The Income Investor: two dividend stocks to grab before this trend ends

The old investment adage “the trend is your friend” is unlikely to prove useful to income-seeking investors over the coming years.

Certainly, UK interest rates at least are likely to continue their recent trend and move higher in the short run. Inflation currently stands at 6.8%, which is more than three times the Bank of England’s 2% target. And while the full impact of recent monetary policy tightening on inflation has not yet been felt due to time lags, policymakers are likely to retain their hawkish stance to subdue ongoing rapid price rises.

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However, the era of high inflation and soaring interest rates will ultimately come to an end. History shows that no such period has ever lasted in perpetuity, with the cyclicality of the economy meaning there is continual change. Indeed, the Bank of England expects inflation to fall below its 2% target within the next two years. As a result, market participants currently expect a rise in rates to 6% over the next year before falling to 5.2% by the third quarter of 2025, and to 4.5% a year later.

The prospect of interest rate cuts may seem far-fetched at the present time. However, a combination of below-target inflation, a rising unemployment rate that is set to increase by 0.5 percentage points to 4.8% within two years, and GDP growth of just 0.3% per annum over the next 24 months, means the Bank of England is likely to adopt an increasingly dovish monetary policy in an attempt to stimulate a flagging economy.

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Indeed, the International Monetary Fund (IMF) recently forecast that developed economies such as the UK are likely to experience a fall in interest rates to pre-pandemic levels over the long run, as the impact of an ageing population takes hold. This may take many years to play out, but suggests a “new normal” for interest rates may not be anywhere near as high as some income investors are currently anticipating.

A positive impact on shares

The end of the current trend of rising interest rates, and its replacement with a new era of monetary policy easing, means dividend shares have significant relative appeal on a long-term view. Falling interest rates are likely to have an overwhelmingly positive impact on income stocks for two main reasons.

First, falling interest rates act as an economic stimulus. They encourage consumers to spend rather than save, by cutting the cost of borrowing and reducing the returns they receive on cash balances. An improving economic performance is likely to prompt better corporate prospects that allow companies to pay larger dividends. This means shareholders are likely to enjoy a higher pace of dividend growth that ultimately beats inflation.

Second, an increasingly dovish monetary policy has a more positive impact on equity markets than other mainstream assets such as cash and bonds. As well as the aforementioned improved corporate performance acting as a catalyst on stock market valuations, greater economic activity levels are likely to prompt an increasingly “risk-on” attitude among investors that pushes them from less-risky assets such as cash and bonds to riskier assets such as stocks. The end result is likely to be substantial capital gains for holders of dividend stocks.

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Of course, rising share prices mean dividend yields decline. And while increased shareholder payouts may offset this effect to some degree, ultimately today’s stock market dividend yields are likely to fall as interest rates peak and begin their descent. Therefore, while it is presently possible to obtain a yield in excess of 5% from easy-access cash savings and two-year gilts, which is above the FTSE 100’s 3.9% yield, income investors should grab today’s attractively priced dividend stocks.

Over the coming years, they are set to produce significant capital gains and deliver high rates of dividend growth. By contrast, the return on cash is set to fall as interest rates decline. And while bond prices are also likely to be positively impacted by interest rate falls, they are unlikely to benefit to the same extent as shares because increasingly optimistic investors tend to seek riskier assets. And since bonds offer zero income growth, dividend stocks have greater overall appeal.

Source: Refinitiv as at midday 13 September 2023. Bond yields are distribution yields of selected Royal London active bond funds (31 July 2023), except global infrastructure bond which is 12-month trailing yield for iShares Global Infras ETF USD Dist as at 11 September. LIBOR is interest rate that banks lend money to one another (3 month LIBOR as at 12 September). Best accounts by moneyfactscompare.co.uk refer to Annual Equivalent Rate (AER) as at 13 September.

Long-term potential

Paper and packaging company Mondi (LSE:MNDI) is an example of a dividend stock worth buying at the present time. It offers a relatively attractive yield of 4.7%, with dividend payouts having risen at an annualised rate of 7% over the past three years. This is ahead of an average inflation rate of 4.1% per year over the same period. Since dividend payouts were covered 2.8 times by underlying earnings last year, they appear to be highly affordable.

Certainly, the firm is experiencing a tough operating environment. Its latest half-year results showed that revenue declined by 14% and underlying earnings fell by 32% in response to slowing demand. However, with a net debt-to-equity ratio of under 20% and interest cover in excess of 10 in the first half of the current financial year, it has a solid financial position that enables it to ride out present challenges to benefit from an improving economic outlook.

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Indeed, the world economy’s growth rate is forecast to improve from 2.7% in 2023 to 2.9% in 2024, according to the OECD. Furthermore, demand for Mondi’s packaging is set to grow as e-commerce becomes an increasingly important part of global retail sales. In the UK, for example, the proportion of retail sales conducted online has risen from 10% to 26% over the past decade and is likely to maintain its upward trajectory in future. With the company focused on sustainable packaging, it is also well placed to capitalise on changing industry and consumer trends as the world moves towards net zero.

Trading on a price-to-earnings ratio of around 7.6, Mondi’s shares offer a wide margin of safety, and investors appear to have factored in a tough operating environment. Due to its attractive yield, dividend growth prospects and capital return potential in an improving global economic backdrop, the stock has long-term income appeal.

A refreshed strategy

Sustainable technologies firm Johnson Matthey (LSE:JMAT) also looks attractive as a long-term income investing option. It currently yields 4.5% from a payout that was covered 2.3 times by underlying earnings last year. Although dividends per share were unchanged versus the prior year, an improving operating environment could act as a catalyst over the coming years.

Indeed, the company is implementing a revised strategy that seeks to create a more focused business, which is positioned to capitalise on the world’s net-zero transition. Alongside this, it is becoming more efficient, with £45 million in cost savings delivered in the most recent financial year as part of a total aim to reduce costs by £150 million within the next two years. With a debt-to-equity ratio of 40% and interest cover of over 6, the company has a solid financial position that provides the required flexibility to deliver its refreshed strategy.  

Clearly, Johnson Matthey continues to be a relatively unpopular stock among investors. Its shares have fallen by over 50% in the past five years, which means they trade on a price-to-earnings ratio of just 9.6. This suggests that, alongside their income appeal, there is scope for a rating adjustment as demand increases in tandem with growing global decarbonisation.

Alongside Mondi, the company offers a favourable risk/reward opportunity for income-seeking investors that is unlikely to persist once interest rate peak and begin to fall. As a result, the attractive yields, dividend growth potential and capital return prospects of both stocks are worth seizing today.

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