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Raji O. Manasseh
PIMCO’s secular outlook includes several themes, the most well-known being the New Normal: an environment of below-average global economic growth, accompanied by negative real yields (so-called financial repression) and modest asset class returns. Over the recent past this scarcity of yield and returns has led investors, thirsty for income, to diversify their yield-oriented allocation by including dividend-paying stocks in their portfolios. So far this year through October, net inflows into dividend mutual funds are over $30 billion, according to EPFR. For U.S. investors, these stocks have been seen as even more attractive, because since 2003 qualified dividends were taxed at a 15% rate. This combination of a hunger for yield and favorable tax treatment made dividend investing very popular. But there is a risk of the latter condition changing.
With the impending broad-based tax increase on everything from personal income, capital gains and dividends combined with deep national defense-related spending cuts (commonly referred to as the “U.S. Fiscal Cliff”), the reelected president and Congress must reach a compromise to avoid the most draconian of economic consequences. Whatever the outcome of these negotiations, we believe that some dividend investors may no longer enjoy the low favorable tax rate of 15% – indeed, the rate could revert to as high as it was in 2002: the marginal personal income tax rate. To be sure, the attractiveness of dividend-paying stocks should continue in an environment characterized by financial repression, but we also believe that such a tax increase has the potential to result in higher near-term price volatility in certain dividend-paying stocks.
The dividend cliff It is important to acknowledge that a large portion of dividend stocks are sheltered in tax-deferred retirement plans such as 401(k)s and pension plans, and the tax change will not affect these holdings. That said, we believe the stocks at greatest risk of a selloff are those with large U.S. shareholder bases susceptible to the tax increase, because higher tax rates will likely make dividend yields less attractive, promoting a flight toward better-yielding assets and heavily discounting these stocks. Specifically, we believe near-term volatility in dividend stocks will affect the narrow spectrum of U.S. dividend payers with greater than 3% yields that investors have crowded into, including U.S. telecoms and utilities. The risk to those two industry sectors is amplified by the fact that they are already richly valued relative to the broad market (see figure 1). In our estimate, price-to-earnings multiples of high yielding stocks have risen in part to reflect the favorable tax treatment they have had thus far. A recalibration of tax rates presents the risk that these multiples meaningfully compress.
Avoiding the dividend cliff
This dividend tax circumstance reinforces the case for being an active, global dividend investor. Global companies have diverse and international shareholder bases. For example, a Latin American utility with shareholders from Europe, Asia and the Middle East unaffected by the possible U.S. tax change is unlikely to see less demand for its stock. Because these international investors are not affected by changes in U.S. tax rates and dividend yields are still attractive in the current environment, we do not anticipate a broad-based flight from global dividend-paying companies stemming from the U.S. Fiscal Cliff. Conversely, most U.S. investors have a home-market bias, and their dividend stocks and mutual funds are therefore more likely at risk, as U.S-centric dividend funds can have as much as 30% to 40% in telecom and utilities combined, according to a recent review of publicly available fund holding data.
Finally, despite the near-term volatility any tax rate changes are likely to cause, such market activity has the potential to present a forward-looking fundamental equity investor interesting value prospects: A near-term over-reactive selloff in U.S. dividend stocks could create select opportunities to own high-quality assets at a discount.
Go global PIMCO continues to believe that in a low-rate, low-return environment, dividend yield will be an important component of equity total return. While the very real possibility of higher taxes on dividend income could reduce the relative attractiveness of dividend-paying stocks and lead to a near-term selloff, the most vulnerable of stocks will likely be those with large U.S. investor shareholder bases. We believe this reaffirms our focus on global dividend stocks. Indeed, any possible near-term volatility in U.S. dividend stocks could present investors with a value opportunity.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Dividends are not guaranteed and are subject to change and/or elimination. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2012, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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