Andrew Pyle
November 18, 2022
The income competition between stocks and bonds heats up
Just when equity bulls were getting comfortable with the notion that interest rates were peaking and that perhaps a major recession could be avoided, a Federal Reserve official (St. Louis President James Bullard) came out and poured freezing cold water on that view. On Thursday, Bullard told reporters that he believed the minimum fed funds rate should be at least 5%. The target currently sits at 4%, so this would imply not only another sizable rate hike in December, but continued tightening in the first half of next year.
The comments resulted in a modest push higher in bond yields and pulled stocks lower after reaching 2-month highs on Tuesday. The S&P has slipped back below 4,000 after failing to test its 200-day moving average near 4,075. The TSX, which had broken above its 200-day line for a brief moment last Friday, when it pushed past 20,150, has also faded. As for the NASDAQ, the uptick in bond yields had a relatively larger negative impact on tech shares and we are back to re-testing the index’s 50-day moving average after stopping short of climbing above its 100-day line earlier this week.
The adjusted target from Bullard represented only a quarter-point upward revision to his previous estimate of where the minimum terminal fed funds rate would be; but it served as a reminder to investors that there is more to projecting Fed policy than just guessing how big the next hike will be. Even if rate hikes moderate, the second key variable is how high rates go, followed by the third consideration – how long do they stay elevated (or how soon are rates cut)?
As I have discussed before, there is not always a direct correlation between incremental moves in central bank official rates and the yields we observe in the bond market, and that correlation becomes weaker the further out the yield curve we go. For example, the US 10yr Treasury yield is back to basically where it was at the start of October (near 3.75%), even though the Fed funds rate is 0.75% higher than where it was then. Indeed, on the day the Fed hiked its rate to 4%, the 10yr was trading at 4.1%. The backing up in short-term yields against stable or lower long-term yields has created one of the worst curve inversions on record and this has reinforced calls for a 2023 recession.
But, we aren’t going to get into that topic this week. Instead, I want to focus on how the climb in bond yields, regardless of the shape of the curve, plays into the relative value of stocks. Specifically, how do higher bond yields compare with the dividend yields offered by equities. I am going to limit the analysis to the TSX, given that this is where most Canadian investors gravitate to when looking for income. Safety and stability of dividends is also very important for the income investor, so we will narrow this examination to the TSX 60 index (the top 60 companies by market cap on the TSX).
Considering that short-term rates are now hovering near 4%, I looked at those companies in the TSX 60 that have a dividend yield of 4% or better. Remember that the dividend yield is simply the annual dollar value of dividends per share divided by the company’s share price. If we strip out those companies with less than a 4% yield, we are left with 18 of the TSX 60. The highest yielding stock is currently Algonquin Power & Utilities (9.4%) and the lowest is TD Bank (4%). The total market cap of these 18 stocks is just shy of $1 trillion. If I take the individual stock dividend yields and weight them according to their share of market cap, I end up with a weighted-average dividend yield of 5.1%.
As the above chart shows, this weighted yield for those companies paying 4% or more is higher than the overall yield of the TSX 60 and the TSX composite. In both cases, however, there has been substantial growth in dividend yields over the past year as a result of two factors. First, several companies have boosted their dividend distributions in line with improved profitability and cash flow generation. Second, share prices have fallen this year. If I increase dividends (the numerator) and decrease share prices (the denominator), I will definitely create growth in dividend yield. Investors need to beware of the “dividend trap”. This is where a company’s stock price falls precipitously, such that the dividend yield soars. It looks like an income-lover’s dream, however, if the company’s fundamentals have deteriorated (explaining the stock price retreat) it’s possible the dividend gets cut or eliminated altogether.
The problem is that bond yields have also been rising – both because of higher interest rates and a sizable drop in bond prices. As the chart below shows, this year marks the first time since 2011 that the Government of Canada 10yr bond yield has matched the dividend yield of the TSX since 2011. Let me turn your attention to the period leading up to the financial crisis. Bond yields were well above the yield on the TSX, reflecting an overvalued stock market and tighter monetary policy. In fact, bond yields weren’t that far away from where they are today.
Even though we are talking about two different asset classes, serving mainly different investment objectives (capital preservation and income for bonds versus income and growth for stocks), it’s the commonality of the income objective that can tilt things at the margin. No one knows whether central banks will keep hiking rates into 2023, just as no one knows if inflation has turned the corner. Where there seems to be more agreement is on the view that the North American economy is cooling and likely will suffer some sort of a correction. With that will come downward pressure on corporate revenues and earnings, which could also lead to slower growth in dividends or a stall-out. Share prices, in our opinion, will also need to reflect the changing economic landscape – meaning valuations will likely fall.
The good news is that interest rates will eventually have to come down in order to stabilize the economy. That will bring bond yields down, at a time when dividend yields might climb – not because companies are raising dividends, but because share prices are down to the point where the yields are influenced higher. The financial crisis and the start of the pandemic show how those yields can spike in extreme circumstances and, while I don’t anticipate a repeat of either, I do believe that we haven’t yet seen the pop in yields that would tell us the bottom of the market is in place.
The next Pyle Group conference call will take place on Wednesday November 23rd at 7pm ET. As always, we will be taking participant questions live on the call, but will also answer any questions that are emailed in to myself at andrew.pyle@cibc.com. Details for the call are below.
Participants:
Toll-free dial-in number (Canada/US): 1-800-806-5484
Local dial-in number: 416-340-2217
Participant passcode: 8185460#
International dial-in numbers: https://www.confsolutions.ca/ILT?oss=7P9R8008065484
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
CIBC Private Wealth consists of services provided by CIBC and certain of its subsidiaries, including CIBC Wood Gundy, a division of CIBC World Markets Inc. “CIBC Private Wealth” is a registered trademark of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc. This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2022.CIBC Wood Gundy, a division of CIBC World Markets Inc.
These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.
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