Fiscal-cliff concerns create ‘buying opportunity’ for US dividend stocks, says J.P. Morgan’s Hart

Clare Hart, portfolio manager of the JPM US Equity Income Fund, says that concerns over the looming US fiscal cliff are overdone, creating opportunities for long term investors.

The risk that US politicians will drive off the fiscal cliff is remote. 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.

One issue that has concerned investors is a possible change to the tax treatment of dividends. Since 2003 dividends have been treated as long-term capital gains, at a rate of 15% for most investors. However, recent proposals could mean this treatment will expire for wealthy individuals and families in 2013. If the proposals are passed, dividends will go back to being treated as ordinary income. 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?

History shows us that 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. 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 as the budget calls for taxing dividends as ordinary income only for individuals earning more than US$ 200,000 and households earning more than US$ 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.

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*. It is also worth noting that these dividend-paying companies still come at very reasonable valuations compared with past standards and with other markets.

In addition, with Treasury yields at extreme lows, equities look more attractive relative to bonds than they have for more than 98% of the time since 1960.

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. Yet in the market more broadly, there are plenty of examples of companies yielding 2% or more at attractive valuations.

The coming weeks 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.

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