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January 2022

Equity Income: Bright Prospects Remain, Volatility May Increase

Key Points

  • Generating income from companies with resilient, growing free cash flow
  • Positioning for economic growth, inflation and interest rates, all elevated but moderating
  • Looking at valuation gaps and yield spreads as ongoing tailwinds relative to the broader market

As we enter 2022 we reflect on a historic year for dividend stocks, with total returns of 32.2%, well above the broader market and even edging out growth*. Can this continue? And what is the outlook for dividend stocks?

Our outlook for the year is for the expansion to continue, but with some key differences. Ongoing economic growth, still above trend, but moderating. Inflation, still elevated, but moderating over time. Supply disruptions, a similar story, ongoing, but improving into the back half. We expect modest interest rate increases from levels that remain near historical lows.

We see our holdings managing through all of these issues, with some benefiting outright from inflationary pressures and rate hikes, and others offsetting them to different degrees by executing against their inflationary playbooks. Many of them offset higher costs by implementing pricing, taking advantage of their scale, their brand or other competitive advantage. In general, we see business conditions benefiting the sales, earnings and cash flow growth of dividend stocks.

For us, the inflationary, rising-rate playbook is similar to that of the management of our holdings. Our research team focuses on pricing power as a key offset to inflation, and we heighten its prioritization. Similarly, to offset the impact of rising interest rates, we emphasize dividend growth over yield level. And we continue to overweight real estate, a more direct beneficiary of inflation than other income sectors.

We do anticipate the potential for higher volatility in coming quarters as we get later in the cycle. But we also see several relative valuation metrics supportive of a continued tailwind to income stocks. Valuation spreads for our value-like dividend stocks vs. growth remain historically wide and ripe for mean reversion. Similarly, yield spreads remain elevated. And dividend stocks provide attractive income in a world where it is harder to find.

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