Wednesday, August 21, 2013

Nowhere Else to Go: Rising Rates Won't Be Enough to Curb Stocks

Fed Taper Talks Drive Rates Higher
Since Fed taper talks began in early May, 10-year U.S. Treasury yields have risen from a 1.6% to 2.9%, an increase of nearly 100%.  At their current pace, rates will be near 4% by year-end.  Worries that the Federal Reserve might taper their Quantitative Easing program have speculating futures traders betting on higher rates in the near-term.  We don’t believe it.

The question is not as much where rates are headed, but how quickly they will get there.  We agree that
rates will eventually normalize.  However, we do not believe rates will continue to rise towards 4% in the same linear path they have held over the past few months.  Even the most aggressive analyst’s interest rate projections don’t have interest rates reaching 4% until 2015.  In the short term, we believe the 10-year U.S. Treasury yield will likely stabilize within a trading range of around 2.5% to 3.0%.

Fixed Income Cheapening Up
As interest rates rose last week, prices dropped for all fixed income assets including municipal bonds, investment-grade corporate bonds, and preferred stocks.

We expect preferred stocks to be hurt less in a rising interest rate environment than they have been over the past few months.  In general, rising interest rates are indicative of improving economic times.  A better economy strengthens the financial condition of underlying issuers of preferred stocks, which improves credit ratings and normally narrows the spread to U.S. government securities.

The market is selling off in all fixed income assets – regardless of credit.  Prior to the banking crisis in 2008, the yields of investment-grade preferred stocks, on average, traded at about 1.6% over the 30-year Treasury yield.  Many investment grade preferreds are currently trading at as much as a 2.6% spread to the 30-year – even though banks and many financial institutions are in far better financial condition than they were even prior to 2008.

This appears to be a good buying opportunity.  However, we believe the fixed income market may cheapen up even further over the coming weeks – which would present an even better buying opportunity.  The market is going to take its cue from the Fed.  It probably won’t be until the September Fed meeting when more clarification about the future of QE is going to come.  Until that uncertainty is taken away, rates will likely creep higher.

The municipal bond market has weakened as much as any fixed income market – mainly as a result of the bankruptcy filing in Detroit.  We do not believe there are many other Detroits out there.  The municipal market selloff has presented as good of a buying opportunity as we have seen in a couple of years.

Dividend Growth Will Continue to Outpace
Recent volatility in the stock market has come as a result of uncertainty about the Fed’s intentions with regard to tapering.  Once intentions surrounding QE are cleared up, we believe stocks will again begin to move higher.  Dividend stocks have been favored in this market and we believe that trend will continue. 
While earnings on a year-over-year basis are up only about 3%, dividend growth since the beginning of the year is already up nearly 9%.  It is clear that companies understand that investors are rewarding dividend payers.  The Dow Jones’ dividend payout ratio (calculated by taking dividends per share divided by earnings per share) is around 36%.  Its historic 100-year average has been nearly 50%.  We have said in the past and continue to believe that – in a slow growth economy – dividend payout ratios will push back towards its historic ratio of 50%.

When the dust clears and interest rates stabilize, there are still no good risk-free investment options.  A 3% yield on the 10-year U.S. Treasury is still too low.  With the Fed targeting inflation at 2%, the 10-year yields a mere 1% after-inflation return.  That is not enough for pension funds, insurance companies, college endowments, charitable foundations, or retirees who need to live on investment income. 
Corporate America is aware of the lack of good fixed income alternatives.  That is why we believe companies are going to continue to pay a lot of attention to dividend growth because it is clear that it is desirable and needed by the investing public.