Trade War Fuels Fire Under Stable Dividend Plays

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Posted: May 27, 2019 11:55 AM

People love to talk about winning streaks and why not, it’s a fun topic. Leading up to the month of May, the U.S. stock market had been on one of its own, marking a series of new highs from the first of the year.

However, the tide went out of the market in a classic “sell in May and go away” decline that has damaged investor sentiment in a meaningful way. There is fear that the latest U.S. vs. China situation will evolve into a technology and currency cold war that could drag on for months, if not years.

As of the closing bell last Friday, there were no deals made, no new meetings scheduled to resume talks and no sense that either side was about to give an inch on their now entrenched positions. China’s President Xi misjudged President Trump’s zeal to do a deal as well as miscalculated how hard his trade team should press American trade representative Robert Lighthizer, who has Mr. Trump’s full trust in the matter.

Sadly, the latest set of circumstances puts the whole ‘public shame and saving face’ cultural syndrome that greater Asia suffers from into the global spotlight after China, in the final stages negotiations, substantially altered the terms that had been verbally settled on previously. The fissure in the deal was the United States demand that China change its domestic laws to achieve accountability standards that senior Communist party leaders saw as giving in to the United States.

The concern going forward is that because of China’s top-down political structure, it is likely that new rhetoric out of China will be combative and nationalistic, leaving little room to pick up the trade talks where they left off. Without verifiable systems in place to protect and weigh justice against violations, then in my estimation, tariffs will be in place for a long time. And, quite frankly, the genuine takeaway from China’s missed opportunity for a deal that it turned into debacle is that Chinese leaders were willing to make promises that they never intended on keeping.

Looking at how the trade war will affect China’s future rate of gross domestic product (GDP), the Organization for Economic Cooperation and Development (OECD) is forecasting China’s growth rate to slow to 5.49% in 2020, fall below 4% in 2025 and below 2% in 2039. How accurate are the forecasters at OECD? Well, they published an internal report and found that the OECD tended to be too optimistic (aka: eurozone). Given China’s current debt to GDP ratio of 300%, it stands to reason that a protracted trade war with the United States is only going to bring those future lower numbers forward sooner than expected.

Long-Term China Growth Forecast

Now, President Xi has backed himself into a political and cultural corner that carries the risk of only getting messier. “No doubt Xi has tightened the overall policy atmosphere so few want to voice opposition,” said James Green, who was the top trade official at the U.S. Embassy in Beijing until last August. “And that doesn’t leave much room for the negotiators.” (source: New York Times — May 16, 2019)

“The Trump administration had demanded stronger penalties for violating foreign patents and tighter laws to prevent the Chinese from demanding that foreign businesses transfer critical technologies. And the administration sought changes to cybersecurity laws that China’s national security establishment saw as interference.”

The impasse between the two countries and China’s egregious behavior is on full display around the world. Once again, we all learn that doing business on a transparent level with China’s Communist regime is fraught with risk and prone to fail. Now, the Trump administration is preparing to hit China with 25% tariffs on the balance of the $300+ billion of Chinese imports to the United States while aggressively pushing American and foreign manufacturers to move supply chain operations out of China altogether.

A flight of investment capital from a devaluing yuan being manipulated by China’s government to offset the cost of tariffs and large multi-national businesses hitting the exits to set up shop in neighboring Asian nations is probably the only way China will buckle to terms the United States can accept. Until then, the stock market is going to be under pressure to reset its growth expectations that only recently had the major averages setting new bull market records.

Rate cut expectations began inching higher, even though Fed Chairman Jay Powell said he does not see the need to move the fed funds rate range in either direction at this time. The implied likelihood of a rate cut in October increased to 55% from 41.9% and the Fed funds futures market sees a 70.9% likelihood of a rate cut in December, up from 57.4% two weeks ago. Meanwhile, odds of a rate cut in January 2020 rose to 73.9% from 62.1% in the past two weeks. (source: CME FedWatch Tool)

What does the bond market’s message send to investors? I think it indicates that the U.S. economy will grow, but at a slower pace with allocation of more capital to defensive blue-chip stocks paying high-dividend yields and to stocks that raise their dividends aggressively. Under this scenario, capital flows into both these areas of the market likely will be very bullish. Capital flows into utilities, real estate investment trusts (REITs) and consumer staples is very strong, since they offer higher yields and an attractive alternative to bonds.

One can throw a dart at the utility sector and hit a winning stock. The Utilities Select Sector SPDR ETF (XLU) trades at new all-time high against a tough market landscape. The “who’s who” of power companies occupies the top positions in the fund that, even at its new lofty level, pays a dividend yield of 3.01%.

Top 10 Holdings (61.58% of Total Assets)

Get Quotes for Top Holdings

Name Symbol % Assets
NextEra Energy Inc NEE 11.68%
Duke Energy Corp DUK 8.32%
Dominion Energy Inc D 7.82%
Southern Co SO 6.92%
Exelon Corp EXC 6.21%
American Electric Power Co Inc AEP 5.30%
Sempra Energy SRE 4.41%
Public Service Enterprise Group Inc PEG 3.79%
Xcel Energy Inc XEL 3.65%
Consolidated Edison Inc ED 3.48%

The consumer staples sector is considerably more selective in which stocks are outperforming. Leading the pack are Procter & Gamble (PG), Kimberly-Clark (KMB), PepsiCo Inc. (PEP), Nestle S.A. (NSRGY), Colgate Palmolive (CL) and Mondelez International (MDLZ). These front-running consumer staples stocks are all paying yields as high as 3% even after the recent run up.

The Vanguard Real Estate ETF (VNQ) pays an attractive 3.9% dividend yield, even at its recent high of $88, with top holdings in American Tower (AMT), Simon Property Group (SPG), Crown Castle International (CCI), Prologis Inc. (PLD), Equinix Inc. (EQIX) and Public Storage (PSA). What a nice mix of holdings — cell towers, mixed-use commercial property, logistics warehousing, data centers and self-storage.

So, while 56% of the S&P 500 stocks are now in bearish technical patterns, there is a bull market in utilities, REITs and consumer staples taking place in the wake of the handwringing about a trade war with China. While the global investing world tries to anticipate when a break in the trade war will stoke a new rally, there is already one in full swing within some of the most boring businesses in the world. And that’s perfectly fine when those boring businesses are generating profits hand-over-fist.

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