How Can You Benefit From The Interest Rate Cuts?
How Can You Benefit From The Interest Rate Cuts?
We are reaching a turning point in this credit cycle. Small businesses and individuals had hard time to access credit in the last two years. This is about to change.
Market moves in cycles and there are two types of extreme attitudes:
1) When the Fed hikes interest rates, you see fear mongers:
“Recession is coming, sell everything!”
2) When the Fed cuts interest rates, you see hope merchants:
"Stock market boom is coming!”
These two are equally faulty ways of looking at the markets.
You can lose huge amounts of money by buying into either one of these calls.
The right way to look at it? You have to understand what it means.
So, join me in this post and let me explain how you can benefit from the interest rate cuts:
Credit Cycle Has Reached A Turning Point
Market moves in cycles but there is no one general cycle that governs everything.
There are smaller cycles: Profit cycle, risk cycle, psychological cycle…
They together create the big economic cycle.
Among those smaller cycles, perhaps the most influential one is the credit cycle:
Credit cycle bears on the investing decision of companies and individuals. More accessible the credit, the more investments are made.
Higher investment means faster expansion which means more profits.
Increasing profits and availability of consumer credit keep hopeful.
As you see, the credit cycle has a bearing on the profit cycle and psychological cycle so its effect on the greater economic cycle is leveraged.
Credit cycle also follows the same path as the greater economic cycle:
Peak of the credit cycle usually coincides with low interest rates and an extremely optimistic environment.
Low interest rates encourage getting credit because making 2% on the principal is easier than making 5% on the principal.
As it’s easier to generate excess return, businesses get more credit.
As debtors pay easily, lenders demand less risk premium.
This phase is naturally followed either by high inflation or worse-a financial bubble.
Inflation happens because when access to credit is easy, demand increases and suppliers can easily increase their prices.
Bubble happens because lenders overly ease their lending criteria and end up lending to unqualified people.
These two can happen together or individually.
Normally, inflation ticks up first and the Fed raises interest rates as a response.
As the interest rate goes up, default rate adjustable loans made to unqualified people increase and the unraveling starts.
Widespread fear ensues, lenders become extremely risk averse, investment drains so the economy slides into a recession.
Even when inflation is not followed by a burst of a bubble, lenders can become overly risk averse as the Fed hikes rates as they know a bursting bubble could follow. This again results in drained investment and recession.
As the Fed cuts rates to avoid or to get out of the recession, lenders start asking for less risk premium again. This repeats itself over and over again.
We talked about a risk premium, but “risk premium” relative to what? It’s relative to the risk-free investment, which is US Treasury Bonds.
The difference between the interest lenders ask for and the interest on treasury bonds is called the “credit spread”.
In the spread above, ground zero is the risk free instrument (government debt) and others are the premiums requested for corporate bonds of different classes with a comparable maturity.
As you see, spread widens significantly in:
2000s
2007-2009
2016 and 2020
These are the recessions (2001, 2008, 2020) and economic downturns (2016) the US went through in the last 20 years.
As you see through the end of the 2022, cycle spread started to widen as economic actors forecasted a recession because of the rate hikes, so it got harder to get a credit.
This expectation hasn’t materialized so far and the Fed is set to cut interest rates today.
As you see in the chart, CCC credit spread consistently went below 10% as the Fed cut rates following the 2001, 2008 and 2020 recessions and also 2016 downturn.
Now that the Fed is starting to cut, the spread will shrink because lenders will ask less premium. Credit will become more accessible.
Now that we understand where we are likely standing in the credit cycle, let’s look at how we can benefit from it.
Look At These Opportunities Not To Regret Later!
Just like the economic cycle is more sensitive to what’s happening in the credit cycle, some businesses are also more sensitive to the developments in the credit cycle.
Consumer staples are less sensitive to the credit cycle as they mostly provide basic needs.
Discretionary spending, especially big spendings like buying a car, is more sensitive to the credit cycle as people use a combination of credit and cash equity.
Companies that make money by lending are extremely sensitive to the credit cycle, naturally.
It should have been obvious by now where you are going to find the opportunities: In discretionaries and financials.
However, note that this is just the beginning of the rate cuts so we won’t likely see people borrowing a lot of money to finance big spending items.
Financial institutions may be a bit more willing to lend and as the rates keep going lower, they will be increasingly willing.
This is why I think you may take a position in quality financial stocks before we see the effects of lower rates on the earnings.
This post doesn’t aim to provide concrete stock tips but it aims to provide the right mindset to benefit from what’s coming.
However, to those who are interested, I recommend to look at the below names:
SOFI: A big position of mine, still trading at very reasonable levels.
Dave: Fintech focusing on cash advances, it’s growing fast and trades at 17 PE.
RobinHood: June 2024 earnings is 5x of December 2023 earnings. Just at 68 PE.
Ownership Disclaimer: I have a huge position in SOFI. I don’t have positions in DAVE and RobinHood. Not because I don’t like them but because buying them would have been too much exposure to financials for me as American Express is also one of my largest positions.
Key Lesson
We are not doing an economic forecast here. We are trying to understand where we are in the cycle and position accordingly to extract the most benefit.
🚨Reminder: You can figure out cycles, opportunities and valuation all by yourself.
Don’t depend on others. It’s not a sustainable way to succeed in the market.
This is why I am starting an email newsletter on investing. It starts this Saturday!
Here is the curriculum:
Week 1: Stock Market Dynamics
Week 2: The Concept of Fair Value
Week 3: How to Calculate Fair Value
Week 4: Exceptional Companies & Businesses to Avoid
Week 5: How to Find Exceptional Companies
Week 6: Portfolio Strategy
Week 7: Right Way to Think About the PE Ratio
Week 8: When to Buy & When to Sell
Week 9: Advanced Valuation
Week 10: Case Studies & Sample Portfolio
Bonus: Online meeting at the end of the course.