The Long-Awaited Announcement
The time has finally come to lower policy rates. After spending fourteen months at a peak rate of 5.5%, the U.S. Federal Reserve (Fed) announced a 50bps cut in the fed funds rate to 5.0% in September. This marked the Fed’s first rate cut of this business cycle and, while not exactly on a predetermined path lower, its intention is to ease off the brakes as long as inflation continues to trend within its target zone of 1% to 3%. The Bank of Canada (BoC) is already a few announcements ahead, having lowered its overnight rate from 5.0% to 4.25% over three meetings in June, July, and September. The long campaign against inflation appears to finally be contained for the time being, with year-over-year headline CPI for the U.S. and Canada measuring at 2.5% and 2.0%, respectively, for August. This is a wide contrast from the peak inflation rates of 9.1% (U.S.) and 8.1% (CAN) experienced back in June 2022. But more importantly, after undershooting the 2% long-term trend for a decade following the 2009 financial recession, inflation has finally recovered. As it normalizes further, restrictive policy rates require adjustment. With price pressures contained for now, central banks have shifted their focus to the labour markets in an effort to engineer a soft landing.
Source: Bloomberg, QV Investors
Time for “Current Income” to Shine
One argument shared amongst strategists to explain why the economy has been so resilient in the face of elevated policy rates has been the mountain of excess household savings that arose from the pandemic. However, estimates suggest this horde of capital (“past income”), which had arisen from outsized government fiscal transfers and unspent savings, is now depleted, leaving just pay cheques (“current income”) to sustain the economy. Recall, consumers account for two-thirds of U.S. gross domestic product, so the labour market is an important component within the U.S. economic engine.
Source: Federal Reserve Bank of San Francisco, QV Investors, Aug 2024
With that said, the labour market is rebalancing after posting very strong and healthy readings over the last few years. Indicators still point to a robust employment backdrop, but the trend is moderating. Job openings, a measure of labour demand, returned to the pre-pandemic level of 4.8% in August. But, importantly, the ratio of job openings to the unemployment rate also continues to normalize, reaching 1.1 as was last seen in 2018. September’s jobless rate of 4.1% has been remarkably resilient but has been slowly softening, albeit still at a healthy level. However, with business bankruptcy filings (reorganizations) seeing an increase as of late (Q2 2024), perhaps it is a matter of time before this labour market will begin to show signs of weakness.
Source: Bureau of Labor Statistics, QV Investors
Source: Bloomberg, QV Investors, Q2 2024
The Calculus is not so Straight Forward
Central banks are in a shaky spot. With policy rates so elevated despite softening inflation, central bankers are at risk of maintaining restrictive real rates if they lower rates too slowly. The real policy rate (nominal policy rate minus inflation) is important because it reflects the actual cost of borrowing, after factoring for inflation. If inflation continues to moderate (a big IF), then the slow and steady glide path of normalizing policy rates may simply be too cautious as the real cost of borrowing remains unjustifiably high for a quieting economy such as Canada. The BoC will need to intentionally lower rates at a quicker pace than inflation declines to avoid a policy error. Adding to the already complex equation is the fact that changes in monetary policy work with a lag, which further compounds the risk of a policy mistake during this cutting cycle.
Source: NBC Economics and Strategy
Equities Climb the Wall of Worry
Despite these concerns, equity markets are unfazed and continue to post strong returns. Year-to-date, the S&P 500 returned 22.1% (in USD), and the S&P/TSX Composite posted 17.2% (in CAD). Total return from common equities can be disaggregated into earnings per share growth (EPS), changes in the price-to-earnings (P/E) multiple, and dividends per share received. The chart below shows the return contribution from the first two components year-to-date in U.S. dollar terms. The good news for investors is that year-to-date returns are attractive and are supported by EPS growth, which we believe is a more sustainable form of return contribution. However, multiple expansion (what the market is willing to pay for a dollar of per-share earnings) has also been a major contributor to returns. As long-term investors, we appreciate the benefits multiple expansion brings, but we are also cautious about the eventuality of multiple contractions. After all, markets do not move in a straight line. The belief that multiple expansion will continue to perpetually grow is what typically feeds FOMO (fear of missing out) and overextended bull markets.
Source: Scotiabank GBM Portfolio Strategy
Is the Price Right?
As value-conscious investors we are always questioning the assumptions embedded in current market prices (price-to-earnings, equity risk premium, credit premium) for our equity and bond investments. Fluctuating investor assessments of business franchise quality, balance sheet risk, as well as the persistency and growth of earnings, constantly cause market prices to oscillate above and below fair value. While there are many embedded considerations, EPS growth is arguably the most influential. Although we have yet to close out on 2024, the consensus EPS growth estimate for the S&P 500 is tracking at a healthy rate of 10.1% year over year, as shown below. Looking further, the EPS consensus estimates for 2025 and 2026 are also quite optimistic at 15.1% and 13.0%, respectively. While the chart shows it is typical for forward growth estimates to start strong and be revised lower as the year progresses, EPS estimates for the next two years are unusually outsized compared to prior years. This is especially notable considering that we are more likely in the later stages of this economic cycle, versus earlier stages when EPS growth is typically this strong.
Source: Scotiabank GBM Portfolio Strategy, QV Investors
Below is an updated forward P/E valuation chart of the S&P 500. We have discussed this in the past and the same themes are intact. Index concentration remains high, with the top ten stocks accounting for 35.8% of the total market capitalization of the index. These top ten stocks boast a collective P/E of 30.5x versus the remaining 490 stocks at 18.4x. While we acknowledge that the top ten stocks are pulling the overall market higher, we also recognize that the remaining stocks are still relatively expensive when compared to the S&P 500’s long-run median of ~16x. If current EPS growth estimates do end up being overly optimistic, then cold reality will catch up with expectations (market valuation) and set the market up for a repricing event.
Source: Scotiabank GBM Portfolio Strategy
Clarity for the Long Term
“Everybody in the world is a long-term investor until the market goes down.”
– Peter Lynch
Today’s macro economic landscape is unusually complex – from wars to elections to recession concerns, the volume of scenarios seems endless. Against such uncertainty, it is important to remain focused on investment objectives and the clarity provided by a time-tested process and philosophy.
Investing is a marathon. The power of compounding requires time to work. With time, company earnings will grow, economies will expand, and markets will ebb and flow. Markets are emotional and therefore cyclical in nature as expectations are constantly revised and repriced as new information is incorporated. Daily newswires cause commotion and confusion amongst the unfocused.
A long-term investment mindset can provide clarity in a confusing and jarring marketplace. It starts with security selection. This includes but is not limited to the assessment of business franchise strength, the management teams we align ourselves with, and the balance sheets we are exposed to. Controlling what we can from the bottom up has always been a key focus of our investment process.
Below are some tips we have found to have been valuable for maintaining focus and never losing sight of the end goal through all phases of the market cycle:
- Trust in the franchise strength of great quality businesses. Their competitive advantages are likely to last the test of time and even grow through challenging economic periods. You bake resilience into your portfolio simply by investing in strong franchises at reasonable valuations.
- Recognize and accept that markets are cyclical. Being prepared ahead of eventual corrections can be a powerful tool when market participants are acting emotionally. A well-vetted inventory list puts you in a position of strength to be opportunistic when valuations disconnect from fundamentals.
- Look through the valleys in sentiment. Market corrections are temporary. Those who have lived through market turmoil understand the power of positive thinking when market sentiment is at its bleakest.
- Recognize that the opportunity set available today is not permanent and that different opportunities will reveal themselves in time. Avoid the temptation of being an investment glutton at all costs. Market valuations can come down as swiftly as they move up.
Our investment teams are constantly building resilience into their strategies – from upgrading quality and margin of safety, to refreshing inventory lists. Maintaining a long-term focus means trusting in the earnings power of our investments, but also preparing for the worst. Markets don’t move in a straight line, there are wiggles along the way. Choosing to be proactive instead of being reactive brings clarity to emotional situations, helping put the odds in our favour over the long term.