XLU - Buy Alert For These 6-15% Yields: Little-Known Indicator Is Very Bullish

2023-11-30 07:05:00 ET

Summary

• A seldom-referenced - but highly compelling - indicator is flashing a very bullish signal for defensive high-yield stocks.
• We look at this indicator more closely and explain why we think that high-yield stocks offer a very attractive risk reward in the current environment.
• We also share some of our top picks of the moment that offer well-covered 6-15% and growing dividend yields.

The recent shift in the monetary policies of central banks worldwide indicates that the Federal Reserve may soon pivot toward cutting interest rates themselves. In this article, we will look at this indicator along with several others to explain why we believe that the Federal Reserve is on the cusp of pivoting from rate hikes to rate cuts and how it sends a very bullish indicator for some of our top high yield stock picks of the moment.

Why Central Banks Are Cutting Interest Rates

Central banks across different countries have been cutting interest rates primarily in response to economic challenges such as slowing growth, trade tensions, and geopolitical uncertainties. Moreover, the fact that more central banks are now cutting interest rates than raising them is a strong signal that the global economy has shifted its priority from fighting inflation to staving off a severe economic downturn.

Weak Chinese economic data in particular is driving concerns of a global recession. For example, the recent downturn in Chinese venture capital funding, as highlighted by the 30% decline in the first ten months of 2023 compared to the same period last year, reflects deepening economic uncertainties that are dampening investor confidence. The contraction in China's venture capital activity, which includes substantial investments in sectors such as semiconductor and electric vehicle manufacturing, is indicative of broader issues such as the challenges posed by strict pandemic measures, regulatory crackdowns on the private sector, and escalating geopolitical tensions, particularly with the United States. Given that China's economy is highly interconnected with other major economies and accounts for 17.1% of total global venture capital deal value underscores the potential ripple effects of its economic slowdown on global markets.

As a result, it should not be surprising that China's central bank recently cut interest rates in an effort to stimulate borrowing and spending, which, in turn, should support economic growth. Another way that slashing interest rates may boost economic growth in China and other countries is that it makes its currency less attractive to foreign investors (due to the lower interest rate yield on saving in that currency). Therefore its exports become more competitive in the global marketplace.

Why Global Rate Cuts Could Force The Fed To Do The Same

Given the interconnectedness of the world's major economies - and particularly the politically sensitive balance of trade between the U.S. and China - the moves by China and other economies to cut interest rates will likely force the Federal Reserve's hand into doing the same soon.

Moreover, if U.S. interest rates remain elevated for too long, its businesses may no longer be able to compete in many important international markets, accelerating the rate at which our economy slows down and potentially making a mild recession a severe one, as extreme divergences in interest rates could lead to destabilizing capital flows and exchange rate volatility.

In fact, the Federal Reserve has recently adopted an increasingly dovish stance on interest rates, given that it has been holding interest rates steady in recent meetings and some of the rhetoric coming from members of its committee such as Governors Waller and Bowman. This shifting sentiment has pushed the S&P 500 ( SPY )( VOO ) higher and 10-year Treasury yields lower. Moreover, prominent investors like Bill Ackman believe that the Fed may cut rates as soon as Q1 2024.

Buy Alert For These 7-15% Yields

To take advantage of this expected shift in U.S. interest rates in the near future, we are weighting our portfolio towards stocks of quality businesses whose valuations have been beaten down by rising interest rates despite their underlying fundamentals remaining sound. Moreover, we are focusing on businesses with defensive business models in case the Federal Reserve does not cut rates fast enough to avoid a recession.

The S&P has held up quite well during the 2022-2023 rate hiking cycle, largely due to the A.I. fueled boom in its largest technology stocks. For example, utilities ( XLU ), REITs ( VNQ ), and yield cos have experienced considerable underperformance over that period due to the higher-for-longer interest rate narrative. As a result, we think that a material decline in interest rates could reverse this trend, leading to massive outperformance for these beaten-down names. The outperformance relative to the broader market would likely be even more pronounced in the event of a recession, as many of the most beaten-down names in these sectors are also very recession-resistant. Here are some of our favorite picks of the moment in order of increasing risk:

• Realty Income ( O ) stock is a low-risk investment by virtue of its very defensive triple-net lease REIT business model and A- credit rating. It has a vast, well-diversified, and highly defensive business model, as well as a strong balance sheet. O also has a very impressive track record of growing its monthly dividend payout every year for over a quarter century. This alongside delivering exceptional total return outperformance makes it a compelling buy at valuations not seen since the COVID-19 crash and a near 6% dividend yield.
• Brookfield Infrastructure Partners ( BIP )( BIPC ) stock is a little bit riskier than O due to its more aggressive use of leverage and value-add and capital recycling-dependent approach to creating value for shareholders. However, it is backed by one of the leading global alternative asset managers in Brookfield ( BN )( BAM ), and it owns a well-diversified portfolio of high-quality and pretty defensive infrastructure assets. It also has a solid balance sheet with a BBB+ credit rating and boasts a stellar track record of growing its distribution at a high single digits CAGR for over a decade alongside delivering exceptional outperformance. As a result, it offers investors a very attractive opportunity to buy in at a near 6% yield and a stock price that is ~30% below 52-week highs.
• NextEra Energy Partners ( NEP ) is by far the highest-risk investment in this group given its lack of an investment-grade credit rating. However, it could also possibly double or triple in the next few years alongside paying out a 15.1% and growing dividend yield if the investment thesis works out. As a renewable power producer with decades-long power purchase agreements with investment-grade counterparties and an A-rated parent in NextEra Energy ( NEE ), NEP appears well-positioned to weather a recession. However, the big risk facing NEP right now is that it has a wall of convertible debt, equity, and corporate debt all coming due in the coming years. With interest rates at elevated levels and its stock price trading at a very low level, the market is concerned that NEP's cost of capital will soar, leading to a dramatic decline in cash available for distribution and forcing the board to slash the dividend. However, NEP's board recently signaled confidence in the company's prospects by hiking its latest dividend and management continues to guide for a 5-8% dividend CAGR through 2026, which is quite remarkable for a company currently yielding 15.1%. Moreover, management plans to finance repowering projects with project-level debt and/or tax equity, thus preserving CAFD for paying down debt and helping to finance an attractively-priced dropdown. Additionally, the company's recent successful sale of its STX pipelines to Kinder Morgan ( KMI ) at a valuation that enables it to take out the vast majority of its CEPFs through 2025 meaningfully reduced the risk profile, though it is still elevated. Thus, the company's future largely hinges on its ability to manage its upcoming debt refinancings, remaining convertible equity and debt maturities, and Meade pipeline sale without reducing its dividend. If interest rates indeed fall meaningfully in the next few years, this could give NEP the breathing room it needs to navigate these issues and see its stock price jump from ~$23 to its previous level of ~$70, resulting in a tripling of the stock price in a fairly short period of time.

Investor Takeaway

While it seems to be seldom paid attention to, the shifting monetary policies of global central banks towards rate cuts suggests a potential shift from rate hikes to cuts for the U.S. economy, presenting very bullish prospects for high-yield stocks that have been beaten down severely by interest rate hikes.

To capitalize on this expected trend shift, our portfolio is increasingly weighted towards businesses with sound fundamentals and defensive characteristics, but has seen their stock prices crater in response to rising interest rates. As a result, we expect that - particularly in a recessionary scenario - these high-yielding stocks (such as O, BIP, and NEP) will generate significant total return outperformance for our portfolio compared with the broader market.

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