You have probably heard that the U.S. Federal Reserve is likely to raise interest rates soon. The market is pricing the odds of the rate hike at 71 per cent on December 14th and only 16 per cent this week according to futures contracts that price the federal funds rates.
Back in 2013, the Fed, then under the leadership of Ben Bernanke, discussed their plans to "normalize" interest rates. They started to provide a forecast of where the federal funds rate would be over the coming years in what has become known as "forward guidance or the dot plot." The presidents and governors of the federal reserve banks who make up the Federal Open Market Committee (FOMC) forecast where rates will be in the future based on their economic assumptions.
The FOMC's median forecast in 2013 was that the federal funds rate would be about 3 per cent by the end of 2016. That didn't exactly happen. The target rate today is 0.5 per cent.
Forecasting markets is difficult enough, but when the people who make the decision to move rates do not know where they will be, who does? What investors need to understand is that the global economic backdrop, in many respects, is far worse than the Great Depression era as it pertains to economic output. In order to generate an anemic 1.4 per cent average annual gross domestic product (GDP) since the Lehman moment (Sep 15, 2008), the U.S. federal government has borrowed about $9 trillion (U.S.) and municipal governments have borrowed $3 trillion while the Federal Reserve has held interest rates at zero and bought trillions of bonds to force longer-term rates lower. The U.S. economy would be shrinking at about 5 per cent annually were it not for all that added government spending and debt. Most of the huge economies in the world have been leveraging up like bulls in a china shop to (fiscally) pump up the economies and it is not working. Japan, China, U.S. and much of Europe have much worse debt-to-GDP ratios today than they did before the economic crisis with far worse economic growth. The structure of the aging demographic in the developed world and the legacy of entitlements (social benefits) are likely to limit the global economies' normal level of interest rates and we are likely to see decades of low rates. The natural rate of interest is simply going to be lower for far longer.
Investors should not fret too much about rising rates and the impact on their portfolios. The global economy simply cannot handle it and governments cannot afford it. But from time to time, they may try and raise rates and stocks and bonds that are interest rate sensitive will fall in anticipation of such a move.
One of my favorite yield-focused ETFs is ZWU-T (BMO Covered Call Utilities). The strategy own highly interest-rate sensitive equities: pipelines, telecoms, and utilities, of which 80 per cent are Canadian and 20 per cent U.S.. These are all very high dividend paying sectors and the covered call overlay adds a per cent or two annually in yield. (Covered call writing is designed to generate income from a stock by selling a call option against it (the right to buy the stock at a set price in the future).
Companies that have high amounts of debt like these, as well as REITs, are interest-rate sensitive. Investors have loaded up on these high dividend payers because bond yields have fallen to such low levels that your real return (after inflation) is negative in most places in the world. Investors that have these high dividend payers have more interest-rate sensitive portfolios than they think. These stocks are far more at risk than bonds are when rates go back up due to their financial leverage.
So when we go through these periods when the world is worried about the U.S. raising rates and bond yields globally start to rise, these highly leveraged companies start to get cheap and that is when I like to add them to portfolios. Months ago, when bond yield globally were falling to new all-time lows, these sectors were strong, but the risk to your portfolio in seeking those quality dividends were far too expensive from a risk perspective. These sectors are now getting interesting and their juicy dividends are not likely at risk to materially higher rates in the coming years.
I've been nibbling at ZWU around $13.60 and will add all the way down to $12.50. Don't fear the weakness; look at it from the perspective that you are buying a quality dividend at a better price. As for REITs, I'll start to buy them too when they are about 3 per cent lower than where they are today.
Larry Berman is co-founder of ETF Capital Management. He is a Chartered Market Technician, a Chartered Financial Analyst charterholder, and is a U.S.-registered Commodity Trading Advisor.