Market anxiety? An old, reliable friend may be able to help.

In a volatile start to 2022, markets came to the realization that inflation isn’t so transitory after all, and some of the worst fears of escalating geopolitical tensions became reality. With central banks’ signals towards increasingly decisive monetary policy and Russia’s invasion of Ukraine, the resulting market corrections have been more painful than many prior bouts of volatility because both stocks and bonds traded meaningfully lower. With so few asset classes providing any form of ballast, diversification has been in short supply.

Asset class performance year to date

Uncertainties around geopolitical events and domestic monetary policy may persist, but a surging VIX does not need to cause a surge in your blood pressure. At times like these, I like to remind myself (and clients) that market pain sows the seeds of future opportunities.

Coming into the year we felt that 2022 would bring a good, but not great year for markets, and one that might reward investors who consider 3 things: 1) avoid the most expensive growth stocks, 2) focus on more mundane dividend payers/growers and 3) emphasize credit over duration in fixed income.

We remain convicted in these views, and we’ve already seen some prove true during the volatility year-to-date.

Income spotlight: the case for dividend stocks

A seismic shift in markets has been underway as policymakers catch up to the strength of the economy, and investors acclimate to what finally may become a post-COVID-19 environment. This shift has already resulted in a number of casualties, most notably the industries that had benefited the most from stay-at-home economic trends and the influx of liquidity engineered by policymakers.

Taking a step back and surveying the landscape, we believe dividend-paying stocks, an old stalwart of income investors’ portfolios, are well-positioned in the current environment, offering reasonable valuations, limited interest rate sensitivity, and more favorable exposures to evolving risks.

1) Dividend stocks look attractive from a relative valuation perspective. We expect 2022 will be another positive year for stocks and another year of outperformance relative to bonds. However, the heightened volatility has us more measured in our return expectations. Taking a look at valuations, while the majority of the stock market has gotten considerably more expensive over the past 5 years, dividend stocks are actually trading at a lower P/E today than in 2017 (see chart below).

Valuation difference is still massive
Forward P/E Multiples

2) Dividend stocks today are exhibiting stronger resilience to rising interest rates. Recent geopolitical developments have exacerbated the near-term inflation challenge facing central banks, but we do not expect the Fed to materially change its stance. In our view, investors looking for diversification away from rising rates need to look no further than those same dividend payers in this environment. While historically it would be correct to say that dividend stocks tend to be more correlated to interest rate moves than the broader market, the environment today is very different. The part of the equity market most adversely exposed to rising rates are the expensive growth stocks. As an example, the Nasdaq 100’s 1-year correlation to interest rate (10-year Treasury) returns is well above its 20-year historical ranges, suggesting growth stocks may struggle if rates continue to move away from the pandemic era lows. Meanwhile, the correlation of dividend stocks (S&P 500 High Dividend Index) to interest rate returns has been negative in recent years, suggesting dividend stocks may serve as a better diversifier in the current environment.

Dividend versus growth stock sensitivity to interest rate returns
1-year rolling correlation to 10-year Treasury returns

3) Dividend stocks offer favorable exposures in a period of heightened geopolitical risk and fragmentation. Relative to broad equity markets, domestic dividend-paying stocks are overweight both energy and more defensive industries, offering investors a balanced exposure to beneficiaries of rising energy prices as well as businesses that provide stability through heightened volatility. While certain industries and companies may suffer lasting consequences, analysis of past geopolitical conflicts suggests they typically do not have a lasting impact on markets. Thus, our bias is to view dislocations as opportunities. To the extent that there are lasting broader impacts, it will be through the growth, inflation, and policy channels, and Europe will be more adversely impacted than the US.

All of this suggests that mundane (and lately overlooked) dividend payers may be poised to offer investors attractive risk-adjusted return opportunities going forward, potentially attracting capital from not only income-oriented investors, but also yield-agnostic investors looking for a more dependable return stream in a period of heightened risk and volatility.