The prospect of interest rates remaining higher for longer is sending investors scrambling back to dividend-paying stocks.
Investors poured a net $272 million into U.S. mutual and exchange-traded funds that buy dividend-paying stocks in the two weeks ended Wednesday, according to data from Refinitiv Lipper. They added a record $48 billion to such funds in 2022 but pulled $835 million from them in January when shares of speculative companies propelled a market rebound.
The stock market's early-year rally has fizzled in recent weeks. A string of stronger-than-expected economic data has forced investors to reconsider their bets that the Federal Reserve is nearing the end of its rate-raising campaign.
Instead, many now fear the central bank will be forced to continue raising rates and keep them elevated for longer than expected to bring inflation down. The minutes from the Fed's latest meeting, which were released Wednesday, reinforced those concerns.
Although higher rates would likely be punishing for the market as a whole, dividend-paying stocks would see another chance to shine. Shares of companies paying big dividends outperformed the broader market last year when red-hot inflation, higher rates and worries about an impending recession weighed on risk assets.
The S&P 500 High Dividend Index -- made up of the S&P 500's top 80 dividend-paying companies -- fell 1.1% including dividends last year, compared with a negative total return of 18% for the broad benchmark. In 2023, the index is up 2.5% but is trailing the S&P 500's 4.8% advance.
"I want to get a cash flow and hopefully an increasing cash flow from my investments, just in case the market doesn't do as well as we think it could," said Ken Van Leeuwen, founder and chief executive of Van Leeuwen & Co. "In dividend stocks, I get paid to wait."
Mr. Van Leeuwen, whose registered investment adviser manages about $350 million in client assets, said he is steering client portfolios to dividend-paying stocks. Over the past month, he bought shares of electrical-components maker Eaton Corp., which has a dividend yield of 2% and has climbed about 10% this year on a total-return basis.
After falling to start the year, government-bond yields are rising again. The yield on the 10-year U.S. Treasury note settled Friday at 3.948%, above the 3.826% where it ended last year. That has dimmed the allure of shares of fast-growing companies and the other speculative stocks.
"My view is that what happened in January is essentially a little bit of a junk rally," said Christopher Huemmer, senior investment strategist for FlexShares Exchange Traded Funds at Northern Trust Asset Management. "However, February is shifting. Equity returns are going to be lower. Dividend income will be a crucial component of total returns."
Although many investors and strategists agree that the U.S. is nowhere near a recession, they say dividend-paying stocks serve as a defensive play given the uncertainty facing the current economic, market and geopolitical environment.
Even if continued interest-rate increases tip the economy into a recession and inflation remains sticky, investors seeking a safe harbor in income-generating stocks should still do well, according to UBS Group AG analysts.
The S&P 500's dividends per share will rise 1% this year, despite a potential 11% fall in per-share earnings in a recessionary environment, they forecast in a Tuesday note. A bonus of investing in dividend-paying stocks now: Many of them are trading at a 15% to 20% valuation discount relative to the market, making them attractive bargains that pay a steady cash flow, the analysts added.
The S&P 500 is trading at 17.7 times its expected earnings over the next 12 months, down from 18.5 times earnings a year ago. That is partly because corporate-profit expectations have fallen sharply. Analysts polled by FactSet expect earnings among companies in the S&P 500 to rise roughly 2.2% this year. That is down from their forecasts for around 9.2% growth at the end of June.
George Ball, chairman of investment firm Sanders Morris Harris, which manages $4.9 billion in client assets, said his firm has shifted a significant portion of its clients' equity portfolios into stocks with "excellent earnings prospects" and "higher dividend payouts" over the next several quarters.
In recent weeks, his firm has added to client positions in energy company Enterprise Products Partners LP, which has a dividend yield of 7.6%; Bank of America Corp., which has a yield of 2.6%; and JPMorgan Chase & Co., with a yield of 2.8%.
However, investors could be burned by dividend-paying stocks if they cut payouts amid economic uncertainty. Intel Corp. said Wednesday it is slashing its dividend by about two-thirds as the chip maker seeks to cut $3 billion in costs this year. Its shares have fallen 55% -- including dividends -- from its 2022 high.
Although companies with high debt levels and low margins could afford to pay dividends in a low interest-rate environment, their financial health is going to be tested as raw-material and labor costs go up in a rising rate environment, potentially leading to a reduction or elimination of the dividend, said Mr. Huemmer of Northern Trust.
"Don't be fooled by dividend growth or consistent dividend payment as proxies for the quality of the company," he said.