Interest rates down, borrowing costs…up? – A few months after the Bank of Canada’s first rate cut, the Federal Reserve finally kicked off its long-awaited rate cutting cycle with a 0.50% reduction to its policy rate on September 18th. Going into the meeting, markets were split between a 0.25% and 0.50% decline, but the Fed decided to go with the more aggressive half-percent reduction, with the promise of more to come. Yet a quick look at bond yields (see the chart of the month below) reveals that the reaction since that larger-than-expected rate cut has been for the average term borrowing cost to governments, corporates, and mortgage-holders to rise by roughly a third of a percent. How is that possible?
The key distinction to make here is between rates and yields. Central banks like the BoC or Fed directly control what rate banks pay when they borrow from the BoC on an overnight basis. But the BoC does not set what fixed term loans or bonds pay – this is set by the market. If you’re borrowing for 5 or 10 years, you’re concerned about not just today’s floating interest rate, but what that rate is likely to be over the entire term of the loan. That’s why longer-term bonds/loans tend to yield less than short ones today: the market is pricing in an expectation that policy rates will decline over the term of the bond/loan. So while a 1-year bond is quite sensitive to changes to policy rates, 10-year bonds are less concerned about what that rate is doing today and more concerned about what rates and inflation and growth are going to do over the next decade.
This all serves as a timely reminder that aggregate borrowing costs aren’t pre-destined to continue falling as they’ve done for most of this year, even if the Fed and BoC continue cutting rates for months to come. As we mentioned last month, many borrowers (whether corporate, consumer, mortgage, or government) are going to see their debt-service costs rise meaningfully in the next two years as low-rate obligations are renewed. Our view is that the risk of high inflation and rising yields is being underestimated by much of the market, and for this reason we prefer equities with low interest expense and clean balance sheets that generate high levels of free cash flow.
Terms
- Policy Rate – each central bank conducts monetary policy in a slightly different way, but in general their main lever for impacting interest rates in their respective economies is by setting an “overnight” rate that banks can borrow at (this is also very close to the rate that banks will lend funds to each other to cover their day-to-day liquidity needs or surpluses). This rate can be thought of as the 1-day floating interest rate for entities with no credit risk, or “risk-free rate”. In Canada this rate is called the “Overnight Lending Rate”, and in the U.S. it is the “Fed Funds Target Rate”.
Chart of the Month
The Fed’s first rate cut of the cycle has, for the time being, marked a low in government and corporate bond yields (5-year federal Canada and US yields shown below). With central banks shifting to a more accommodative stance while labor data continues to show some resilience (see the U.S. jobs print in the data digest below), bond investors are shifting some of their concern toward the risk of inflation rising back above target in the years to come.
Source: Bloomberg
Equity Highlight - Dollarama
This section will periodically look at names we hold in the portfolio where there has been a significant trend or development in place. This month we’re looking at Dollarama, which is up over 40% YTD, even while key competitors in the U.S. have seen their share prices cut in half over the past 3 quarters. Below we take a quick look at Dollarama’s execution in recent years, what’s set them apart from competitors, and what risks and opportunities we see for the company from here.
Comparing Dollarama’s financials to U.S. competitors like Dollar General or Dollar tree reveals a stunning gap in operating efficiency. Dollar Tree, for example, turned $31B in sales into $1.1B in profit over the last twelve months, whereas Dollarama earned a similar bottom line (U$800m) despite a fraction of the sales (U$4.5B) – this equates to a 3.7% net income margin for Dollar Tree, compared to 17.9% for Dollarama. The fact that Dollarama has reached this level of profitability despite continuing to offer the lowest price-points available to Canadians (lower on average than Walmart, No Frills, and Food Basics) is a testament to the effectiveness of their cost control measures.
We believe there are two key factors that underpin Dollarama’s positioning:
- More room for growth: adjusted for population, Canada has fewer than half of the number of discount retail stores that the U.S. does, and provides a long runway for growth in new locations without overcrowding the market. There is also less competition in Canada from non-dollar store lower-cost retailers such as Sam’s Club, Lidl, Aldi, Trader Joe’s, and others.
- Leaner business model: Dollar Tree spends $7.9B on overhead, Dollar General spends $9.6B, while Dollarama spends just $881M, about a tenth of the other two (and just 14% of sales compared to 24-26% for the two competitors). This strategy of larger stores with less complexity and lower costs has been a significant driver in Dollarama’s outperformance recently. Although there are countless small efficiencies that contribute to this leaner business model, one example is the company’s choice not to carry frozen or perishable goods, which saves on power, equipment, maintenance, and spoilage.
We’ve been very pleased with Dollarama’s performance this year and believe it is well positioned going forward, even as consumer spending slows – in fact a more cost-conscious consumer base could be an advantage for DOL, and we believe this company to be more defensive than most retailers for that reason.
Now the key risk with this company is simply valuation: the success of Dollarama’s business model is no secret, and investors have continued to buy into this name, pushing the price higher. We still view this as an attractive part of Canadian portfolios, but we will be watching valuation metrics closely to ensure that the price of the business does not exceed the fundamentals underpinning it.
Data Digest
A selection of key economic data-points for the month.
| Country | Event | Period | Survey | Actual | Prior | Surprise |
| USA | Change in Payrolls | Sep | 150,000 | 254,000 | 142,000 | +104,000 |
| Comments: Job creation in the U.S. in September was substantially stronger than expected, which sent both equities and bond yields higher. The higher bond yields reflect a market that is now expecting a slightly slower pace of rate cuts from the Fed given the risk of a resilient labor market re-igniting inflation. | ||||||
|
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||