Dividend Informer Update: February 2025: Profits, Not Rates, to Fuel Stock Returns from Here
Absent interest rate support, profit growth is key for shareholder returns. A U.S. recession appears distant, favoring continued stock market expansion.
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Market volatility has picked up in early 2025, a continuation of December’s fluctuations. This shouldn’t come as a surprise as several factors are each promoting increased volatility.
The greatest impact results from investor concern over interest rates. The Federal Reserve controls short-term interest rates by setting the Fed Funds rate, the interest banks charge each other when lending or borrowing excess reserves. The Fed has cut this rate three times since September 18, kicking off its easing cycle with an eye-catching 50 basis point reduction prompted by a weak employment market in the late summer and early fall.
The market, however, determines interest rates for everything else. While the Fed Funds rate is down a cumulative 100 basis points since the September Fed meeting, yields on the 10-year Treasury Note have risen 80 basis points during that time from 4.00% to a recent high of 4.80%.
Market volatility has also increased as some investors may be taking some chips off the table after a strong market run over the past two years. This particularly impacts large institutions that focus on stock-bond ratios and 401k participants who rebalance their accounts.
Lastly, there is “political risk,” the risk of missteps or surprises as we change administrations and control of Congress.
Rates and Yields
While the Fed cut rates a quarter of a point (0.25%) at its December meeting, the accompanying news release, comments by Fed Chair Jerome Powell, and projections by Fed governors suggest only one or two rate cuts this year.
The current 4.25%-4.50% Fed Funds rate represents slightly restrictive monetary policy with the neutral line considered by many economists to be about one percentage point above inflation.
Given level inflation and reasonable job growth, the Fed is not currently forced to address either end of its “dual mandate” to maximize employment and stabilize prices. Sitting slightly north of neutral is reasonable.
The Economy
Despite the drag from 11 rate hikes from March 2022 to July 2023, the U.S. economy has continued to grow solidly overall with a few pockets of weakness emerging, particularly in manufacturing.
Employment growth has remained positive with modest job growth from April through October giving way to stronger numbers in November and December:
Progress on inflation has stalled with the core Consumer Price Index leveling off in the low 3% range for more than half a year, including the 3.2% core inflation rate for calendar 2024. This is above the Fed’s desired 2% inflation rate.
The Fed uses its own indicator, the price index for Personal Consumption Expenditures (PCE), which at 2.8% is also above target:
Most consumers are learning to live with higher trendline inflation than we’ve seen in 15+ years, even if it is lower than in 2021-2022. Consumer spending is rising at a modest rate excluding inflation. Businesses are investing, particularly in technology.
In contrast, economic growth overseas has been uneven. Parts of Europe have flirted with recession and Japan recorded one quarter of negative growth in 2024. India continues to grow strongly.
China is a wildcard as reported growth has been solid, but there are pockets of weakness such as real estate. Its aggressive mercantilist policy of promoting exports invites retaliation such as the 100% tariffs on Chinese electric vehicles imposed by the Biden administration and 17%-35% tariffs by the European Union.
Foreign trade is a much smaller part of the U.S. economy than most other developed nations, so overseas economic weakness shouldn’t harm U.S. companies even though it will hold back their foreign operations. The strength of the U.S. dollar will hurt export volumes and reduce the value of exports and foreign operations when converted to dollars.
We’ve also been asked whether the wildfires in Los Angeles County will have an impact on the market. Beyond the human tragedy, past natural disasters have sometimes produced short-term economic dislocations, but spending on rebuilding has frequently enhanced subsequent economic growth.
Conclusion
Economic growth fosters growth in corporate profits, which will have to be the driver of shareholder returns in the absence of help from falling interest rates. Protracted declines in stock prices, particularly bear market declines of 20% or more, are highly correlated with recessions. Since a U.S. recession appears highly unlikely for the foreseeable future, the odds of an extended market pullback are low. However, elevated share prices increase the risk of a short-term market “correction” of 10% or more.
One risk factor to monitor is the trend in long-term interest rates. Despite the market volatility it is causing, the normalization of the yield curve is actually a good thing in contrast with the “inverted” yield curve of the past few years. A steady upward slope in Treasury yields as maturities lengthen reflects the normal “term premium” investors demand for lending money for a longer period of time.
However, rising Treasury yields are a particular risk factor for dividend-oriented investors if they rise to a level that attracts investor dollars away from dividend stocks.
This month, we have on deck two dividend payers that are timely and offer attractive reward-to-risk at their current prices. Be sure to subscribe to receive the full analysis in your email inbox when these two recommendations are published.