Here Comes the Sun

Little darlin', it's been a long, cold, lonely winter 
Little darlin', it feels like years since it's been here 

Here comes the sun, doo-doo-doo-doo 
Here comes the sun, and I say 
It's alright 

- The Beatles 

The Investment Backdrop is Changing

Around the world, many countries have seen interest rates peak. Some central banks have already started to cut rates, while others are likely to follow soon. As the environment changes, we continuously adjust our portfolios to optimize exposure. 

After reaching a peak of 5%, the Bank of Canada began cutting rates on June 5, 2024, with a second cut on July 24th. The economy has slowed, the labour market has cooled, and many homeowners will renew their mortgages at much higher rates in 2025 and 2026. The path to lower rates seems clear. Provided inflation remains under control, the consensus is that rate cuts will continue. Economists estimate the BOC Overnight Lending rate will drop to 4.15% by the end of 2024 and further to 3.05% by the end of 2025. Consequently, we expect a shift in investment leadership. 

In fixed income, despite tight credit spreads, we continue to see value in investment-grade credit supported by relatively strong fundamentals and a supply/demand imbalance. We have cautiously increased our duration while managing our overall exposure prudently. The yield curve remains inverted, already pricing in interest rate cuts, making large increases in duration exposure less attractive. However, equity markets are not aligned with the fixed income market in their pricing of interest rate cuts. 

Canadian Market

After a challenging 2023, dividend investment strategies have continued to underperform in 2024. The S&P/TSX High Dividend index, which includes 50 to 75 stocks with dividend yields above the median in the S&P/TSX Composite, has struggled. The main issue has been competition from higher bond yields, GICs, and high-interest savings account rates. Higher rates and bond yields have overshadowed high dividend-paying stocks, attracting investors seeking yield. After all, why opt for dividends from potentially volatile stocks when short-term risk-free rates are so high? 

Looking ahead, the pressure on high dividend-paying stocks should ease as the rate-cutting cycle continues. In the meantime, we see a buying opportunity in many blue-chip companies that have been overlooked and ignored.

For instance, the past few years have been challenging for Telus, but we believe the future looks brighter. Traditionally, the telecom sector has provided stable but low growth, resulting in companies paying elevated levels of dividends. Buyers of Telus own it for the yield, and predictably, the stock has sold off since the rate hikes began. Telus is a prime example of a stock suffering from competition with high rates offered by GICs and high-interest savings accounts, despite resilient corporate results. 

Currently, the yield is over 7%, the highest level in the past decade. The yield it pays compared to the 10-year Government of Canada bond yield is attractive and well above the long-term average. While increased competition in both the wireline and wireless businesses has pressured profitability, we do not have any concerns about the company’s ability to pay the dividend. As the company nears completion of its $7 billion fibre-to-the-home program, we anticipate there should be plenty of free cash flow starting in 2025 for dividend increases, debt repayment, and possibly share buybacks. As interest rates fall, this sets up a better environment for Telus, and we believe yield-hungry investors will return. 

U.S. Market

Similar to Canada, U.S. dividend strategies are having a difficult year. The S&P 500 Dividend Aristocrats has underperformed the S&P 500 Index by 13% year-to-date (as of June 30th). The driving force of the market over the last 18 months has been large-cap technology names with exposure to artificial intelligence. Significant fund flows into these technology names have pushed the S&P 500 technology weight close to levels last seen during the 2000 Tech Bubble. 

Investor interest has also been strong in retail money market funds, where retail investors can earn close to a 5% yield. There is over $2.4 trillion in retail money market funds, which now exceeds retail bond funds; the last time this occurred was during the Great Financial Crisis. These headwinds have led to many high-quality dividend-paying stocks being left out in the cold, as they are viewed as less attractive relative to the yields earned on U.S. Treasuries or the enticing growth opportunities found in AI-related names. In fact, only 8% of S&P 500 companies are paying a dividend higher than 10-year U.S. Treasury yields, the lowest since October 2007. 

More recently, we have started to see a broadening out of the market. Companies with stable and growing dividends should start to get the attention they deserve. A reduction in interest rates would provide a boost to the interest rate-sensitive sectors. 

The Fed has been reluctant to lower the Fed Funds rate, but recent data, such as the June CPI (Consumer Price Index) report, showed lower inflation, service wages slowing down year-over-year and returning to pre-pandemic levels, and a mixed employment picture where the Household survey has been weakening over the last few months. These factors could justify a cut at their September meeting. The market seems to agree, with two rate cuts expected and a third one fully anticipated for the first quarter of 2025. 

Some sectors and names in the Nicola U.S. Equity Income Fund that have defensive features and sensitivity to interest rates could benefit from lower interest rates and increased uncertainty in the latter half of 2024 due to the events leading up to the U.S. election. The fund currently has more exposure to Real Estate, Energy, and Consumer Staples than the S&P 500, which are some of the highest-paying sectors on a trailing 12-month basis. A high dividend yield is not enough to justify owning a name; a company must also have strong fundamentals such as steady and growing earnings, a responsible balance sheet, and capable management with good capital allocation discipline to sustain and increase the company’s dividend. 

Some of the companies we invest in, such as Walmart, Becton Dickinson, Lowe’s, and Texas Instruments, have not only maintained but also raised their dividends since the 1970s. These companies even raised their dividends during the Great Financial Crisis, demonstrating their strong dedication to shareholders. 

One of the fund’s names with the highest dividend yield is AT&T. AT&T is a major wireless operator in the U.S. with more than 114 million wireless customers. The company has made several moves in the last five years to simplify its business operations and lower its debt level. They offloaded DirecTV in a partnership with Private Equity Firm TPG in 2021, separated and combined Warner Media with Discovery in 2022, and sold the advertising business, Xandr, to Microsoft in 2022. 

We believe the company is in a better position with a healthier balance sheet and more focused business segments (mobility, business, and consumer wireline). It has a strategic edge over its rivals in fibre deployment due to its ability to use its existing wireline network. AT&T offers a strong dividend of almost 6%, which only accounts for 45% of its free cash flow; the rest of the free cash flow can be used to reduce debt and buy back shares. We like AT&T for its defensive qualities, solid dividend yield, and attractive valuation, trading at 8.2x 2025 earnings compared to the S&P 500 at 20.2x.

Utilities and the Energy Transition 

Over the last few years, rising interest rates have been a significant headwind for utility stocks, including those with large investments linked to the energy transition, given their capital-intensive nature. With the interest rate outlook stabilizing, we expect investor interest to return to the sector due to its relative stability and consistent dividends over time. This change in sentiment could uplift our funds with large exposure to the sector, including the Nicola Sustainable Innovation Fund, where utilities make up more than a third of the portfolio today. 

Among our core holdings in the fund is Brookfield Renewable Partners, one of the largest publicly traded companies focused on renewable power and decarbonization. Their portfolio spans five continents and includes technologies such as hydropower, solar, onshore and offshore wind, and storage solutions. Investors benefit from Brookfield’s scale, expertise, and experience. The company has a relatively strong, investment-grade balance sheet with several levers for future growth. Their current yield is over 5.6%, and they expect to deliver 5-9% annual distribution growth, targeting a 12-15% total return. 

Despite uncertainty around global election outcomes, which may drive further market volatility, we expect operators like Brookfield to continue being opportunistic and prudent investors. They are likely to further establish themselves as global leaders in clean energy development and operations, supporting our long-term outlook. 

International Markets

In international markets, the ECB (European Central Bank) has begun its easing cycle as lower growth and a reversal of energy prices have helped bring inflation back towards the central bank’s target. Similar to domestic markets, high dividend-paying stocks have been out of favour over the past two years in international markets. The MSCI ACWI ex-USA Dividend Masters Index has underperformed the MSCI ACWI ex-USA Index by approximately 13% cumulatively over the past two years. The Nicola International Leaders Fund should benefit from a larger focus in Europe and companies with high dividend yields. 

An example of one of our stocks that should benefit from declining rates is Vonovia, which owns and manages the largest multifamily residential property portfolio in Germany (almost 500,000 units). Vonovia’s portfolio is focused on middle-income households and is diversified across several urban centres in Germany. The brutal real estate cycle of the last few years gave us the opportunity to purchase Vonovia at a 50% discount to its NAV (Net Asset Value). Although recent times have been challenging, the company has made solid progress towards its goal of reducing leverage by selling down assets. Vonovia has likely made it through the worst part of the cycle. Going forward, we believe the company remains well-positioned to benefit from favourable supply/demand dynamics in Germany, lower interest rates, and a return to growth as it nears completion of its asset disposal targets. 

The Complex Relationship Between Interest Rates and Market Dynamics

The relationship between interest rates and the overall market is complex. Central banks are more comfortable lowering rates due to softening inflation; however, several economic indicators are also rolling over. Only time will tell if elevated interest rates have had a lasting impact on consumers. However, our focus on quality companies with resilient earnings and attractive valuations creates a buffer if such impacts do emerge. With over $2.4 trillion sitting in cash alternative investments, investors have significant amounts of dry powder. As rates move lower, sentiment will likely change, and concerns about overly tight monetary policy will ease, increasing the appetite for alternative sources of yield. 

Thematically, we adjust our portfolios to take advantage of emerging opportunities. The strength in many equity indices has been driven by select sectors and a concentrated list of names. Despite some markets hitting all-time highs, many dividend-paying stocks have been left out in the cold and trade at attractive valuations. With rates having peaked, the environment is warming up for these dividend payers, and we are well prepared for the summer sunshine.