Modest dividend expectations even as stocks trade near highs


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In markets, every price tells a story about what investors implicitly believe to be the most likely future scenario. Indeed, one of the most basic questions confronting most investors is, “what is already priced into the market scenario?” The picture painted by equity and fixed-income markets reflects pessimism, but it has become less so in recent weeks. It might sound odd to characterise stock markets as reflecting a downcast scenario given that U.S. indices like the S&P 500®, Nasdaq 100 and Russell 2000 are trading near record highs. However, since the creation of S&P 500 Annual Dividend Index Futures in 2015, we have been able to peer into the equity market’s expectations for the first time and currently those expectations are bleak. After growing by 155% in the past decade, dividend futures price almost no growth in the decade going forward (Figure 1). That said, the expectations are somewhat less pessimistic than they were three months earlier when they priced an outright decline in dividend payments into the early 2030s.

What is curious is that since the beginning of 2017, the expected amount of dividend payments has hardly moved at all. Yet, the S&P 500 index itself has risen by more than 70% (Figure 2). So how is it possible that stock prices have risen so much even as expectations for future dividend payments have gone sideways? The answer lies in fixed income markets. Changing expectations for long-term bond yields influence equity valuations. When long-term yields fall, that raises the net present value (NPV) of future earnings, dividends and other corporate cash flows.

Long-term interest rates were falling even prior to the pandemic. Between November 2018 and the end of 2019, 30Y U.S. Treasury yields slumped from 3.45% to 2.33% (Figure 3). That alone explained most of the increase in NPV of future expected dividend payments over that period. Indeed, between early 2016 and the pandemic striking in Q1 2020, NPV of future expected dividends moved in almost lockstep with the value of the equity market (Figure 4).

Since the pandemic struck, long-term interest rates plunged to unprecedented lows and have only recently begun to recover. Since March 2020, neither changes in long-term rates nor changes in expected dividends can explain what happened subsequently: beginning in April 2020, equity prices diverged from the NPV of dividends.

This equity-expected dividend divergence coincided with quantitative easing (QE) by several central banks. Between March and May 2020, the Federal Reserve (Fed) created $3 trillion, absorbing U.S. Treasuries, mortgage bonds, state and local debt, as well as corporate bonds purchased through ETFs. Since June 2020, the Fed slowed the pace of its QE to $40 billion per month, or roughly half a trillion dollars per year. Overall, the Fed took its balance sheet from 19% to 35% of GDP.

Simultaneously, the Bank of Japan took its balance sheet from 108% to 131% of GDP. The European Central Bank went from 39% to 62% of GDP, while the Bank of England and Bank of Canada conducted their own QE programs.

QE has paralleled unprecedented budget deficits. The U.S. budget deficit hit 16.7% of GDP by January 2021. Deficits have grown to a similar size in Japan and throughout Western Europe. As such, the world’s central banks and fiscal authorities appear to have stumbled into a form of modern monetary theory (MMT) whereby central bankers directly fund government deficits. This, in turn, has reawakened inflation expectations.

These developments could create dilemmas for central banks and investors. For investors, the key questions include:

  • Are equity valuation levels sustainable if long-term interest rates continue to rise?
  • What impact would less fiscal and monetary support have on equity prices?

For central banks, the questions include:

  • To what extent have their QE programs inflated asset values?
  • If prices of equities and other assets begin to fall, will central banks feel obliged to support them with further rounds of QE?

The answers to some of these questions could be revealed over the course of 2021.

Executive Director and Senior Economist
CME Group

Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions. Prior to joining CME Group, Norland gained more than 15 years of experience in the financial services industry working for investment banks and hedge funds both in the United States and in France working for hedge funds and investment banks. Norland holds a bachelor’s degree in economics and political science from St. Mary’s College of Maryland and an M.A. in statistics from Columbia University. He is also a CFA Charterholder.

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