The U.S. interest rate hiking cycle is nearing an end. What comes next?

The U.S. Federal Reserve kept interest rates unchanged at its most recent meeting held on
June 19, but it pivoted to a rate cut bias. Specifically, the Fed dropped its “patient” stance
and stated it “will closely monitor the implications of incoming information for the economic
outlook and will act as appropriate to sustain the expansion.” In plain English: they’re
concerned about decelerating trends in the U.S. economy and rising global risks and are
ready to preemptively cut interest rates to keep the economy buoyant. A change in the
direction of interest rates marks an important milestone for the economic cycle and perhaps
the most noteworthy indication that the current cycle may be ending. Indeed, previous
interest rate cuts have been associated with economic and market peaks (see exhibit 1).

Interest rate policy is the primary tool central banks use to facilitate economic growth and
contain inflation. Over the course of a normal economic cycle central banks increase interest
rates as the economy accelerates and cut interest rates when economic growth
deteriorates. Some may be surprised that the next move in interest rates may be lower
given that the U.S. central bank rate is currently sitting at a paltry 2.5% (the next Fed
meeting is July 31). At the beginning of the year, we expected the interest rate path would
be influenced by macro factors such as U.S.-China trade negotiations, with a successful trade
deal being a catalyst for modestly higher rates. However, the souring of trade negotiations
and the resulting impact on consumer/business confidence has increased the odds of an
interest cut(s). Furthermore, the impact of nine consecutive 0.25% rate increases since late 2015 has started to show some early signs economic fatigue. Some important economic
indicators, such as consumer and business confidence, employment, and new home sales
have been sliding recently and likely point to weaker GDP growth ahead. Consensus
forecasts suggest that corporate profits are also expected to grow at a decelerating rate for
the balance of 2019.

Bad news is good news?

Having already priced in the 2018 corporate tax cut, the U.S. equity market has been looking
for further catalysts to propel markets higher. The prospect of lower interest rates, which
would sustain consumer/business spending and possibly extend the current business cycle,
is one such catalyst that has driven the equity market higher in recent weeks. Meanwhile,
movements in the bond market, namely declining long-term bond yields, are sounding a
cautionary tone for what lies ahead. The spike in gold bullion to a six-year high appears to be
corroborating the bond market’s message. The simultaneous rally in equity and bond
markets, on the same set of economic data, is not sustainable in our view and eventually
one of these markets may have to capitulate. In the short-term we think equity markets can
sustain current levels due to the dual prospects of a U.S./China trade deal and lower interest
rates, but we also recognize that these catalysts are already partially priced into current
stock prices.

With so much of the market’s direction now hinging on interest rate policy, every major
piece of economic data now carries more weight than at other times in the cycle.
Counterintuitive as it may seem, weaker economic data is now being applauded by bond
and equity markets as it increases the likelihood of interest rate cuts. Similarly, good
economic news is being frowned upon. This was evident on Friday July 5 as the U.S. reported
stronger than expected June employment data and the market responded negatively. We
continue to advocate a defensive portfolio strategy at this late stage in the economic cycle,
reflected primarily by lower equity exposure and greater concentration in defensive sectors.

Same same but different

The Rosedale Group joined Wellington-Altus Private Wealth in May and has been
transitioning clients to our new platform. We are truly grateful for the overwhelming
support and congratulatory messages from our clients. Our forward-looking investment
strategy and commitment to service will not change. What has changed (and will change
again!) is our address. We are happy to announce that starting in early-2020 we will be
moving back to our namesake neighbourhood and look forward to welcoming you to our
new office located at 10 Alcorn Avenue.

In addition to enhanced technology platforms, we are excited about the broad universe of
investment alternatives at Wellington, particularly those that are uncorrelated to the equity
market. We have been conducting our due diligence on several of these investment
opportunities in the context of client portfolios and look forward to discussing them with
you.