Relief

Tiff Macklem’s Bank of Canada has now delivered two rate cuts.

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   By Guest Blogger Ryan Lewenza

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It’s been a challenging time for many Canadians. The combination of sky-high inflation and surging interest rates has stressed the balance sheets and cash flows of many households.

Running some quick numbers, assuming a $500k mortgage with a 25-year amortization period, the monthly mortgage payment increases from $2,240, based on a 2.5% mortgage rate, to $2,908 based on a 5% mortgage rate. This would equate to a 29% increase in the monthly mortgage payment. Add in the rise in prices, with inflation up over 20% since the pandemic, it’s no wonder why many Canadians are feeling the pinch.

A recent survey by Transunion Canada found that 57% of Canadian households said their incomes are not keeping up with inflation, while 32% of those polled can’t even cover their debt payments. Hard times, indeed.

Well, relief is on the way!

This week the Bank of Canada (BoC) followed through with a second 0.25% interest rate cut, with our Canadian benchmark rate falling to 4.5%, from its recent peak of 5%. This 0.5% drop alone will start to help Canadians through lower mortgage and credit rates, but more is coming.

I spent a little time this week on the Bloomberg looking at bond market expectations for further BoC rate cuts. Currently, the bond market is pricing in another three 0.25% cuts by January 2025, which would take the overnight rate down to 3.75%. We were calling for three cuts this year, so it looks like we’ll be pretty close with this forecast.

Canada’s overnight rate and outlook

Source: Bloomberg, Turner Investments

Some clients have asked me why the BoC is cutting rates, especially when they hear from our leaders how strong and resilient our economy is.

Well, first, our economy is not doing great and in fact has completely stalled out. Our economy has grown at an average 0.7% on a yoy basis over the last 12 months. Contrast that to the US, which just grew at 2.8% in the second quarter. And this doesn’t even adjust for our massive population growth over the last few years. Our GDP per capita, which arguably is a more important metric, has actually gone negative, so hardly ‘strong and resilient’.

The BoC and Federal Reserve (Fed) have a dual mandate of stable prices and maximum employment. These are the main drivers behind the BoC rate policies. Let’s review where these stand.

As captured below, inflation has steadily declined in Canada since peaking at 8% in 2022. We’ve had six consecutive months of inflation below 3% and as of last month sat at 2.7% yoy. We’re getting very close to the BoC’s desired inflation target of 2%.

On the employment front, we’ve seen a sizable increase in our unemployment rate since bottoming at 4.8% in July 2022. Our unemployment rate has steadily increased since then and now sits at 6.4%.

So, with inflation slowing, and our labour market weakening, the BoC is completely justified to ease interest rates, and we see more cuts coming in 2025. This relief or stimulus should start to work it’s way through our economy in the coming quarters and we see the potential for our economy to rebound later this year and into 2025. This is one reason we remain optimistic about the TSX stock market over the next 12-18 months.

Our inflation falls while our jobless rate rises

Source: Bloomberg, Turner Investments

Now let’s discuss the investment implications of the lower rates.

We’ve been steadfast in our belief that rate cuts were coming this year (the Fed will likely start cutting in September) and therefore have been positioning our portfolio for this new environment of lower rates.

Over the last year we’ve made a number of tweaks to our portfolio to benefit from this decline in rates. Let’s review those changes and portfolio positions:

• First, we’ve made some material changes to our bond portfolio. When interest rates got down to 0%, and they couldn’t go any further, we switched into short-term bonds, which are less sensitive to rising rates. When rates surged to 5%, our short-term bond ETFs (and we bought a floating rate bond ETF which did very well) held up much better than longer term bond ETFs. Over the last year we’ve been switching out of these short-term bonds and into longer term bonds, as they benefit more from falling rates. So, in a declining interest rate environment you want longer term or ‘higher duration’ bonds and we’re right there.
• Second, late last year we added to dividend paying stocks and REITs. When interest rates rise, dividend paying stocks and REITs often get hit as they have more competition. When GICs and government bonds are yielding 1-2% then a 5% paying REIT looks great. But, when GICs are yielding 5% then REITs don’t look as attractive and they fall in price. This happened last year. We saw this as a buying opportunity as the inverse is true when interest rates fall. Look at the chart below. It shows that REITs are up 23% since last November (around when we added to them) and are now starting to breakout as a result of these rate cuts. We see better days ahead for REITs and dividend paying stocks like banks, utilities and telecoms.
• Finally, one area in particular that we’re positive on is small cap stocks. Small cap companies benefit from declining rates as these companies often have higher debt ratios and use variable debt. As rates drop this lowers interest expense and boosts earnings. We also note how cheap US small caps stocks are. Currently small caps – the Russell 2000 – trade at 15x earnings and 1.9x price to book (P/B). Compare that to the S&P 500 at 22x earnings and 4.5x P/B. So, the S&P 500 is over 40% more expensive than small caps based on P/E.

It’s been a tough go these last few years, and global headlines remain concerning, but relief is coming through the rate cuts. This should help provide a boost to the economy and stock market in the coming months, and dividend paying stocks and REITs should be beneficiaries of the lower rates.

REITs are starting to break out

Source: Stockcharts.com

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.

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Source: https://www.greaterfool.ca/2024/07/27/relief/