I See a Rate Cut And I Want it Painted Green

While this week is no different than your typical seven-day, 168 hour week, it was still a special one. On September 18th, for the first time in two years, the Federal reserve cut interest rates.

Background

For those who needed a refresher, the world went through a bit of a shock when having to respond to Covid-19. We experimented with lockdowns, which started March 2020 and resurfaced sporadically across the world for another two years, which were disruptive enough in their own right. When we were not locked down, however, businesses were operating at a reduced capacity; restaurants could only seat half their guests and assembly lines could only have so many employees working it all at once. What this meant was that the goods and services that we could offer, collectively referred to as supply, would be reduced significantly. This disruption in supply was so severe, that four years later, we still feel some consequences of this even if the majority of the supply chain has returned to normal.

The temporary and reoccurring disruptions to our normal activity, disrupted many people’s and businesses’ income streams. To offset this disruption, central banks aggressively dropped interest rates and governments spent indiscriminately. This fiscal and monetary generosity, however necessary it was initially, was a bit too generous and lasted a little too long with the consequences being that aggregate demand (that is the demand that each of us have for restaurants, travel, shopping, etc) did not drop and even increased a little.

Economics 101: when demand exceeds supply, prices increase. Rapid increases in prices are what we refer to as high inflation.

The Response

To cool economic demand sufficiently to a point where supply could catch up, central banks rapidly increased interest rates to their highest levels in 20 years. This was a risky move as consumers and governments were significantly more indebted than they were 20 years ago; we had no idea if our battle against inflation was going to come at greater cost. Many had seen the economic ‘soft landing’ scenario (one where inflation returns to more tolerable levels without plunging the economy into recession) as close to impossible to achieve.

Two years into the rate hiking cycle, the economy and consumer have proven to be resilient. While inflation has been a thorn in the side for everyone, we haven’t witnessed any mass suffering; no rapid spike in unemployment, no jump in mortgage defaults and the stock market has performed admirably throughout. Economic activity slowed down to a point where inflation approached the 2% target held by both the Fed and the Bank of Canada.

The Rate Cuts

The Bank of Canada had already cut rates three times this year, showing confidence when it comes to their battle on inflation but also casting doubt about the country’s economic strength. The American economy has been the bright spot in a world of converging fortunes, however, it too has decelerated over the last year triggering recession fears earlier this summer. With inflation at 2.2% and unemployment creeping up to 4.2%, the Fed was reminded of its dual mandate of stabilizing pricing and maximizing employment; on Wednesday, they announced a 50bps rate cut which was seen as a mild surprise for markets.

The debate between 25 or 50 bps cut raged back and forth throughout the summer months; some thought the Fed was already late and that a 50bps cut would at least speed up the process when it came to responding to economic slowness while others were not entirely convinced that the battle on inflation was won. Ultimately, Mr. Powell and co. saw this rate cut as a recalibration of policy which responded to both elements of their mandate.

The Implication

The economic impact of interest rate changes are lagged; it takes about 12 months to feel the effects. Some industries which are more rate sensitive, like the real estate sector, may see the impact more rapidly but for the most part, it is important to anchor expectations of an immediate pick up in economic activity. What this does signal for consumers and businesses alike, is that the future cost of doing business will likely be lower and should encourage more investment, consumption and risk taking. The psychological impact of this rate cut should be felt quickly; the markets needed the Wednesday afternoon to digest the rate cut but ended up rallying Thursday. Over the next few weeks, equity valuations will also see change as lower interest rates increase valuation multiples.

Finance 101: equity valuation is the discounted value of expected future cash flows. In simpler terms, the price of a share is the sum of estimated future profits valued in today’s dollars. Think of it in this way: when interest rates are high, and money is ‘expensive’, money today is more appealing than money tomorrow. As money becomes less expensive and more abundant, future money increases in value. High growth companies' valuations are more sensitive to their future earnings growth and have a strong chance of benefitting from this and future rate cuts.

Final Thoughts

25 bps, 50 bps, it did not really matter to us. What’s most important is that inflation fears are taking a backseat (although they should not be entirely ignored) and with the cost of capital going down, economic activity should see a little bit of a pickup. We also believe in the theme of divergence; in a slow growth environment not every business will flourish. The businesses who have a well thought out plans and the ability to execute on said plans will be the winners in this environment; our job here is to figure out who’s got it right.

Healthy Distraction

I attended the Gina Cody School’s Dean Homecoming reception last night at Concordia University. There, we were treated to a fireside chat with Concordia alumni John Sicard (CEO of software firm Kinaxis) and Bob Courteau (senior board member at Kinaxis).

Beyond the life and business lessons that these gentlemen had to share, these events are a fantastic showcase for the University. Here you have the CEO of a successful, publicly traded company going back to his alma matter to give back in the form of time and access. While there are many other Canadians who give back to their schools, we can afford to do a lot more to support our educational institutions.

Whether you graduated from a university, college, trade school or high school, there is always a new generation of students that also need to figure it all out for themselves. Although some schools have more resources than others, there’s always more we can offer to this generation. If you have time to offer, maybe you can volunteer and fundraise. If you have wisdom to share, take on a mentorship role. If you have some spare change, redirect some of that to a school that was there for you when you needed it.

For those interested, Concordia offers many of these types of events which are free to alumni to register and attend. Keep an eye out on your email inbox or occasionally visit the alumni relations website; there may be a guest speaker that would appeal to you!

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