With inflation reaching 3% in September, alarm bells may now be ringing in the ears of many income investors. It is now more difficult than it has been for a number of years to obtain a real income return.
Looking ahead, the task could become more difficult as there may only be limited scope for a tighter monetary policy. Therefore, buying stocks which offer a high dividend yield and dividend growth potential which is in excess of inflation may be a sound strategy to pursue.
Rising inflation
Of course, inflation has risen to the current 3% level largely because of Brexit. Confidence in the UK economic outlook remains low, and talk of a potential ‘no deal’ as a viable option could cause businesses, investors and consumers to take an even more downbeat view on the UK’s economic future.
Normally, interest rate rises would be used to curb inflation. However, with UK GDP growth already having been downgraded, there may be limited scope to deliver a sustained rise in interest rates over the medium term. Doing so could risk tipping the UK into recession. Even if interest rates do rise, a time lag could mean that a tighter monetary policy has less effect than hoped for in the short run.
Dividend growth
Since inflation could realistically move above 3%, dividend shares could become more popular among investors. Even though the FTSE 100 is close to an all-time high, there is a plethora of large-cap, high-yielding stocks around at the moment. Therefore, it could be argued that there is an obvious remedy to the problem of 3%+ inflation.
Even though the FTSE 100 is close to an all-time high, there is a plethora of large-cap, high-yielding stocks around at the moment.
However, some of the stocks with high yields face uncertainty themselves. Therefore, dividend growth may prove to be lacking, or at least less than the rate of inflation. This could mean that while a high income return is obtained at the outset, it is gradually eaten away by rising inflation. This could have a negative impact on the company’s valuation and total return.
Dividend potential
Chart provided by Sharescope.
With prospective dividend yields of 5.3% and 5.8%, HSBC (LON:HSBA) and Legal & General (LON:LGEN) are two of the FTSE 100’s highest-yielding shares. With dividend coverage ratios of 1.3x and 1.6x respectively forecast for the current year, both companies appear to have sustainable payouts which could grow in line with earnings over the medium term.
HSBC is in the process of reducing costs, which could positively impact on profits. It also has high growth potential from its exposure to the rapidly-growing Asian economy. Wealth levels and demand for financial services products are rising as China shifts towards a consumer-focused economy.
Similarly, Legal & General has a sound growth strategy which consists of six long term macro and demographic growth drivers. Investment in the US could catalyse its earnings and dividends in future years.
Chart provided by Sharescope.
Outlook
Both stocks appear to offer a mix of high income returns today, as well as the potential for dividend growth to beat inflation in future. Therefore, they could be worth buying ahead of what may prove to be a sustained period of relatively high inflation.
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