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.
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.