If action is not taken, automatic spending cuts and tax rises will take effect at the start of next year, with potentially severe repercussions for the US economy.
Equity income investors, in particular, are concerned about the possible impact of a change to the tax treatment of dividends. In the near term, increased volatility looks likely, but the worries appear overdone and may create opportunities for long-term investors.
Evasive action now looks likely
The risk that US politicians will drive off the fiscal cliff is remote. It was always unlikely that any progress towards a resolution would be made ahead of the election, but with the new landscape in Washington now clear, political expediency is likely to push the two parties towards a compromise.
President Obama canvassed on increased taxes for the wealthy, so it is likely that he will seek to extend most of the Bush-era tax cuts for those in lower income brackets and rescind many of the scheduled spending cuts as he seeks to enact long-term revenue and entitlement reform. In his second term, he is likely to continue his current fiscal policy of slowly cutting the deficit without pushing the US back into recession.
One issue that has concerned investors is a possible change to the tax treatment of dividends. Prior to the Bush era, dividends were taxed as ordinary income, but since 2003 they have been treated as long-term capital gains, at a rate of 15% for most investors. Obama’s proposed 2013 budget allows this change to expire for wealthy individuals and families. If this decision is passed, dividends will go back to being treated as ordinary income (39.6% for Obama’s planned new top tax bracket). The rate of tax paid by UK investors in US funds would not be affected, but would a change in tax treatment affect the performance of dividend-paying US stocks?
The lessons of history suggest not. Dividend-paying stocks have outperformed non-dividend stocks even when taxes have been much higher. From the end of 1979 to 2002, when dividends were taxed at a higher rate of 50-70%, dividend stocks outperformed non-dividend stocks by 3% per annum (Source: S&P). There has been no historical correlation between the performance of dividend-paying stocks and the tax treatment of dividends.
It’s also important to note that the proposed tax change would not affect everyone. Obama’s budget calls for taxing dividends as ordinary income only for individuals earning more than USD 200,000 and households earning more than USD 250,000. Furthermore, many of the dividend-paying stocks owned by US investors are held in individual retirement accounts and company pension funds. US taxpayers do not pay taxes on dividends held in these products until they withdraw the funds at retirement. Companies do not pay taxes on dividends at all.
Dividend growth is robust
The attractions of US equity income investing therefore remain intact. Dividend growth in the market is robust, and looks set to continue to accelerate. 2012 should set a record high for cash dividend payments, with payouts currently looking likely to be at least 16% above 2011 levels (Source: S&P). Many companies, including CME Group Inc. and Limited Brands Inc., are even considering an extra dividend payment between now and the year end.
And these dividend-paying companies still come at very reasonable valuations. Profits are growing at around 8%, putting the S&P 500 at 13x current earnings, hardly expensive by past standards and reasonable compared with other markets. With Treasury yields at extreme lows, equities look more attractive relative to bonds than has been the case for more than 98% of the time since 1960 (Source: J.P. Morgan Asset Management).
Investors do need to be selective. On a sector basis, the highest yielding sectors in the S&P 500 undoubtedly look expensive, with telecoms and utilities – the traditional favourites of dividend investors – trading above their long-term averages on a price-to-earnings basis. However, looking at the market more broadly, there are plenty of examples of companies yielding 2% or more at attractive valuations.
The coming months are likely to see some volatility, for US stocks in general as a deal is sought on the fiscal cliff, and perhaps for dividend stocks in particular as investors worry about tax changes. But with dividends growing, valuations looking reasonable and history suggesting investors have little to fear, this volatility should be seen as a buying opportunity.
