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Happy and Yielding

By Ari Charney on May 5, 2017

“Don’t fight the Fed,” as the old adage goes. But what about simply ignoring the central bank altogether?

That’s certainly what a lot of income investors seem to be doing.

The conventional wisdom is that dividend stocks perform poorly in a rising-rate environment. But on a year-to-date basis, the S&P 500 Dividend Aristocrats Index is up 5.7% on a price basis, while the Dow Jones Utility Average is up nearly 6.0%.

The S&P 500 only just reopened its lead over the past couple weeks, with the broad market up 6.7%, barely ahead of the two equity-income benchmarks.

Meanwhile, the Fed is basically saying it plans to press ahead with at least two more rate hikes this year, almost regardless of what the short-term data suggest about the economy.

Our customarily cautious central bank is eager to show that it’s finally serious about raising rates, and that means abandoning its occasionally embarrassing dovishness when economic data disappoint.

For instance, the government’s initial reading of first-quarter gross domestic product (GDP) showed that the U.S. economy expanded by a feeble 0.7% annualized, a substantial three-tenths of a percentage point shy of economists’ consensus forecast.

Following its latest meeting on Wednesday, the Fed said it views the slowdown as “transitory.”

Presumably, it also views the weakening in its preferred inflation metric to be transitory as well.

Although the consumer-price index (CPI) is the best-known inflation indicator, it has two shortcomings: 1) It only tracks spending by urban consumers; and 2) it gathers data from household surveys, which can be unreliable.

Instead, the Fed uses the personal consumption expenditure index (PCE), which is a much more expansive metric, to track prices paid for a basket of goods and services by consumers, employers, and federal programs. The PCE is calculated by collecting retail-sales data from businesses.

Although the PCE showed inflation rising 2.1% year over year in February, just above the Fed’s 2% target, it dipped back below that threshold in March, to 1.8%.

Happily, the latest jobs data suggest the Fed has achieved its other mandate—and then some. The April employment report showed the economy added 211,000 jobs last month, well ahead of estimates. Equally important, the unemployment rate dropped to 4.4%, the lowest level in nearly a decade.

While most commentators would note that the U.S. is technically at full employment at these levels, there’s still the pesky U-6 unemployment rate to remind us that things aren’t as rosy as the triumphant headlines might indicate.

The U-6 is also referred to as the underemployment rate because it includes those who are willing to work but haven’t looked for a job recently due to being discouraged, as well as those who work part-time for economic reasons. As such, some consider the U-6 to be the true measure of unemployment.

While the underemployment rate still stands at 8.6%, nearly double that of the headline unemployment rate, there has been marked improvement in this category too. Indeed, the U-6 has declined by more than a percentage point since last September.

Even with the economy taking one step forward and two steps back, the Fed is still widely expected to hike rates by another quarter-point at its June meeting. That would bring the upper bound of the benchmark federal funds rate to 1.25%.

Thereafter, the market expects to see one more quarter-point increase before the end of the year, with traders concentrating their bets on the Fed’s December meeting. But with the central bank anxious to start winding down its $4.5 trillion balance sheet later this year, that rate hike could come sooner than expected.

So how much longer can income investors get away with ignoring the Fed? If the central bank makes another concerted push to prepare the market for a June rate hike, then we could see traders repositioning in advance of the Fed’s next meeting on June 14. That could give value-oriented income investors a decent buying opportunity.

On the other hand, the effect of future rate increases could be temporarily offset by the Fear Trade, if political and economic shocks continue to roil global markets. That partly explains dividend stocks’ surprising show of strength so far this year. And there’s no reason to expect the uncertainty that helps drive the Fear Trade to abate anytime soon.

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