How Long Will Investors Have to Wait for the Fed to Cut Rates?

Ruth Saldanha: Here’s what’s ahead on this week’s Investing Insights. Are Tesla, Netflix, and Verizon stocks a buy right now? What’s the real cost of owning an ETF? And when will the Fed finally start cutting rates? This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ruth Saldanha. Let’s get started with a look at the Morningstar headlines.

Tesla’s Slower Growth in 2024

Tesla has signaled that its growth will slow in 2024. The electric vehicle maker announced a strategic shift during its fourth-quarter earnings call. It’s planning to develop a new affordable vehicle while making its current EV lineup cheaper. This differs from Tesla’s 2023 effort to cut prices to sell more cars. Morningstar expects delivery growth to rise just 10% this year and 6% next year. Those numbers sit far below the 50%-plus annual growth that Tesla produced over the past decade. But launching an affordable vehicle in 2025 could result in higher deliveries growth again in 2026. Lower automotive gross margins are expected while Tesla produces its new vehicle and ramps up its Cybertruck production. However, profit margins are predicted to expand over the long term. Morningstar has lowered its estimate for what Tesla’s shares are worth to $200 from $210. The stock looks fairly valued. However, Morningstar recommends investors wait for a lower price.

Verizon’s Strong Q4

Verizon delivered a strong fourth quarter. The wireless carrier added nearly 450,000 postpaid phone customers. That marks its best performance in two years. But management says customer growth may slow down following upcoming price increases on older plans. However, the company still expects to add customers this year. Morningstar believes this reflects solid pricing discipline. It also sends the message that Verizon won’t allow rivals to pick off accounts with aggressive promotions. Meanwhile, phone sales declined along with the number of prepaid phone customers. Free cash flow almost hit $19 billion for the year. The figure rose more than 30% compared with 2022 and exceeded management’s expectations. Management forecasts that wireless service revenue will grow and capital spending will decrease in 2024. Morningstar thinks Verizon’s stock is worth $54 and is currently undervalued.

Netflix’s Booming Subscriber Growth

Netflix’s subscriber growth boomed globally in the fourth quarter. The leading streaming service added more than 13 million new subscribers. It’s the most since the beginning of the pandemic-related lockdowns in 2020. The company cracked down on password sharing and offered cheaper plans with ads in 2023. Morningstar predicts subscriber growth will remain high but will likely slow down. Netflix’s fourth-quarter revenue grew 13% year over year. Average revenue per member ticked up year over year following previous declines. Price increases in the U.S., the U.K., and France helped push that number higher. The metric could increase as the company’s advertising business grows. Morningstar thinks Netflix’s stock is worth $425 per share, up from $410. Shares look overvalued.

The Total Cost of Owning an ETF

At Morningstar, we always say that fees are among the single biggest predictor of investment returns. My colleague, Ian Tam, ran the numbers and found that in percentage terms after 10 years, the impact of a 2% fee results in 18% less wealth when compared with no fees. And after 20 years, that gap balloons to 33%. One of the cheapest investment options out there for individual investors are exchange-traded funds, or ETFs. While they might seem cheaper, though, there are costs associated with these products. Zachary Evens is a market research analyst for Morningstar Research Services, and he recently calculated the total cost of owning an ETF. He is here today to tell us what he found.

Zachary, thank you so much for being here today.

Zachary Evens: Happy to be here.

Why Do the Costs of ETFs Vary?

Saldanha: So, the costs of ETFs vary quite a bit. What are some of the reasons for this variance?

Evens: Yeah. So, it really depends on an ETF’s annual fee and investor behavior. So, if an investor trades frequently, they’ll incur a higher transaction cost, resulting in a higher fee to them. While if they’re invested in a higher-priced ETF, they’ll incur higher fees than an investor that invests in a lower-fee ETF.

How Should Investors Measure ETF Holding Costs?

Saldanha: Let’s start by talking a little bit about holding costs. What exactly are they? And how do they impact the overall fee of an ETF?

Evens: There are a number of holding costs implicit in an ETF’s annual fee. But the most important of those is that ETF annual fee or its expense ratio. That is expressed as a percentage. So, imagine a $100 investment in an ETF that charges a 1% fee. So, you only have $99 of those $100 working for you, where if that fee is lower, you have more money working for you. And over time, that difference can compound into something meaningful. So, it’s important for investors to look for the lowest price option.

Tracking Costs vs. Tracking Error

Saldanha: Another thing that you talk quite a bit about are tracking costs and tracking error. Can you give us the sense of what’s the difference between the two of those things?

Evens: Tracking error is really … the ETF managers assume those costs. It’s the price of tracking their index. What really matters to investors is that those tracking costs lead to tracking error. So, what that is is how closely a passive ETF tracks its index, and investors should prefer passive ETFs with a low tracking error.

What Are Transaction Costs?

Saldanha: Now, one of the things that investors can somewhat control are transaction costs. Isn’t it true that if an investor trades less, they end up spending less? Is it a little bit in the investor’s hand?

Evens: Yeah, you’re exactly right there. So, if an investor trades very frequently, they’ll incur much higher transaction costs than a buy-and-hold investor who trades only once a year or once every few years. So, it’s very important for investors to be mindful of how often they trade their ETFs.

Holding Costs vs. Transaction Costs

Saldanha: Between the two, holding costs and transaction costs, which one impacts the investor more and which should the investor keep a closer eye on?

Evens: It really depends on the investor’s behavior. So, for a long-term investor, holding costs will really be the most important costs to them since those compound over time, as I mentioned with the fee example, whereas shorter-term or frequent traders should really be mindful of transaction costs. So, it really can vary between different types of investors. But over time, for long-term investors, that total cost of ETF ownership will converge at an ETF’s annual fee. So, you should keep an eye out for the cheapest ETFs available to them.

Saldanha: Great. So, it all adds up. Thank you so much for being here today, Zachary.

Evens: Thanks, Ruth.

Fed Unlikely to Cut Interest Rates in March, but What About May?

Saldanha: The Fed signaled they would start cutting interest rates in 2024. But when? Morningstar Inc.’s lead multimedia editor Ivanna Hampton and Morningstar Research Services senior U.S. economist Preston Caldwell discuss the Fed’s latest meeting. Hear what they had to say.

Ivanna Hampton: An interest-rate cut in March is looking less likely. Federal Reserve Chair Jerome Powell says the committee is confident about where inflation is headed. However, it wants to see more good data before starting down a new path. Preston Caldwell is a senior U.S. economist for Morningstar Research Services.

Thanks for joining me, Preston.

Preston Caldwell: Thanks for having me, Ivanna.

Hampton: Now you have forecast that the Fed would start cutting rates in March. What’s your outlook following Powell’s news conference?

Caldwell: Yeah. So, previously I had the Fed cutting in March, and then I thought they would skip in May and then cut in every other meeting the rest of the year. So, right now, I do think that the odds have shifted slightly toward the first cut being in May. And then if they continue to cut in every meeting for the remainder of the year, then that leaves our end-of-year forecast unchanged. So, it’s not really a big change, but I do think the timing has shifted a little bit. It’s interesting, it wasn’t until about 40 minutes into the press conference almost that Powell gave his clearest statement about what the Fed is likely to do in March, saying that a rate cut was not the base case. I’m not even sure if he intended to deliver that remark, but nonetheless it came out, and I have to take it as the best indication right now of what the committee will do. Although keep in mind a lot more data will come out between now and the March meeting, and that could shift the committee’s decision-making. And in our view, there will be continued progress on bringing inflation down. So, there is still a decent possibility, let’s say a third or more, that the Fed will actually cut in March, but probably May is the most likely. And I think by May the inflation data really will leave no room for doubt that it’s time to start cutting rates.

Hampton: And a follow-up to that, are you still thinking six interest-rate cuts for 2024?

Caldwell: Yes. So, because I had originally a skip penciled in for May, if they start cutting in May, then we’ll still get in six cuts through the end of the year, which will take the target range for the federal-funds rate to 3.75% to 4.00%. So down 150 basis points from where we’re at right now. And then we continue to think that the Fed will cut further going into 2025 and early 2026, ultimately bringing the federal-funds rate down to 1.75% to 2.00% as a target range, which would be roughly in line with prepandemic levels.

Hampton: Well, the Fed has called the current interest rate range, “the peak.” Can you describe if there are any benefits or risks to the economy with rates in this range?

Caldwell: With rates in this range, the federal-funds rate and interest rates as a whole are at restrictive levels and so that means they’re at levels designed to cool off economic activity and thereby bring inflation back to the Fed’s 2% target. So, the ultimate goal is to bring inflation back to normal. However, the longer that rates are kept at a high level, the more downside risk there is to economic activity. Once the inflation has assured its goal on the inflation front, it then wants to switch to propping up economic activity in order to assure its other main mandate of creating full employment. So once the inflation goal is reached, then it will be time to manage risks on the economic activity/full employment front and yes, there are risks and those can be hard to anticipate.

As the Fed, as Powell noted today, if the Fed waits until the economy begins slowing down to start cutting rates, it could be too late because of the lags in monetary policy. So, it needs to stay ahead of the economy and how it calibrates rates. And nobody knows exactly what the vulnerabilities are of the economy to high interest rates. There could be much more effects in the pipeline, and we think that there could be, which is why it is a sagacious decision for the Fed to begin cutting rates sooner rather than later. But that could turn out not to be the case. The economy could be more resilient to higher rates. But hopefully, the Fed will foreclose any of those risks playing out by cutting rates in an expeditious manner.

Hampton: Now, what do you think the Fed needs to see in the data before declaring the economy has made a so-called “soft landing”?

Caldwell: So, it’s interesting, in the last six months, core PCE inflation, that’s the main index the Fed looks at, came in at 1.9% annualized. So, in the last six months, if we just zoom into that, we’ve hit the Fed’s 2% inflation target. But on a 12-month or what we call year-over-year basis, it’s still at 2.9% because we had higher inflation in the first half of 2023. So once that rolls off, if we continue to have the monthly data rolling in at a 2% inflation rate, then that year-over-year number will continue to glide back down to 2%. So, I think that’s what the Fed is looking for is really the year-over-year or 12-month number getting back to 2%, which will be the case if inflation continues at its current trend and will be the case if our forecast plays out. And the Fed is just going to wait for that. And I think based on our forecast, that will happen sometime in the second quarter with that year-over-year number getting right back to 2%. And that will be, I think, by the May meeting in particular, the data will be at about 2.3% year over year because they’ll have the March data to work with when they’re doing their May meeting. And that will be enough for them to start cutting.

Hampton: Well, Preston, thank you for your time today.

Caldwell: Thanks, Ivanna.

Saldanha: Thanks, Ivanna and Preston! Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to senior video producer, Jake VanKersen, and thank you for watching Investing Insights. I’m Ruth Saldanha, editorial manager at Morningstar Research Inc.

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