By iA Private Wealth, August 26, 2022
If you’re shocked by rising interest rates, it’s understandable. For developed-economy countries like Canada, interest rates have been very low – sometimes at historic lows – for decades.
Recently, the Bank of Canada (BoC) has been among the central banks raising rates aggressively, with more increases expected. Why? In a word, inflation.
Inflation means rising prices for goods and services. Since it occurs when the economy is growing, some inflation is good. If inflation soars well above target – the BoC prefers inflation around 2% annually, but Canada’s inflation rate hit 8.1% in June – then buying power decreases drastically. Central banks raise interest rates to help control surging inflation by cooling off consumer demand.
Impact of high rates on investors
Investing is a proven way to build wealth over the long term, but under these trying conditions of high inflation and rising interest rates, how are investors affected?
When rates are low, the overall economy runs smoothly. People are more willing to spend when they know that borrowing costs (e.g., mortgages, credit cards, loans) are reasonable, so demand grows for many goods and services. In turn, companies tend to be more profitable and the markets perform well as stock and bond prices rise.
The reverse happens when inflation is high. As interest rates rise, corporate earnings and stock prices tend to fall. The bond market may decline since bond prices usually move in the opposite direction of interest rates. So, where can you find attractive opportunities when rates are high? Here are seven possibilities:
- Big bank stocks. Banks can generate more profit as the spread increases between the interest they must pay to lenders and the interest they can charge borrowers. When market rates are low, there’s less ability to widen spreads.
- Energy stocks. Historically, high inflation means soaring energy prices, and the current environment is no exception. Investors with a healthy allocation to Canada’s energy sector heading into 2022 have seen a handsome return year to date1, even with the recent dip in oil prices.
- Price-maker stocks. Some companies have the ability to pass higher costs of production on to the consumer without any meaningful reduction in sales and profitability. Many such companies will be found in the consumer staples sector.
- Floating rate securities. As the name implies, the yield on these securities will move up or down in tandem with rising or falling interest rates.
- Real return bonds. Issued by the government, these bonds are pegged to the Consumer Price Index (CPI), which tracks the inflation rate of key goods and services. Real return bonds are designed to help protect investors against inflation since they pay interest based on the CPI.
- Savings products. Guaranteed Investment Certificates and high-interest savings accounts are two popular products to help savers earn more income. Their rates of interest are linked to general market rates, so when inflation pushes interest rates higher, savers benefit.
- Annuities. Issued by insurance companies, annuities pay out a fixed stream of income to individuals, sometimes for the life of the annuity holder. They are generally long-term products designed to generate steady retirement cash flow. If you purchase an annuity when interest rates are high, you can receive higher cash flow than with annuities bought when rates are low.
Investing is difficult at the best of times, but an environment of high inflation and rising interest rates adds complexity. When markets are volatile, staying focused on your financial plan and long-term goals can help you through the challenges – and remember, inflation will eventually subside and market conditions will improve again.
We can help you invest for the long term under a wide range of economic and market conditions. Contact us today.
1At August 17, 2022, the Canadian energy sector is up over 20% on a year-to-date basis. This article is a general discussion of certain issues intended as general information only and should not be relied upon as tax or legal advice. Please obtain independent professional advice, in the context of your particular circumstances. iA Private Wealth is a trademark and business name under which iA Private Wealth Inc. operates. iA Private Wealth Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.