Max Wasserman is a co-founder and senior portfolio manager at Miramar Capital. Wasserman previously served as a senior portfolio manager at UBS and Merrill Lynch and boasts over three decades of experience as a portfolio manager and research analyst.
Russ Alan Prince: How do falling interest rates typically impact dividend-paying stocks, and what sectors benefit most?
Max Wasserman: Let us start by looking at why there is a falling interest rate environment and who is positioned to benefit from it. A falling interest rate environment usually occurs because the economy is starting to slow down, inflation is under control and the Federal Reserve is trying to reverse a tightening policy. The federal funds rate is 4.8%, while inflation is under 3%. This means that to achieve a neutral rate where the federal funds and inflation rates are evenly matched, the Fed would have to cut its funds rate by approximately 180 basis points.
Lower interest rates and lower inflation benefit the consumer. One area, in particular, would be the housing market, as lower mortgage rates would allow people to finance more or free up capital by refinancing homes. In the present environment, consumers have no incentive to buy new homes due to high financing costs. Falling rates would not only benefit buyers, but the general home improvement market as well. Consumers are in a better position for home improvements when equity credit lines are cheaper. Companies like The Home Depot would benefit under these conditions.
Another area that stands to benefit is consumer spending. Consumers have more money to spend when both rates and inflation are lower. Consumer companies such as McDonald’s, PepsiCo, Starbucks and General Parts are all beneficiaries of circumstances where consumers can act as stronger spenders. Many of these entities are consumer staples and have taken a hit amid rising inflation.
There are multiple reasons why dividend stocks do well in a falling rate environment, the first being their ability to provide higher yields relative to other comparable income investments. For example, if money markets are yielding 5% and dropping to around 2%, investors who need to live off their cash flow start searching for other areas of the market for income. Normally, investors would flock to the bond market, but with lower interest rates making it less attractive, they will start going out on the risk curve because they want more yield. That is why dividend stocks with the capacity to grow can be enticing to investors. Historically, companies that pay higher dividends can be found within sectors such as utilities, REITs, energy, industrials and the more traditional spaces within the market that would benefit from the demand.
Dividend stocks also tend to perform better when the economy is slowing down because investors look for companies with stable growth and stable earnings. Those companies are usually the ones that pay dividends and are more dependable.
Prince: With lower interest rates reducing yields on bonds and savings accounts, how should dividend investors adjust their portfolios to balance income generation with risk management?
Wasserman: When Treasury yields start to decline, bonds become less attractive for new money, and investors begin shifting away. Under these conditions, investors typically take on more credit risks by buying longer-term and lower-rated quality bonds to pick up additional yields. In low-interest rate environments, investors start reallocating away from both money market accounts and bonds, instead moving toward higher-income general investments like dividend stocks.
If a 10-year Treasury only pays 3% but someone can get 3 to 4% on an energy company that's increasing their dividend, naturally, they’ll opt for that because they’re receiving more money. Likewise, the people who live off the cash flow from their dividends will need a higher yield that they’ll no longer be able to get from bonds or money markets in a lower-rate environment. Similarly, those who were storing money in savings accounts that were once paying 5% but are now suddenly paying 2% are ultimately taking a 3% hit, which is a big adjustment to a portfolio.
Prince: How might falling interest rates influence the valuation of dividend-paying stocks, and should investors expect increased competition for these assets as alternative income sources become less attractive?
Wasserman: As with any market, the more people want something, the more they will bid up the price. There wasn’t a pronounced desire for dividend-paying stocks over the last couple of years because interest rates were high, and money markets were an attractive alternative. Dividend stocks were trading at discounts to their average multiples. Today, with rates declining and valuation of growth companies so high, dividend stocks become more attractive to the investor.
Now you are taking slower-growing companies that are paying dividends, and investor demand is driving their multiples to expand. Investors start to pay higher multiples for companies with more protracted growth because they want dependable cash flow. They do not want to pay 40 to 50x for growth and not earn a dividend yield. However, they are willing to pay 20 to 30x to get a 3 to 5% yield plus the potential for growth. Eventually, investors bid the price up so much that the current yield on these investments is no longer attractive.
Remember, with a slowing economy and unemployment ticking up ever so slightly, uncertainty is bound to bleed into the stock and bond market. Ultimately, investors feel that by going to companies that pay dividends, they will net more stability in their portfolios.
Russ Alan Prince is a strategist for family offices and the ultra-wealthy. He has co-authored 70 books in the field, including Making Smart Decisions: How Ultra-Wealthy Families Get Superior Wealth Planning Results.