SCHD: No Interest Rate Cuts Expected Soon

seekingalpha04-18

The Fed is unlikely to start cutting rates soon due to a resilient U.S. economy, strong labor market, and steady increase in energy prices, supporting the case for dividend stocks.The ETF's portfolio ...

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On the one hand, the ETF provided a solid 10% return since early November 2023. On the other hand, it underperformed compared to the broader U.S. market because the rotation from growth to value did not happen yet. Today I want to update my thesis because almost half a year has passed since my first SCHD article and I must share my opinion about recent developments. I see three big reasons why the Fed is unlikely to start cutting rates soon, which will highly likely make growth stocks less attractive compared to dividend stocks. All in all, I reiterate my \"Strong Buy\" rating for SCHD. Why I am still bullish To begin, I want to refresh the information regarding SCHD's major holdings. The ETF's portfolio is mostly represented by defensive sectors, with technology occupying a position far from the leading spot, comprising less than 9% [compared to 30% in S&P 500]. The largest sector in SCHD is financials with a 17% share. Seeking Alpha Understanding the breakdown of holdings is crucial because the big rally of recent months in technology stocks made dividend opportunities like SCHD less attractive. However, recent developments suggest that the rally in tech is likely to cool down, which will highly likely increase demand for safe-harbor high-quality dividend names. I believe so because of the recent March inflation data, which was substantially hotter than expected. A new uptick in CPI is crucial because combating inflation has been the primary rationale behind the Fed's current tightening cycle. Therefore, decision-makers are likely to heavily rely on inflation data when evaluating the timing of rate cuts. The market had been very optimistic about the pace of monetary policy easing in 2024, but the odds that the first cut will happen in June 2024 has dropped significantly in recent days. Indeed, I concur with Jerome Powell, who sees no reason for the Fed to rush into rate cuts. Firstly, the U.S. economy appears resilient, indicating no immediate need for urgent monetary policy easing. Despite experiencing record-high interest rates across multiple decades, GDP growth is expected to persist over the next five years. Moreover, the projected U.S. GDP growth rate until 2028 is not far below that of the pre-pandemic 2019, a year of market with record low-interest rates. Statista Secondly, the monetary policy should not adversely affect the labor market, as the Fed operates under its \"Dual Mandate\". Hence, considering unemployment rates is also crucial. From this perspective, the overall picture also looks exceptionally good. The current 3.8% unemployment rate is almost two percentage points lower than the long-term average. Referring to the below chart, we see that the current level of unemployment mirrors pre-pandemic levels when interest rates were at record lows. Therefore, from the perspective of the labor market, there is also no need for the Fed to start cutting rates soon in my opinion. Data by YCharts Third, inflation is closely tied to energy prices, especially oil and gas prices. Despite the U.S. became the largest hydrocarbon producer in recent years, OPEC still produces around 40% of the world's crude oil. It is apparent that decisions made by a significant player will affect the supply demand balance in energy commodities. Oil-rich nations like Saudi Arabia and Russia endured nearly a decade of low-energy prices and are likely hesitant to repeat past mistakes. The recent extension of voluntary oil output cuts illustrates OPEC's commitment to maintaining elevated energy prices. Therefore, this year's steady increase in crude oil prices is not surprising. Should the Fed commence rate cuts soon, it could stimulate economic activity and energy consumption, which will drive energy prices even higher and exert upward pressure on inflation. Therefore, the current state of energy markets also does not give the Fed much room to cut rates much in the foreseeable future, in my view. Data by YCharts To summarize, the U.S. economy remains robust, supported by remarkably low unemployment levels. Oil prices are climbing as well, indicating that global consumption is still expanding, and OPEC might introduce new output cuts. In case the Fed starts cutting rates too early, it might boost energy prices even higher, which could highly likely cause a new wave of high inflation. As observed in 2022, growth stocks are vulnerable to high inflation levels and in this situation, it is highly likely that investors will rotate to safe harbors like high-quality dividend names. Yahoo Finance Interest rates are likely to stay higher for longer, adversely impacting the valuations of growth stocks, which heavily depend on discounted future cash flows [DCF models]. As risk-free rates [10-year Treasuries on the above chart] rises, the present value of these cash flows decreases, especially for those with longer durations. On the other hand, high-yielding value stocks offer immediate returns through high dividend yields and potentially significant stock buybacks. Therefore, I believe value investors stand to benefit the most from high-interest rates. SCHD's top holdings currently boast attractive forward dividend yields coupled with solid dividend growth, positioning them as a 'safe haven' in the event of a significant correction in growth stocks. Compiled by the author based on Seeking Alpha SCHD is not the only large ETF with exposure to high-quality dividend stocks. There are two notable dividend ETFs from Vanguard: High Dividend Yield Index Fund ETF (VYM) and Dividend Appreciation Index Fund ETF (VIG). I have chosen these two for comparison with SCHD because they are not smaller than SCHD in terms of AUM and the expense ratio is identical at 0.06%. The reason I prefer SCHD over its competitors is because it strikes a solid balance between current dividend yield and growth. VYM's dividend yield does not look far from SCHD, but its historical growth rate is much slower. On the other hand, VIG looks competitive in terms of dividend growth, but its TTM yield is around two times lower compared to VIG. Seeking Alpha While SCHD may have underperformed some of its peers in terms of past long-term performance, my thesis emphasizes the significance of high dividend yields and growth for investors anticipating a rotation from growth to value. Therefore, I believe investors will be increasingly attracted to SCHD's stronger performance in terms of dividend payouts. Risks to consider The outstanding financial performance of major technology companies in recent quarters has been the primary driver of the significant market rally. It appears that technological companies have adapted to high rates, and substantial layoffs initiated in late 2022 have enabled them to sustain and even enhance their EPS. However, they cannot indefinitely reduce their workforce and this could potentially lead to stagnating profits in the future. However, we should not discount their ability to drive revenue growth through the cross-selling of new services, particularly in an era of rapidly advancing AI capabilities. That being said, if technology sector profits continue to surge in Q1 and are accompanied by positive Q2 guidance, my bullish thesis on SCHD may likely continue to lag the S&P 500. The geopolitical situation in the world is rapidly evolving, marked by ongoing large military conflicts and sanctions imposed on major oil producers like Russia and Iran. For example, if Russia's relationships with the West show signs of improvement, the markets might interpret this as a potential easing of sanctions on Russian oil. Should Russian oil become available to the developed world, it could disrupt the global supply and demand balance, potentially leading to lower oil prices. Such a scenario could positively impact inflation, potentially prompting a more dovish stance from the Fed and sparking a new rally in growth stocks. Bottom line  To conclude, SCHD is still a \"Strong Buy\". I think that there are several big reasons for the Fed not to start cutting rates soon, which will likely undermine the market's sentiment around growth stocks. Therefore, a rotation from growth to value appears to be approaching, in my opinion.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2428597457"}