February and March have seen an incredible rise in interest rates. No they aren’t the 15% from the 1980’s but take a look at the 5 year Government of Canada Bond Yield over the last year:
5 year Canadian bond yields have gone from a low of around 0.30% in July and August of 2020 to now in the range of 0.90%. This is TRIPLE the lows seen last year. That’s right, a 300% rise in interest rates.
This has an effect on 5 year mortgage rates and as a result will have an effect on the housing market, consumer sentiment and borrowing activity overall.
This may seem scary at first but let’s look at why rates have increased.
First, we were in rolling shutdowns for most of the year. We are now opening back up even with diminishing risks of shutting down again for prolonged periods of time.
Second, we did not have firm distribution dates for vaccines that were being developed, nor did we have significant efficacy data until November 2020.
Third, we are seeing people continue to spend. There were a lot of unknowns with credit lines were being paid down and cash balances were rising. People are beginning to feel more confident and are starting to spend.
Fourth, The pace of vaccination is accelerating in the US, the world’s largest economy. China, the world’s second largest economy is also doing very well.
Fifth, commodity prices are increasing which indicates growth and demand. This indicates that economies are starting to do well, causing an increase in costs to more than just the volatile raw materials.
Is this good or bad?
It depends on who you are. If you’re borrowing new money then you might see slightly higher borrowing costs. You might also see an easing of credit standards as the economy starts to reopen and rebound.
If you’re an investor you will see a repricing of risk assets. Future cash flow and earnings were being priced off of a very low discount rate, read high multiples. Now those same cash flows are being priced off of a higher interest rate, read lower multiples.
Not all markets are created equal.
Bond markets will generally see a decrease in value when interest rates rise.
Stocks can still rise in this environment due to increased economic activity but not all sectors are going to perform the same.
Sectors that should suffer in rising interest rate environments are:
Tech stocks with low or no dividends. The biggest part of the earnings will be dependent on future values rather than being returned to shareholders in the form of cash earlier. If rates are rising and I won’t see a return on that money for a long time then when rates rise, I’m going to demand a higher return or pay less for that asset.
Utilities and telecom stocks should underperform due to their non-cyclical business models and high regulations. They are also very capital intensive and have large borrowing costs. As rates rise the cost of financing increases and due to the slow growth in revenue, the cash being returned may be lower or there may be other areas of the market that will perform better.
Sectors that should outperform in rising interest rate environments are:
Resources, as the interest rate rise is a reflection of the improving health of economies. Economies will have increase demand for resources and build an increased ability to pay higher prices.
Financials will benefit because as interest rates rise, they are able to take bigger margins between the rate that they borrow at and the rates that they lend at. The higher interest rates are also a reflection of an improving economy and will improve the credit worthiness of their borrowers.
Industrials may have increased costs of raw materials however they normally are able to pass those prices along to their customers. With an increase in demand from an improving economy their earnings are expected to rise. They are often bigger dividend payers and return larger amounts of cash flow to their investors.
As seen from 2016, international investors will flock to markets and buy bonds that have low risk and higher yields. Think the safety of the US who has a slightly higher yield compared to Euro or Japanese bonds.
For pension funds that have billions of currency to invest and a requirement to earn a return for the pensioners, they need to increase yield. Therefore investors across the world in search of yield will flock to stable countries like the US and Canada and hedge out the currency risk.
Europe and Japan are likely to keep interest rates lower for longer and those domiciled in those countries will be hungry for yield. As a result, they will likely help to keep US and Canadian rates lower than they should be as well as keeping those currencies higher and well in demand.
Overall, I view this as a positive. I’m not concerned about rising rates when we are coming out of a pandemic. I do think that the economy is able to pay slightly higher rates and that as pockets open up, central banks and government fiscal stimulus remains accommodative, and the economy begins to open up that we have the potential to see growth like we’ve never seen before.
I believe that we have a unique opportunity to recover from one of the most difficult economic situations in modern history and come out very strong.
The stock market is one reflection of this and we should take lessons from the markets: That now is the time to be forward thinking and build wealth.
Build businesses, invest in yourself and follow the 4 Pillars of Wealth: Make, Keep, Grow and Protect your Money.
Do you find it hard to stay on top of the markets, interpret data, filter out biased news and make portfolio decisions? Consider hiring us as your Private Wealth Manager.
Until next time,
Trevor Dale, CFA
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