Markets
Interest rate cuts in Canada and the US this year have been welcome news to consumers, but investors may be wondering what these cuts mean for markets—especially if they’re taking a look at historical performance. At three major points between the late ‘90s and 2024, the Bank of Canada and the US Federal Reserve raised rates to slow a heated economy and then started cutting interest rates—equity markets reacted and declined by an average of 46% from their peaks.
The Bank of Canada is now on the path to reducing interest rates and was one of the first of the G20 to do so. Similarly, the US Federal Reserve has taken the first step and reduced rates by 50 basis point or 0.50% this week. We explore how longer term markets reacted in the past and discuss how investors can cushion their portfolios from a possible downturn in the market.
As rates start to decline in the US, will the stock market follow?
For the most part, central banks around the world increased interest rates to combat inflation. After three years of tighter monetary policy, which pushed interest rates higher, interest rate cuts are now a reality and monetary policy in North America appears to be easing. Understandably, investors still have concerns—mainly about how the steep increase to rates and their duration at high levels have slowed economic growth.
This lack of growth may impact businesses, leading to a risk of a stock market downturn. This was witnessed the last three times central banks dramatically changed monetary policy and adjusted interest rates—during the dot com bubble, the global financial crisis and the COVID-19 pandemic. Here’s a look at each of those periods.
Three times rising and falling interest rates impacted the market
Source: Bloomberg
1. 2000: The dot-com crash
A period of lower interest rates in the late ‘90s provided an abundance of capital for the technology industry. A variety of new startup companies were benefiting from the increased importance of the World Wide Web as home computer purchases grew exponentially. In 2000, interest rates climbed to 5.75% in Canada and 6.5% when central banks became more concerned about rapid economic growth and the impact of entrenched inflation. The S&P 500 and the Nasdaq peaked in March 2000, and the technology bubble burst—leading to a dramatic decline in the stock market. Central banks including the Bank of Canada and the US Federal Reserve began an easing cycle to help cushion the fallout from many bankrupt technology companies.
2. 2007-2008: Global financial crisis
The years leading up to the global financial crisis will be remembered as a different bubble. This time it was housing. Loose lending policies contributed to a variety of regulatory shortfalls and as the housing market heated up, central banks raised rates to tap the brakes on the economy. Mortgage-backed securities (MBS) and other derivatives associated with mortgage lending in the US collapsed with the housing market and led to insolvency at Lehman Brothers and Bear Stearns. Along with the rapid decline in equity value came a decline in interest rates—effectively lowering borrowing costs and encouraging consumer and business spending/investment—to facilitate growth in the aftermath of the global financial crisis.
3. 2019-2021: COVID-19 Pandemic
The COVID-19 pandemic brought about a unique economic challenge. As businesses shut down, supply chains adjusted their manufacturing to account for the expected decline in demand. With various governments around the world taking different approaches, uncertainty exacerbated product manufacturing while the service industry was shut down in various parts of the world. Equity markets declined as expectation of declining economic conditions resonated through the market. As a result, central banks quickly reduced interest rates to help facilitate economic growth leading to a significant rally in the equity markets.
Cushioning your portfolio from a potential downturn
If investors are concerned about a downturn in the market there are other defensive options, such as the Utilities or Consumer Staples sectors that can act as a buffer in a declining economic and stock market environment due to their necessity in society. It’s important to revisit your portfolio to ensure the strong performance of certain names such as Nvidia, Microsoft or Apple haven’t shifted the sector weights or asset allocation too dramatically. These names can sometimes represent a significant proportion of a mutual fund or ETF and can also be held by a variety of different fund strategies. The importance of revisiting your portfolio to ensure it accurately reflects your risk tolerance is important at all points of the economic cycle.
Quarter-to-date S&P 500 sector returns (July 1, 2024 to Sept. 13, 2024)
Certain sectors are benefiting from expected declines in US interest rates.
Source: Bloomberg
A soft landing is still possible
Central banks enact a delicate balancing act when setting policy interest rates to combat high inflation. They must increase rates enough to hamper inflation levels, while preventing markets from overheating and catalyzing a more severe or protracted economic slowdown (the feared “hard-landing” or “crash”).
We’ve had a dramatic increase in interest rates over the last three years and investors are trying to get a sense of the impact of the rise in rates for the next one or two years. While these effects can be immediately felt through higher interest rates on lending, it is more difficult to measure how these rates will resonate through consumer spending and how businesses have adjusted their spending. Central bankers are hopeful they have achieved an economic soft landing instead of the dramatic economic and stock market crashes we’ve seen in other significant historical downturns.
Final thoughts
Every historical instance of central bank policy changes is inherently unique, such as with the infamous dot-com crash, the 2008 financial crisis and mortgage-backed securities collapse, the COVID-19 market crash—and ultimately where we are today. And, while we’ve seen volatility increase in the market recently, we haven’t had a dramatic market turn comparable to what we’ve seen in the past. Just because rates have been higher for longer and rates are now expected to decline further, it does not guarantee certain future behaviour in equities.
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