- Reduction of the U.S. FED’s federal funds rate
- Impacts on businesses and consumers.
- Impacts on stock markets.
- Our investment strategy
- Overview of some recent transactions
Reduction of the U.S. FED’s federal funds rate
The U.S. Federal Reserve cut interest rates this past week, joining the central banks of many other developed markets which have started to reduce interest rates in recent months. The notable decline in Canada’s inflation rate allowed August’s headline inflation to reach the Bank of Canada’s target of 2% for the first time since 2021. Below, we take a closer look at the Fed’s decision and explore how lower interest rates may impact the economy, as well as potential implications in terms of market outlook.
The Fed opted to cut interest rates by half of a percentage point - larger than the quarter percent reductions seen from other central banks. Fed Chairman Jerome Powell characterized the move as one that was needed to “recalibrate” the bank’s approach given the fall in inflation and increase in unemployment over the past year. In contrast to the past few years, when the Fed felt the balance of risks was skewed more heavily towards inflation, it noted the risks between inflation and employment are now “roughly in balance”. It telegraphed that additional rate cuts are likely through the remainder of the year, but Mr. Powell emphasized they are meant to preserve and extend what it regards as a reasonably healthy economy.
Lower interest rates translate into reduced borrowing costs for businesses, consumers, and governments. As with interest rate increases, there is often a lagged effect from interest rate cuts, with the speed at which any relief is felt varying and depending on the circumstances of borrowers. On the business front, small businesses often hold floating-rate loans which adjust quickly to lower interest rates, while larger companies often hold longer-term fixed rate debt that takes longer to reprice.
Consumers may also feel the impact to varying degrees. Credit card users should see some early benefit given the variable-rate nature of credit card debt. Meanwhile, the impact to mortgages will likely be more mixed. Consumers looking to buy a new home may be encouraged by the decline in mortgage rates, though they may also be tempted to wait given that the Bank of Canada and U.S. Federal Reserve have telegraphed the potential for even lower rates in the months to come. Meanwhile, for Canadian homeowners already facing mortgage renewals, the reduction in rates this year may simply reduce the headwind that some are facing as a result of needing to renew at borrowing costs that are still substantially higher than the ultra-low rates, they locked in years ago.
While global equity markets have responded favorably to this initial round of interest rate cuts from central banks, history suggests some caution is warranted. There have undoubtedly been periods of strong equity markets gains following the beginning of an easing cycle. However, there have also been some notably weak periods following the first interest rate cut, typically reflecting a deteriorating economic and corporate earnings backdrop. Overall, the range of historical market outcomes following an initial interest rate cut has been wider than the overall average range.
We view the path forward with cautious optimism, acknowledging that lower interest rates will eventually lead to easier financial conditions. Nevertheless, as is the case with hikes, the cuts will take time to provide meaningful relief to consumers, businesses, and the economy. In the meantime, we are mindful of the lesson that history has taught us: the start of interest rate cuts can either extend the economic cycle or mark an important turning point. We will be watching closely for signs of either scenario unfolding.
Our investment strategy
As an analogy, investing is like a marathon. As opposed to sprinting, energy must be deployed efficiently over a long period of time. Obviously, a short-term strategy can be spectacular for a while, but it will inevitably invite a great deal of trouble when it is least welcome!
It goes without saying that being a long-term investor, just like a marathon runner, is not easy and the difficulty lies in consistency. The volatility of the financial markets, combined with various geopolitical elements, is changing the minds of many investors despite good intentions.
One of the keys to success is diversification: holding multiple types of investments from many different sectors to reduce volatility. Having a diversified portfolio also requires owning stocks beyond just those few celebrated in the media. It is a question of holding a portfolio that is less "glamorous", but much more effective in the long term.
During the period from 1928 to 2023, the American market experienced a decline in 26 out of the 95 years, with an average decline of 14%. During that same period (beginning the year before the great stock market crash of 1929), the overall annual return of the U.S. stock market has been 9.9%. Historically, the most consistent results have been based on the conservative behavior of investors during periods of turmoil.
Our plan of action remains:
- Maintain an asset allocation balancing stocks, bonds, alternative securities according to your personalized Investment Policy Statement.
- Leverage strong diversification and invest in high-quality securities.
- Receive increasing dividends over time.
- Have a healthy dose of patience, it’s a marathon.
Overview of some recent transactions
We recently took advantage of the sharp rise in share price to crystallize some profits on certain stocks such as Capital Power (+38% in the last 12 months), Manulife (+61% in the last 12 months) and RBC Royal Bank (+44% in the last 12 months).
We also took advantage of a slight decline in the share price to increase our position in Rogers Communications and Alimentation Couche-Tard.
In addition, we increased our position in the shares of some global consumer leaders such as Nestlé and LVMH (the Louis Vuitton Moët & Chandon super conglomerate), as their prices traded at their lowest levels of the past 52 weeks.
Finally, some healthcare stocks such as Merck and Johnson&Johnson drew our attention with their advantageous valuations: attractive and increasing dividends as well as resilient long-term business models.
We continue to maintain our investment discipline based on experience and results.
As always, we remain available to answer your questions.
Benoit Legros, B.A.A., CIM, FCSI
Senior Portfolio Manager and Wealth Advisor