Canada’s benchmark interest rate hit an all-time high of 16% in 1991 – and here investors are in 2022, freaking out over projections it’ll touch 1% by June. But there’s a reason for the current unease. Despite rate increases being forecast the minute governments and central banks opened the floodgates on trillions of dollars of stimulus, things have now “got real”.
The Bank of Canada raised its policy rate 25 basis points in March to 0.5% but, just as importantly, it signalled there are more hikes on the way. After the bank’s first increase since 2018, some analysts are now predicting one of the fastest hiking cycles since the central bank adopted an inflation target three decades ago. According to Bloomberg, markets are betting the benchmark interest rate will reach 1.75% by March, 2023.
The reason? Inflation is now in play. A combination of the base effect, supply chain bottlenecks, high personal savings, and labour issues have all played a role in the inflationary picture. The early insistence from central banks that inflation would be temporary has proved at best confusing and at worst, plain false. The annual inflation rate in the U.S. accelerated to 7.5% in January of 2022, the highest in 40 years, while Canada’s rate surged to 5.1%, its highest point in 30 years. In addition, certain sectors are also dealing with crippling staff shortages, while burnt out and disillusioned workers are leading the so-called “Great Resignation”.
The time to act is here and central banks’ biggest lever to regain control of the economy is to increase interest rates, which in the U.S. and Canada were lowered to zero-bound range after COVID hit. Pacing these increases right and avoiding shocks to the markets will be crucial, but what do rising rates mean for investors?
Equities – no one size fits all
Overall, there is no direct correlation to valuations but rising rates will affect stock prices. Companies with debt on their balance sheet will be impacted, as will their dividend payouts. Higher rates also hurt consumers’ ability to borrow and pay off debt, resulting in less disposable income, which can impact corporate profits and, in turn, affect a company’s value.
There is no one size fits all, however. Some sectors within the market are more sensitive to rising interest rates than others. For example, financial institutions benefit from increased profit margins, while insurance stocks, too, can flourish because those with steady cash flows must hold lots of safe debt to back the policies they write. Both sets of institutions can earn more from the spread between the interest rate they pay to deposit holders and what they can earn from debt like Treasuries.
Other areas are arguably more nuanced and the economic recovery from COVID-19 is uneven. While some sectors thrive, others languish. Passive investing, where you track an index, will expose investors to both winners and losers, which is why many people believe active management is now back in the driving seat.
With that in mind, and given that rising interest rates mean, typically, a strengthening economy, once confidence improves, there may be opportunities in consumer discretionary (think re-emergence of travel and eating out) and industrials (think construction and transportation).
In other words, value stocks are back in, although for how long this rotation lasts remains to be seen. According to Forbes, which cited the Russell 1000 Growth and Russell 1000 Value indices, as of January 21, 2022, growth was down -12.3% while value was down only -3.6%. Being diversified, and having exposure to the best of both worlds, should be the aim.
Tread carefully with REITs
Broadly speaking, REIT returns and interest rates move in the same direction, which is shown in the periods 2001 to 2004 and 2008 to 2013. In a study carried out by S&P, since the 1970s, over six periods of interest rate hikes, REIT returns increased during four of them and outpaced the stock market during three.
This is because, typically, a stronger economy, is good for landlords – and real estate remains one or the best inflation hedges. As construction costs go up, so do existing property values and rents. Higher rates also price many people out of home ownership, increasing the demand for rentals.
However, every scenario is different and not all REITs are created equal. There are a wide variety of funds covering different industries, sectors, and geographies, while some may be more leveraged than others. The impact of COVID has been uneven, so it’s vital to know and understand where these sensitivities are. Industrial REITs have done well, for example, but office space, not so much.
COVID restrictions in different jurisdictions will also have an impact and influence REITs’ pricing power and earnings growth. Tread carefully.
Fixed income – stay active
It’s important to understand that bond prices have an inverse relationship with interest rates. Therefore, when rates go up, bond prices go down and when interest rates go down, bond prices go up. This is because the price reflects the value of the income it delivers, so if, for example, rates on government bonds surge, older bonds become less valuable as their coupon payments are now lower than those of new bonds being offered in the market. The price of these older bonds drops and, therefore, trade at a discount. This can really hurt the value of your bond portfolio.
For investors, the first thing to do in a rising rate environment is cut bond duration and reinforce positions in short- to medium-term bonds, which are less sensitive to hikes. However, it’s worth remembering that shorter-term bonds provide less income-earning potential.
Again, many believe fixed income in a rising rate environment is where active management earns its spurs. And in this asset class, there are a number of strategies that can be used with the help of an independent investment advisor.
Firstly, floating-rate funds, unlike traditional bonds that pay a fixed rate of interest, have a variable rate that resets periodically. Therefore, when interest rates rise, the fund’s holdings adjust to the new rate, meaning it can enhance returns when rates increase. To get the maximum benefit, buy floating-rate funds when rates are low and expected to rise.
Active tactical bond funds are another option, especially given a portfolio manager’s need to minimize interest-rate risk by keeping a fund’s duration short. These funds offer a wide range of duration flexibility but also extra tools to manage credit risk by reaching for higher yields during expanding markets, while opting for higher-quality bonds (with a lower risk of default) when markets are volatile.
Finally, preferred shares are a hybrid security that combine the consistent income payments of bonds with the equity ownership advantages of common stock. In Canada, this market is dominated by discounted rate-reset preferred shares, so higher rates may mean higher interest returns and, hence, higher share prices. Preferred shares also qualify as dividends and are, therefore, taxed at a lower rate than bond interest.
The prospect of a prolonged run of rate increases has sent shudders up the spines of investors, especially those who remember the pain of meaningfully high rates. But perspective is required. Firstly, remember that interest rates remain historically low – and that will remain so for some time yet. Secondly, rate hikes can unmask opportunities. Index trackers do not have the ability to target these gems and maximise returns, but portfolio managers do.
