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Financial Post / Rechtshaffen: Interest rates are still rising, but investors should start preparing for when they come back down

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Variable rates will likely be a benefit once again in the midterm

The Bank of Canada over the past 30 years has had six periods of interest-rate hikes, ranging from 1.25 to 3.2 percentage points, before this most recent set in 2022.

The one thing they all had in common was that it didn’t take long for each of them to be followed by a period of declining interest rates, ranging from 1.25 to 5.125 percentage points.

One logical reason for this is that rate rises are meant to slow down the economy, and rate declines are meant to boost the economy. There is a general view that the increases typically start too late, and so rates are still rising after the economy is already slowing. Once they really start to take effect, the impact can be too much, and the central bank has to do a quick about-face.

Let’s do a quick review of the six rises and falls since 1994.

In October 1994, the Bank of Canada’s overnight rate was 4.94 per cent. Over the next four months, it rose significantly to 8.125 per cent — a rise of 3.2 percentage points. Over the following nine months, it declined to 5.94 per cent, and one year later it was sitting at three per cent. This was a large rise and fall historically, but it outlines how quickly rates can rise and how steep the ultimate decline can be.

The next period of rate adjustments saw the overnight rate rise to 5.75 per cent from three per cent over a 15-month period in 1997 and 1998. The subsequent decline wasn’t as steep, but it did drop over the following nine months to 4.5 per cent in May 1999.

In October 1999, the rate was still 4.5 per cent, but then rose to 5.75 per cent by May 2000. One year later, it was back to 4.5 per cent and it was all the way down to two per cent by January 2002.

Over a 25-month period from March 2002 to April 2004, the rate went from two per cent to 3.25 per cent and back to two per cent.

During a relatively prosperous time, the rate rose to 4.5 per cent in July 2007 from 2.5 per cent in August 2005. But the financial crisis of 2008 started to rear its head, and rates fell first to three per cent by April 2008 and all the way to 0.25 per cent a year later.

More recently, the rate in June 2017 was at 0.5 per cent, rose to 1.75 per cent by October 2018, and then dropped to 0.25 per cent by March 2020 when COVID-19 began.

What does this mean for today? So far, we are 1.25 percentage points into an interest-rate-hiking cycle. Some think there are another one or two more points in front of us. Others think it will be less than that. What if the overnight rate goes from 0.25 per cent (where it was in February 2022) to 2.75 per cent? For many of us, that would be a bad thing because our borrowing costs would be meaningfully higher. However, if we were somewhat confident that rates would soon be heading down from there, would that ease our concerns?

History suggests this will happen. The six hiking cycles averaged 13 months in length. The current one is four months in. The six declining cycles began on average 5.7 months after the hikes stopped, but it happened within three months in three of the six scenarios. The average interest rate hike was 1.95 percentage points and the average decline was 2.85 percentage points.

History can be a guide, but certainly not a clear roadmap. If all we did was simply look at the averages here, it would suggest that we have another 0.7 percentage points of rate hikes, which would take another nine months to reach. Interest rates would then start to decline by September 2023 and eventually drop all the way back to 0.25 per cent (or more if it was possible).

Of course, each scenario is different, so things won’t simply follow these averages. The causes are different and the starting point on interest rates is different. That said, this cycle has been very repetitive over the past 30 years.

If I had to guess, I would expect the rate-hiking timeline will be shorter than 13 months, but that rates will move up by more than just 0.7 percentage points. I believe the start of the rate declines might happen sooner than September 2023. The implied policy curve for Canada currently suggests that rate hikes will peak in six months and then start to decline with the following year. This doesn’t mean that this is a fact, but it shows that even today, the implied policy rate is giving some indication of the same cycle we have seen several times before.

Another clue as to why the next cycle might look like the past is that even the Bank of Canada has said one of the reasons for increasing rates is so it will have some greater tools and leverage to help the economy by lowering rates if we go into a recession or something similar.

If that is the future, what does that mean for investors and borrowers?

Variable-rate borrowers will feel more pain in the near future, but it isn’t a one-way road. Variable rates will likely be a benefit once again in the midterm.

If you are looking at buying guaranteed investment certificates, annuities or bonds, it may still be a little early to lock in or invest, but there will likely be a sweet spot to do so later this year or in the first half of next year.

High inflation and higher interest rates seem like the obvious situation today, but this may shift in the not-too-distant future, so don’t go overboard with this investing thesis as it can turn on you. You want to be nimble.

The key message here is that we should not panic about runaway rate hikes. They will continue to rise, but it is also very likely that we will see rates fall shortly after the hikes stop. Maybe this rollover will happen by the end of this year or at some point in 2023, but being prepared for this scenario will allow for some investment opportunities and debt opportunities to be maximized.

Reproduced from Financial Post, July 12, 2022 .

Ted Rechtshaffen
Provided By:
Ted Rechtshaffen, MBA, CFP
President and CEO
tedr@tridelta.ca
(416) 733-3292 x 221

Financial Post / Rechtshaffen: Hang on a minute: Inflation is actually good for some people

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Don’t fear inflation if you have low or no debt, higher assets and are receiving some form of indexed income

There are few words in the financial world scarier than inflation.

Many remember the early 1980s and mortgages of 20-plus per cent, but if you are a student of history, or even lived in certain countries during periods of hyperinflation, you might recall these unbelievable cases: in Venezuela, consumer prices grew at 65,000 per cent from 2017 to 2018; in Zimbabwe, the daily inflation rate was 98 per cent from March 2007 to mid-November 2008; in Hungary, the daily inflation rate was 207 per cent between August 1945 and July 1946. Now that is an inflation problem.

In North America, our inflation rates have never really topped 20 per cent annually. I am not suggesting 20 per cent is nothing to be afraid of, but for many of you, inflation may actually be your friend.

One of the fundamental components when we do a financial plan for clients is a fair estimate of annual spending. If the client doesn’t have any debt, then this annual spending number is the only part of the plan that is negatively affected by higher inflation. For example, if someone spends $100,000 a year and inflation is 10 per cent, then the same level of spending would be $110,000. They now have an extra $10,000 of costs to worry about.

Now let’s look at parts of the plan that will be helped by higher inflation.

Let’s say this same client, a couple both aged 70, does not have a defined-benefit pension to fall back on, but they receive full Canada Pension Plan (CPP) and partial Old Age Security (OAS) benefits that total $50,000 a year. This income is fully indexed to inflation and, based on the 10-per-cent inflation rate, it will now go up to $55,000 a year. This couple would have $5,000 of that extra $10,000 covered by index increases in their government pensions.

Next, the couple has $2 million in investment assets and likes to keep $150,000 in high-interest savings accounts and money market funds. These were earning one per cent in a low inflation environment, but in a 10-per-cent inflation world, they are now perhaps paying six per cent. The extra five percentage points on $150,000 is $7,500, which puts them in a positive cash flow position.

Next, they have another $1.85 million of investments. In a high inflationary world, you want to invest differently than in a low inflationary one. It isn’t as easy to mathematically show a net benefit or negative in this part of the portfolio, but there are some ways that we would manage investments differently (we are doing so to some extent now) that can add net dollars.

Let’s start with bonds. For most clients, we have already been holding significantly lower weights in bonds than usual. The reason was that yields on bonds were so low, and there was a heightened risk that rising interest rates would hurt bond returns. This has been the case.

However, there will be a time when holding bonds goes back to traditional weights or even higher. If inflation is 10 per cent, yields on bonds will be much closer to 10 per cent than they are today. Simply owning bonds and collecting the coupon payments will generate much higher income. In addition, at 10-per-cent inflation, the odds of interest rates going back down to more normal levels from there would be much greater, and this would also add to bond returns.

We aren’t there yet, and may not get there, but the point is that when inflation and interest rates reach a high enough level, bonds once again become a good investment option for almost all clients and that hasn’t been the case for a few years.

As a quick example, the Fidelity Canadian Bond Fund in its first five years from 1988 to 1993 returned an annualized 8.7 per cent. The same fund is negative over the past five years, with a five-year annualized return of -0.31 per cent. If $200,000 was invested in this fund during higher inflationary times than we’ve had during the past five years, the difference at the end of five years is more than $106,000, or over $21,000 on an annual basis. That would certainly have a big impact on the extra $10,000 in costs that high inflation brought to bear.

In terms of other investments, you traditionally want to be more in value than growth stocks during high inflation periods. The main reason is that growth investments rely on a high value of their future potential. If interest rates are high, a dollar in five years will be worth much less than if interest rates were low. As a result, many growth stocks (good and bad ones) are getting hit hard this year.

Value stocks generally include sectors such as utilities, consumer staples, some real estate and commodities. These hard assets have traditionally been less reliant on high future growth, and more reliant on quarter-to-quarter profits and stable-to-growing dividend payments. As a firm that leans towards value investing, we certainly don’t mind a little inflation.As a quick aside on value vs. growth, a 2016 study by BofA Securities Inc. found that the average annual price return of value stocks since 1926 was 17 per cent versus 12.8 per cent for growth stocks. It found that value outperformed growth in roughly three out of every five years during this period. Since 2016, there is no question that growth has meaningfully outperformed value, but that has turned in the past year. We believe, based on this history, there might be a long period of value outperformance ahead.Getting back to real estate, this is one hard asset that people sometimes say will benefit from inflation, while others say it will decline due to higher interest rates. Both are right, which means you need to be careful in terms of how you invest. For example, a real estate investment trust with a larger ratio of debt would be in for a rougher ride than one with lower debt.

One private REIT we currently invest in is Rise Properties Trust, which is focused on residential rental properties in suburban Seattle and Portland. Its rental income is tied much more to inflation than Canadian residential properties, because of the relative lack of rent control in those markets and a culture that moves more frequently, thereby allowing average rental income to be more closely tied to current (inflationary) rates.

Of course, many people do suffer from rising inflation. If you have high debt and low assets, as many younger people do, rising inflation is a real risk and concern. However, don’t fear inflation if you have low or no debt, higher assets and are receiving some form of indexed income (including CPP and OAS). It is actually your friend.

Reproduced from Financial Post, June 14, 2022 .

Ted Rechtshaffen
Provided By:
Ted Rechtshaffen, MBA, CFP
President and CEO
tedr@tridelta.ca
(416) 733-3292 x 221
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