All this fuss over 25 lousy basis points.
What has to be the most-anticipated interest rate cut in history has consumed financial markets of late, with speculation running wild over when the U.S. Federal Reserve will start to walk back policy rates from their 23-year high.
This past Wednesday was a Fed Day, as they have come to be known, when the central bank announces its policy plans.
Investors weren’t expecting the Fed to make any big moves just yet. But there was an intense appetite for any signals about when that coveted first cut will be coming. It’s a question that is monopolizing financial media, market research and investor sentiment.
Blowout U.S. jobs report tempers market views on when BoC rate cuts will begin
Do we really need to care this much? Sure, there is symbolic significance in play. The Fed lowering its benchmark rate would mark the beginning of the end of the higher-for-longer interest rate environment that began in 2022. And it would start the process of reversing what was one of the boldest rate hike campaigns in history.
You could even argue the first cut would represent a victory of sorts in the fight against inflation.
But we’re talking about a 0.25-percentage-point move, the mere timing of which is causing great swings in global stock prices.
Look at how Fed Day played out in the markets. First came a press release, which noted that a rate reduction would be unlikely before the Fed “gained greater confidence that inflation is moving sustainably toward 2 per cent.”
The mood quickly darkened and stock benchmarks dived. Hope was soon restored, however, when Fed Chair Jerome Powell said that the last six months of inflation data were right where they need to be. Cue the stock rebound.
Then came the gut punch, when Mr. Powell said a March rate cut was “not the most likely case.” With that, the S&P 500 index sagged to a 1.6-per-cent loss – its worst trading day since September. The bad vibes spread to the Canadian market, with the S&P/TSX Composite Index losing 1 per cent.
To cap off the emotional roller coaster, by the end of the trading day, the market was somehow back to pricing in a March rate cut, despite Mr. Powell’s unusually direct guidance to the contrary.
“This stuff makes you stupid. Own good companies,” Barry Schwartz, chief investment officer at Toronto-based Baskin Wealth Management, wrote on Twitter. It’s a case for focusing on company fundamentals over the mood of the market.
It seems like the last couple of years has made central bank watchers of us all. It makes sense when you think back to the colossal rate hikes of 2022, from which it was impossible to look away.
In an effort to contain the inflation crisis, the Fed and the Bank of Canada increased policy rates by roughly five percentage points – the equivalent of 20 rate hikes of 25 basis points in a little over a year. These were monumental moves to a system accustomed to near-zero interest rates.
We’ve been captivated ever since. Economic data is viewed through the lens of how it might affect interest rate decisions. Good news is bad news. On Friday morning, U.S. job creation for January came in hotter than expected, which wiped out what was setting up to be a strong market opening after some blockbuster Big Tech earnings reports.
But lost in the noise of Fed-induced sentiment convulsions is what ultimately sustains the stock market: company profits.
Earnings drive long-term stock gains
Contribution to S&P 500 index returns
Dividend growth
Earnings growth
Valuation growth
40%
30
20
10
0
-10
-20
-30
2019
2020
2021
2022
2023
10-year
20-year
the globe and mail, Source: purpose investments; bloomberg
Earnings drive long-term stock gains
Contribution to S&P 500 index returns
Dividend growth
Earnings growth
Valuation growth
40%
30
20
10
0
-10
-20
-30
2019
2020
2021
2022
2023
10-year
20-year
the globe and mail, Source: purpose investments; bloomberg
Earnings drive long-term stock gains
Contribution to S&P 500 index returns
Dividend growth
Earnings growth
Valuation growth
40%
30
20
10
0
-10
-20
-30
2019
2020
2021
2022
2023
10-year
20-year
the globe and mail, Source: purpose investments; bloomberg
The stock market is a moody beast. Short-term returns bounce all over the place based on the whims of investor sentiment. But over long periods of time, those ups and downs smooth out, giving way to a remarkably stable upward trend. In the case of the S&P 500 index, the average return has been roughly 10 per cent a year dating back nearly a century.
Earnings growth is the overwhelming force lifting stock markets over time. Total returns in the S&P 500 over the past 20 years have been almost entirely driven by earnings, with a bit of a boost provided by dividend growth, according to a recent report by Craig Basinger, chief market strategist at Purpose Investments.
In any given day, month, or even year, however, it’s a different story. “When you look at shorter periods, the importance of earnings growth fades, and the mood of the market dominates,” Mr. Basinger wrote.
Last year, for example, was a strong rebound year for U.S. stocks, with the S&P 500 gaining 26 per cent. Breaking down that return: 2 per cent came from dividends, 6 per cent from earnings growth, and 18 per cent from a rising market multiple, the Purpose report said.
That multiple, or price-to-earnings ratio, tends to rise and fall based largely on investor emotion. In 2022, when sentiment was fouled by the outbreak of inflation and jumbo rate hikes, a falling market multiple was solely responsible for dragging the S&P 500 to an 19-per-cent loss on the year.
Should you worry about sentiment at all? If you’re investing for the next year, then the market’s mood swings matter a lot. But if you’re in it for the next 10 or 20 years, it’s all just noise.