Dividend stocks drove the S&P 500 and TSX Composite indices to their best September performances in 71 and 14 years, respectively, and these stocks will likely continue to be the best place for investors for some time, finds a new report from CIBC World Markets Inc.

The report notes that a low interest rate environment will be with us for the foreseeable future hurting returns on the short-term bond market. It also finds that while longer bonds benefitted from the capital gains associated with the recent rally, the party may be over soon since prices are being pushed to artificial highs by expectations the U.S. Federal Reserve Board will again go shopping for bonds.

“That leaves equities as the refuge from the low growth, low return environment,” says Avery Shenfeld, chief economist at CIBC. “Reliable dividend paying equities stand out in a non-recessionary, but slow growth world. Cashing dividend cheques, as opposed to paycheques, or bond coupons, may be the best way to make some money when others aren’t.”

The TSX’s dividend yield is currently about 70 basis points higher than the yield on 5-year Government of Canada bonds. This compares to a historic deficit or shortfall of over three percentage points. As a result, investor inflows into dividend and income funds this year have risen at twice the pace of inflows into equity funds overall, and into bond funds.

Historically, dividend stocks perform well when the economy is running as it is now — growth at less than 2% and inflationary risks tilted to the downside. In both Canada and the U.S., these stocks have fared better over the medium term than those with low or unstable payout histories, and the gap has been widest in periods of subdued economic performance.

This compares to what Shenfeld calls “abysmal” short term fixed income returns over the next year or more. “We see no end in sight to zero short rates in the U.S. Before the Fed even thinks about raising rates, it will have not only delivered another dose of quantitative easing, but started the process of mopping up the extra money by sending bonds back to the market, and perhaps raising the rate on excess reserves. With so many steps to come first, we’ve pushed back the move off of a zero funds rate beyond 2012.”

As a result, he believes this softens the outlook for the Bank of Canada, which has to be concerned about the impact of much wider spreads on the Canadian dollar, and the resulting drag on exports. “The pause at 1% could last until the second half of 2011, and another long pause at 2% in 2012 could be in the cards.

“Closing the output gap by the end of 2012 does not, as some assume, imply that rates go back to some fixed “neutral” level over the same period. Rates could stay low to the benefit of the economy, but to the detriment of T-bill investors, if needed to offset a weak external environment.”

Dividend stock outlook remains strong

While traditional dividend stocks like utilities, financial and telecommunication have historically led the TSX in average dividend yield, sectors such as energy, industrial and health also have pockets of firms with better than 5% yields.

The number of firms cutting dividends has also sharply declined as only around 3% of TSX dividend announcements in the third quarter contained rate reductions, a fifth the level at the recession’s peak.

“While it depends on a number of considerations, high corporate liquidity levels could point to further dividend increases,” says Peter Buchanan, senior economist at CIBC.
“Based on cash to sales levels, our analysis suggests TSX Composite members’ cash and cash equivalents are about 20% above historical levels currently. Payout ratios are the furthest below historical norms in the materials, utilities and consumer staples spaces. Firms in those segments have some room to raise dividends based on 2010 earnings, while others may have room to do so if earnings advance in 2011.

IE