In this new inflationary reality, the best FTSE 100 dividend stocks are not just those which are highest yielding, but also those which are most likely to continue to pay their dividends through what could become a severe recession.

The FTSE 100 is by its nature defensive, down a mere 1% year-to-date. But with the downturn almost upon the UK, this could change rapidly.

And with the base rate already at 1.75%, the markets are pricing in an increase to 4.1% by mid-2023. This automatically rules out FTSE 100 dividend stocks with high net debt levels and irregular cash flow, as their dividends could fast become unsustainable.

FTSE 100 stocks: recessionary environment

CPI inflation is now into double-digits at 10.1%. The Bank of England has already warned this figure will exceed 13% by winter, and Citi predicts it will strike 18.6% in the new year.

The primary inflationary factor is of course energy. High energy prices affect everything in the economic supply chain; from manufacturing, to services, to consumer demand.

From October, the UK’s average household’s annual energy bill will rise to £3,549 a year. Consultancy Auxilione has predicted this will rise to an unaffordable £7,700 by April. And this prediction keeps going up, as wholesale gas prices bound on with no upper limit.

In addition, there is no price cap for businesses. Many smaller companies will collapse this winter unless there is government intervention on the scale of the covid-19 pandemic response.

Interestingly, this could be a net positive for some FTSE 100 companies that will benefit from a larger market share without any additional investment.

Best FTSE 100 dividend stocks

1) Legal & General (LON: LGEN)

Down 15% year-to-date, Legal & General shares now boast an enviable 9.2% dividend yield and price-to-earnings ratio of just 7.6.

This level of correction could imply the blue-chip financier is simply being affected by wider negative market sentiment, rather than specific sell-off pressures, such as those affecting Aviva and Direct Line.

L&G is a £15.5 billion titan, with £1.4 trillion of assets under management. It now focuses on four complementary sectors: retirement planning, investment management, capital investment, and insurance.

This diversification is a highlight for dividend investors, as it provides dividend protection against headwinds in any one sector. For example, the new laws aimed at stopping insurers from overcharging renewal customers that are damaging its insurance arm leave the other three sectors unaffected.

Encouragingly, it remains the UK’s most popular life insurance provider, a sector which is likely to grow as the population demographic continues to shift.

In half-year results earlier this month, CEO Nigel Wilson noted ‘we have delivered for our institutional clients and retail customers, while generating good volumes and margins in a buoyant PRT market...our balance sheet is strong and highly resilient, with a solvency ratio of 212% and with 100% of cash flows received from our Direct Investments.’

Moreover, the financial services giant saw operating profit rise by 8% to £1.16 billion, while cash generation increased by 22% year on year to £1 billion.

However, L&G operates in a hypercompetitive marketplace, with competition from the likes of RSA Insurance Group and Aviva. This makes maintaining profit margins difficult, especially as consumers are keenly incentivised to switch providers amid the cost-of-living crisis.

Key risk: Strong companies with sustainable dividends are few and far between in recessions. Beware overvaluations as investors flood to safety.

2) Persimmon (LON: PSN)

With its dividend yield now at 15.7%, Persimmon has remained the highest-yielding FTSE 100 dividend stock for months. Housebuilders more generally, including Taylor Wimpey and Barratt Developments, have dominated the top yielding FTSE 100 dividend stocks for years.

The reason behind this is simple: there is too little domestic housing supply for available demand, and since the 2008 financial crisis, interest rates have been held down to near-zero levels. This means that in addition to sustained owner-occupier demand, buy-to-let has (until recent legal and monetary changes) been an excellent investment for portfolio diversification.

This housebuilder dividend trend has been accelerated by the pandemic-induced ‘race for space,’ and exacerbated by the stamp duty holiday. The average UK house price now stands at £286,000, up 7.8% over the past year.

The group delivered 6,652 homes in H1, down from 7,409 in H1 2021. But it says ‘demand across the UK remains strong,’ and is 75% forward sold for the full year.

However, the housing market is cyclical. Persimmon is down 48% year-to-date, as institutional investment exits, implying that the dividend is not sustainable amid tightening monetary policy. And for earlier investors, any dividend gains have been wiped out by capital losses.

Moreover, further share price falls are very possible. Persimmon could well be a future exemplar of the dividend trap. Of course, a 15.7% dividend yield is hard to resist.

Key risk: Further share price falls, especially if rocketing inflation, rising interest rates, and the coming cessation of help-to-buy conspire to cause a housing market crash at the lower end of the market.

3) Imperial Brands (LON: IMB)

Up 14% year-to-date to 1,880p, Imperial Brands shares are delivering an 8.5% dividend for investors prepared to overlook the ethical issues associated with investing in tobacco stocks.

Further, it has a price-to-earnings ratio of 8.8, compared to the FTSE 100 average of 15. On the fundamentals, it still represents value for money despite recent share price growth.

Imperial Brands possesses a quality that is highly sought after in recessionary environments; inelastic demand. Tobacco is addictive, and users will sacrifice every other non-necessity to acquire it regardless of discretionary income or price. Accordingly, Imperial Brands’ strategy to increase prices in line with inflation is working.

In May’s half-year results, CEO Stefan Bomhard enthused ‘we are now 18 months into our five-year strategy to build a more sustainable Imperial capable of consistent growth – and I am pleased with the progress we are making... during the first half of the year, we increased aggregate market share in the five priority markets which account for around 70 per cent of our operating profit.’

Unlike competitor British American Tobacco, the company has reduced its ambition to expand its non-cigarette division, and has sold off its premium cigars business. Instead, Imperials Brands is focusing on increasing its market share for cigarettes in key growth countries.

Of course, this could backfire. Regulation is already tight for tobacco, and further restrictions can be brought in at any time. For example, the 2007 UK smoking ban was unthinkable in the 1990s, but now the country plans to be ‘smokefree’ by 2030.

However, in the near term, Imperial Brands could be an excellent source of dividend income in this time of severe financial stress.

Key risk: Tobacco, very reasonably, is a key ingredient in many defensive stock portfolios. This can make tobacco stocks overvalued in recessionary environments, and at risk when capital eventually deserts for growth.

Charles Archer | Financial Writer, London
30 August 2022 06:55