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How rising interest rates will impact investors

By Roger Lydiatt, Director and Investment Counselor, ATB Wealth ATB Investment Management Inc.; Todd Hirsch, Chief Economist, ATB Financial 2 January 2020 5 min read

Canadians have enjoyed historically low interest rates for over a decade, but all good things must come to an end. The Bank of Canada steadily increased its benchmark rate throughout 2018, and some forecasters are anticipating a 6 percent overnight lending rate by 2020. This change from the near-zero interest rate will have implications for Alberta’s economy, and two of ATB’s experts recently discussed how this will impact both investors and consumers.

Back to the future

Roger Lydiatt, Director and Investment Counselor, ATB Wealth ATB Investment Management Inc.

 

To a lot of Albertans the prospect of rising interest rates must seem like the financial equivalent of an outbreak of the mumps or a party line on your home telephone – part of a distant and more difficult past. After all, when interest rates sky-rocketed in the early 1980s the Edmonton Oilers had yet to win their first Stanley Cup and people were lining up at the movie theatres to watch E.T. But while the timing of the next Oilers Stanley Cup victory is a matter of debate, there’s no question that the 35-year bull market for bonds is over.

As a result, many investors have forgotten how to navigate a more challenging market for the fixed income portion of their portfolios or, more likely, they’ve never had to deal with one in the first place. For more than a generation, bonds have offered reward without much risk. Now, that’s evening out, as central banks continue to raise rates and tighten monetary policy in order to ward off inflation and return economies to a more normal environment.

This isn’t a reason to panic, mind you, provided you’re not leveraged to the gills or invested in companies that are. Now, and for the foreseeable future, the average bond will return to its more traditional role as the ballast in the average portfolio – a safe haven and refuge, one that will probably generate more modest gains compared to the last three decades.

You might even see some short- term capital losses show up in your bond portfolio. But it’s not a reason to panic, as long as you’re not excessively exposed to long-term bonds, those losses will be made up by rising yields and richer payouts as interest rates start to move up. And since this is capital you’re not going to be touching for decades, you don’t need to worry about short-term gyrations.

What should you worry about, then? Debt, first and foremost, both on the balance sheets of the companies you’re invested in and your own household. 

Rising rates are also a reminder of the importance of being diversified – not just between asset classes, but within asset classes as well. Just as equity managers pick stocks that diversify a portfolio between industries and geographies, competent bond managers must consider credit quality of the issuer and sensitivity to such factors as rising rates and inflation when choosing bonds. There’s a big difference between holding a properly diversified portfolio of bonds and one entirely composed of 30-year treasuries – the latter being extremely sensitive to rising rates. In other words, not all bonds are created equal and as rates rise you want to stay closer to the shallow end of the pool, where the shorter-term bonds from high-quality issuers tend to swim.

Most importantly, rising rates represent an important opportunity to reassess your risk tolerance. Back in the 1980s, a lot of people had to learn that lesson the hard way. The good news here is that, with a few simple steps, you don’t have to.

A graph shows the Bank of Canada interest rate announcements from July 2017 to December 2018.

This graph shows the Bank of Canada interest rate announcements from July 2017 to December 2018.


Under pressure

Todd Hirsch, Chief Economist, ATB Financial

 

Like most economic recoveries the one that Alberta’s still in the midst of right now hasn’t been without its challenges. Instead, it’s been a process of taking two steps forward and one step back. That’s certainly the case with interest rates, which have moved up from near-zero to something approximating a more normal economic environment over the course of 2018.

While rising rates are a sign of economic strength, they’re also a bit of a gut-punch for an Albertan economy that’s still a bit wobbly on its feet. After all, recessions tend to leave both businesses and households in weaker financial shape, a level of fiscal fitness that usually takes the form of excess debt and leverage. In order to stay afloat, many people had to lean on their creditors more than they might have otherwise liked – and they’d surely like to have rates stay as low as possible while they pay them back.

Unfortunately, the Bank of Canada isn’t really in a place where they can keep rates down any longer. With inflation in the American economy showing signs of picking up, the U.S. Federal Reserve has had to hike fairly aggressively, and Canada is getting dragged along for the ride.

Mercifully, that ride looks like it’s going to slow down in 2019. With U.S. President Donald Trump actively encouraging Federal Reserve Chair Jerome Powell to stop hiking rates, and the American economy starting to look like it’s going to come down from its tax cut fueled growth, the preoccupation with containing inflation may be replaced by concerns about a potential recession.

This should mean a less hawkish posture by both the Federal Reserve and the Bank of Canada, and a more gradual increase in the benchmark interest rate. For now, at least, 2.5 percent seems like a reasonable target for Canadian rates – and one the Canadian economy should be able to handle.

The bigger risk for businesses, in my opinion, is the impact that rising rates will have on households in Alberta. Consumer debt levels remain dangerously high and rising rates will act like a tax on those with stretched finances. Dollars spent on rising debt service costs will inevitably reduce the income they’ll have available to spend in other areas, and businesses will be the first to feel that. If consumer insolvency levels start moving higher, then it’s time to really worry.

The good news is that we haven’t seen any signs of that yet. And while good news is in tragically short supply these days for the energy sector, one silver lining here is that most firms who have weathered the downturn are ready for this latest challenge. That’s in large part because they’ve been aggressively deleveraging for more than two years now, whether that’s by selling assets or reducing costs. They certainly have other challenges to deal with right now – from market access to commodity prices – but rising interest rates should be manageable.

All told, it’s another headwind for an economy that’s had to deal with some gale force gusts lately. But I’m confident that we’ll continue to make progress as we recover from one of the biggest recessions we’ve ever seen in Alberta. And if nothing else, it’ll give the Bank of Canada some much-needed dry powder for when the next one comes around – which hopefully won’t be for a very, very long time.

 

 

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