George Doyle
There's no deep mystery behind the rally in income-generating investments: The market is giving up on the idea that central banks, faced with serious economic challenges, will boost their key interest rates any time soon.
The market can get caught up in some baffling obsessions from time to time, but it is hard to fault it on this one. If it's right, dividend-paying stocks and real estate investment trusts remain attractive, despite their shrinking yields.
For sure, these investments are hardly undiscovered bargains. U.S. tobacco stocks, loved for their generous quarterly payouts, are hovering near record highs after surging close to 20 per cent from their recent lows in early February. That's about double the return for the S&P 500 over the same period.
The Dow Jones Equity REIT total return index has gained about 17 per cent since the start of the year. Even the iShares 7-10 Year Treasury Bond ETF, which tracks investments that were given up for dead in January, has delivered a decent return of 4.7 per cent.
The gains follow an apparent shift in views on monetary policy over the past five months as the world's major central banks remain fixated on fighting deflation, high unemployment and slow economic growth. The shift makes rate hikes – let alone a return to normalized rates – look downright improbable.
This week, the European Central Bank became the first major central bank to drop a key interest rate into negative territory, meaning that it is willing to pull out all the stops to encourage bank lending and bolster the economy.
The Bank of Canada has been talking up the possibility of rate hikes for years, yet its key rate has been stuck at just 1 per cent for 31 consecutive policy decisions dating back to 2010. With the bank now arguing that inflation is too low, the key rate will likely stay at 1 per cent for a while longer, if it isn't cut.
The U.S. Federal Reserve has held its key rate close to zero per cent since the dark days of the financial crisis, in 2008. While it is winding down its extraordinary bond-buying stimulus program, known as quantitative easing, the Fed has assured investors that it will keep rates very low for a long time.
How low? Fed officials think the key rate will rise to 1 per cent by the end of 2015 as the economic recovery gains traction.
However, investors think even this projection is little more than wishful thinking: Fed funds futures contracts peg a rise in the key rate to just 0.6 per cent by the end of next year, a remarkably low rate five years into an economic expansion.
The interest rate environment – and investors' reaction to it – has even officials at the Federal Reserve concerned. If rates rise, the worries go, markets will turn ugly.
May 2013 offered a lesson in what could happen. When the Fed floated the idea of tapering its monthly bond purchases in a first step toward policy normalization, markets flipped out. U.S. bond prices tanked, the REIT index fell 18 per cent by August and those beloved tobacco stocks fell 12 per cent.
But what if we are living in a prolonged era of lacklustre economic growth and stubbornly low inflation?
The U.S. and euro zone economies barely grew in the first quarter. Sure, growth is expected to pick up – but Fed projections for the U.S. economy have been going down, not up; and its outlook still looks uninspiring despite the extraordinary boost the economy has received from monetary policy.
In an ideal world, the global economy will recover over the next year and central banks will be able to start normalizing their policies.
With a bumpier future, though, stocks that offer generous payouts and a history of raising them look like a sound bet.
David Berman