The Income Investor: dividend stocks still appeal after Budget

The government’s decision to vastly raise spending in the Budget could have a profound impact on the income investing landscape. After all, it is likely to prove inflationary.

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Indeed, the Bank of England’s November Monetary Policy Report showed that it now expects inflation to rise to 2.7% over the next year. This compares with a previous forecast at the time of its August Monetary Policy Report of an increase to 2.2% over the same period. And, looking two years out, the central bank now anticipates that inflation will be 60 basis points higher than its previous forecast of 1.6%.

Interest rate cuts

A higher rate of inflation is likely to dissuade the Bank of England from cutting interest rates. Although monetary policy easing is still widely expected to be implemented over the coming years, the pace and scale of rate cuts may be less ambitious than anticipated prior to the Budget. After all, with inflation now set to remain above the central bank’s 2% target until 2027, policymakers are likely to adopt a relatively cautious stance when it comes to the unwinding of restrictive monetary policy.

In turn, a slower pace of cuts is unlikely to be beneficial to the economy’s growth rate. Although higher government spending could bolster GDP growth, its overall impact in the long run may be tempered to at least some extent by a less accommodative monetary policy than previously anticipated.

Limited appeal

The prospect of higher inflation means that cash savings are likely to become even less appealing from an income investing standpoint. Certainly, a slower pace of interest rate cuts means that the return on cash savings is likely to be higher than previously envisaged. But cash is still set to ultimately offer a falling return that is now more rapidly eroded in real terms by a faster pace of price rises, thereby further reducing its purchasing power.

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A higher rate of inflation than previously expected is also set to erode the real income return from bonds at a faster pace. While gradual interest rate cuts should have a positive impact on bond prices, thereby providing some capital growth for holders, a less accommodative monetary policy than previously envisaged means this could prove to be lower versus prior expectations.

An uncertain future

The outlook for equities is uncertain following the Budget because of potentially higher inflation and a slower pace of interest rate cuts. A less accommodative monetary policy could mean tougher operating conditions that are less conducive to profit growth and rising dividends for UK-focused firms.

When combined with a higher rate of inflation, real-terms dividend growth may prove to be more limited than many income investors had previously been anticipating.

That said, inflation is still expected to remain within touching distance of the Bank of England’s 2% target. Therefore, gradual rate cuts are ultimately set to boost economic activity. In fact, UK GDP growth is expected to rise from 1.1% this year to 2% next year, according to the Office for Budget Responsibility. This means that UK-focused companies should experience at least some improvement in their operating environment that provides scope for higher dividends.

Focusing on fundamentals

Given the uncertain near-term outlook for equities, fundamentally sound FTSE 350 dividend stocks that offer a relatively reliable income may offer the most favourable risk/reward opportunity at present.

They could provide a worthwhile compromise between a dependable income and dividends that have the potential to grow as interest rate cuts are gradually implemented. This is especially relevant while global geopolitical risks are elevated, with future US fiscal policy yet to be fully determined and having the potential to significantly affect the UK economy’s prospects.

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Clearly, the long-term outlook for dividend stocks still appears to be upbeat after the Budget. Inflation is set to remain at modest levels and interest rate cuts are likely to be implemented, thereby providing an improved economic outlook that boosts dividend growth. Investors who adopt a long-term focus with high-quality dividend shares are therefore likely to be well-rewarded, albeit to a potentially lesser extent than previously expected.

Dividend appeal

National Grid (LSE:NG.) could prove to be a worthwhile income opportunity given the uncertain near-term economic outlook. The firm offers significant defensive appeal, with its financial performance typically being less impacted by the economic environment than many of its FTSE 100 index peers.

As such, it offers a relatively reliable income outlook that complements its attractive dividend yield of 4.6%. This is around 90 basis points higher than the income return of the large-cap index. The firm’s dividends were covered 1.3 times by profits in its latest financial year, with the company aiming to grow shareholder payouts in line with the Consumer Prices Index including owner occupiers’ housing costs (CPIH) in future. Given the prospect of higher-than-expected inflation following the Budget, this could prove to be a useful ally for income investors.

Growth plans

The company’s recently released half-year results showed that it is making encouraging progress with its ambitious investment strategy. Having completed a £7 billion rights issue earlier this year, it spent a record £4.6 billion in the first half of the year, up from £3.9 billion in the same period of the prior year, and expects to invest £60 billion in total over the next five years.

This should have a positive impact on the company’s underlying value, given that it expects asset growth to amount to 10% per annum in the five years to 2029, while earnings per share should rise by 6-8% per year over the same period. Indeed, earnings per share rose by 8% in the first half of the current year, which allowed the firm to increase dividends per share by an inflation-beating 6%. And with the company’s regulatory gearing set to remain at or below its current level in the coming years, it has a sound financial position from which to invest in its asset base while paying a relatively reliable and growing dividend.

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As part of its growth strategy, National Grid is increasingly focusing on electricity rather than gas. In fact, electricity assets now account for 75% of its business versus 60% three years ago, and it expects to move towards an 80/20 split between electricity and gas over the next five years. This could prove to be a sound move given the world’s continued push towards net zero and the current government’s ambitious plans regarding renewable energy infrastructure.

Fair value

The company’s shares have risen by a rather modest 3% since they were first featured in this column during December 2023. They now trade on a price/earnings ratio of 16.3, which is relatively high at a time when many FTSE 350 stocks offer wide margins of safety due to an uncertain economic outlook.

However, National Grid’s relatively attractive yield, prospective increases in dividends that match inflation and forecast earnings growth in the mid-to-high single digits over the medium term, mean it could offer fair value for money. When combined with its defensive characteristics that may prove highly useful during an uncertain period for the UK economy, the stock appears to have income investing appeal.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.