Cutting Interest Rates Won’t Change Much

I’ve gotten a number of questions about interest rates recently, and I assume there are more lingering in the minds of our clients and community that I haven’t been asked yet.

So here’s what I think in a nutshell:

• The Fed cut rates because the economy is weakening.
• It won’t change the way we invest or the nature of economic value.
• Our income strategy is well suited for these times.

But I think quite a few things, so here is a more extended Q&A.

If it prompts more questions, send them in!

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What’s your take on Federal Reserve interest rate policy right now? Are they heading toward a series of rate cuts?

The Federal Reserve is and has always been data-dependent, which means they are responding to the underlying economic reality in an adaptive way. There has been some criticism that they have been a little slow to cut, but I think people need to understand that rate cuts are not something to get excited about. They’re a symptom of a weakening economy! So, I expect that if we continue to see signs of developing weakness, we will continue to see cuts, but I would be shocked if they depart from that data-dependent framework.

What was your reaction to the Fed’s decision to cut rates by 0.50%, higher than the typical 0.25% reduction?

I think they did their job. The markets would have rebelled if they didn’t get some kind of concerted action and a tangible response to the criticism that the Fed has been behind the curve in the economic cycle. It doesn’t really factor into the way that we view companies or the way that we see the world, except that we are grateful to have a prudent central bank that acts in a disciplined way to advance its dual mandate of managing inflation and unemployment.

What will a rate cut (or cuts) mean for stock market investors? Any big changes?

We’ve seen a rally in some of the more interest rate-sensitive, lower quality companies that tend to have a lot of debt. But for most long-term investors, it’s insane to be predicating investment decisions on reading the tea leaves and trying to see what a couple of guys in Washington are going to do in the near term. The heart of building portfolios is finding fundamental economic needs addressed by good companies and owning them throughout whatever may come. That is not going to change because of an act of the Federal Reserve, no matter what the action.

How will the rate cut impact various sectors like housing, loans, and savings?

This is where the impact of the Fed’s action is really going to be felt. A lot of loans and savings products are floating rate, which means that when interest rates change, so does the yield that savers receive and borrowers pay. I know a lot of households are feeling anxiety right now, and it’s hard to imagine that a slightly lower interest payment won’t be helpful at the margin.

On the saver’s side of things, there’s likely to be increased concern about how to generate income from capital. But it will remain possible, and it’s important to remember that we’ve been through a period of really low interest rates that lasted for most of my adult life, so we will get through this.

On the corporate side of things, a lot of lower-quality companies have effectively gotten a reprieve from the lowering of interest rates. That’s because they often carry large amounts of debt, and the reduction in interest rates flows almost directly to their bottom line. I expect that will be a relatively passing phenomenon. I don’t consider that to be a way to build durable value.

People who are in debt, especially the most indebted folks, are breathing a small sigh of relief for sure.

How will the rate cut affect the average American?

I’m not sure the rate cut will affect the average American, but the conditions that gave rise to it certainly will. The Fed was pointing to increased risks to the unemployment outlook in their release, and it’s hard to imagine that not affecting the average American. The government support during Covid led to household balance sheets that were unusually cash-rich for the United States, and that effect has largely subsided by now. The money has been spent.

Against this backdrop, a lot of people are having a hard time getting by. We see that the most indebted folks are really having a tough time. And they’re not indebted because of moral failure; they’re indebted because it’s hard to make ends meet.

That creates a precarity that tends to pervade how one sees the world. And so I think at a very deep level, every American has been affected by this underlying reality.

Should market investors look for opportunities during a rate cut phase? If so, what stock market opportunities might work for them?

Investors should always be looking for opportunities. That’s how we keep our portfolios fresh! This is a business where you have to kill your darlings (sell positions you like) sometimes in order to stay disciplined, which means it’s important to be continuously looking at what else you could own instead of only focusing on the things that you currently own.

We’ve been finding significant opportunities overseas. A lot of European industrial companies are regarded poorly by international investors, but we find that they are often very high-quality companies trading at compelling valuations with an acute appreciation of their stakeholders’ needs. Over the course of the last couple of months, we’ve been able to upgrade and upgrade and upgrade our Growth portfolio (our flagship long-term investment strategy) to the point where it’s trading at a cash flow yield that’s more than five times that of our index. Those opportunities are out there!

We also manage an income strategy that has had a really excellent couple of months of performance by investing in preferred stocks, pools of loans, and longer-maturity corporate bonds. I expect that approach will continue to pay dividends both figuratively and literally.

What about bank savers (CDs and money markets)? What does a rate cut or two mean for them?

I generally don’t think that long-term investors should be using bank savings products for a couple of reasons. First of all, CDs in the best cases generate rates of return that are not much higher than the inflation we’ve experienced. It can be riskier, but for people who genuinely are trying to put money away for a longer period of time, I think it’s kind of foolish not to get the capital markets involved at least a little bit.

I think that’s because CDs are basically contracts in which the bank wins no matter what interest rates do. If rates go up, they’ve locked you in at an existing rate. If rates go down, you don’t get any mark-to-market appreciation from the value of your investment. All you get back is your principal instead of interest. Whereas with a bond, if you took out an 8% bond and rates went from 8% to 6%, you would be sitting on a hefty gain if the bond was relatively long-dated.

That’s not to say bank savings products don’t have a purpose, but that purpose is often to serve very specific short and intermediate-term needs, like saving for a down payment on a house or putting money that you’re going to spend on tuition somewhere so it gets a little bit of yield before it gets sent out the door. Those are appropriate uses for money market funds and CDs. But I find that many bank savers I meet do not explore these other options, and they really should.

Any advice for investors concerned about falling interest rates and the impact on their investment and retirement portfolios?

We’re going to get through this. There are still ways to generate income. There are still ways to generate capital gains. Those will not change because of interest rates.

But with that said, a lot of investors are operating strategies that are really more mismatched collections of tactics than truly well-thought-out investment portfolios. In general, I think fretting a lot about Fed decisions, elections, or anything like that is a symptom of an underdeveloped investment strategy.

So anybody who’s got these concerns should either call up their advisor and have a conversation or get one, because it’s likely that there is a speculative element in their portfolio design that they may not even be conscious of.

But I mean, think about it. Interest rates were pretty close to zero for most of my adult life. This moment of real tangible interest rates has been a nice breather. But it’s a departure from recent history, and I worry that it may have deceived some investors into thinking that risk-free returns exist. The reality is that they don’t. Even if the risks are minimal, they still exist.

It can be kind of scary to hear that because it implies that we live in this very flimsy world. But I don’t think that’s the case. Throughout history, humans have found ways to respond to challenging situations and generate shared value in the process.

That basic engine is fundamentally human. It’s what’s behind all of the investment returns that are generated in your portfolio. That adaptive force is innate to markets, and I think understanding and appreciating it gives us a real sense of their beauty and resilience.

How do you think the Fed’s recent rate cut will impact inflation, the job market, and GDP growth?

I think it will help keep inflation and expectations under control and provide a little bit of support to the job market at the margin. But I don’t think it’s going to be a material factor in driving GDP growth. That’s not the point of Federal Reserve policy. They are trying to minimize inflation and control unemployment, not manage growth. There’s a clear interplay between what they do and GDP growth, but it would be concerning if they began to make decisions with an eye towards short-term economic numbers.