Never miss an issue of Master Investor Magazine – sign-up now for free!
Inflation spiked to 2.7% in August. That’s its highest level in six months, and means that the Bank of England has missed its 2% inflation target since January 2017. Inflation is forecast to remain above 2% throughout 2018, 2019 and 2020. With interest rates set to remain low during the same period, dividend shares could become increasingly important to investors.
A simple way of obtaining an inflation-beating yield is to buy a FTSE 100 tracker fund. After all, the index yields 4% at the moment. It is possible, though, to obtain a much higher income return within the large-cap index. Shares such as Imperial Brands (LON:IMB) and Legal & General (LON:LGEN) offer 6%+ dividend yields which appear to be sustainable.
The return of higher inflation could shift the focus of many investors towards income shares. Assets such as government bonds and cash offer negative real returns at the moment, with the 10-year gilt yield being 1.6% and the very best online savings accounts offering around 20 basis points less than that figure.
Over the next two years, inflation is expected to remain ahead of interest rates. The latter is forecast to reach 2% in 2020, although given the political and economic uncertainty provided by Brexit, expectations could change significantly over the coming months. The key takeaway, though, is that further pain could be ahead for savers and for investors in government bonds. Negative real returns look set to continue, and this could make those assets less appealing.
FTSE 100 companies Imperial Brands and Legal & General may offer a higher return on capital over the medium term. The two stocks are expected to yield 7.3% and 6.4% respectively in the 2018 financial year. Respective growth in dividends of 7.7% and 6.8% in 2019 strengthens their income investing outlook yet further, although it is their prospects from a business perspective which could hold the greatest appeal.
Imperial Brands has the potential to generate improving profitability from next generation products. It has a relatively strong position in this fast-growing segment, with its blu brand of e-cigarette being a significant operator in US and UK markets in particular. Further investment in reduced-risk products could help to offset declines in cigarette volumes, while pricing potential due to inelastic demand could keep the company’s bottom line moving higher. With dividend cover of 1.4x, Imperial Brands’ shareholder payments seem to be sustainable.
Legal & General also seems to be performing well. Five of its six business segments were able to deliver improved operating profit in the first half of the year. The company seems to have momentum, with its current strategy forecast to deliver EPS growth in 2019. It trades on a P/E ratio of 8.4, which suggests that it offers a margin of safety. Since dividends are covered twice by profit, above-inflation growth in shareholder payments could be ahead over the medium term.