When the Bank of Canada cut its benchmark interest rate by 25 basis points in early June, news outlets reported that the move was “widely expected by economists and markets” and that forecasts were calling for another rate reduction in July. There is nothing unusual about the way these reports were presented. But the standard, familiar language they used speaks volumes about the pivotal role expectations play in moving financial markets.

Consider this recent quote from veteran economist Mohamed El-Erian, which is packed with emotional language about expectations: "So far, we've had disappointing retail sales,” El-Erian told Fox Business. “We've had disappointing PMI manufacturing numbers, [and] job vacancies were considerably below expectations. We’ve had nothing but negative surprises.” ¹

Policy rate expectations are constantly shifting, as illustrated in the chart below.

Anticipating Rate Changes

In this uncertain rate environment, expectations about the direction and speed of changes in monetary policy can become especially strong catalysts for shifting markets. For example, when the Bank of Canada (BoC) announced in April that it was leaving its target for the overnight rate unchanged, disappointed investors dragged Canadian equities down to their first monthly loss since October of last year. Likewise, when the U.S. Federal Reserve (Fed) decided to hold its federal funds rate steady in late April, a decision that was triggered by an unexpected uptick in inflation, U.S. equities suffered their first monthly decline in six months.

Why did markets respond so forcefully to these rate decisions in April? One possibility is that analysts’ forecasts for rates to remain unchanged were overshadowed by wishful thinking that April would mark the beginning of an interest rate easing cycle, which is generally good for most businesses because it reduces the cost of borrowing. Former Federal Reserve Chairman Alan Greenspan called this type of wishful thinking "irrational exuberance" at the height of the dot-com craze. Three years later that market bubble burst in dramatic fashion.

Projecting Future Earnings

Expectations are not always emotional. Stock prices are largely a reflection of a company’s expected future earnings and growth rates for those earnings. Because these forecasts can vary significantly, our approach to valuations considers a range of possible scenarios.

Scenario number one is our base case, representing a reasonable growth forecast for a company’s earnings. Then we construct best- and worst-case scenarios by introducing different combinations of variables to illustrate various potential outcomes. This exercise is particularly important when valuations are considered high, as they are today, because prices for stocks trading at a premium tend to be punished when earnings growth falls short of the mark.

One of the key variables we examine is the company’s cost of capital, which is a combination of its equity and debt costs, expressed as a percentage or “discount rate.” A company’s expected future earnings stream is reduced, or discounted, by this rate in order to arrive at a reasonable estimate of its current stock price or “intrinsic value.”

The discount rate offers a clear example of how one thing leads to another in the financial world, and how high-level policy expectations factor into stock valuations.

The discount rate is largely determined by the cost of debt, which is in turn influenced by the general level of interest rates, which is heavily influenced by policymakers like the BoC and the Fed. So, anticipating moves by policymakers is an important part of our fundamental analysis.

As you can see, it is possible to set expectations in an objective manner—to a degree. They are an integral part of our research and analysis as we look for companies that trade at reasonable valuations and offer indications that their earnings and dividend growth rates will remain relatively consistent or accelerate. We do this analysis in an effort to meet or exceed the expectations of our clients to help them achieve their financial goals.

 

1. Source: Fox Business, June 5, 2024. PMI is the Purchasing Managers' Index, which measures purchasing activity in the manufacturing sector and is considered a leading economic indicator