Dividends proved resilient in the first half of 2023. Richard Saldanha considers what the rest of the year might have in store for income investors.

Read this article to understand:

  • The outlook for dividends across sectors
  • How income investors can respond to the artificial intelligence boom
  • Why the resilience of healthcare and consumer staples should not be overlooked

For much of this year, equity investors have been preoccupied with the impact of rising interest rates and stubbornly high inflation on companies and sectors. Geopolitical concerns and a weaker than hoped recovery in China after the easing of COVID-19 restrictions have added to the uncertainty, although developed economies have proved resilient. 

From an income perspective, the year started with strong dividend growth. There was a higher level of special dividends in the first quarter, and share buybacks also showed up strongly as many companies proved adept at generating cash. 

In the US, S&P 500 dividend pay-outs totalled a record $146.8 billion in the first quarter, while total pay-outs for the 12 months ending March 30 were $573.7 billion – another record and 9.3 per cent up on the equivalent period in 2021/22.1 Despite uncertainty as to what might happen in 2024 and 2025, the resilience of dividends seen in the US this year is evident in other markets. The UK’s benchmark FTSE 100 index, for example, is expected to generate total dividends of £83.8 billion in 2023, up ten per cent on last year’s £76.1 billion, according to AJ Bell estimates.2

Some of the highest pay-outs are expected in sectors traditionally associated with dividends, including energy, utilities, mining, financials and tobacco. But attention has also been focused on the tech sector, and companies associated with artificial intelligence (AI) in particular, with investors seeking to identify potential winners, from chipmakers to cloud computing providers.

So, what might the rest of the year hold in store for income investors? To find out, we put the questions to Richard Saldanha, manager of the Aviva Investors Global Equity Income strategy.

How have earnings and dividends held up this year?  

Earnings have come under pressure as economic activity continues to weaken. Markets had at one point been looking for double digit earnings growth globally, but expectations have come down significantly as markets factored in the impact of higher interest rates and slowdown in economic growth. 

The US is experiencing a technical earnings recession, whereas Europe has held up slightly better

However, the picture in the US is different to Europe. With two quarters of year on year negative earnings growth, the US is experiencing a technical earnings recession, whereas Europe has held up slightly better. Earnings have still been growing despite the war in Ukraine and knock-on impact on energy and commodity prices, although we are seeing European consumers come under significant pressure from rising costs. The big question is whether companies will lower guidance for future earnings. 

The picture is better for dividends: we still see growth despite the challenging environment. This proves a point we have made previously, that dividends tend to be more resilient than earnings during volatile periods or slowdowns. While dividend growth has come under pressure, mainly as a function of the slowdown in earnings and cashflows, companies are continuing to prioritise pay-outs to shareholders (see Global equity income Q&A: Richard Saldanha on dividends and downturns).3

In Q1, a large proportion of dividends were one-off payments. Do you expect this to continue? 

A lot of those one-off special dividends in the first quarter were the result of windfalls from oil companies, as well as auto manufacturers such as Ford and Volkswagen. In many cases, companies returned the additional cash to investors, not just through extraordinary dividends but also share buybacks. Given the windfalls look to be behind us now that energy prices have fallen, it is fair to assume that trend will not continue.  

Buybacks hit record levels in 2022 and there are indications the total for 2023 may be higher. How is that affecting your outlook? 

In 2020, the pandemic forced many companies to cut back on dividends and buyback plans because of cash constraints. The situation reversed quickly as economies re-opened, and we saw a massive resurgence in dividend pay-outs and buybacks that carried into last year. 

Today’s higher rates make servicing debt a lot more difficult – and expensive

A lot of the buybacks have come from big, cash-generative companies, such as Apple and energy majors with bumper profits. Others, though, have been fuelled by debt. In a period of low interest rates, it was easy for companies to pile on more debt and use the funds to repurchase shares. But today’s higher rates make servicing debt a lot more difficult – and expensive.

Given where rates are, buybacks will likely become more constrained. If we see a slowdown in economic activity or recession, companies will naturally decide to preserve cash. In such a scenario, the buyback taps are likely to be turned off before the dividend ones as companies tend to prioritise dividend payments even in an environment where earnings are under pressure.

Figure 1: Dividends versus buybacks (US$ billions)

Note: S&P 500 dividends and buybacks, quarterly data.
Source: S&P Global, Aviva Investors. Data as of 31 March 2023.

The boom in generative AI is a hot topic. Which dividend payers, if any, could be winners and are we seeing AI have an impact on revenues or share prices?

There is one clear winner: the semiconductor sector. It provides the "nuts and bolts” that help the likes of Microsoft, Amazon, Alphabet and Meta grow. ChatGPT and other generative AI platforms all need enormous amounts of computer processing power, which is enabled by chips produced by semiconductor companies.

One example is Nvidia, whose share price has rocketed. Although Nvidia does not pay dividends, there is a long list of other companies in the semiconductor sector that might reap the benefits of AI, some of which may interest income investors. 

There is a long list of other companies in the semiconductor sector that might reap the benefits of AI

Take Broadcom in the US, which develops and supplies semiconductor and infrastructure software. The company manufactures “custom silicon” components – processors that meet specific customer requirements – which are the elements that go into high-powered AI computing chips. Broadcom’s biggest customers include Alphabet and Meta, who are at the forefront of AI innovation. With the huge uptick in demand for these chips, its AI-related revenues are expected to double over the next year, and this is reflected in the substantial rise in its share price. The company also pays a healthy dividend, which has grown around 20 per cent in the last five years. 

Another interesting area is storage. We see demand for data storage increasing, along with demand for electricity and the need for further investment in the underlying grid. Within industrials, companies like Schneider and Siemens that can help with the infrastructure for huge data centres and grid networks, or with power generation to meet the increased demand for electricity, should also benefit from the boom in AI.

Are any themes going under the radar?

Companies that have traditionally proved defensive and resilient, such as those in the healthcare or consumer staples sectors, are being overlooked right now as investors rush to invest in technology names. These firms delivered solid earnings and dividends last year in a volatile environment, in no small part due to their pricing power and ability to offset inflation. Given there are still questions over whether we are heading into a recession, they deserve more attention.

Now is the time to look for companies that have proven their ability to navigate volatile markets

With plenty of risks out there, now is the time to look for companies that have proven their ability to navigate volatile markets, generate stable cashflows and pay consistent dividends, which should provide significant value over the long term.

How concerned are you about inflation and the risk of recession?

The situation is not straightforward. Although there are welcome signs of inflation falling from the high levels of last year, core elements (which exclude more volatile food and energy prices) are proving sticky, which should concern everyone. Companies and consumers continue to face elevated costs, especially in the UK. 

Markets, on the other hand, remain benign, with volatility indices such as the VIX remarkably low. While this suggests they are pricing in a soft landing, there are nuances to consider. First, a narrow group of tech companies is driving the rise in stock markets this year; most sectors are down. Second, wider pressures remain. Central banks have yet to conquer inflation and geopolitical tensions are ongoing, from Ukraine to the US-China relationship. We also should not forget the mini banking crisis earlier this year, which could yet have a longer-term effect as US bank lending tightens. We expect a slowdown in the global economy over the next few quarters, which makes us more cautious than many other investors.

Banks traditionally pay good dividends, but the sector has been shaken by the recent collapse of regional US banks and government-brokered takeover of Credit Suisse by UBS. How has this affected your outlook for the sector?

Banks serve as a bedrock for many income funds. However, unlike many of our peers, we have never had a significant amount of exposure. We currently do not own any banks in the portfolio and the crisis has not changed our views on the sector.

Unlike many of our peers, we have never had a significant amount of exposure to banks

Dependent on net interest income, the bank business model is clearly a function of interest rates, which are hard to forecast, as we have seen in recent years. This makes it difficult to estimate banks’ earnings. In recessionary periods, such as during the pandemic, banks cut dividends substantially. This raises questions over the sustainability of their income streams.  

But while we believe there are reasons to be cautious on banks, there are other financial sector companies whose business models are resilient. Stock exchanges, payment companies and insurance brokers, for example, tend to deliver more sustainable earnings and income streams over the long term.

How has the reopening of the Chinese economy affected the outlook? 

The rapid unwinding of COVID restrictions in China raised hopes the release of pent-up domestic demand would lead to a resurgence in GDP growth, which could offset the slowdown in the West. To some extent, that has played out through luxury goods and travel sectors: companies such as the French luxury goods LVMH or Swiss-owned Richemont have seen a strong rebound in Chinese demand for their products. 

However, the picture is different elsewhere. Economic data, such as the Purchasing Managers’ Indices (PMIs) are mixed, youth unemployment is still high and problems in the property sector remain. Our conversations with big industrial businesses with significant footprints in China indicate the anticipated rebound in domestic consumer activity is taking longer to materialise than was expected.

What are the benefits of a benchmark-agnostic approach to a global income strategy in this environment?

It means you can take advantage of opportunities outside of crowded trades. We do not think about benchmarks when constructing a portfolio; our focus is on delivering resilient income and capital growth for clients. 

Our focus remains on parts of the market where we see resilience and have good visibility of income streams

Take the AI trade and the popularity of Nvidia as an example. It represents around 1.7 per cent of the MSCI All Country World Index but pays no dividends and is therefore not suitable from an income standpoint. While a few big tech names have driven a lot of the benchmark returns this year, other companies can also participate in long-term secular growth stories, such as those in the semiconductor sector, as I mentioned. Our focus remains on parts of the market where we see resilience and have good visibility on income streams.4

Related views

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Investments can be made in emerging markets. These markets may be volatile and carry higher risk than developed markets.

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Investments can be made in derivatives, which can be complex and highly volatile. Derivatives may not perform as expected, meaning significant losses may be incurred. Derivatives are instruments that can be complex and highly volatile, have some degree of unpredictability (especially in unusual market conditions), and can create losses significantly greater than the cost of the derivative itself.

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Concentration risk

Investments can be made in a small portfolio of securities. Losses from a single investment may be more detrimental to the overall performance than if a larger number of investments were made.

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