Nothing lasts forever, not in capital markets, at least. The extraordinary performance of markets recovering from the debacle that lasted from mid-June 2008 to early March 2009 ended with a spectacular recovery that saw the S&P/TSX Composite Index rise more than 30 per cent for 2009. That was its best performance since 1979. For the record, the best performance of the 20th century was the 46.8 per cent recovery in 1933.
It was not just stocks that thrived. Mutual fund investors were treated to a one-year gain of 31.7 per cent in financial services stocks, a 29.0 per cent gain in junk bonds, a 47.0 per cent gain in Asian stocks (excluding Japan) and a strong 9.8 per cent gain in bond funds.
This year, 2010, is not likely to be so robust. Big issues are hanging over the market. From an investor’s point of view, the biggest is that markets have already priced in more good news than there is out on Main Street. “If you’re looking for a job, the recession ain’t over,” is how one job seeker put it. And that, in a nutshell, is the problem.
The real economy, as distinct from the financial economy, is recovering, but far from recovered. Scotiabank’s economics department notes that the Canadian unemployment rate remained at 8.3 per cent in November 2009, a little less than the 9.3 per cent unemployment rate in the U. S. Economists figure that the real rates of joblessness are about twice the reported rates, for many discouraged former workers just stop looking for work and therefore drop out of the statistics.
Today, we are looking at a global economy sustained by artificially low interest rates. Bonds, which move up as interest rates move down, are now as expensive as they are likely to get. Yields are nearly nothing on short government debt and not much on medium to long-term debt. High-yield bonds have doubled in value compared to where they were in December 2008.
Looking ahead, there remain prospects for healthy if not spectacular growth in Canadian and global stocks. Preferred stocks with fixed dividends will behave like bonds and decline in price as interest rates rise — as they are bound to do when central banks stop handing out free money to banks and borrowers. Anyone going cap in hand to the Bank of Canada and the Fed has been able to get a short-term loan for what is usually less than the rate of inflation. It doesn’t get cheaper than this. But rising rates don’t mean soaring rates. If the Bank of Canada does raise rates, it will be a sign of recovery. No forecasters expect interest rates to rise dramatically, so interest rate increases will not be of the sort to kill the recovery.
INVESTORS GET RISKIER
In the 2010 market, the watchword will be “risk.” Everybody is going to have to accept some risk in order to make money. Bonds, as we have said, are going to be stagnant at best. Investors will sell long bonds and move to short maturities where interest rate changes mean very little. They will get their paltry coupons and not much more.
The best bet on stocks will be those that have healthy dividends and a history of growing dividends through good and bad times. As CIBC World Markets economists Avery Shenfeld and Peter Buchanan note in the January issue of Monthly World Market Report, “The number of firms paring or eliminating dividends has fallen sharply from early 2009 peaks. Only three per cent of the firms setting dividends in Q4 of 2009 have announced reductions. That’s down from the cyclical peak of 16 per cent in Q1/2009.”
Looking ahead, the best play in 2010 may be those dividendpaying stocks. Many are boring critters like phone company BCE Inc., utilities like Emera Inc., and recovering technology and entertainment firms like Rogers Communications Inc.
Cash will be a wild card. To date, it has paid almost nothing in savings accounts. Canada Savings Bonds issued in the fall of 2009 carried a distressingly low interest rate of 0.40 per cent.
INTEREST RATES TO CREEP UP
Looking ahead, it’s a sure thing that interest rates will go up. Scotia Economics predicts that three-month Canada Treasury Bills will move from paying 0.35 per cent in the first quarter of 2010 to 1.05 per cent in the third quarter. Tenyear Canada bonds’ yields will rise from a current level of 2.60 per cent to 3.20 by the end of the year. U. S. T-bill rates should rise to 1.00 per cent by mid-2010 from a current level of 0.15 per cent, and the 10-year U. S. T-bond should be paying 4.40 per cent by mid-2010, up from 3.75 per cent at the beginning of the year.
Significant interest rate moves should come in the second half of 2010, says Adrienne Warren, senior economist with Scotiabank in Toronto. “Prime based rates won’t move up much in the first half, but they will rise in the second. The Bank of Canada and the Fed will be unwinding their stimulus programs and commercial and consumer loan rates will rise,” she notes. Longer-term rates tied to the bond market should rise ahead of short-term rates, she adds.
These are huge jumps in rates, though admittedly all in the low single digit range.
As rates rise, corporate costs of borrowing will soar. For companies able to increase their sales and to maintain or increase their profit margins, higher interest costs will be bearable. For companies with tight or shrinking margins, higher interest costs will cut earnings and are likely to lead to lower stock prices.
“Rising interest rates should not be an issue for the first half of 2010,” says Patricia Croft, chief economist of RBC Global Asset Management in Toronto. “We have not seen a lot investing or borrowing from the corporate sector until fairly recently.
“Growth of credit demand has been modest so far in the recovery. For 2010, inflation won’t be a big worry. But there will be concern that the end of artificially low interest rates may create a shock for consumers.”
Ms. Croft says the tough question is whether, when interest rates do rise, consumers will be able to take the shock. “We don’t know the tipping point,” she says. “We do know that the outstanding mortgage balance for Canadians could become a burden if borrowers find that they have to roll from a few per cent to what could be significantly higher rates.”
By sector, winners should be:
Banks. Declining loan losses, higher interest rates and more business loaning money
Commodity transport networks. Pipelines and railroads will move more oil and freight.
Commodity producers. Coal, potash, copper and other minerals and fuels will thrive.
Consumer durables. Increased spending by consumers
House building. Borrowing costs remain low
Losers could be:
Tourism. Vulnerable to the rising loonie, which makes business tough for hotels, resorts
Exporters. Traditional manufacturers that produce durable good geared to the U. S. market could suffer
Will the party end? Yes, Ms. Warren says. “Every boom ends, but we see a good year of sustainable recovery. This is going to be a moderate recovery compared to previous recoveries.” But invest with care. Bonds are going to be out, dividendpaying common stocks that fly high with the recovery should do well, she adds.
Andrew Allentuck’s book, When Can I Retire? Planning Your Financial Life After Work, was published last year by Viking Canada