What to expect from equity markets if interest rates continue to decline

Generally speaking, a lower interest rate environment should be positive for equity markets. High quality stocks with sustainable and predictable dividends should see an improvement in their valuations, and longer-duration growth equities should also benefit.

Let’s consider Canadian banks as an example. When Canadian banks announced earnings earlier this year, by and large they were better than expected. Although the banks continued to add to loan-loss provisions, overall credit conditions remained stable. And while we don’t see any significant concerns in their loan books, we feel the lower rates will provide a relief valve for the banks. Canadian bank capital positions remain strong and provide confidence that they can weather any economic uncertainty or surprises going forward.

When we position our investment portfolios across equity management styles, we try to construct them with a bias to overweighting companies generally less affected by changing interest rates. These resilient companies tend to be service-oriented, have high quality characteristics, strong balance sheets and superior pricing power. These attributes should empower them to outperform through the cycle. That being said, there will be some Canadian companies that will be more impacted by rate cuts than others — especially if Canada continues to lead the U.S. in making the cuts. For example, small-cap and expensive high-growth companies tend to see their valuations get rated higher as the lower-discount rate boosts long-term cash flows.

The BoC’s (Bank of Canada) decision to cut rates will impact the valuations of many interest-sensitive stocks and sectors. This has historically contributed to a rotation in sector leadership in the market. Traditionally, real estate, utilities, telecom, pipelines and financial services benefit from falling rates. In the U.S., the Federal Reserve is moving to cut rates — likely later this year — which will also be an important event for market sentiment.

Our dividend-focused and value strategies seek out high quality businesses with attractive valuations and strong dividend yields. In the current market the best total return opportunities have been in many of the interest-sensitive sectors. In a falling interest rate environment, that steady and predictable dividend yield and growth will become more attractive to income investors.