Introduction
Let me start this article by saying that I am fully aware that I went with an extremely catchy title. However, it’s far from clickbait, as this article will be about a few very important (interrelated) issues: inflation, central bank rates, and dividends.
All of this is related to the “cash trap” I promised to give a lot more attention to.
On June 29, for example, I wrote an article titled “Here Are 4 Fantastic Dividends Yielding 6% To Avoid The ‘Cash Trap’.” Last month, I went with another article that elaborated on what I consider to be one of the best opportunities for dividend investors in recent years.
So, I decided to keep this intro short and get right to it, as we have a lot to discuss!
The Cash Trap & Why It Matters
When the Fed started hiking rates in 2022, something really interesting happened. Even short-term governments “suddenly” yielded 5%. This makes sense, as the Fed funds rate is a benchmark for short-term interest rates in the United States. Also, investors use bonds to bet on the Fed’s next move, which is why the short-term yield is currently below the Fed funds rate.
When risk-free government debt suddenly yields 5%, something very interesting happens. Investors who invest for income started shifting their money to bonds, as they found a lower-risk alternative for their dividend stocks.
This, too, makes sense in a lot of cases. Why should I own a 5% yielding dividend stock if I can hold a government bond with the same yield and no risks?
Needless to say, I am painting with a very broad brush here. While I could name many exceptions, the fact that bonds suddenly became sources of elevated income caused a rotation.
As of the first quarter of this year, assets under management of money market funds (funds holding short-term debt) exceeded $6.5 trillion – $3.5 trillion more compared to pre-pandemic levels!
Not only did it become much more attractive for people to buy bonds, but it also helped that many people retired in recent years. Especially, retired people benefit from lower-risk income alternatives.
On a side note, this retirement wave was fueled by the massive surge in stock market value after the pandemic. The number of excess retirees in the United States exploded in recent years.
So far, so good.
What about the cash trap?
The cash trap is a situation where the Fed is going to cut rates, causing people to find other investments to secure income. When bonds become less attractive, stocks turn into a more attractive alternative.
Right now, it looks like the start of the Fed’s rate cut cycle is imminent, as the debate isn’t whether the Fed should cut this month but by how much.
The central bank is set to reduce rates for the first time since 2020 at its meeting on Sept. 17-18. Because officials have signaled greater confidence that they can make multiple rate cuts over the next several months, they are confronting questions over whether to cut by a traditional 0.25 percentage point or by a larger 0.5 point. – The Wall Street Journal
Although the Fed is known for starting rate cycles with small cuts of 25 basis points, history suggests that it “never” ends after just one rate cut. Usually, the first rate cut is followed by a series of cuts – often pressured by very challenging economic conditions.
Using the data below, one can make the case the market only gets a series of bigger cuts in times of a recession (shaded area).
Right now, the market expects up to 240 basis points in cuts over the next 12 months, which would make it one of the biggest easing cycles without a recession in the Fed’s history.
Moreover, we’re witnessing more unusual developments:
- Stocks are at an all-time high. Most cuts start after market weakness has set in.
- The Atlanta Federal Reserve Bank shows that wage growth is still at 4.7% (July 2024). This is very challenging for the Fed.
- Core inflation is at 3.2% (August) – 120 basis points above the 2% target.
- The Fed is dealing with headwinds caused by housing shortages, deglobalization, and other unfavorable factors that include aggressive government spending.
I believe the Fed is easing to protect economic growth. As I have written in prior articles (like this one), I am convinced that central banks will settle for 3% or more inflation to allow “us” to inflate our way out of elevated debt levels.
While this is a risky endeavor, it has happened in the past.
Moreover, given unfavorable trends in unemployment (down), ISM manufacturing expectations (down), and consumer sentiment (down again), I believe the Fed will use this opportunity to cut rates, even if the timing with regard to inflation is highly unusual.
This is also why I care so much about buying inflation protection when picking dividend stocks.
Buying High-Quality Dividend Stocks Is Critical
One of the reasons why I am writing this article is the discussions I had with many readers in the past few days, including the reader who left the comment below:
This philosophy looks very sound and thanks for revisiting the topic. I think it’s also very good timing to be reminded of that. Rates on euro cash funds approach less than 3% in some cases, meaning a lot of stocks which I previously crossed out as yielding too little start making more sense now. I think the moment when it drops below 2.5% will be very interesting. – Comment
This comment perfectly captures what many investors are going through right now: rates on bonds are declining, making many dividend stocks much more attractive on a relative basis.
Before I continue, there is evidence that suggests we need to be very careful.
As we can see below, Fed rate cuts almost always cause a short-term decline in assets under management of money market funds.
However, this does NOT always bode well for the market.
Using Ritholz data, the correlation between money market assets and the S&P 500 is positive, meaning lower money market fund assets tend to result in a lower S&P 500.
Does this mean my thesis is wrong and I just wasted 1,000 words on a nonsense thesis?
No, as we need to dig a bit deeper.
For example, when (short-term) government bond yields fall, people in need of income do not suddenly jump into low-yielding stocks like the ones that currently dominate the S&P 500’s largest holdings (see below).
Note that these ten holdings accounted for roughly 36% of the S&P 500’s weighting, one of the biggest overweight weightings in modern history. This does not necessarily help the risk/reward of the market if higher-yielding stocks become more attractive.
Although all of the companies in the list you just saw are high-quality organizations, I believe the benefit for higher-yielding dividend stocks and dividend stocks with an “average” yield of 2-3% with decent dividend growth is much better.
To give you some examples, even high-yield stocks with poor returns in recent years are now “ripping.” This includes cigarette producers like Altria (MO) and Philip Morris (PM), which yield 8% and 4%, respectively.
Even after their recent rallies, I’m bullish on both, as the market expects them to maintain mid-single-digit annual EPS growth in the case of Altria and low-double-digit annual EPS growth in the case of Philip Morris.
Altria (article):
Philip Morris (article):
I am also a huge fan of midstream companies in this environment. Midstream companies own infrastructure (like pipelines) that are used by oil producers. These companies are not directly dependent on the price of oil and gas but benefit from low-risk income related to throughput and/or take-or-pay contracts.
After the pandemic, this industry became extremely attractive due to lower capital spending requirements, investments in the past that started paying off, and long-term growth in oil and gas output, natural gas liquids, liquified natural gas, and commodities that require infrastructure.
In this industry, I like many players, including ONEOK (OKE), which comes with a 4.5% yield (it’s a C-Corp), 7.8%-yielding MPLX (MPLX), and 8%-yielding Energy Transfer (ET) – among many others. MPLX and ET are MLPs that issue K-1 forms.
ONEOK (article):
MPLX (article):
Energy Transfer (article):
Lower-yielding ideas with higher dividend growth rates are L3Harris Technologies (LHX) and RTX Corp. (RTX). These defense contractors yield slightly more than 2% and come with elevated dividend growth expectations – on top of anti-cyclical business models. I own both.
L3Harris Technologies (article):
RTX Corp. (article):
On top of that, I like asset managers, including private equity giants like Blackstone (BX). Currently yielding 2.3%, this giant benefits from strong financial inflows and new investment opportunities in an environment of falling rates.
Blackstone (article):
Additionally, real estate is a great place to be for income. In this area, I like many players, including consistent dividend growers like Realty Income (O) with a 5.1% (monthly) dividend, and VICI Properties (VICI), which has a 5.2% yield and owns major properties on the Las Vegas strip.
Realty Income (article):
VICI Properties (article):
I am also a big fan of oil and gas producers. Especially after the recent oil price correction, values are terrific, as I discussed in a recent article. In this space, I like companies like Canadian Natural Resources (CNQ), which comes with a 4.7% yield, deep reserves, and a pledge to return 100% of its free cash flow to shareholders.
Canadian Natural Resources (article):
Although there’s no way I can give each of these stocks the attention they deserve in this article, I wanted to provide some food for thought, including links to in-depth articles.
As we are potentially looking at a serious, multi-trillion rotation, I believe we need to focus on high-quality dividend income, a sector I expect to outperform the market in the years ahead.
Needless to say, going forward, I will continue to discuss these developments and provide much more in-depth research on potential dividend opportunities.
For now, the biggest takeaway is that we are looking at massive macroeconomic shifts with implications for inflation and the relative performance of dividend stocks.
I believe with the right stocks, investors can make “a lot of money” in the years ahead, in addition to building attractive income-producing portfolios.
Takeaway
The investment landscape is shifting rapidly, and understanding the dynamics between inflation, central bank rates, and dividend stocks is crucial.
As the Fed prepares to cut rates, the “cash trap” could trigger a significant rotation from bonds back to dividend stocks.
While the market’s reaction is uncertain, high-quality dividend stocks, especially those offering inflation protection, are poised to benefit.
By focusing on well-selected dividend stocks, I believe investors can navigate these macroeconomic shifts and build portfolios that not only provide attractive income but also offer substantial long-term outperformance!
On a side note, do you know which National Park I used for the header picture of this article?
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