Stock market historically strong six months before and after rate increases
The likelihood of a Bank of Canada rate hike in July should not derail the stock market rally, finds a new report from CIBC World Markets.
“Higher interest rates are not yet a reason to hit the sell button,” says Chief Economist Avery Shenfeld in the bank’s latest Economic Insights report. “History shows that the half-year in the lead-up to the first Bank of Canada rate hike tends to coincide with a very strong run for stocks, and stocks still outperform bonds in the early months after that first tightening move.”
CIBC’s latest Economic Insights report examines how the TSX fared in the run-up to, and early stages of, the last 13 interest rate tightening cycles. The results show that in the six months before the Bank started to lean into the wind, Canadian stocks historically provided, on average, a 22 per cent annualized return (dividends plus capital gains) measured by the total return index for the TSX Composite.
The best performance was a 34 per cent return (unannualized) in the six months leading up to May 1983, when the Bank began to reverse gears after the early 1980s double dip. The worst was a four per cent decline (unannualized) in the half-year period prior to August 2004. In only one other case was performance measurably negative.
In the six months after a rate trough, Canadian stocks in comparison returned 8.3 per cent in annualized terms. That’s less, on average, than in the pre-hike period, but within a per cent of the TSX’s longer term performance. Total returns were significantly negative in only one of the thirteen half-year periods after a rate trough. Stocks outshone bonds, the main competing asset class, about 70 per cent of the time in the half-year before the trough in rates and over 85 per cent of the time in the half-year after.
“That makes eminent sense,” states Mr. Shenfeld. “Equities should be linked to the present value of a future stream of earnings and dividends. Central banks don’t start to step on the brake unless they see strong economic momentum. In that regard, we recently lifted our growth outlook for Q1 to just over five per cent, marking a second consecutive quarter at that pace. With that economic momentum will be an attendant lift to earnings expectations. That could end up being overdone, but the recognition of any excess optimism about corporate bottom lines will await news of slower quarterly growth late this year and in 2011.
“Rate hikes tend to be more damaging later in the cycle, when the central bank is more willing to risk a stall or recession to create anti-inflationary slack. At this point, we are a long way from the demand-driven wage-price spiral that would see the central bank willing to seriously sacrifice growth. Rate hikes are coming, but not at the growth-crushing pace that should at this point strike fear in the hearts of equity investors.”
CIBC further examined sector-specific performance on the TSX back to late 1987, the year when the exchange started tracking consistent detailed total return data. It found that the some of the best performers in the six-month lead-up to the low point in rates in that interlude were the banking, base metals and transportation groups. These sectors did better than the market as a whole 80 per cent of the time–or in four of the five tightening episodes that occurred during that period.
In the half-year following rate hikes, the transportation and durables sectors were among the best places for exposure. Those sectors are not as strongly sensitive to higher bond yields as others, but are still key beneficiaries of an economic upturn.
“As notable as the effect of overnight rate changes may be, our analysis confirms the widely held view that long term rates have much more of an impact on equity valuations than short-term rates do,” says Peter Buchanan, senior economist at CIBC. “That is not all that surprising, since what matters for investors is not earnings this year or quarter, but over a longer time frame. They are, consequently, more likely to compare the return with those from other long-lived assets.”
Mr. Buchanan notes that while he expects the Bank of Canada to start tightening rates before the U.S. Federal Reserve Board, he believes Canada’s low inflation and better fiscal fundamentals will help temper the adverse effects of the hike. “Balance sheets in corporate Canada are in appreciably better shape than in the past. The debt-to-equity ratio for the non-financial sector stands at just over 50 per cent, a little over half its level 15 years ago. With a higher dollar and fiscal tightening doing some of the Bank’s work and still ample slack limiting prospects for a truly serious deterioration in inflation, we expect short-term rates to rise by only about 75 basis points from today’s comparatively low levels through year-end.
“In absolute terms, that means rates at both the long and short end will remain low, relative to their historical averages for some time,” he adds. “That’s a plus for corporate cash flows and it also means that the payouts on dividend-yielding equities will remain attractive compared to fixed income vehicles. Those forces suggest higher rates may well be an annoyance but are unlikely to deliver a knockout blow to equity markets.”
The complete CIBC World Markets report is available at: http://research.cibcwm.com/economic_public/download/smar10.pdf.
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For further information: please contact Avery Shenfeld, Chief Economist, CIBC World Markets Inc. at (416) 594-7356, [email protected], or Kevin Dove, Communications and Public Affairs at (416) 980-8835, [email protected]