Australia equity – what is a lower dividend yield telling us?

Backed by Australia’s dividend imputation system, which allows companies to pass on tax credits to shareholders, FTSE Australia has delivered the highest average dividend yield in the Asia-Pacific region over the last ten years, largely thanks to the country’s high yielding Basic Materials and Financials industries. Basic Materials companies, buoyed by stable commodity prices, maintained high payouts, while financial institutions, rebounding from the global financial crisis, increased dividends, reflecting improved profitability and robust balance sheets.

However, Australia’s dividend yield outlook has recently shifted. After peaking at 5.3% in 2022, the yield on the FTSE Australia Index has declined to 3.8%, as of August 2024. In contrast, markets like Hong Kong, Singapore and Indonesia now offer higher yields (Figure 2).

To assess the key drivers of the recent decline in Australia’s dividend yield, we first look at the sub-components of dividend yield. For any company, the dividend yield can be rewritten as a function of its earnings yield and its payout ratio. Fluctuations in dividend yield can then be explained by changes in either of these two subcomponents:

The earnings yield can be thought of as a valuation component, given that it is the inverse of Price to Earnings (P/E).

In Australia’s case, apart from a recent uptick in August of this year, the payout ratio has been consistently below its 10-year average since February 2022. Meanwhile, valuations have turned more expensive, placing downward pressure on yields. Over the past two years, the FTSE Australia index has seen a total return of more than 20% (see Figure 1) while earnings per share (EPS) for the index has exhibited significant volatility and been on a downward trajectory since January 2023. This combination of rising share prices and volatile earnings has resulted in an increase in the trailing P/E. Consequently, elevated valuations and diminished earnings appear to be the primary factors behind the declining dividend yields. Australian firms have not necessarily reduced their dividend payouts on average, rather, lower EPS coupled with higher equity prices have driven the yields down. 

At an industry level, the Australian equity market is notably concentrated, with Financials and Basic Materials comprising 36% and 17% of the market, respectively. These industries not only dominate market capitalisation but also significantly contribute to the dividend payouts. 

Over the past decade, Financials have delivered an average dividend yield of 5.1%, while Basic Materials have offered 5.0%. Recently, however, these yields have declined to 4.1% for Financials. The yield for Basic Materials is higher at 5.3%, but significantly lower than the peak level of 9.4% in 2022.

Although industries such as Energy, Telecommunications, and Utilities also provide high dividend yields, their relatively small index weights limit their overall impact. Conversely, Health Care, despite its larger size in the universe, typically offers lower dividend yields due to its industry characteristics. Below, we discuss what a change in dividend yield is telling us about the trend of Financials and Basic Materials – the major contributors to Australia’s dividend yield.

Following the Covid-19 outbreak, dividend yields for Financials experienced a sharp decline but have since stabilized. Part of this decline can be attributed to a fall in the industry’s payout ratio, which decreased from approximately 80% in 2019 to around 68% in August 2024. However, increasing valuations have also played a role in the industry’s declining dividend yields. During the pandemic, trailing P/E ratios for Financials surged on the back of weaker EPS and, although they have moderated somewhat since, valuations for the industry remain elevated and have continued to climb since 2022. 

In 2021 and early 2022, Australian Financials enjoyed high net margins, buoyed by robust housing loan growth in a low-interest rate environment thanks to the country’s positive upward-sloping yield curve (long-end loan yields higher than short-end funding yields for banks). Over this period, EPS remained stable and even saw an uptick in the second half of 2021. However, as the RBA raised rates from 0.10% to 4.35% in 2023, loan growth slowed, and financial firms’ margins compressed as the country’s yield curve flattened. As a result, Australian Financials and Real Estate stocks, which had peaked from higher levels in 2021, were rangebound throughout 2022 and 2023 and found themselves in a less stable earnings environment.

In 2024, a reversal of fortunes emerged for Australian Financials. With market expectations leaning towards rate cuts by the RBA, Financials stock surged over 25% YTD as of August in US dollar terms. Financials also posted unexpectedly strong earnings results, buoyed by a rebound in loan growth and a slight easing in deposit competition. Share buybacks further bolstered EPS, particularly in the banking sector.

Despite surging in 2021, the dividend contribution from Basic Materials began to decline markedly in 2022, reducing the aggregate Australian dividend yield. During this period, the payout ratio for the industry also dropped from 90% to 60%. This shift was primarily due to an increase in EPS following the rally in commodity prices amid the global economic recovery and expectations of China’s rebound post Covid-19. Over this period, net income for the industry grew at a faster pace than the dividends paid out, causing the payout ratio to decline, despite the rally.

However, since 2023, demand for metals has waned due to China’s economic slowdown, and commodity prices have become volatile. This volatility has negatively impacted the earnings of Australia’s Basic Materials, again impacting payout ratios - this time due to weak earnings and a drop in actual dividends paid out, unlike in 2022 when strong earnings but stagnant dividends paid were the issue. Consequently, data shows that both dividend payout ratios and EPS have declined over the past two years. For instance, during its recent Q4 2024 results, BHP, the largest firm in Australia’s materials industry, announced cuts to both its full year dividend and its payout ratio by USD 0.06 and 6%, respectively.

Financials and Basic Materials are pivotal to Australia’s dividend yields. For Financials, market expectations are for the RBA to initiate rate cuts in 2025, driven by easing inflation pressures. If the RBA begins to ease, a steeper yield curve would likely be positive to Banks’ net interest margins, resulting in a more stable earnings environment. This could encourage Australian banks to increase their payout ratios and consequently increase their dividend yields. However, we note that if Financials’ stock prices rally on the back of these expectations, then higher valuations may temporarily offset the effect of these higher payout ratios, temporarily lowering dividend yields in the process. In contrast, the earnings outlook for Basic Materials hinges largely on the uncertainty around commodity prices and China’s economic performance. A significant uptick in China’s growth and subsequent demand for commodities will be important to monitor.