DIARY OF A PORTFOLIO MANAGER

SEPTEMBER 27, 2024

Good day,

Not exactly sure why but it’s been a hectic few weeks with kids back to school and some extra time spent meeting people outside of the office.

What’s been happening?

I was going to reference the lyrics from the song “The First Cut is the Deepest” done by various artists but they didn’t resonate past the title so I opted to pass on that. The U.S. Federal Reserve cut interest rates last week, joining many other major developed central banks who have started to reduce interest rates in recent months. Another important development was the notable decline in Canada’s inflation rate, with August’s headline inflation reaching the Bank of Canada’s target of 2% for the first time since 2021.

The Fed opted to cut interest rates by a half of one percent - 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. I think that he is more concerned about labour numbers than he lets on. This is 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”. The Fed 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 and consumers. 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. The impact to mortgages may be mixed. For consumers looking to buy a new home, they may be encouraged by the decline in mortgage rates though they may also be tempted to wait given 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 that are facing mortgage renewals, the reduction in rates this year may simply reduce the headwind that some Canadian mortgage holders are facing given many will have to renew at borrowing costs that are still substantially higher than the ultra-low rates they may have locked in years ago.

While global equity markets have responded favorably to the initial round of interest rate cuts from central banks, history suggests some caution is warranted. There have undoubtedly been some periods of strong equity markets gains following the beginning of an easing cycle. Likewise, there have also been some notably weak periods following the first interest rate cut, typically reflecting a deteriorating economic and corporate earnings backdrop. We are seeing this in our strategist’s recession scorecard. I am also seeing valuations a bit above normal which doesn’t mean much over 3-5 years but can mean a lot over 3-5 months. Overall, the range of historical outcomes for equity markets has been wider than normal after the first interest rate cut.

So what is your DS team thinking? We view the path forward with cautious optimism, acknowledging that lower interest rates will eventually lead to easier financial conditions. Nevertheless, as with hikes, the cuts will take time to provide some 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. Luckily, we are nimble and have orders in to trim into strength and add to positions on weakness.

Should you have any questions, feel free to reach out.

Have yourself a great weekend,