You’ve likely noticed higher prices at the grocery store, the gas pump and other retailers. The return of high inflation is a notable feature of the post-pandemic economy.
With consumer prices spiking for nearly a year now, the Bank of Canada (BoC) and the U.S. Federal Reserve (Fed) are shifting gears to help curb inflation. This year’s expected series of rate hikes, the first since 2017, marks the beginning of BoC’s policy normalization. It has also increased market volatility and changed sector leadership so far this year.
The economy: no help needed
Some experts fear removing the BoC’s emergency accommodation will end the economic expansion prematurely, but we believe the economy is strong enough to handle any interest rate hikes. Heightened geopolitical risk is a headwind, but GDP is growing at an above-average pace, and the unemployment rate has declined to near historic lows. Longer-term rates are also still negative in real terms (after accounting for inflation).
While lifting the policy rate from near zero is unlikely to choke off the economy, in our view, the rise in borrowing costs and the withdrawal of support will likely mean more volatility and pressure in market valuations.
Compressed valuations vs. rising earnings
Looking at the four previous tightening cycles since 1990, stock valuations tended to fall when the Fed and BoC raised interest rates and the cost of money increased. For example, the TSX price-to-earnings ratio declined about 20% on average between the first and last BoC hikes. But stronger earnings growth tended to outweigh the negative effect of valuation compression in past cycles, and stocks gained overall with the exception of the 1994-1995 cycle when stocks moderately declined.
We think this time will be similar, with earnings well-supported by a growing economy, resilient profit margins and healthy corporate balance sheets. With a tug of war between valuation pressures and rising earnings, equity market returns should moderate but stay positive, in our view.
This may change if the BoC overtightens, but this tends to happen at the end of a rate-hiking cycle rather than the beginning. A few warning signs are an inverted yield curve, rising credit spreads and weakness in interest rate-sensitive economic sectors (such as housing and autos), but none of these are close to flashing red yet.
What you need to know now
Although we expect to see higher levels of volatility and lower returns in 2022, this doesn’t mean an end to the bull market, in our view. Stocks have historically experienced some weakness around the first interest rate hike. Generally, though, they’ve continued to rise six months and a year out, but past performance is not a guarantee of future results. We recommend staying opportunistic during any BoC-induced pullbacks or corrections.
As central banks tighten policy amid the economic expansion, we think long-term yields will grind higher. Rising yields will likely continue to challenge fixed income returns, but we still expect bonds to play an important part, helping to stabilize portfolios during volatility. With credit spreads expected to stay low, an appropriate allocation to domestic and international high-yield bonds might help enhance returns.
Equity markets can absorb higher bond yields, but valuation pressures on growth-style investments could continue. Value investments, which have lagged meaningfully in recent years, might see the pendulum swing their way.
Overseas markets are also trading at lower valuations. Much like Canada and unlike U.S. markets, their sector composition is tilted toward value and cyclical sectors. If pandemic conditions improve, geopolitical tensions ease and global rates rise, we think overseas diversification will likely help returns.
Important information :
Investors should understand the risks involved of owning investments, including interest rate risk, credit risk and market risk. The value of investments fluctuates, and investors can lose some or all of their principal.