Rate cuts are finally here. So will we actually hit that vaunted “soft landing” everyone’s been talking about?
Well, I’ve got a (contrarian, naturally!) take that I know most people haven’t thought about—especially since last week’s jumbo 50-point rate cut dropped:
What if we hit a “no landing” scenario, where the economy ticks along and inflation comes back?
I’m bringing up that unpleasant idea because, usually in a rate-hiking cycle like the one that just ended, the central bank pushes the Fed funds rate higher until it breaks something.
But this time, it’s not clear it has.
In fact, when it looked like it finally had—when Silicon Valley Bank and friends crumbled to dust in March 2023—Jay blinked, and pumped liquidity into the market through the back door, a move we’ve referred to as “Quiet QE” here many times before:
With that in mind, last week’s oversized cut was understandable: The Fed has been keen to take its foot off the brake for a while now. Now that inflation is close(-ish!) to its 2% target, it’s making its move.
But here’s the thing: The government’s deficit spending is completely out of control. It is possible, perhaps probable, that Uncle Sam will overwhelm Powell.
For fiscal 2024, the Congressional Budget Office (CBO) projects a $1.9 trillion deficit on $4.9 trillion in tax receipts. (And yes, this is the CBO that paints its projections with rose-colored ink.) So we have nearly $5 trillion in revenues, and almost $7 trillion in expenditures.
A 40% overshoot.
Give me an extra $2 trillion, and I’ll show you a good economy! But the resulting monetary inflation could flow back into consumer price inflation. So how do we profit if rates bottom before the media expects them to?
Here’s an answer that might surprise you: We’re buying a company that lends money to small businesses.
Get Set for “Refi Wave 2.0” (But on the Business Side This Time)
We’re going with a small-business lender because an economy that’s nicely humming along will encourage companies—especially smaller, domestic firms seeing strong demand—to expand in the near term.
In the long run, if rates show a hint of moving up, these same firms are also likely to try to front-run them by moving up their expansion plans.
It reminds me of the “refi wave” of 2020.
Remember that? I sure do. Your income strategist nearly missed the window to get in on it, despite many reminders from my wife. Fortunately, I managed to wake up and lock in a 2%+ mortgage before rates skyrocketed (and I wound up sleeping on the couch!).
I bring this up because we could see something similar on the business side: At any hint of rates bottoming, I expect the nation’s companies to borrow more upfront to “lock in” an attractive rate, just like homeowners did.
And Ares Capital (ARCC) will be here for it.
Ares is a business development company (BDC), a class of firms that lend to small businesses. These days it’s nearly impossible to get a business loan from a bank, so BDCs have stepped in to fill the gap, providing debt, equity and other finance solutions.
A key thing to keep in mind about BDCs is that they get special tax privileges, and in exchange, they must return at least 90% of their taxable profits to shareholders as dividends. They trade just like regular common stocks, with tickers we buy and sell.
(If this sounds like a real estate investment trust, or REIT, to you, it’s because REITs get the same deal from Uncle Sam.)
As with REITs, the tax savings mean more money available to send out to us as dividends, juicing the yields on these stocks. (ARCC, as we’ll discuss momentarily, pays an outsized 9.5% dividend today.)
Ares, unlike many BDCs, builds real long-term value (I’ve been hard on BDCs in the past for chasing too many bad loans instead of creating shareholder value). Ares was, for example, one of the only BDCs that kept on lending in 2020.
On the dividend front, the company’s 61 cents a share earnings last quarter easily covered the 48-cent per share payout. A 79% payout ratio is great in the land of BDCs.
And about that dividend: Ares not only yields 9.5% but has a history of hiking its payout. I know I don’t have to tell you that this is a rare setup in dividend-land: We usually have to pick between a payout that grows (but with a low current yield) or a high yield now.
ARCC gives us both!
Look at this chart, generated through our recently upgraded “toy” here at Contrarian Outlook—our Income Calendar dividend tracker:
The “bump” at the end of 2022 was a special dividend. Ares keeps a “spillover” of extra earnings that it pays out to shareholders periodically, or it may choose to keep these funds on hand for a rainy lending day.
Plus, Ares increased its net asset value (NAV) over the past year. And those gains may begin to accelerate with a reheating economy.
Brett Owens is Chief Investment Strategist for Contrarian Outlook. For more great income ideas, get your free copy his latest special report: Your Early Retirement Portfolio: Huge Dividends—Every Month—Forever.
Disclosure: none