The Big Picture
Interest rates have come down in anticipation of policy rates coming down. That anticipation has been rooted in pleasing inflation news, some less than pleasing employment news, and the pleasant acknowledgment by Fed Chair Powell that, "The time has come for policy to adjust."
Just how much and how fast that policy adjusts remains to be seen. The fed funds futures market thinks there will be 100 basis points of rate cuts before the end of the year followed by another 125 basis points before the end of 2025, according to the CME FedWatch Tool, leaving the target range for the fed funds rate at 3.00-3.25%.
The fed funds futures market is ambitious. The Fed's Summary of Economic Projections provided in June showed a median estimate of 4.10% for the fed funds rate in 2025. New projections will be provided at the September FOMC meeting.
The fed funds futures market could end up being right, but it has been wrong on the pace and timing of rate cuts many times before.
In any case, the interest rate environment that has been friendly for savers since the Fed's tightening campaign began in March 2022 is about to get a little less friendly. Interest rates offered on certificates of deposit will be coming down (and already have), interest rates on Treasuries will be coming down (and already have), interest rates on money market funds will be coming down, and interest rates on savings accounts will be coming down (or, in some cases, not going up from their still rock-bottom levels).
What that means, however, is that the fortunes of dividend-paying stocks should be turning up.
A Competition Factor
Let's be clear. Dividend-paying stocks will still have their competition from investments offering less risk.
For example, the Annual Percentage Yield on a 1-yr online CD from Capital One is 4.50%; the yield on a 2-yr Treasury note is 3.92%; the 7-day SEC yield on the Vanguard Money Market Reserves Inc Federal Money Market Fund (VMFXX) is 5.26%; and a Lending Club savings account has an Annual Percentage Yield of 5.30%.
When the Fed cuts the policy rate, interest rate products will follow suit, maybe not step for basis point step but moving in the same direction of travel -- a direction that Fed Chair Powell also said was clear (i.e., lower).
There isn't going to be a mad dash to dividend-paying stocks, but we do anticipate there being a turn. It will be slow at first but it should pick up speed if, and when, a series of rate cuts comes to fruition.
The usual suspects will be in play (and already are). Think utilities, REITs, and energy, which generally have some of the most attractive dividend yields, as well as dividend growth. The same goes for the consumer staples sector.
Selection Matters
One needs to be more selective these days, however, when looking at dividend payers. The energy, REIT, and utilities sectors all have dividend yields in excess of 3.0%. None, however, have dividend yields higher than the risk-free 2-yr Treasury note.
That isn't true of every sector component. Chevron (CVX), for instance, sports a 4.47% dividend yield. The point here is that stock selection is key for investors seeking income. There is an opportunity to extract more income from some individual components than there is from the sector as a whole. That is relevant if income generation is the main priority.
An S&P 500 index fund isn't a great option for income generation. The dividend yield on the SPDR S&P 500 ETF (SPY), for instance, has a dividend yield of just 1.25%. That low yield is owed in large part to the fact that the S&P 500 is also trading near a record high.
To be sure, there are plenty of good dividend payers and higher dividend-yielding companies within the S&P 500, which, again, is why stock selection matters greatly for the income-oriented investor.
It matters because the economy is expected to slow. How much it slows is the great unknown, but labor market conditions will hold the answer. What we know now is that the labor market has softened, but it hasn't broken. Initial jobless claims -- a leading indicator -- continue to run well below levels typically seen in recessions.
The unemployment rate of 4.3%, though, is up nearly a full percentage point from its low in April 2023 and up 0.4 percentage point in just the last three months. That move has caught the Fed's attention and is a key reason why it is thought the time has come for policy to adjust. The aim is to forestall a worsening of the labor market with pro-active rate cuts; however, some think the Fed is already behind the curve in doing so.
What It All Means
A slowing of the economy, led by a slowdown in consumer spending, should lead to a slowdown in earnings growth. An outright recession, though, would most likely lead to a contraction in earnings growth. In either case, a prudent approach to dividend investing is to favor companies with a track record of not only paying dividends but increasing their dividend.
The best starting point in our estimation is the S&P 500 Dividend Aristocrats. To qualify, a company must be an S&P 500 component and increased its dividend every year for at least the past 25 years.
The "Aristocrat" distinction currently belongs to 66 companies, including luminaries like Coca-Cola (KO), Clorox (CLX), Walmart (WMT), Chevron (CVX), T. Rowe Price (TROW), and Johnson & Johnson (JNJ). One could favor individual stock selection among the Aristocrats or take a basket approach via an ETF like the S&P 500 Dividend Aristocrats ETF (NOBL). The latter fund's explanation contains a list of all 66 Aristocrats.
Whether you favor a Dividend Aristocrat approach is up to you. There is always a place for dividend-paying stocks in a balanced portfolio looking to lower volatility and enhance total return potential.
That potential will be held dear in a tougher economic climate, were one to arise, and in an environment of falling interest rates that lessens the return potential of cash and cash proxies.
