Interest rate cuts: 5 ways to prepare your portfolio

Article content

After much angst over inflation, the weaker economy in this country finally prompted the Bank of Canada to cut its interest rate by 0.25 per cent, but what now? What should investors do next now that a cut is finally official?

Well, first, keep in mind that the rate move was very much widely anticipated. Stocks and the market have a good way of pricing in expectations well ahead of time. Thus, we would certainly not suggest doing anything dramatic to a portfolio since the rate cut is likely already reflected in the valuations of securities.

Article content

But investors can still look to potentially tilt their portfolio in certain ways to position themselves for possible longer-term gains, especially if the first rate cut sets off a series of cuts. Let’s look at five strategies to use in the new rate regime.

Dividend stocks

Dividend stocks got crushed in 2022 when inflation soared and interest rates followed. Then, costs rose and earnings dropped at some stalwart dividend companies such as BCE Inc. and Telus Corp. It got pretty ugly out in dividend land. BCE — the classic widows-and-orphans stock — is down 18 per cent over the past year. Some orphans might be going hungry.

Article content

Now, a rate cut won’t help all companies. Those with fundamental problems will still have them. But it should be positive for dividend stocks in general. For example, with high debt levels and high dividends, utilities are particularly sensitive to rates. The S&P/TSX composite index utility sector is still down 0.74 per cent this year, but is up 12.4 per cent off its low, and should be poised to do better as rates drop.

Mergers and acquisitions

Frankly, we are almost not keeping up with the merger news these days. In the past month or so, Park Lawn Corp., Canadian Western Bank, Cloud MD Software & Services Inc. and Nuvei Corp. have all received takeover offers or decided to privatize. These are not all just related to interest rates, but the prospect of lower interest rates will certainly encourage more M&A.

Article content

Article content

Canadian stock market valuations remain low (sigh) and lower rates will encourage buyers to make a move while prices are cheap. We would expect a lot more M&A activity this year as confidence returns to the market now that the inflation-boogey man has been put back in the closet.

GICs

As stock market guys, we don’t talk much about guaranteed investment certificates, but if an investor wants absolute security (for amounts up to $100,000), there really is no better option. Rates for one-year terms are currently about 5.5 per cent if one shops around. That may not sound like much, but with zero risk, it’s not bad. It beats the year-to-date return of the S&P/TSX composite, at least.

But as rates drop, so will GIC rates. If an investor wants to protect some cash, we would suggest buying GICs sooner rather than later. Two-year GIC rates are already moving lower, as companies anticipate more rate drops and price accordingly.

Long-term bonds

The bond market has been horrible now for several years. Bonds are highly sensitive to rates, and when rates spiked upward, bonds got crushed. Bonds are not supposed to lose money for investors, but they sure did in 2021 and 2022, and (almost) in 2023. Case in point, the $7.2-billion iShares Core Canadian Universe Bond Index ETF’s annualized five-year return right now is a blistering 0.01 per cent. Ouch.

Article content

But bonds can quickly react to rate cuts, and we certainly would expect a better return from bonds over the next five years than has been achieved during the past five years. The bond ETF above, for example, is up 1.75 per cent in the past month alone, providing some much-needed relief for tapped-out bond investors.

Growth stocks

The pain of 2022 is still fresh in our minds. We saw hundreds of companies report great earnings growth, only to have their stocks crushed. It was disheartening. But that’s what higher rates and higher inflation do to growth stocks. With higher rates, the future earnings of companies get discounted much more. Thus, the faster a company grows, the more of a discount it gets if investors are focused on ever-increasing interest rates. It was ugly out in growth land, and even uglier in small-cap growth land.

Recently, though, growth stocks are behaving better. The iShares Russell 2000 Growth ETF is now up 3.4 per cent this year. Nothing to write home about just yet, but it is up a blistering 27 per cent since it bottomed out late last year. There is still, of course, a big investor focus on the Magnificent Seven, but growth stocks should continue to improve as rates fall. As a bonus, growth stocks are also often the subject of M&A activity, as discussed above.

Peter Hodson, CFA, is founder and head of Research at 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. He is also portfolio manager for the i2i Long/Short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/Short Fund may own non-Canadian stocks mentioned.)

 If you like this story, sign up for the FP Investor Newsletter.

Bookmark our website and support our journalism: Don’t miss the business news you need to know — add financialpost.com to your bookmarks and sign up for our newsletters here.

Article content