Indexology^® Blog

Questions and some answers on issues facing, or created at, the Fed

Raise Rates?

Not very likely next week at the September 21^st FOMC meeting.  Recent data including August jobs report, declines in Industrial Production and Retail Sales and comments from FOMC members argue against a move now.  The November 2^nd meeting is just days before the election so attention will be the December 14^th FOMC session.  As of now the probability appear to be close to, but a bit below, 50%.

Policy Puzzles – The last eight years have seen more changes in the Fed’s policy making and operations than any time since 1979.  Some comments on the innovations:

Quantitative Easing (QE) raised the price and lowered the yields on intermediate and long term bonds in an effort to spur business investment and encourage consumer spending on big ticket items. Lower long term interest rates increased the prices of houses and stocks, adding to household net worth.  The same low interest rates raised havoc for pensions and insurance companies facing long term liabilities. Business investment gains were harder to identify.

Negative Interest Rates were the next step when the combination of QE and near-zero central bank policy rates didn’t provide sufficient stimulus. In Switzerland, but not in Japan, negative interest rates weakened the currency.  They did manage to push real interest rates farther into negative territory despite extremely low inflation. However, negative interest rates damage consumer confidence and encourage saving more than spending. They also distort normal relations among different debt instruments and the yield curve.

Raising the Fed’s inflation target maybe one way to raise interest rates and give the Fed more room to lower rates when the next recession appears.  The arithmetic works but pushing the inflation target to 4% would add to fears that past QE is setting us up for much higher inflation.  Given the difficulty the Fed and other central banks have in even getting inflation up to 2%, everyone may doubt that a 4% inflation target could be achieved.

The Phillips curve seems to have disappeared. A building block of monetary policy is the inverse relation and trade-off between inflation and unemployment usually referred as the Phillips curve. A basic tenet of monetary theory is that raising the policy interest rate – the Fed funds rate in the US – will raise unemployment and lead to lower inflation.  This worked until recently. Then after the 2007-9 recession ended, unemployment came down from 10% to 5% but inflation remained a bit under 2%.  Although current data suggest this theory isn’t valid now, it is still being cited in arguments for and against higher interest rates.

One counter to policy built on the Phillips curve is called Neo-Fisherism, named after economist Irving Fisher.  Fisher is known for two things: predicting that stocks had reached a permanently higher valuation level just before the 1929 crash and explaining that the nominal interest rate is the sum of inflation and the real interest rate. (Most economists prefer to remember Fisher for the second item.) Traditionally Fisher’s interest rate rule is understood to mean that causation runs from inflation to the nominal rate. Borrowers and lenders focus on the real rate and nominal rates adjust to compensate for inflation. Neo-Fisherism turns this upside-down: The central bank sets the nominal interest rate. The real (or natural) rate of interest is determined by economic conditions – it may vary in the short term but not in the long term. Inflation then adjusts to re-establish the proper relation between the nominal and real interest rates. In this world, the Fed would raise interest rates if it wanted to raise inflation. Moreover, the same logic argues that if the Fed keeps interest rates low, it will not be able to raise inflation.

Another alternative to traditional monetary thinking is the Fiscal Theory of the Price Level (FTLP) which also attempts to explain why QE and low interest rates haven’t succeeded in raising inflation.  Under QE, the central bank buys bonds and increases the money supply by raising the cash banks have on hand or on deposit at the Fed.  Traditionally this increase in the money supply should have raised inflation – more money chasing fewer goods means higher prices.  A simplified version of FLTP says all QE did was swap bonds and money – in a modern market economy with rock bottom interest rates bonds and money are both liquid ways to hold cash. Since they are almost equivalent, QE doesn’t affect the supply of liquidity and can’t effect inflation. If the central bank really wants to increase liquidity, it must turn to the fiscal authority – the Treasury – for expanded fiscal spending. Without the credibility of increased debt-financed government spending, liquidity won’t increase and inflation won’t move.

As the Fed and others debate all these theories, interest rates are likely to stay low for a while longer. If the economy picks up in the third quarter, the Fed may deliver a rate hike as an early Christmas present.

Something unusual happened in August in commodities where energy was the only sector that rose.  Despite the negative non-energy performance, supply shocks created pockets of opportunity for some individual commodities within industrial metals and agriculture.

Now, oil has turned negative again from record high inventories despite U.S. production cuts, because OPEC producers have more than filled the gap and demand growth is faltering.  Not only is emerging demand from China and India more unstable from slowed expansion and weak infrastructure demand, but developed market demand is also slowing as the stimulus from low oil prices is running out of fuel.  As oil has become a major macro economic factor in GDP growth estimates, its low price seems like more of a liability than an asset as the horizon for a balanced market seems further away.

Upon inspection of the equity sectors, there is equally as rare and gloomy of a picture as in the commodities market. History shows that like with all commodities that rise with oil, rising oil supports the majority of equity sectors most of the time. In 120 positive oil months, 6 or more sectors were positive in 74 of those months or 62% of the time. In fact, there were 17 months where all ten sectors were positive with rising oil, which was the most common scenario with rising oil. On the other hand, when oil fell, the impacts on sectors were mixed with all 10 only simultaneously falling with oil in 8 months of 93 negative oil months and a total of 213 month in the time period since Jan. 1999.

Month-to-date as of Sep. 14, 2016, oil is down and all the equity sectors are down with it. The last time this happened was over five years ago in Jun. 2011. Back then, the S&P 500 lost 14.0% in the following three months. However, the last time the unusual lonely rise of energy in the commodity spectrum happened in Mar. 2008, it took place near the same time as the as the unusual simultaneous equity sector drop back in Jan. 2008, right after the peak before the global financial crisis.

It may be coincidental timing or it may be related to the demand crisis in oil that might be hurting the economy enough for negative sector performance across the board, even if there is a rogue month of a bear market rally in oil alone.

Additionally, the sector risk premiums, a measure of the sentiment showing where investors are excited to participate in the upside of the stocks versus hide in the safety of the bonds, show 8 of 10 sectors with discounts. This is the most since Sep. 2015, when the Chinese stock volatility was rippling through the market.  Now just technology and utilities are still positive but the technology risk premium has fallen to just 1.3% from 6.6% just two months ago.

One last possible reflection that market participants are feeling the fear is evidenced by a spike in VIX, at its highest levels since the end of June.

The hunt for stable income is an increasingly challenging task.  Bond yields across major fixed income markets are at historically low levels, with some of the central banks in developed countries even going as far as adopting a negative rates policy.  Together with an aging population that is living longer and relies predominantly on fixed income, it is no surprise that dividends have become a major source of yield.

Not all dividends are the same.  In a quest for yield, it is important to distinguish between stable yield versus absolute high yield.  The S&P Dividend Aristocrats^® Series fall into the former camp.  Since the early 1970s, S&P Dow Jones Indices has been identifying stocks with a long history of consistent dividend increases, which we call “dividend aristocrats.”  The S&P 500^® Dividend Aristocrats is an index that consists of dividend-paying securities of the S&P 500 that have followed a payout policy of increasing dividends for at least 25 consecutive years.

As shown in Exhibit 1, not every dividend-paying stock in the S&P 500 can become a dividend aristocrat.  Between 1994 and 2016, the number of stocks that qualified to be part of the index ranged from 41 to 64, representing approximately 8% to 13% of the underlying S&P 500 universe.  One can argue that the dividend aristocrats symbolize the tier-one, blue-chip companies with solid balance sheets, and therefore, they can weather market cycles.  We can see what a difficult feat that is by observing the number of constituents from 2009-2011, the years following the 2008 financial crisis, when many dividend-paying companies either cut or omitted their dividends altogether.

A portfolio that is constructed solely on the basis of highest-yield securities can potentially run the risk of overloading on the financials and utilities sectors, as those two sectors typically have stocks that pay high dividends.  This exposes the portfolio to sector-concentration risk arising from sector-specific risk factors, such as adverse interest rate movements.

Since companies across all sectors may follow an increasing dividend-payout policy and can exhibit consistent dividend growth, the S&P 500 Dividend Aristocrats draws its constituents from a broad spectrum of industries (see Exhibit 2).  The index is sector diversified, thereby reducing the risk of being overexposed to a particular sector and taking on large active sector risk relative to the underlying benchmark.

Join us for a webinar tomorrow discussing the importance of dividend growers and their characteristics.  We will be highlighting the importance of dividends in generating total equity return in addition to the risk/return characteristics of the S&P 500 Dividend Aristocrats.

Equity markets are notoriously volatile, at least when compared to fixed income. Dividend payments, by contrast, while not fixed like many bond coupons, offer  market participants a much less volatile and more fixed income-like risk and return profile.  For the 25 years from 1990 to 2015, the annual variation in S&P 500® dividend points has been 7.65%, compared to 17.4% for the S&P 500® itself.  Similarly, since the inauguration of the S&P 500® Dividend future, the realized volatility of the December 2020 contract has been 6.5%, annualized, compared to 15.8% for the E-Mini S&P 500® Index future.

Dividends and GDP Correlation
Although payout ratios and corporate earnings as a percentage of GDP change over time, S&P 500® dividend payments have correlated with changes in nominal GDP at around 50% since 1990 (Figure 1). This contrasts sharply with the S&P 500® itself, whose correlation with annual changes in GDP is only 0.1% over the same period.  This is largely because equities anticipate future changes in GDP whereas dividends are more apt to reflect present conditions.

Bottom Line

• The main drivers of dividends are corporate profit growth and payout ratios.
• Corporate profits vary as a percentage of GDP, and payout ratios can be influenced by the economic cycle and tax policy.
• While corporate earnings are challenged by the low inflation and sluggish global growth environment, which may lead to more stock price volatility, dividends are far less volatile than equity indices, displaying slightly less than half of the annualized variation.

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

S&P Dow Jones Indices is an independent third party provider of investable indices.  We do not sponsor, endorse, sell or promote any investment fund or other vehicle that is offered by third parties. The views and opinions of any third party contributor are his/her own and may not necessarily represent the views or opinions of S&P Dow Jones Indices or any of its affiliates.

In step with the July, global markets calmed further in August. Based on the dispersion-correlation map, which provides a framework through which we can assess market volatility, equities have entered a very tranquil environment.

It wasn’t too long ago that correlation spiked in equity markets due to geopolitical events. That heightened correlation was resolved swiftly and benignly last month. Current dispersion for the S&P 500 is near a historical 25-year low (which means the environment remains inauspicious for active management to add value), while correlations are also well below their historical average.

Both dispersion and correlation also declined for the S&P Europe 350. For the S&P Pan Asia BMI, dispersion increased slightly but correlation remains well below average.

Dispersion-Correlation Maps