Higher for Longer

Income investing is still a winner’s game for the era of elevated interest rates.

No rate cuts this year: That’s the conclusion many investors seemed to come to last week, and pretty much all at once. 

The Federal Reserve paused its historic pace of rate increases in June. But current inflation is more than twice its target of 2 percent. And the central bank left little doubt it intends more boosts, despite the risk of recession as well as “Black Swan” events such as Russian political turmoil and a potential commercial real estate/banking crisis.

In addition, monetary policy can do little to combat at least two of the major catalysts for recent inflation: A decade of under-investment in energy, and the systematic global relocation of supply chains resulting from US/China political tensions.

This week, the Mountain Valley Pipeline won its last needed approval to resume construction. And barring a successful court challenge, it will be transporting low cost Appalachian natural gas to the energy-hungry Southeast US later this year.

MVP’s victory, however, was the result of the extraordinary persistence of West Virginia’s congressional delegation. And it took a threatened US default, as well as a deal between President Biden and Senator Joe Manchin (D-WVA) to pass the Inflation Reduction Act last year.

Bottom line: MVP approval is hardly a blueprint for other pipelines and drilling projects in the US. Rather, most will continue to follow the model of Enterprise Products Partners (NYSE: EPD), which is exclusively pursuing incremental projects with predictable costs, easier roads to approval and higher percentage payoffs. And that means no new pipeline boom.

It’s also worth noting that starting in the late 1960s the Federal Reserve pursued a very aggressive monetary policy to corral inflation. And every time it backed off, inflation emerged worse than ever.

That was the consequence of crushing the investment needed to bridge long-term gaps between supply and underlying demand. And it was tamed only by decades of pro-investment policies, including lower taxes, breaking the wage/price cycle, reviving oil and gas production outside of OPEC and the rapid expansion of trade with China.

I’m hopeful investment will eventually quell this round of secular inflation. But as investors, it’s critical we prepare to live with higher interest rates for longer.

Let’s dispense with the fallacy that companies paying dividends always fare poorly in higher interest rate environments.

Since the Korean War, the Fed has launched 11 sustained monetary tightening cycles. The Dow Jones Utility Average posted positive total returns in 7 of those. And it was meaningfully underwater only in the early 1970s, when the combination of raising rates, the OPEC oil embargo and the Nixon Shocks triggered a deep recession.

Since 1993, the 10-year Treasury note yield has finished the calendar year lower 16 times and higher 15 times. Dividend stocks finished higher across the board in more years when the yield rose than in years when it fell. In fact, all the worst years for dividend stocks coincided with falling rates, for example 2008 when the 10-year yield basically fell in half.

Rather, the common element of good years for dividend paying companies was a strong economy, just as it was for the rest of the stock market. And the best dividend stocks to own throughout the cycle have been companies with reliably growing earnings.

In a rising interest rate environment, debt does matter to those earnings. And the greater a company’s capital needs, the more important is maintaining an investment grade rating.

In the telecom sector, for example, BBB+ rated Verizon Communications (NYSE: VZ) has bonds maturing in October 2056 yielding 5.36 percent to maturity. That compares with CCC+ rated DISH Network (NSDQ: DISH) has bonds maturing next year yielding 17.3 percent!

Reliably generating free cash flow probably matters even more. I define that as what a company earns after all of its capital spending, debt service and dividends.

Verizon expects more than $6 billion this year, enough to repay everything coming due the next two years without having to refinance. DISH, in contrast, projects negative free cash flow of $1.4 billion. And it has $3 billion coming due next year, roughly equal to the stock’s market capitalization.

Both companies are dealing with higher interest expense from a year ago. The difference is Verizon has a strong enough business and balance sheet to absorb the added cost, while DISH may be headed for restructuring.

Every stock sector has similar studies in contrast. And the longer interest rates remain elevated, the more they’ll affect earnings and investment returns. In fact, with few exceptions such as regulated utilities, I want all of the companies I own to generate free cash flow after paying dividends.

That’s not a problem for the biggest technology companies, which are now leading the stock market. Apple Inc (NSDQ: AAPL), for example, draws an Aaa rating from Moody’s and expects more than $86 billion in free cash flow after dividends for the 12 months ended September 30. That’s enough to pay off more than 80 percent of its entire debt.

On the other hand, these stocks’ super-charged valuations are now largely based on a discounted cash flow model. And the prospect of elevated interest rates for longer diminishes the value of cash earned in future years.

Any deflation of those valuations would have a massive impact on big stock ETFs, funds and algorithmic strategies across the board. That’s because Apple alone now accounts for 7.58 percent of the S&P 500, which is 27.8 percent the seven largest tech stocks and 37 percent weighted in its top four big tech sectors.

From early 2000 through late 2022, the first great tech wreck knocked more than -70 percent off the value of the Nasdaq 100 and almost 50 percent from the S&P 500.

It’s certainly possible the Fed will thread the needle and avoids a recession and severe stock market decline. And maybe more enlightened politics will eventually boost energy investment and restore mutually beneficial cooperation between China and the US.

But at this point, higher interest rates appear to be our future. And that makes choosing the right stocks the essential element for success, now more than ever.