Linda Duessel: Hello, and welcome to the 'Hear & Now' podcast from Federated Hermes. I'm Linda Duessel, senior equity strategist. Today's episode is a special recording of a roundtable I led with Dan Peris, Head of Strategic Value Dividend Team, and Don Ellenberger, Head of Multi-Sector Strategies Group, on how inflation and monetary policy have led to the rise of what some may consider 'boring' investment solutions for 2022.
Don Ellenberger: Yes, Linda I do. It's tempting to add to risk now, given the big sell off in stocks and bonds we've seen this year, and decades of low and stable inflation and supportive Fed policies have kind of trained us to always want to buy the dip. But I don't think the pain is over just yet for risk assets. One reason I'm still cautious is that the Fed put is just so very far out of the money because inflation is so very high. But remember, inflation is a lagging indicator, inflation keeps going up for nine to 12 months, even after the economy has turned down. So, if the Fed is chasing something that lags the economy, there is a significant risk that the Fed will overtighten and break something and drive the economy into recession. I'm not saying a recession is inevitable, but clearly, the risks are rising, even if we somehow avoid a recession, which is possible, given the consumer and corporate balance sheets have never been this strong heading into a potential recession. It's still hard for me to like risk assets if inflation doesn't come down much, because there's only two possible outcomes, right? Either companies absorb cost increases and profits shrink, or they pass along those cost increases, which keeps inflation elevated and it forces the Fed to slam on the brakes even harder.
Linda Duessel: Yes, Don, we've been talking about recession so much. I think it must be the most highly Googled word out there these days. And, gosh, we've suffered in the in the bond market. So, when you look at the various fixed income sectors, you know, what should we really expect for the rest of the year? Can there be much more pain in some of these sectors? Are you more worried about some than the others?
Don Ellenberger: I definitely am. Here's an interesting and I think a very powerful statistic. If you look at the correlation between the S&P 500 and the size of the Fed's balance sheet, over the past 12 years, it's 91%. So, as the Fed's balance sheet grew through quantitative easing, stocks went up almost lockstep and remember, quantitative easing creates money, it does it out of thin air, and a lot of that money went into the stock market. But now we have the opposite of that. Now, we have quantitative tightening and quantitative tightening destroys money. So, not to be too much of a Debbie Downer, but I think it's still too early to think about adding a lot of risk here. I think you want to keep some dry powder.
Linda Duessel: Dan, I always said that the bond side, the fixed income side, they are just curmudgeons, they were always curmudgeons, and what a fantastic environment to be one. I think Don is telling us loud and clear that for the for the moment anyway, the Fed put is caput. And now here you are managing stocks, of course, dividend stocks. Do you agree with Don that this risk off environment must continue through the end of this year? And then, how do you expect the rest of this year's behavior out there to impact dividend paying stocks?
Dan Peris: Thank you. Thank you, Linda. And, Don, thank you for quite that lead in, that's a hard act to follow. I actually agree with many of Don's analyses concerning the difficulties in the current situation but might differ in some of the conclusions in regard to the choices within the stock market. We as dividend investors are sort of benefiting from the return of risk and the sensibility of investors. I wouldn't say it wasn't just a matter of the last five years or 10 years in many ways, it's been a risk off environment, meaning less risk perceived and inflation coming down, or disinflation, and interest rates going down and investors willing to take on more and more risk for the last 30 years. And during that period, dividend paying securities had been pushed into the background, you know, the markets come down, large, successful companies not paying dividends, not having to compete for capital with cash payments, all a very adverse environment for the dividend investor.
Dan Peris: And what gives me great kind of confidence and kind of optimism, oddly, for the next, not just the end of the year, but for the next decade or so, is the return of a risk-oriented sensibility to stock market investors. I think that will actually benefit the holders of, shall we say, kind of old-ish economy, old economy cashflow paying, cash flow generating businesses. A lot of them in the current stock market tend to be in the non-discretionary part of the economy, not completely acyclical or non-cyclical, but less cyclical. So, the economic slowdown that I think Don has pretty articulately and accurately, I'm afraid to say, limbed, is going to have less of an impact on the cash flows for the types of companies that the current dividend investor, current meaning anyone who's defined themselves as a dividend focused investor over the past decade or so. We're not currently seeing much in the way of threats to our cash flows or the dividends, what we are seeing is the return of risk in the sensibility - it may not be interest rates, it's not just a matter of interest rates going up. Interest rates may or may not go up, but clearly risk is going up. And that's actually benefiting the investor in dividend focused securities, they've been kind of at the wrong end of this risk trade for the last again, not just the last five years, but the last 30 years. And now I think, high dividend paying securities and very patient, dividend focused investors are actually being rewarded in the marketplace and you can see that in 2022. And I think that that's going to continue, Linda, for I really think for the next decade or so.
Linda Duessel: I'd like for you to maybe dive in a little bit more and explain to us which are these dividend paying sectors that can be considered more like havens, like the havens that Don was referring to on the bond slide?
Dan Peris: I have the luxury of being a little less sensitive to worrying about whether we have a technical recession or not. Because utilities and phone companies and pharma companies, their profits may go up or down slightly in a recession, rather than not a recession, but they're not highly cyclical, where the question of the dividend is at risk in a recession. So that discussion about whether there will be a technical an earnings recession and inventory recession, any number of these things doesn't really affect the dividend focused investor, fortunately, because they tend to be located in the less cyclical parts of the economy. Again, that's the usual suspects. It's been a kind of a besieged minority for the last 10, 15, 20 years, but they're still there. They are investable in the in the U.S. stock market, there's enough to put together a nicely diversified portfolio of income streams. And they do consist of utilities, phone companies, food, beverage, tobacco, household products, large pharma, regional commercial banks, they weren't available for 15 years during the financial crisis, but they are currently and they're, frankly, in reasonably good shape, Don might have a different view on that, we can also access it is a little bit more cyclical. There are a number of names in the energy space pipelines and even integrated energy names, now they do rise and fall with economic activity. But it's not that hard right now, even in a proto recessionary or potentially recessionary environment, to put together a nice high and rising income stream from the less cyclical again, I'm not going to claim they're not. They are not they are not non-cyclical, but the less cyclical parts of the economy. And there are also individual securities from other sectors from industrials and even consumer discretionary and even information technology that can fit into a nicely diversified income stream that should hold up well, in a difficult economic environment, whether it technically becomes a recession or not, I leave it to others to determine.
Linda Duessel: So, thoughts along those lines, Don, any thoughts in response there?
Don Ellenberger: Yeah, I agree a lot with what Dan said. But I should clarify. I'm not predicting recession. I'm just saying the odds of a recession have certainly risen here. I think the bigger picture for risk assets, is that for nine of the past 13 years, Linda, as you know, the Fed funds rate has been 0. Nine of the last 13 years has been zero, money wasn't just cheap, it was literally free. This ultra- accommodative monetary policy has, I believe, distorted prices for stocks and corporate bonds. And it's led to just a general mispricing of risk, but now it's time to get off that train because now monetary policy is tightening. Liquidity, we can see, is drying up, money is no longer free, and stocks and corporate bonds no longer have that Fed put safety net right beneath them. The Fed has told us that they are committed to getting inflation under control and that commitment is unconditional. So, they have to slow the economy down by tightening financial conditions. And what's the definition of tighter financial conditions? It's lower stock prices, it's wider credit spreads, and it's higher interest rates. So, we may easily see stocks bounce and credit spreads tighten for a couple of weeks or a couple of months. So, value is being created, but I think those are dead cat bounces. I wouldn't buy just yet. I would keep your dry powder. I think you'll have a better opportunity to pick up cheap risk assets in the future. And with those happy thoughts, Linda, I'll yield the floor.
Linda Duessel: I know that we're going to come up with a happy thought. A real, legitimate, happy thought somewhere along the line here. I do appreciate that. And I do want to follow up with that. If recession is one of the most highly Googled names, inflation is right up there with it. And how many months in a row now are we trying to say this is peak inflation, peak inflation now? This month for sure, peak inflation. So for those that are still worried about that, Don, would you say now is a good time for the Treasury Inflation Protected Security as an investment, the so called TIPS? Or would you say there are more appropriate alternatives for investors worried about inflation?
Don Ellenberger: That's a tough question. I think the short answer is small exposure to TIPS, yes. Large exposure, no. TIPS richened a lot last year and into the first quarter of this year, because the Fed said inflation was transitory, and they wanted to let the economy run hot to make up for years of inflation falling below their 2% inflation target. Once the Fed realized this year, their mistake and they got serious about corralling inflation, TIPS have cheapened up pretty significantly. So, given that recent cheapening, I think TIPS still have some value as an inflation hedge in your portfolio. But I wouldn't go overboard. There are four reasons why I wouldn't recommend a big allocation to TIPS right now. One is the Fed is determined to kill inflation. Chair Powell said that getting inflation under control was the job they absolutely cannot fail at. Right? If the Fed is truly willing to risk a recession, to get inflation down to 2%, then TIPS probably don't have much upside from here. Second reason is that TIPS are pretty highly correlated with risk assets, as you know. So if stocks keep going down, which I worry about, TIPS are going to struggle to outperform. And then the third reason is the last couple of years, as the Fed was growing its balance sheet, they were buying a lot of treasuries, including TIPS. As a matter of fact, they bought almost all of the new TIPS issuance. They're by far the biggest buyer of TIPS. Today, they've just walked away from that market, right? And then the fourth reason to be careful is liquidity and TIPS can be spotty. Okay? So the bid ask spread getting in and out of TIPS can be pretty high, if you're buying when everybody else is buying, and especially if you're trying to sell when everybody else is trying to sell. But the time to take a big position would be if inflation stays stubbornly high, and I think it might, and if the Fed starts to worry more about a recession and inflation and starts to get scared, and they back off rate hikes.
Linda Duessel: Dan, coming back to you now, given the high rate of inflation, do you think companies will raise their dividends at higher rates than they have over the past decades?
Dan Peris: Initially, the answer's no, meaning inflation, initially is a headwind, to the operations of even the non-discretionary companies, the phone companies, the food companies, certainly with rising food costs, or all of the companies that make the small items that are purchased by consumers globally, and in the US, on a daily, weekly, monthly basis. So we're dealing with inflation as a headwind as it works its way through the system. The inflationary pressures began soon after the shutdown in the middle of March of 2020. And it's been two years of dealing with rolling waves of inflationary pressures. The companies' initial reaction was not to take price but was to work on cost management, they have now moved sort of to phase two, which is a combination of price and cost management. It's too early to expect dividend growth, however, to equal nominal inflation. Over time, under normal circumstances, and again, the last 30 years, 40 years from 1980s through 2020, I would say we're abnormal or anomalous, but over time, dividend growth and inflation actually sort of cancel each other out and what the real return that you get from equities in my world is, is the actual dividend yield. Again, I realized in a tech driven market over the past couple of decades, that's sort of a strange comment. But if you look over longer data series, that's the case. So inflation and dividend growth do end up matching, but there's a lag and right now we're on the wrong side of the lag. But we've been two years into it, and we are going to eventually see nominal dividend growth begin to pick up because of nominal profit growth, I think we'll eventually recover.
Linda Duessel: So, if we're going to have to suffer inflationary times, it's going to be, you know, a more difficult investing environment, I think, as you've both indicated, at least it sounds like dividend growth can kind of keep our heads up above water on the equity side. So, Don, on the bond side, with inflation spiking to rates that we have not seen in 40 years, are there any bond sectors that can provide adequate income, try to keep our heads above water, and a diversified portfolio that includes some bond sectors?
Don Ellenberger: There are several sectors of the bond market that can provide a lot of income. And those are, of course, the floating rate sectors right, as the Fed raises rates, that short term rates go up, and these floating rate bonds pay higher and higher yields. If we manage to skirt a recession, kind of the higher beta, higher income sectors, you know, bank loans, high yield bonds, you know, EM, BBB corporates are going to do just fine. But I would personally recommend you stay in something less risky for now. Because I think you'll have an opportunity to buy bank loans and high yield bonds and EM bonds cheaper later this year or early next year.
Linda Duessel: Dan, what about you? Now? Let's say we must suffer a recession. And you're talking about high quality dividend-oriented stocks, but they are stocks and stocks go down in a recession, don't they? And what would your outlook be there in terms of what would be experienced and then what the dividend stream can do to offset that pain, if we must have it in these high-quality dividends?
Dan Peris: First of all, our goal is to deliver a high- and rising-income stream from high quality business assets. And that's been the case whether we've been in favor, out of favor, high growth environments, low interest rate environments, rising rate environments, declining rate environments, Mondays, Thursdays, even Tuesdays, Wednesdays, and Fridays. That being said, these assets do reprice on a daily basis, they go up and they go down, they can go down, they have gone down in the past, for reinvested dividends, that creates a higher yield, for new money that creates a higher yield. In terms of a recession in which share prices go down, I think Don's opening comments are most relevant, which is the share prices that have been going down the most are the ones that don't have any income stream. The types of companies that have been paying dividends through thick and thin over the last century, and we've been doing this only for the last 20 plus years, but for the last century, have not been dramatically overvalued. Were not caught up dramatically in the zero-interest rate period that Don described so eloquently. Can the share prices go down? Sure. Will, they possibly go down? Absolutely. But the valuation metrics for those types of portfolios look nothing like the valuation metrics for the broader market.
Linda Duessel: Okay, so invest in dividend stocks on any day that ends in d-a-y. What would you say to someone who says, I think I should just go in cash, I just should be in cash? You're painting a bad picture, I should just go in cash.
Dan Peris: Yeah, as the stock person where we own assets in perpetuity. Again, even in the past 21 years. There have been times when the stocks were going up, stocks were going down, investors have had the chance to make that cash call. That's up to them. That's fine. Our mandate is to deliver a high and rising income stream in all environments. For those investors who can't sleep at night, ultimately, the test is not modern portfolio theory or any of the risk measures that your financial advisor has. The test at the end of the day for the investors is can they sleep at night? If they can't sleep at night, then you know cash makes a great deal of sense. But hopefully over the last couple of decades, we've been able to at least train our investors in understanding the virtues of slow and steady wins the race, long term equity ownership, business ownership approach focused on a high- and rising-income stream. And there, you don't really make too much in the way of cash calls.
Linda Duessel: Yeah, I guess, if you're if you're not looking at your portfolio all the time, and you've got professionals looking after it for you, and the income stream is coming through on dividends. Well, maybe that's a good result over there. What about on the bond side? What have you got to say about that?
Don Ellenberger: Another reason to be bearish on risk assets is that for years, cash was trash, remember, nine out of 13 years it was zero. But by the end of this year, investors will finally have a safe alternative to stocks and bonds that at least pays them something on a nominal basis. I like cash as a tactical trade this year. Okay, tactical trade this year short term, because of the rising risks of recession, we may or may not have a recession, but the risks are going to go up.
Linda Duessel: Okay, anybody wants to sleep at night, I think the message has come loud and clear from Dan and Don here. And as we're coming close to the end of our hour, we do have some questions that have come in. Regarding Fed monetary tightening for forthcoming FOMC meetings. Do you think there's any space left for a soft landing? Can they land successfully? Any space? Give us something. This is your chance Don, to lift us up. But only if you think you should do.
Don Ellenberger: The path to the mythical soft landing is very, very narrow. And the risks of straying off that path into a recession are pretty high. It's just very difficult for the Fed to thread the needle because it has two main policy tools, manipulating the Fed funds rate up and down, and its balance sheet, quantitative easing and quantitative tightening. But the problem is that both of those policy tools are just so blunt. They cannot be used with surgical precision. And history, let's face it, it's not on the Fed side. The last time the Fed tightened at least 175 basis points in a 12-month period, was back in the mid-2000s, and a recession followed nine months later. Of course, not every Fed tightening cycle results in a recession. But here's the thing: when inflation has been as high as it is today, every single tightening cycle has ended in recession. So, we are on high alert for recession signs. One is the labor market. The other is corporate profits. So, keep an eye on profits. Keep an eye on the labor market. Because recession risks are high and the path to that soft landing is going to be really tough for the Fed.
Linda Duessel: I've come to hear, I don't know how many times in the last number of years, the Fed won't allow a recession. And again, as someone who was there in the 70s, and all the decades since that time, recessions, I thought were natural curves, a natural part of a cycle that we suffered. And I think it's great you're telling us what to keep our eye out for. I like to move this one next on to you, Daniel, if I may. This is asking I think about equity market and which sectors do you think have the most opportunity for growth, given the global economic stress? And this particular listener is suggesting that he or she has heard a lot about consumer discretionary and financial institutions? And banking is having the most opportunity for growth in this economic stress that's going on globally? Thoughts there?
Dan Peris: I have an answer, it's just not the answer to that question. So normally, what the dividend investor, focused dividend investor has given up the past 20 years, it's been phenomenal growth, the zero cost of money growth, the eyeballs the chasing, the rainbow, the pots of gold, and we have settled for lower nominal GDP growth as part of our exercise. But if you do consider, what I consider to be a paradigm shift occurring over the next couple of decades, it is going to involve some of the factors that Don mentioned that are listed at the beginning of the of the podcast, and that is on shoring, perhaps lower margins due to higher capital expenditures, friend-shoring, and so forth. And that's an investment theme as we shift from one paradigm to another. History doesn't go backwards, but the pendulums do swing, and I am looking for even in, particularly in our old economy companies, I'm looking for increases in capex and spending, and really not margin expansion going forward as companies are going to have to spend more to meet some of the labor costs that Don articulated, as well as manufacturing on shoring. And embedded in that is a higher growth rate. An example of that, and you'll be surprised to hear this, are utilities. Utilities are going to have to spend an enormous amount to kind of future proof the grid, and they've already started, it's been really on the case for the last couple years. It's both the transition to a lower carbon economy, but also just bringing the grid into the modern age. And so, they get a regulated rate of return. We've seen this in Europe, prior to the Russian invasion of Ukraine, the utilities were viewed as the growth stocks, believe it or not, and you have seen that in a handful of utilities in the United States that have gotten ahead with renewable spending. But I think the entire sector is actually going to be spending a good deal more over the next decade or two. Does that make them growth opportunities? No. But does that put them in the game? Absolutely. They will be spending a lot more. And I think almost all of the old economy companies will be I can't speak that much about the new economy companies because they don't pay dividends. But the old economy companies are going to be spending more and putting more chips on the table as we go forward, and that should pay dividends going forward.
Linda Duessel: Yeah, that's a very important point that the starvation of capital expenditures and the need be and I guess, if you're a company that that makes whatever needs to be purchased that way. This, I think, is an interesting question. Compared to those nearing retirement, which, of course, very keenly interested in the income discussion that we've already had here on both sides. How should younger investors be navigating this volatile market?
Don Ellenberger: Just start buying stocks anytime they go down. Just buy.
Linda Duessel: That is the most upbeat thing I heard from you today, our bond leader wants us to buy stocks. And what would you say, Dan, to that?
Dan Peris: Towards the end of the hour, I don't know that I would start this discussion about rejigging asset allocation and modern portfolio theory, I'd be happy to take up another four or five hours to discuss that. But in the way I view the world from an asset allocation perspective and a portfolio construction perspective, there is room for the casino. And it's just a smaller percentage of one's allocation. But in that there is room for pocket money, where you might remain as bullish as I have been for the past 20 years. And again, I've been bullish when we've been dramatically out of favor and been cautiously bullish the handful of times we've been very much in favor, but dividend paying stocks have been out of favor from my somewhat jaundiced perspective for 30 years, with one exception in 2015/16. And we have a long way to go back to just get to even, meaning I think we have significant potential as risk rates rise. That was my opening comment. I don't know about interest rates rising. But I do believe firmly that risk rates are rising. And in that context, this very solid cash flow generative types of companies that we tend to focus on will, will do well.
Linda Duessel: I think that's a very important powerful message that you've given there for 30 years, your kind of a high-quality dividend strategy has been kind of out of favor as interest rates have been coming down and down and down and down for 40 years. And if we look at the long history of investing in the stock market, dividends routinely were the biggest piece, or a very big piece of total returns. So, regardless of your age, it would seem, there's some wisdom in that and gosh, what a very enjoyable discussion with both gentlemen today. Our time has quickly come to an end. Dan, Don, thank you both so much for your time and insights.
Linda Duessel: And thank you to our listeners. We look forward to you joining us again on the Federated Hermes 'Hear and Now' podcast. If you enjoyed this podcast, we invite you to subscribe to the Federated Hermes channel to get every 'Hear and Now' episode, plus our other series, 'Amplified' and 'Fundamentals' for a global perspective on the issues, challenges and trends shaping the investment landscape. I also encourage you to subscribe to our 'Insights' email updates for the latest market commentary from the many great minds at Federated Hermes and follow us on LinkedIn and Twitter.
Views are as of June 28, 2022, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Past performance is no guarantee of future results. Investments involve risk, are not guaranteed, and may lose value. There are no guarantees that dividend paying stocks will continue to pay dividends. In addition, dividend paying stocks may not experience the same capital appreciation potential as non-dividend paying stocks. The value of equity securities will rise and fall. These fluctuations could be a sustained trend or a drastic movement. Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices. High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risks, and may be more volatile than investment grade securities. In addition to the risks generally associated with debt instruments, such as credit, market, interest rate, liquidity and derivatives risks, bank loans are also subject to the risk that the value of the collateral securing a loan may decline, be insufficient to meet the obligations of the borrower or be difficult to liquidate. Variable and floating rate loans and securities generally are less sensitive to interest rate changes but may decline in value if their interest rates do not rise as much or as quickly as interest rates in general. Conversely, variable and floating rate loans and securities generally will not increase in value as much as fixed rate debt instruments if interest rates decline. International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of EM, or emerging markets securities, can be significantly more volatile than the prices of securities in developed countries and currency risk and political risks are accentuated in emerging markets. Federated Equity Management Company of Pennsylvania