China’s economy grew at a 7.6 percent rate in the second quarter of 2012. That’s the sixth consecutive quarterly reduction from the prior year’s rate, and the slowest rate of growth in three years for the world’s most populous nation.
A month ago, I urged Utility & Income readers to take their cues from China, rather than Europe. My premise was a stable and growing China would make it difficult for Europe’s woes to drag the whole world into a 2008-style crisis. With the Middle Kingdom’s economy showing definite signs of life, my forecast was that global market action for the rest of 2012 would more closely mirror the turbulence of 2010 and 2011.
That’s still my view now. At first glance, China’s slackening growth in gross domestic product (GDP) does not look like good news. It not only lagged consensus expectations of 7.7 percent, but it also confirmed what so many bears have said numerous times in recent months–that Chinese growth is going to take a while to reassert itself despite a shift in government policy from fighting inflation to spurring growth and employment.
Markets, however, always look ahead, never behind. And the reaction to the news–at least for now–is extremely positive, with beneficiaries ranging from higher oil, gold and copper prices to a jump in utility stocks to a new four-year high. The Canadian dollar has moved back up within a stone’s throw of parity with the US dollar, and the similarly commodity-focused Australian dollar tacked on a gain today as well.
One likely reason for this reaction was the fear that China’s growth number would be even worse. That’s a classic example of how lowered expectations due to bearish sentiment can actually increase the likelihood of a rally.
A bigger reason, however, is the growing expectation that Chinese fiscal and monetary policy will become increasingly expansionary. This week, for example, the State Council affirmed it will ramp up investment in the company’s aviation industry, as well as ease some taxes. That follows loosened controls on banks and real estate.
Chinese GDP growth may not accelerate next quarter, or even the quarter after that. But sooner or later, the money it’s pushing through the system now will create activity. And that will more than offset the dismal situation in Europe.
Meanwhile, Europe is still fertile ground for negative developments. Spanish government bonds continue to slump, forcing the government to resort to using national lottery funds to provide aid to regional governments. And no less a luminary than Warren Buffett declared today that the euro is destined for failure without major changes in the rules.
The euro itself has also been a beneficiary of today’s news out of China, rallying back from a two-year low. And Italy, which has been the target of speculation that it could abandon the euro, held a successful bond auction, selling USD4.3 billion of three-year bonds at a lower interest rate than it was able to a month ago. That suggests all is not lost. But so long as the Continent’s credit markets are in turmoil and its economies in retreat, it will be a drag on global markets.
Finally, there’s the US, still the world’s largest economy. US government bonds continue to trade at record-low interest rates, with the yield on the 10-year note yield slipping under 1.5 percent today. That’s a clear sign of general bearishness about the country’s growth going forward.
To be sure, there have been some hopeful signs. The unemployment insurance claims number announced this week was far lower than anyone expected, with private sector growth more than offsetting the loss of state and local government jobs. Sectors such as natural resources are showing strong employment growth.
The property market crash that began in 2007 has been the biggest drag on the US economy ever since. But here too there are definite signs we’ve seen the bottom, as transaction activity and prices have been picking up for several months.
The overall picture of the US economy, however, remains one of slow and jagged growth that’s benefitting some sectors and not others. That’s the same environment we’ve had since the markets bottomed in March 2009. And despite a Federal Reserve that’s more than willing to stimulate, we’ll likely be stuck with an anemic economy for some time to come.
Only the Best
So what’s the best income investment for this tepid environment? First, investors need to lose the misguided notion that there’s any one “best” dividend-paying sector.
Rather, there are great stocks worth holding in myriad sectors. What separates them from the rest are underlying companies that are financially strong, well managed and positioned to keep growing, even when the overall environment remains sluggish.
Electric utilities as a sector have a lot going for them in mid-2012. Most companies’ borrowing rates are at or near all-time lows, and there’s no indication they’re going higher anytime soon. Meanwhile, revenue from selling electricity has proved time and again to be steady, no matter how fast or slow the economy is growing. And regulatory relations nationwide are generally good, ensuring companies can invest in their systems and expect to earn a fair return doing so.
On the other hand, as I pointed out in last week’s Utility & Income, some utilities are landing in hot water for their performance restoring power following the Great Derecho that smashed into 10 states on June 29. One of them is PEPCO Holdings (NYSE: POM). Two Maryland state senators this week urged state regulators to fine the company more than $100 million for keeping customers in the dark so long.
That’s a sum equal to 1.5 times the company’s second-quarter net income. And while it’s unlikely such a bill will pass–Exelon (NYSE: EXC) unit Baltimore Gas & Electric would face a similar fine–it’s likely to mean trouble for the company’s effort to get a 5 percent rate increase from the state.
The best approach to buying utilities, therefore, is to look for the best individual companies. And the same applies to other dividend-paying stock groups including energy producers, master limited partnerships (MLP), communications providers, water utilities, real estate investment trusts (REIT), Canadian stocks, Australian stocks and bank stocks, as well as any other dividend-paying stock on the planet.
In a market environment like this one, virtually every sector is going to have its day in the sun at some point. The market’s pattern the past three years has been for investors to seek the highest yields at the start of the year, then largely abandon those stocks for the safer dividend-paying stocks in spring, dump even those stocks for the safest bonds in the late summer, and finally come back to safer dividend-paying stocks to end the year.
At this point, investors are shifting back and forth between the ultra safe–mainly US Treasuries and select corporate bonds–and what are considered very safe dividend-paying stocks. Meanwhile, the high-yielding stocks that were so popular earlier in the year have been largely shunned, except by bargain hunters.
If we’re lucky, that puts us between stages three and four, with a strong rally on the horizon going into the end of the year. But more likely, given the turmoil in Europe, weakness in Asia and uncertainty in the US, we’re somewhere between stages two and three, and have some downside between now and any year-end recovery.
One lesson from the action of 2010 and 2011–and in fact following the 2008-09 crash as well–is that dividend-paying stocks recover market losses, so long as their underlying businesses stay strong and their dividends remain secure. That’s about the strongest possible argument against income investors trying to time the market by trading in and out of dividend-paying stocks.
It’s also a good reason not to sell stocks that report solid second-quarter results–as well as to sell any stock that reports real weakness in its core business. I define the latter as a significant reduction in a company’s guidance about its results for the rest of the year. Other key numbers to closely monitor include the payout ratio, debt coming due over the next two years, and any numbers concerning the growth and/or profitability of key operations.
The best income investment now is a stock that meets its guidance, covers its dividend comfortably, has little or no debt coming due between now and the end of 2013 and is on track to grow its key operations. That’s the standard to which all dividend-paying stocks should be held over the next few weeks, as companies release second-quarter numbers–no matter what happens to China, Europe or even US growth.
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