The stock market has staged a remarkable recovery since it hit bottom on March 9, 2009. In 2010 alone, the S&P/TSX Total Return Index (stock prices plus dividends) is up 26 per cent compounded annually. In most sectors what was lost has been recovered. On February 16, the S&P/TSX composite index rose over 14,000, the first time it has done that in 27 months. But now the recovery could be heading for the end.
The reason? Rising bond interest rates. Numerous studies show that when government bonds’ yields, which, like those of all bonds, move opposite to bond prices, hit four per cent, money starts to flow out of risky stocks. Investors dump stocks, even those with good dividends, and head for cover.
We are headed for that trigger point. Bond prices have been dropping. The average yield on Government of Canada 10 year bonds, a bellwether for the market, is 3.57 per cent, up from 2.70 per cent just five months ago. In the U.S., 10-year Treasury bonds currently yield 3.64 per cent, up from 2.44 per cent in October 2010.
For now, the story driving Canadian stocks remains a happy one. Exports of wheat to drought-plagued China are up. Oil prices are strong. Base metals remain part of the recovery story. Those are fundamentals, but they cannot outweigh the downdraft interest rates have on corporate profits.
There are two vital drivers of interest rates: inflation, which is rising; and demand by loanable funds, which is not terribly strong and which could falter. Inflation expectations are rising moderately. Bank of Nova Scotia economists figure that it will hold at about two per cent to 2.3 per cent for the next few years. The Bank of Canada aims to keep inflation at about two per cent and it has been successful in doing so.
But demand for loanable funds is the problem. Banks have been piling up cash and using it to buy government bonds. The return isn’t much, just a couple of percent per year, but banks don’t have to commit any reserves when they buy government bonds. There is no default risk, so they need make no provisions for loss on government bonds. Add to this the fact that the Bank of Canada lends banks money at one per cent, which the banks then turn around and use to buy government bonds at two per cent or three per cent, depending on maturities, and you can see why the banks have not been in a rush to lend to business.
What lending to business there has been will start to dry up on the demand side when interest rates rise over four per cent. Studies show that at that point, bond yields and stock prices go in opposite directions. Borrowing declines because interest, which is a cost of business, starts to make deep cuts to profits.
The banks themselves start to suffer when their own funding costs go up. The GICs they issue
and the so-called “high interest” savings accounts start to pay serious interest and that crimps bank lending margins. The process is gradual. Profit erosion is slow, but it is there and it is inevitable.
So how far are we from a major market pullback? For now, the export story trumps the fear of rising interest rates. Yet the clouds are there. Global security worries haven’t yet depressed markets, but with a few more revolutions in the Middle East, they could. Especially if they endanger the flow of oil to major import markets. That could drive up oil to US$120 per barrel or more. A high price of oil would be a tax on the world. Consumers and business would pay more for transportation and heat, for electrical power made by oil, and for competing thermal energy sources like coal. The high price of oil would have the same effect as interest rates in the eight per cent to 10 per cent range or higher.
With so many negatives looming, what’s the right thing to do
bonds, junk bonds, global bonds and especially U.S. bonds have had their day for a while.
2) Consider stocks that can at least hold their own in hard times. Those are issues of companies with sustainable earnings. Consumer products companies, some very broadly based U.S. pharmaceutical/household supply companies, and, still, rock-solid Canadian chartered banks that are eventually going to raise their dividends and so support their stock prices are all candidates for long term buy and hold portfolios.
3) Consider buying into a probable winner in a world in which food prices are rising — agricultural machinery. The sector is volatile, the big manufacturers have a lot of debt. But the prospects for expanding cultivation with rising prices are clear. Tractors and combines have to be a good business in this market. The major makers are U.S.-based. Their dividends don’t get favourable treatment via the federal dividend tax credit.
But buying into the sector or even adding weight to existing investments seems an obvious play. Of course, any investment may need a decade to prove itself. If the concept is appealing, avoid speculating. That means a commitment over one or two 36-to 48-month business cycles.
Canadian stocks have been world leaders for the last decade. The Canadian dollar has risen in value by a third against the American dollar, and investors in Canada have generally fared better than those investing in U.S. and global markets.
All good things come to an end. That goes for Canadian stocks as much as winning streaks of championship tennis players. For the 10-years ended January 31, 2010, Canadian stock mutual funds produced an average annual compound return of 4.96 per cent. Global stock mutual funds actually lost 0.95 per cent per year on the same basis. The odds are that in this decade global stocks will make up the difference. The loonie is not likely to appreciate much more. If it did, our trade with the U.S. and the world would be badly impaired. So surging stock markets in Brazil, China, Russia and India are likely to lead, pulling up European stocks that lost 1.62 per cent per year on an annualized, compound basis in the ten years ended January 31, 2011. World capital markets eventually adjust for risk and expectations. Canada’s moment in the sun of global capital is likely to wane, at least for a while.
Buying into global equity mutual funds with moderate fees or global equity exchange traded funds that do have modest fees is not a bad way to meet the likely surge in stocks outside of Canada. You can buy the ETFs with or without foreign exchange hedges. The case for other currencies to rise in relation to the loonie is strong, so investors who want to take foreign exchange risk can go with unhedged investments.
Nobody ever said that investing is easy, but the fundamentals haven’t changed. Buy companies with solid balance sheets and debt they can service. Make sure the company has paid a dividend without cut or interruption for at least 10 years, 20 is better. Be sure the business model is reasonable — making farm equipment is certainly that. And always compare the rate of growth of sales with the rate of growth of earnings. You want to buy companies that increase their income via selling products, not just by squeezing down costs.
AndrewAllentuck’slatestbook,WhenCanI Retire?PlanningYourFinancialLifeAfterWork, waspublishedbyPenguinCanadainJanuary
Consider stocks that can at least hold their own in hard times