trigger a rally in dividend-paying stocks right away. However, it bolsters the view that the single biggest drag on these stocks over the past two years is about to let up.
If the central bank follows this rate decision with more rate cuts later in the year, as the threat of inflation subsides or economic clouds gather, all the better.
Dividend-paying stocks have been struggling over the past two years as rising interest rates attracted investors to other income-generating investments, such as bonds and guaranteed investment certificates (GICs).
The difference between the performance of dividend stocks and the broader market is striking.
The S&P/TSX Composite High Dividend Index – which tracks 75 stocks, including Bank of Montreal (BMO-T), Enbridge Inc. (ENB-T) and Telus Corp. (T-T) – has delivered a return of only 0.5 per cent over this two-year period.
It lags the total return of the broader S&P/TSX Composite Index by 13 percentage points. These returns include dividends.
The difference is even more stark in the United States, where the Federal Reserve’s aggressive rate-hiking response to inflation has also weighed on dividend stocks.
The S&P 500 High Dividend Total Return Index – which tracks the performance of 76 stocks, including Duke Energy Corp. (DUK-N), Best Buy Co. Inc. (BBY-N) and Verizon Communications Inc. (VZ-N) – has delivered a total return of 1 per cent over this same two-year period. The index has trailed the S&P 500 by 34 percentage points.
Rising yields, largely a consequence of falling share prices, tell a similar story about the recent performance of dividend stocks, especially in Canada.
The yield on the S&P/TSX Composite High Dividend Index is currently hovering around 5.5 per cent. That’s up from a recent low of 3.9 per cent in February, 2022, before the Bank of Canada began to raise rates.
Now, some market watchers expect that these trends will start to move in reverse: rate cuts will make dividends look more attractive relative to bonds and GICs, underpinning a rebound.
There are other aspects to this bullish case.
In several reports on dividend stocks this year, Bank of America strategists argued that dividend stocks are cheap and unpopular among investors, making them a compelling bet on rebounding sentiment alone.
The strategists, who declared 2024 as a “banner year” for dividend stocks, added that trillions of dollars are parked in U.S. retiree accounts in the form of cash. As interest rates decline, the returns on this cash will diminish, providing a powerful incentive for investors to pursue other investments – notably, dividend stocks – that can generate attractive income.
Nonetheless, some observers caution that this first rate cut by one central bank is a small step. Sticky inflation and upbeat economic activity could leave key interest rates, even after cuts, considerably higher than they were several years ago.
As a result, the recovery in dividend stocks might not be swift, or particularly dramatic.
“We wouldn’t view a Bank of Canada cut in isolation as providing a tailwind for dividend stocks,” Ryan Crowther, a portfolio manager at Franklin Templeton Canada, said in an e-mail.
The cost of capital remains high for companies because of borrowing costs that have soared over the past two years. As well, investors can still earn a meaningful return on their cash from risk-free investments, including GICs.
“It would take much more than one cut to move the needle as far as these factors are concerned,” Mr. Crowther said.
What’s more, additional rate cuts would likely pummel the Canadian dollar, which may limit what the Bank of Canada can do until the Fed gets on board. Until then, the Bank of Canada’s first rate cut will likely provide limited relief to some popular dividend stocks.
For example, Canadian banks, whose profits have been crimped by rising credit losses and slowing loan growth, may continue to struggle.
“We believe it will be hard for the Bank of Canada to fully disconnect from the Fed, without strongly hurting the Canadian dollar. If the monetary disconnect remains very limited, we doubt it will be enough to rekindle bank earnings,” Hugo Ste-Marie, an analyst at Bank of Nova Scotia, said in a note.
Given this sort of uncertain backdrop, investors holding cash may be lured toward bonds, rather than dividend-paying stocks.
“With the time of elevated cash rates likely drawing to a close, investors may want to re-evaluate portfolios and allocate back into bonds,” Rachel Siu, head of Canadian fixed income strategy at BlackRock, said in a statement.
David Berman