You’ve heard about low interest rates. You may have even heard about a ZIRP, zero interest-rate policy, as had been the case in the US for years, but have you heard of NIRP, negative interest-rate policy?
Well, that’s the latest with respect to Japan (EWJ), which is home to the third-largest national economy in the world after the US and China. On January 29, the Bank of Japan (BOJ) introduced a negative benchmark interest rate of -0.1%, meaning that instead of paying interest on deposits, it will charge commercial banks to hold their money. This may make Japanese exports cheaper to stimulate growth, but my goodness, talk about a move to push “parked” assets out of the country. The US Treasury markets felt the accelerated asset flow (i.e. the “carry trade”) Friday, helping to drive US government bond yields lower and US equities higher, despite news that the US economy grew less than 1% in the fourth quarter of 2015.
From where we stand, the move by the BOJ looks a lot like a “Hail Mary” pass to see if Japan can finally escape deflation and get economic growth back on track. The causes behind Japan’s deflationary spiral are many and varied, but cheap labor across other emerging Asia nations coupled with pricing pressure from a competitive export market are at least two primary considerations, with some pointing to aging demographics as a contributing cause. Whatever the primary drivers behind Japan’s sluggish growth, the BOJ’s “Hail Mary” pass may fall incomplete, and we’re viewing the odds as long that any monetary policy, by any one nation or collective group of countries, as in the ECB, will permanently solve all the world’s economic ills. It simply can’t. Monetary policy is a relative game, not an absolute one.
Japan is not the only major economy to have negative interest rates. The European Central Bank (ECB), which oversees the monetary policy of the European Union, the largest collective economy in the world, began paying -0.1% (negative 0.1%) on deposits in June 2014, and it has even lowered that rate since then, deeper into negative territory. Perhaps the ECB is the daring example that Japan has followed (Sweden, Denmark, and Switzerland also have negative interest rates). No matter the precedent, the US markets applauded the news from the BOJ, but we’re not buying it fundamentally. The move, in our view, has merely augmented the artificial “carry trade,” a favorite for overleveraged hedge funds. For example, now hedge funds levered to the hilt can borrow yen even more cheaply to convert to an appreciating dollar on a Treasury bill (TLT, TBT) of a relatively higher-quality and higher-yielding rate. Yikes.
There are few things to take note of. First, the data points pointing to global deflation are adding up. We’re certainly not advocates of speculating in the “yellow, shiny” metal (i.e. gold), but traders coming to the same conclusion will start to look to this widely-believed, global deflationary-hedge (GLD). Second, if we were to have any adverse shocks to the US-Japanese exchange rate, we could be in for quite a spill in the event this “carry trade” unwinds. In light of the summer blues of 2015 that generated worries of an emerging-market currency crisis, from Brazil to South Africa and beyond, the risks are certainly piling up. Third, it may be the case that the “surprise” move by Japan may have given the upward march in interest rates in the US pause, at least for the time being.
Fed chair Janet Yellen and team have been communicating to the broader financial markets that the US federal funds rate will go higher, with the next move speculated in March, but many are now betting following the move by the BOJ that the last hike was a policy error, meaning interest rate hikes could be on hold. Many have been positioning for rising interest rates, but could Japan’s move be the catalyst for a change-of-opinion, further inflating dividend–paying stocks than offer higher income streams that US Treasury assets? From our perspective, the chances of a very low interest rate environment continuing for the foreseeable future have increased, which could push yield-seeking assets “back” into dividend-paying stocks, propelling the duration of the “dividend growth” bubble.
Equity investors have been flocking into the dividend-heavy consumer staples (XLP) sector, with the sector garnering nearly a 20 times earnings multiple on its collective earnings stream. This isn’t a sector filled with high-flying technology stocks (XLK, TDIV) or biotech (IBB) “darlings,” but we’re talking about companies like Coca-Cola (KO), Wal-Mart (WMT), Altria (MO) and Procter & Gamble (PG), for instance. We hold the latter two in the Dividend Growth Newsletter portfolio, but please be careful with these high-yielding consumer brand names. Though more discretionary in nature, McDonald’s (MCD), for example, is trading at 20 times fiscal 2017 expected earnings of $6 (which itself may be too optimistic), consumer staple Procter & Gamble is trading at 20 times fiscal 2017 expected earnings per share of $4 (amid a widespread brand transformation), while 3M (MMM) is trading at ~17 times fiscal 2017 expected earnings per share of $9 (perhaps a cyclical peak). Again, these measures are expected annual earnings tallied, not at the end of each firm’s fiscal 2016, but at the end of fiscal 2017, which could very well approximate the peak of global economic growth for some time to come. We’re more than 6 years removed from the March 2009 panic bottom.
Of course we’re not jumping ship early (a classic shortcoming of a pure “value” process), but we are walking a tight-rope as we let these “types” of dividend-paying equities with “lofty” forward earnings multiples run in the Dividend Growth Newsletter portfolio for the sake of income. A 10%-15% correction may not be worth it for some income investors, and they have to think hard about whether receiving a 3%-5% yield is worth experiencing some capital erosion. What we fear the most is that it is very possible that investors are “falling in love” with the brand names, business models and dividend checks of these widely-known equities, forgetting that valuation will always be the supreme magnet that drives all share prices over the intermediate- to long-term. The size of the yield should never be the only consideration within any investment framework. Just look at what happened to investors in Seadrill (SDRL) or Teekay LNG (TGP) or Kinder Morgan (KMI), for example.
As it stands now, 2016 may turn into the year where the “bubble” in organic dividend paying stocks really inflates following the bursting of the “bubble” of financially-engineered distributions of MLPs in 2015. Please be sure to catch up with, “5 More Reasons Why We (Had Expected) Kinder Morgan Shares to Collapse” (they did). There’s a great image in that write-up that walks through how “bubbles” inflate within equities that have financially-engineered payouts, or ones not paid out of free cash flow, as measured by cash flow from operations less all capital spending, and/or earnings. In any case, many feel that “recession-resistant, safe-haven” consumer-staple entities may be the place to hide and get paid to do so in 2016, and they may be right. Just look at top-weighting Altria (see page 5), for example – shares have now surged past $61 each!
We’re not going to take our eye off the fundamental risks, but we’re watching developments closely to not get caught up in the bust. Hope you enjoy this February edition of the Dividend Growth Newsletter!
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The February edition of the Dividend Growth Newsletter will be released later today, February 1.