By Scott Blair
Happy New Year everyone. 2021 as we know was a very good year in the equity markets. The volatility was a bit scary at moments, namely February and November but otherwise the positive trajectory held from the previous year, 2020.
It now remains to be seen what will be in store for 2022. In our opinion and in no way is this contrarian, we believe equity markets will continue to be positive, largely at the expense of the bond markets. As we see it there are two topics which will take the forefront: inflation and interest rates.
First, Some Background
The Bank of Canada carries out monetary policy by influencing short-term interest rates. It does this by adjusting the target for the overnight rate (the rate that banks charge one another to balance accounts “over night”) on eight fixed dates each year. Currently the Policy Rate or target for the overnight rate is 0.25% which is historically low. The BOC sets this rate in accordance with inflation as measured by CPI (Consumer Price Index). In 2020, thanks to COVID, everything slowed down, including inflation and to stimulate growth the BOC slashed the overnight rate to where it is now. We are however at the other side of that curve and as we have all noticed at the gas pump and grocery store, inflation has gone up. Actual CPI in fact went negative in March of 2020 and now it is just under 5% (4.7%) which is way above the 2% long range target.
Source: Bank of Canada
Now for the Mathy Part
The “real” or inflation adjusted Overnight rate is just:
Real O/N rate = Policy Rate – Inflation
From 1960 to 1995 the average policy rate was 7.9%. Way higher. The average inflation rate was 5.2%. Way higher. So the real O/N rate was about 2.6%. From 1995 to 2020 it dropped to 0.6% which still represented healthy growth in the economy. Now, with the O/N rate at a measly 0.25% and inflation at 4.7% that gives us a negative real rate of almost 4.5% which is really bad. The problem is that a super low O/N rate just fuels the inflation fire. What to do?? Raise interest rates, namely the overnight rate.
Currently our inflation target is 2%. That policy started in 1995 and for most of that period, until now we have been close to or even below that target. The BOC thinks that even with intervention inflation will remain above 2% until sometime in 2024. In the meantime, the consensus is that BOC will boost interest rates at least 3 times this year by 0.25% each time to get us to 1.0%, a rate we haven’t seen since 2014. For those old enough to remember, the peak in O/N rates was in August of 1981 at 20.87%. Can you imagine that?
So What Does an Interest Rate Hike Mean to Equities?
Well at the surface, it’s a good thing. Inflation typically means that companies are doing really well and the economy is too. During the hikes (known as tightening) the stock market historically has tended to do well. More specifically, previously high-flying technology stocks fell (as we have already seen), whereas financials and energy tended to do quite well. Defensives like consumer staples pretty much remained the same. In short, we think this year will produce fairly positive equity returns.
And, What Does an Interest Rate Hike Mean to Bonds?
This isn’t really a happy story. As interest rates go up the underlying value of the bonds goes down. Owning straight up bonds or plain vanilla bond funds isn’t a great idea. That’s why we tend to seek those fixed income managers who use alternative strategies in fixed income like high yield and floating rate bonds. It also explains why we have embraced Structured Notes which are fixed income but produce a good potential coupon while also providing downside protection.
As rates go up in the short term we believe that our equity returns will be protected, albeit with potentially more modest returns, and we will do our best to mitigate any risks to fixed income returns.
One Final Note
For mortgage owners out there, typically and historically variable rate mortgages provide the best flexibility at the best rate but in this circumstance, it may be worth locking in for a period to ride out the rising rate environment.
As always, we are happy to discuss further!
Photo by Thought Catalog on Unsplash