Don’t Exit Dividend Stocks Too Soon
With the Federal Reserve widely expected to begin hiking interest rates by midyear, the conventional wisdom is that it’s time to start cycling out of dividend stocks such as utilities.
But I would caution investors from exiting such investments before it becomes clearer how strong growth will be in the U.S. and around the world this year.
It’s true that yields can rise dramatically on the expectation of rate increases. For example, as the Fed moved to begin curtailing its extraordinary stimulus, the yield on the benchmark 10-year Treasury note went from 1.66% in early May 2013 to 3.04% by the end of that year–a jump of more than 83%.
But rates quickly reversed course when it became apparent that the economy was not nearly as strong as had been thought. While the 10-year is currently hovering just above 2%, a little more than two weeks ago it was trading at a trailing-year low of 1.65%.
Investors are concerned that slowing global growth could be a drag on the U.S., a risk that the Fed noted last year. As such, many economists expect the central bank to make only a modest move when it finally raises rates later this year.
And if current conditions persist, a small increase in short-term rates may have little effect on market dynamics or equity-income investments.
Chart A: Corporates and Utilities Still Have Treasuries Beat
There are four potential trends that could continue to put downward pressure on Treasury rates and force the Fed to remain accommodative:
- Slow U.S. Growth
Despite rising employment and a bubbly stock market, 2014 was not a breakout year for gross domestic product (GDP), which came in at a tepid 2.4%, still well below the long-term trend of around 3%.
And with only a few months since the conclusion of the Fed’s third round of so-called quantitative easing, it’s too early to tell if the economy has reached what economists deem “escape velocity.”
As noted earlier, the U.S. recovery is also dependent on how overseas economies fare. And economists are concerned that a Greek exit from the eurozone could further dampen growth in the European Union, undermining one of America’s largest trading partners.
- Strengthening Dollar
Central bank stimulus measures intended to prop up economies in Asia, Europe and elsewhere are also causing the devaluation of their currencies. That’s prompted a flight to safety among global investors, who are putting their money into dollar-denominated assets to preserve wealth.
But a strengthening dollar can be deflationary if it forces U.S. firms to lower prices in order to be competitive with companies overseas. Meanwhile, it also reduces earnings for firms that derive significant income from foreign markets.
In fact, J.P. Morgan recently published a research note speculating that fourth-quarter GDP expanded at an annualized pace of just 2%.
A key component of the bank’s forecast was a jump in the trade deficit during December to its highest level in two years. The trade deficit widened by 17.1% month over month, to $46.6 billion, as exports fell 0.8%, in part due to a rising dollar.
Although the government initially reported that the economy expanded by 2.6% during the fourth quarter, that figure was based on incomplete data and many economists now expect growth will be revised substantially lower.
- Low Oil Prices
Falling oil prices are often considered tantamount to a tax cut, since lower prices at the pump mean more money in consumers’ pockets.
While analysts are predicting a moderate rebound in oil prices during the second of the year, until that happens, anxieties that crude’s collapse is symptomatic of softening global growth will not be dispelled. As a result, the Fed will likely continue to be cautious.
- Central Bank Stimulus
At the end of January, my colleague Ari Charney wrote that in response to disinflation the world’s central banks “have shifted to a dovish stance on the future of interest rates, if not outright monetary easing.”
In his article for our sister service, Canadian Edge, he detailed the recent dovish moves of the central banks in Europe (Switzerland, Denmark, Russia), Asia (India, Singapore, New Zealand, and Australia), and North America (Canada). And a few days after his report, China jumped on the accommodative bandwagon by trimming banks’ reserve requirements to stimulate lending.
Although theses easing measures are positive from the perspective of supporting the U.S. recovery, they will also put pressure on Treasury rates as overseas investors seek safe havens in U.S. Treasuries and other dollar-denominated assets, which will keep rates low and the dollar strong.
Consequently, dividend stocks should continue to be competitive with Treasuries far longer than many had previously expected.