Once the Federal Reserve hikes interest rates, U.S. dividend stocks and exchange traded funds could experience a meaningful correction after investors piled into the yield-paying assets during the low rate environment.
“With investors desperate for yield, dividend-paying stocks have become more attractive and in some cases have been bid up to unsustainably high valuations,” writes Jeffrey J. Winkler, Vice President, Senior Portfolio Manager, Financial Advisor, Senior Investment Management Consultant for Morgan Stanley. “As a result, we are seeing a meaningful correction in some of these stocks this year as interest rates move higher, particularly in the US where QE is finished.”
Specifically, Winkler warned investors of utilities and real estate investment trusts, which have already experienced significant declines this year.
Broad dividend ETFs are already falling off this year. Year-to-date, the Vanguard Dividend Appreciation ETF (NYSEArca: VIG) dipped 0.9%, iShares Select Dividend ETF (NYSEArca: DVY) fell 2.6% and the SPDR S&P Dividend ETF (NYSEArca: SDY) declined 1.3%. [Tried and True Vanguard Dividend ETF Faces Near-Term Challenges]
Meanwhile, the Vanguard REIT ETF (NYSEArca: VNQ), which tracks U.S. REITs, decreased 4.3% and the Utilities Select Sector SPDR (NYSEArca: XLU), the largest utilities ETF, dropped 9.4% so far this year. [Utilities ETFs at a Critical Juncture]
On the other hand, Winkler believes that “dividend growth strategies outside outside the U.S. still make a lot of sense” as foreign central banks’ loose monetary policies pressure yields abroad, forcing investors to turn to riskier stocks for income.
“Outside the US, where QE programs are more nascent, the dividend payers story is alive and well and likely to go further for several reasons,” Winkler said. “First, the average dividend yield in Europe is much higher than in the US. Second, the spread between the average yield and 10-year government bond yields in Europe are still significant compared with the US, where the US 10-year Treasury yield is now greater than the dividend yield on the S&P 500. Third, the earnings cycle is not nearly as mature as it is in the US, meaning there is more potential for companies to increase their payouts.”