Amidst the low interest rate environment of recent years, popularity of dividend paying stocks has increased among investors and asset allocators in an effort to supplement returns for income-hungry investors, baby boomers, and retirees. Typical high-dividend sectors, which include real estate REITs, utilities, telecommunication and consumer staples have outperformed during the past few years. But will this outperformance continue? In this article, I will argue for the bullish case of these securities in 2016, as their sectors are the best to buy in for a stable and long-lasting income.
The Outlook of US Interest Rates
After seven years of the most accommodative monetary policy in U.S. history, the Federal Reserve raised interest rates by 25 basis points in December 2015. However, it is unlikely that it will raise interest rates again as global risk factors are still running high:
- Global Growth Concerns: IMF warned in December that Global growth in 2015 is the lowest since 2009, and revised down the growth that was projected for 2015 to only 3.1% from previous forecast of 3.3%. Things are looking worse for 2016, as the IMF predicts that 2016 economic growth will be disappointing and the outlook for the medium-term has deteriorated. China had been the main engine driving world growth for many years, with an economy accounting for 15% of global GDP and around half of global growth. With emerging markets now faltering and Chinese economy quickly slowing, rich developed economies, such as North America, European Union, Japan, and Australia, have to rely mostly on internal generated growth which is not always evident.
- Continued China Slowing Growth: The Chinese government has taken several steps to combat deflation, after slowing growth in China raised red flag for global economy. These steps include reducing interest rates 6 times in less than one year (current interest rates are around 4.3%), and loosening access to credit. However, the impact of any of these measures is unlikely to be felt in 2016 as it may take several years to resolve the complexity of the situation.
- Plunge in Commodity Prices: The Chinese economic slowdown inflicted considerable pressure on energy and commodity prices, seriously restraining growth of countries depending on commodity prices as the main driver for their economy. A strong price recovery is unlikely to happen in 2016 to lift countries that rely on commodity prices to balance their budget.
- US Rate Hike’s negative effect on Emerging Markets: US rate hike led to IMF Warning of "Spillover Effect": The increase in US interest rate is expected to compound Emerging Markets problems as capital outflows accelerate and money rapidly returns to the US. Furthermore, higher rates make it more expensive for emerging market borrowers to service their debt. This has prompted the International Monetary Fund (IMF) to warn of the "spillover" effect the Fed's decision is likely to have on volatility in financial markets, especially emerging markets.
- Uncertainties in Europe: The European Union (EU), the world second largest economy after China, will face in 2016 several unresolved challenges from 2015 including: Greece being still a country in crisis, worries about Brexit (Britain exit from the EU), on top of the waves of refugees, and the new terror threats.
- China Currency Devaluation Risks: The Chinese government is caught in a very difficult situation. While it needs a weaker Yuan to increase exports and remain competitive, any strong or unexpected devaluation of its currency causes sharp selloff in its stock markets and other global stock markets similar to the one we are currently experiencing, and which we have experienced in August 2015.
Based on the significant risks listed above, the Fed is unlikely to raise interest rates again in 2016. I will go even further to say that the Fed may have to reverse the rate hike soon, if the global economic situation further deteriorates.
International Interest Rates
With Europe, Japan, and China all facing deflation and lower growth, they are all likely to increase their continued aggressive Quantitative Easing (QE), by further easing money supply and lowering interest rates. Such actions make equity investments even more attractive than they were in 2015.
US Government Bond Yield
Historically, many investors looking for income have sought the security of risk-free government bonds. But with yields on some government bonds, especially those of the US government currently below inflation and resulting in negative real yield. Furthermore the 10 year US Government Bond yield of 2.03% is below the average S&P yield of 2.27% and that of the Dow Jones Industrial Index of 2.78% (source: wsj.com).
Demand for High-Yield Products
Demographic trends will continue to favor dividend-paying stocks as retiring baby boomers and retirees drive demand for income strategies to support their lifestyles, and their longer life expectancy.
Typical Sectors in the High-Dividend Space
Typical high-dividend sectors, which include real estate REITs, utilities, telecommunication and Consumer staples have outperformed during the past few years. The following is the list of some of the highest yielding Exchange Traded notes (ETFs) in each of the above sectors:
I have added to the list of high yield ETFs above the Business Development Companies (BDCs) sector. These companies make loans to and invest in a wide range of privately-held small and middle- private companies in need of financing. They are effectively bond proxy stocks, and with an average yield above 9%, they do look attractive. BDCs usually perform well in a healthy US economy, as their loan default ratio goes down. The BDCs pass on almost all of their income to investors, as mandated by law, and often distribute at least 90% of their taxable income, so dividend is usually variable.
Conclusion
The current worldwide environment of low inflation and moderate growth is here to stay for the foreseeable future. History has shown that when inflation is low, there is a positive effect on equity prices, especially those offering high dividends. With the two main alternatives, cash and bonds, still having unattractive returns, income investors have no other place to go but to stick to high dividend equities, which will provide the safest and wisest investment strategy for 2016.