Tuesday, June 19, 2018

Income Stocks Hurt by Higher Interest Rates?

David Burks
Author position
Sr. Vice President | Equity Income Analyst

During the last 12 months, industry groups typically offering the largest dividend yields have underperformed significantly: Utilities, Telecom, REITs, and Consumer Staples. While the Standard & Poor’s 500 Index® rose by over 14% in this period, all four of these segments declined in price. Telecom declined by just over 8%, while Utilities fell by just under 8%.

The REITs fared better, falling by 2.5% – but the Consumer Staples sector fell by 9%, making it the worst-performing of the Standard & Poor’s eleven major industry classifications. (See chart of indexed performance below) These figures exclude dividends, which would have modestly lessened the overall declines. For investors with exposure in these industries, the strength of the broader market may feel like a mirage.

Surging interest rates

So, why have these four sectors underperformed during a period of general market strength, continued
economic expansion, and growing corporate earnings? We believe the primary reason has been the sharp
rise in interest rates over the past nine months:

  • Increases have been especially dramatic in the shorter-term Treasury securities. For example, the yield on the 2-Year Treasury note has doubled since early September, rising from 1.27% to 2.54% currently.
  • The yield on the 10-Year Treasury has risen by 42% in the same time frame, from 2.06% to 2.92%.
  • The yield on 30-Year Treasury bonds has not risen as much, but still rose by 14%, from 2.67% to 3.04%.

There is also fear that the recent spike in rates could continue. Against the backdrop of a better than expected May jobs report and unemployment at an 18-year low, the Fed raised rates once again June 13 – the second increase this year. While the consensus going into the June meeting was the Federal Reserve would raise rates only three times in 2018, the Fed telegraphed that a fourth rate increase is possible later this year. A strengthening economy, unwinding of the Fed’s Quantitative Easing position, and financing the deficit could all potentially put further upward pressure on interest rates.
Historically, interest rates and performance of “dividend” stocks have been inversely related. That is, when interest rates decline, these stocks perform well. That’s largely been the case for many years as interest rates generally declined until bottoming in the summer of 2016. Since hitting that inflection point, interest rates have been rising – and that pace has recently accelerated. Just as lower rates can help dividend paying stocks, the reverse is also true. When interest rates rise, Treasuries offer an attractive risk-free alternative to high-yielding dividend stocks. As a result, we believe the recent sharp rise in interest rates has impaired those stocks’ performance.

What about fundamentals?

With regard to fundamentals, first quarter results were less than stellar. Among the S&P 500’s 11 sectors, REITs, Consumer Staples, Telecom, and Utilities posted the 1st, 2nd, 3rd, and 5th worst absolute earnings growth during the first quarter. This may have resulted in some price earnings multiple compression with these sectors, further hampering performance. Telecom, Utilities, and Consumer Staples also had the weakest absolute revenue growth, except for the financials. However, Telecom, Utilities, and even Consumer Staples typically post slower revenue growth, regardless of economic environment.

What lies ahead?

There is perhaps some modest good news for investors in Utilities, Telecom, REITs, and Consumer Staples. As a result of their share price weakness, dividend yields are clearly higher than before, in some cases significantly so. Many now offer attractive yields, in our view. Moreover, we believe the majority of these companies enjoy strong cash flows, which should allow for the continued payment of dividends. In addition, we believe that many of these companies remain well positioned to raise their dividends each year. So if an investor’s primary goal is income, these sectors could represent an attractive option, despite the potential ongoing headwinds of higher interest rates. Valuations also now appear more reasonable. In fact, all four sectors are currently trading at price/earnings ratios below their historical averages.

Note: Industry price returns as determined by Standard & Poor’s.

S&P Index Compared to Sectors
This chart shows indexed stock performance since June 1, 2017. The brown line on top is the S&P 500 index (all sectors), which has stayed above 100 since last August. The other four lines represent the Utilities, Consumer Staples, REIT, and Telecom sectors, indexed separately.

Each client’s investment needs, risk tolerance, and goals are different. This newsletter is not meant to be advice for any specific investor. Nothing in it should be construed as an offer to sell, or a solicitation of an offer to buy, any securities. This should not be used as the sole basis for an investment decision. Any opinions or estimates are subject to change without notice. For information about how any of this information applies to your personal financial situation, please contact your Wealth Advisor.

Past performance is not a guarantee of future results.

Although the information provided to you in this newsletter was obtained or compiled from sources that we believe are reliable, J.J.B. Hilliard, W.L. Lyons, LLC cannot, and does not, guarantee that the information or data is accurate, timely, valid, or complete.

All investing involves risk, including the possible loss of principal. You should carefully consider investment objectives, risks, charges, and expenses of any investment before investing. Diversification and asset allocation do not guarantee a profit or guarantee against a loss.

Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market or economic developments. The bond market is also volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect can be more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks.