Rising rates have been the top fear among investors since the Fed's first rate hike of the cycle back in 2015. Since then, the central bank has hiked its federal funds rate target eight times, each time boosting the target by 25 basis points (0.25%).
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The rise in borrowing costs has yet to drag on the economy, but it is having a noticeable effect on dividend-yielding sectors.
Sectors like utilities, telecom, and real estat, which once drew yield-hungry investors, are now losing their appeal and shares are suffering.
Rising Rates Could Be The Surprise Of 2019
Powell surprised the markets in an interview on PBS last week, telling Judy Woodruff that "we may go past neutral, but we're a long way from neutral at this point."
That comment sent yields surging 4.5% to 3.2% from the close at 3.05% on Tuesday.
The neutral rate neither stimulates nor hinders the economy. If Powell thinks that at a Fed Funds rate of 2.25% we are far from neutral and that the Fed is willing to overshoot the rate, then the market may be underestimating the number of rate increases coming.
That's bad news for stocks in rate-sensitive sectors like utilities, REITs, and telecom.
Stock prices in these sectors often fall in a rising rate environment because the higher yields are seen as a replacement for bond rates. As bond rates creep higher, these yield-heavy stocks do not look as attractive. Three of the four worst-performing sectors this year, consumer staples (down 5.75%), real estate (-3.6%), and utilities (-0.27%) are from these rate-sensitive groups.
Analysts are not expecting a rate hike when the FOMC meets next in November but an 85% chance of at least a 25 basis point hike is baked into forward rates in December, according to the CME Group. The market is expecting just two more rate hikes in 2019 with only a 23% chance of three or more increases.
That expectation for just two increases next year contradicts the outlook by Goldman Sachs which is expecting as many as four increases next year. It's also below the Fed's own dot-plot expectations which call for three rate hikes in 2019.
Rising rates and pain for rate-sensitive sectors doesn't mean investors have to forego dividend investing. It just means you need to know where to look for dividend-paying stocks that can actually benefit from rising rates.
Two Sectors And Three Stocks With Rising Rate Potential
Financials have historically done well when rates rise because they lend at the long-end of the yield curve where rates are higher while borrowing at near-term rates. The sector has underperformed this year because long-term rates have not risen as quickly as short-term but rising expectations for inflation could change all that.
Jonathan Golub, Chief U.S. Equity Strategist at Credit Suisse, studied sector returns through 2017 on days when the 10-year Treasury increased or declined. Shares of financials in the S&P 500 rose a cumulative 62% on days when the rate increased while shares of utilities fell 13% over the period.
Shares of consumer discretionary companies also tend to do well when rates rise. This isn't as much the effect of rising rates but what they signal, a healthy economy. Unemployment near multi-decade lows and wages gradually rising should keep consumers opening their wallets and revenue growing for companies in the sector.
Principal Financial Group (Nasdaq: PFG) is a diversified financial firm with $540 billion in assets under management and leadership in retirement investment products, fund investments and life insurance. The company missed Q2 earnings on non-recurring items which sent the shares skidding lower but core business in retirement income solutions and insurance remains solid.
While insurers react positively and negatively to rising rates, the larger effect is that the company can reinvest premiums at higher rates for a better return. This is especially true for life insurers that have a greater percentage of assets in longer-dated bonds and stocks compared to property and casualty insurers.
Shares trade for just 11.5 times trailing earnings and pay a 3.6% yield. The company has aggressively returned cash to shareholders with $760 million in dividends and repurchases (approximately 4.5% of market cap) in 2017.
Bank OZK (Nasdaq: OZK) is a $22 billion regional bank with 252 branches in 10 states, mainly across the Southeast and California. The bank is a best-of-breed and has been named top-performing regional bank in the $10 to $50 billion asset range by S&P Global Market Intelligence every year since 2015.
The bank's net interest margin has consistently been above peers, the fifth highest among 100 largest U.S. banks as of June 2018, and net charge offs of 0.06% since 2016 are well below the average of 0.5% at all FDIC-insured institutions.
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Bank OZK has substantial capacity for growth in untapped deposit potential in existing markets and an increase in the net interest spread as rates increase could cause earnings to surge. Shares trade for 10.5 times earnings and pay a 2.2% dividend.
Whirlpool Corporation (NYSE: WHR) was blindsided at the beginning of the trade war with higher steel prices. International volume has fallen though domestic sales are holding up and the company has been able to pass some of the higher prices on to customers.
A gradual increase in pricing throughout the industry and moderating component inflation in steel and freight shipping should help improve margins the rest of this year and next. As long as the economy keeps growing, volumes will bounce back and sales growth will return.
Shares have tumbled 39% over the last year and trade for just 8-times trailing earnings which are expected to grow 12% over the next four quarters. The company pays a 4% dividend and returned over $1 billion to shareholders last year through the dividend and share repurchase.
Risks To Consider: While dividend stocks in financials and consumer discretionary may not be a rate-sensitive, they will likely be more cyclical which could mean higher risk in a market correction.
Action To Take: Position for cash yield in sectors less rate-sensitive than utilities and telecom for solid dividends and upside price potential in a rising rate environment.