For many investors, the U.S. economy’s gain of 215,000 jobs in July “sealed the deal” for a Fed Funds rate hike in September. A 25 basis point rate hike is now more likely, according to the futures market. The current September contract for Fed Funds futures, according to my estimates, implies a 44% probability of no increase and a 56% probability of a 25-basis point increase at the upcoming September 17 FOMC meeting. Alternatively, the CBOE’s black box puts the odds of no increase at 55%. (Of course, the probability calculations are sensitive to the assumptions used. The fact that the current Feds Fund target rate is a range between 0.00% and 0.25% complicates the analysis.)
Despite the growing conviction by market participants of a hike in September, the FOMC did not make any commitments in its statement from the July 29 meeting or even hint that a rate rise was imminent. It did say, however, that when economic activity (including the labor market) returns to “mandate-consistent” levels, economic conditions may warrant keeping the target Fed Funds rate below a normalized level for some time.
This suggests that we may not see another rate increase for many months after this initial rise. Fed Funds futures currently do not cross the 0.75% threshold until September 2016 and 1.00% until January 2017. This trajectory is consistent with the comments made in the latest FOMC statement.
Many market watchers point to the current unemployment rate of 5.3%, a level that in the past would indicate that the economy was approaching “full employment.” But this is not your father’s 5.3% unemployment rate. The broadest measure of unemployment, (U-6, in the Bureau of Labor Statistic’s monthly report on the employment situation, which includes persons marginally attached to the workforce and those part-time workers who desire full-time employment) is still at 10.4%, 190 basis points above the average level of a decade ago, in the years preceding the financial crisis. This suggests that there remains slack in the labor force and gives the Fed additional flexibility to sustain low interest rates without risking a significant pick-up in inflation.
Yet, the prolonged period of low interest rates is distorting economic signals. It has helped push asset prices higher and encouraged trading over investment. The slow recovery in capital spending is a contributing factor in the economy’s tepid rate of growth. Even though the Fed may have the room to keep rates low, a strong case can be made that it should start sooner to reverse these capital market distortions.
Concerns over the future course of interest rates may be contributing to the stock market’s loss of momentum. With nearly two-thirds of the year now gone, the major market averages are showing gains of only 1% or so, well below the 11% percent gains of 2014 and 32% percent gains of 2013. Certainly, other factors – like the plunge in commodity prices (and especially oil), the strength of the dollar, devaluation of the yuan, slower-than-anticipated economic growth outside the U.S. and geopolitical risks – are weighing on the market; but the concern about higher interest rates hurt the performance of income-oriented sectors, like utilities, earlier in the year.
The stock market has had a rough go this week. After a short-lived rally on Monday, stocks gave back all those gains and more on Tuesday and are set to open sharply lower this morning. Consequently, the S&P 500 will break through its 200-day moving average decisively. If the index falls below 2040, it will also break below the trading range that has been in place for most of the year, raising the odds for a correction.
As the stock market’s performance flat-lined in the first half of 2015, there has been a rotation into sectors that are less cyclically sensitive. The market has also bid up share prices of sectors and companies that benefit from stronger consumer spending. Those sectors that are still able to show earnings growth have also led the performance of this range-bound market.
Since the beginning of the second half of 2015, however, there has been a modest tilt toward less cyclically sensitive, income-oriented stocks. Utilities have been the big winner over the past six weeks. Water utilities are up 8.4%; electric utilities are up 6.7%, multi-utilities are up 6.0% and gas utilities are up 2.2%.
REITs, which had likewise lagged in the first half, have gained more than 5% since June 30. Branded foods companies, which offer yields of about 3% on average, have been solid performers throughout the year. Big pharmaceutical companies, many of which pay juicy dividends, have also performed well year-to-date, even though they have faded in recent weeks.
(Chart, courtesy of Stockcharts.com, shows the performance of six Dow Jones U.S. Industry Sectors, including electric utilities ($DJUSEU), gas utilities ($DJUSGU), water utilities ($DJUSWU), REITs ($DJUSRI), food products ($DJUSFP) and pharmaceuticals ($DJUSPR).)
One income-oriented sector that has lagged badly is master-limited partnerships. The Dow Jones U.S. Pipelines industry group, where many MLPs are lodged, is down 11.6% year-to-date. Average yields are now 6.8%, according to Alerian, better than the 4% yields on utilities and REITs and the 2.0%-2.5% average yield on the broader market.
The sector is closely tied to the oil & gas industry. Many MLPs are paying out more in dividends than the free cash flow that they generate from operations. Consequently, many MLPs have to grow to sustain their dividends. But with oil and natural gas prices plumbing their lows, drilling activity has been slowing. Still, some MLPs say that if they must curtail their growth, their existing operations will support their current dividends; so it is worth poking around the sector for bargains.
The relative strength of income-producing stock sectors highlights the more defensive posture that has been taken by many investors since mid-year. Given the sell-off in those stocks in the 2015 first half, yields are now more alluring. For example, the average yield on health care REITs is now 6.0%, which is attractive given the stability of demand and despite concerns about an overheated acquisitions market and overbuilding.
While these stocks do face the risk of rising interest rates, the current consensus view is that rate increases will be gradual. With yields now above 4%, there is sufficient spread to weather the rise in short-term interest rates, if and when it occurs. Continuing economic recovery will also boost company profits, which can offset some of the headwind caused by rising rates.
I am not ready to give up on the overall market just yet, but a focus on income-producing stocks is prudent in the current environment.
Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey 07036