2013 – Mid-Year Review

Are Rising Interest Rates Good or Bad for Investors?

 

We have received a number of questions lately about the recent rise in interest rates and what implications that might have for financial markets.

 

With the general level of interest rates at historical (perhaps artificially) low levels, the concern is that any increase in interest rates could potentially result in capital losses for investors.

 

In the short run, that may be true for bond investors as interest rates and bond prices are inversely related.   There are not such things as “magic bonds”… if interest rates rise, bond prices will go down.

 

That said, the longer the term of a bond, the more sensitive it is to changes in interest rates.  For example, very long-term bonds can actually have stock-like volatility.  We review the roll of bonds in a portfolio is to preserve capital and reduce volatility.  With this in mind, we avoid long-term bonds and keep our bond maturities relatively short-term.   This means that rising interest rates should have minimal effect.

 

The other question is whether a “rising interest rate” environment is good or bad for the equity side of portfolios?

 

It depends.  Although the stock market decline in mid June was sharp and concerning, as we are writing this in early July, most financial markets have already recovered.  So, ultimately, the answer is that the impact of rising rates depends on consumer confidence.

 

While bond yields bottomed over a year ago and have risen since then, consumer confidence has strengthened. The doomsday predictions from a few years ago born out of the financial crisis 2007-2009 have failed to materialize. Some investors have started to believe that the end of the world is not coming and that the economic recovery, albeit slow, is likely sustainable.   Financial assets like stocks and real estate are trading at higher valuations today than in previous years, (albeit lower than historical averages) which are signs of improving confidence.  The decline in gold prices, higher levels of consumer activity in home sales and mutual fund inflows are supportive of this premise as well.

 

So yes, yields have risen lately, but improving confidence seems to be at the core of what has driven them there. If this continues, higher interest rates may not materially impact economic activity and should allow equity markets to continue providing positive results.

 

Major Asset Class Returns to June 30, 2013.

 

 

6 Months

1 Year

3 Years

5 Years

10 Years

Cash

0.46%

0.93%

0.86%

0.83%

2.00%

Canadian Bonds

-1.68%

-0.17%

4.59%

5.53%

5.34%

Canadian Stocks

-0.88%

7.90%

5.39%

-0.53%

8.41%

US Stocks

20.60%

24.60%

17.98%

7.68%

4.68%

Int’l Stocks

6.50%

18.28%

7.89%

-0.02%

5.86%

REITs

-5.62%

11.26%

17.61%

7.65%

7.98%

 

Notes:

1)     Data Source Dimensional Fund Advisors.

2)     Asset Classes:  Cash – Canadian One Month T-Bills, Canadian Bonds – DEX Bond Universe, Canadian Stocks – S&P/TSX Composite Index, US Stocks – S&P 500, International Stocks – MSCI EAFE plus Emerging Markets, REITs – Dow Jones Select REIT.

3)     Returns longer than one year are annualized.

 

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