2024 is the year of transition from decade-high interest rates in the first half to rate cuts in the second half. Why do interest rates matter so much to stocks?
Image source: Getty Images
How interest rates affect stocks
Many capital-intensive companies use a mix of debt and equity to fund their capital investments. When interest rates rise, a higher portion of the net income goes into interest payments, reducing the earnings per share (EPS) attributable to shareholders. Moreover, the higher cost of debt also discourages discretionary spending, affecting several companies’ revenue.
While these are the fundamental aspects of a company, there are also changes in the investing behaviour.
The attractiveness of the stock market reduces as banks offer higher interest rates on deposits, which carry less risk than stocks. Hence, investors pull their money from the stock market and switch to deposits. This happened in 2022-23 when the Bank of Canada increased the interest rate from 0.25% to 5%. Now, it has resorted to rate cuts, reducing the interest rate to 4.5%. This transition will increase the attractiveness of the stock market and drive stock prices.
Those who catch up early to this transition will benefit from the recovery rally.
Two stocks I would pick in 2024
If I were to pick stocks to catch up early on the recovery rally, I would pick the ones that faced the dual impact of interest rate hikes: weaker fundamentals from falling demand and rising interest expenses; and stock selloff during the last two years. Here are my stock picks.
Magna stock
Automotive components supplier Magna International (TSX:MG) had a rollercoaster ride in the previous two years, during which interest rate played a small part. The electric vehicle (EV) boom in 2021 took a setback with a semiconductor supply shortage in 2022. And from there began Magna’s stock price downturn. While 2023 was a strong year for Magna sales and income-wise, most of it was from the pent-up demand from 2022.
New demand had slowed in 2023 as consumers delayed buying discretionary high-ticket items like cars amid the high cost of debt. Hence, the stock did not pick up that year despite strong sales in 2023. Also, the investors were better off getting a +4% interest on the low-risk fixed deposits. The first quarter of 2024 was equally tough as Magna impaired $261 million worth of assets allocated for Fisker, which is facing bankruptcy issues. (When a company files for bankruptcy, it is protected from paying dues. Hence, its suppliers, creditors and shareholders write off the dues as loss.)
Despite all this, Magna posted a net profit of US$26 million, showing the resilience of this company. The worst is over for the company. An interest rate cut could revive the EV boom, and Magna is ready to cater to this demand. Moreover, lower rates will also help Magna reduce its interest expense and enhance its profits further. For a cyclical stock like Magna, now is a good time to buy the dip and wait for the upcycle.
BCE
BCE (TSX:BCE) stock price has been on a downtrend since April 2022, when interest rate hikes began. The telco had increased its debt to fund its 5G infrastructure rollout. A 1% increase in interest rates reduced BCE’s net income by $26 million. In the second quarter of 2023, the company entered competitive pricing with Telus, which affected its revenue. BCE is now undergoing a restructuring that will reduce its 2024 net profit. All this reduced the stock price by 41% to its 10-year low.
However, things will start to rebound from this point. Lower interest rates will provide some respite and increase net profit. Moreover, the company has stopped its promotional pricing and increased its prices. Add to this the cost savings from restructuring and focus on high-growth businesses. All this could help BCE increase its net profit and improve its dividend payout ratio (113% in 2023) from next year.
