As far as the Federal Reserve is concerned, interest rates will be higher for considerably longer than both the stock and bond markets were banking on. The Fed’s policy statement accompanying the rate decision laid out a path where the Fed is not expecting to reduce rates in 2024, essentially modifying (in a negative manner) its June policy statement. The new narrative triggered broad selling in both the bond and stock markets.
This new policy directive implies that the Fed favors one more rate hike by year-end while lowering the expectation for multiple rate cuts in 2024. The negative reaction by the equity market falls under the notion of further price-to-earnings (P/E) multiple compression, primarily for growth stocks, helping to explain the sudden and sharp pullback in the so-called “Magnificent Seven” AI stocks that ruled the market for the front half of 2023. (They are Alphabet, Amazon, Apple, Microsoft, Meta Platforms, Nvidia, and Tesla.)
The policy-making arm of the Fed, the Federal Open Market Committee (FOMC), presented its 2024 median rate outlook which is now a lofty 5.1 percent, up from its outlook for 4.6 percent in June, while its outlook for 2025 rose to 3.9 percent from 3.4 percent. This comes as the committee noted that inflation remains elevated. This adjustment was material in the eyes of market participants and extended the market’s losing streak to three straight weeks, this past week’s losses led by consumer discretion and real estate.
Whether it is right, wrong, or just confused, the Fed is convinced that inflation, in its various forms, will persist. It should be noted that Fed Chair Powell acknowledged that the economy has been more resilient than forecast. If the economy comes in stronger than expected, he said, that just means the Fed will have more to do in terms of monetary policy to get back to its goal of 2 percent inflation, “because we will get back to 2 percent.”
The shift in the interest-rate narrative took the benchmark 10-year Treasury yield up to 4.5 percent before it settled at 4.43 percent last Friday, but a real test of long-term overhead technical resistance is being challenged. The two-year Treasury note closed Friday at 5.12 percent, putting the closely watched two- to 10-year spread at -69 basis points, a 10 basis-point improvement since the first of the month. The narrowing of the two- to 10-year spread implies a lower risk of recession, which is fine, but the market is not so focused on this spread as it is on the troubling increase in short-term rates to over 5 percent for maturities ranging from one month to two years.
Against this backdrop, income investors seeking inflation-resistant income with inflation-beating yields must start to look beyond conventional high-yield debt. I see two primary sectors that are working best for both high yield and capital appreciation: 1) energy shipping and 2) business development lending.
In the first category, spot pricing for transferring oil and natural gas around the globe is higher, with shippers locking in longer-term charter rates that raise confidence about insulating phenomenal levels of free cash flow and the ability to pay out luscious dividend yields for extended periods.
In business lending, several business development company (BDC) stocks are trading higher as a function of holding portfolios of floating rate loans, tied to rates of LIBOR (London inter-bank offered rate) or SOFR (secured overnight financing rate), leading to rising revenue every time the Fed increases its overnight lending rate. As regulated investment companies (RICs), BDCs have to pay out 90 percent of their net income, just like real estate investment trusts (REITs), but with a few exceptions. They can use leverage and derivatives to enhance yield. As a result, there are a few very well-managed BDCs with bullish charts that pay out yields of 10 percent-plus. VanEck’s BDC ETF, for example, pays 10.6 percent, with some top-performing BDCs in the sector.
During September, when it seemed that not much of anything was working in some of the most favored sectors, there are a handful of bright spots that aren’t just holding their own in terms price performance, they also are delivering the kind of payouts that can meet and beat both inflation and taxes on an income and total return basis. That’s a hard combination to find in the current market, but, as the saying goes, sometimes you’ve got to think outside the box.
