Interest rates now give mixed signals

Just in case you haven’t yet noticed, we’ve been getting mixed signals on interest rates of late.

True, yields on corporate bonds have been creeping up to around 4.5 per cent.

And although this is a step in the right direction, it’s still not much more than what you’d now get on a top-notch preferred share.

In the meantime, both politicians and bureaucrats are still trying to hold rates down to help Canada’s “recovery” along.

Canada’s banks are jumping on the bandwagon as well, keeping mortgage rates low.

Of course, you’d think the banks would know better. After all, they make their profits on the spread between what they pay to borrow money and what they charge homeowners for loans.

Yet, with mortgage rates in Canada now at or below three per cent, the banks are dangerously close to losing money.

Of course, most of their mortgage money comes from retail banking which still pays ridiculously low rates.

Nonetheless, as an investor, I’d like to think the banks are doing some contingency planning.

As long as rates rise slowly the banks will face few problems. But if rates take a sudden jump because investors see massive inflation on the horizon, loans will go into default — just as they did in the U.S. back in 2008.

And although I don’t believe massive inflation is imminent, the inflation rate is going to top what we’ve seen over the past little while.

Indeed, over the next few years, rates of four to five per cent are entirely possible.

Digestion necessary

After all, the global economy still has to digest the huge increase in the money supply from the last few years of “quantitative easing” in the U.S. and elsewhere.

Moreover, contrary to official “wisdom,” this money hasn’t pumped up the economy, having instead inflated the prices of financial instruments — mainly, common shares.

Of course, higher inflation rates will lead to higher interest rates which, in my mind, is a good thing.

That’s because current rates, which are artificially low, are distorting the markets.

In the interim, the world’s central bankers are now worrying about deflation. Go figure.

Apparently, many countries, especially those in Europe, are facing inflation rates that are well below target. The solution is simple: raise interest rates.

Indeed, with the drop in the loonie against the U.S. dollar, there’s now plenty of room in Canada to raise rates.

And if rates start to go up now, albeit slowly, this country can avoid a huge shock to its system two or three years down the road.

Unfortunately, there aren’t many sectors of the economy that benefit from higher rates. So, politicians aren’t facing much pressure to raise them.

Moreover, bankers, who should know better, are not only busy making money from the sheer volume of low-interest loans, but dislike the higher losses that result when higher rates cause homeowners to default.

Then, too, consumers — particularly mortgagees — obviously prefer low rates as well. Indeed, the only people who’d benefit from higher rates are savers. And they seem to be a dying breed.

So don’t hold your breath waiting for the Harper government to do something intelligent.

Ottawa will probably flounder around until its policies are overtaken by events. And by then it will be too late to do anything anyway.

Meanwhile, resign yourself to interest rate increases of a few percentage points over the next two to three years, but expect inflation to jump by four to five per cent.

Given the current economy, it’s hard to know how to protect yourself, although you should forget about trying to profit from these conditions.

You can, of course, speculate on gold. In fact, to diversify, you should put up to five per cent of your holdings in gold.

But in general, I dislike speculation. So, I’d advise against buying too much of the precious yellow metal.

Nonetheless, you can almost count on Canada’s financial sector, especially the banks, to be among the hardest hit in any spike in interest rates.

So, if you’re now sitting on some pricey bank shares, you might want to take profits and sell some. You can then use the proceeds to trawl for bargains when the correction comes.

Utilities can probably handle a slow, steady rise in both interest rates and the rate of inflation.

But these companies face a time lag before they can pass along big rate hikes to their customers.

Still, I expect some larger shocks will hit the sector — in some cases, for up to two years.

So, once again, you might want to consider taking some profits while waiting for the correction.

Not surprisingly, because most of their profits come from exports, Canada’s resource companies want to keep the loonie low.

But since the Yanks, the Chinese and others will still want our coal, oil and gas, our resource companies will continue to do OK.

Manufacturing stocks looking anemic

The same can’t be said for Canada’s manufacturing sector. Not only is it anemic, but it will likely remain that way as long as it’s weighed down with legacy labour costs — mainly pensions. Canadian manufacturing is also saddled with high wage rates.

Then, too, rather than make concessions, unions seem to prefer forcing companies to close plants and transfer jobs elsewhere.

(Not that corporations are squeaky clean themselves, given that when they do occasionally manage to extract concessions, they shut down factories anyway).

Impact will be low

On balance, the manufactured goods sector will complain if either the loonie or interest rates go up. Yet, if they do, there won’t be much of a real impact. The few successful manufacturers will continue to do all right, while the others will continue to flounder.

One example of a reasonably successful manufacturing stock is auto parts maker Magna International Inc. (MG-TSX, $106.05).

Now that this Ontario-based company has cleaned up the voting structure for its shares, its stock looks attractive.

Another good company which I regard as a manufacturer, although it more rightly belongs in the consumer products sector, is Maple Leaf Foods Inc. (MFI-TSX, $17.10).

At 1.6 and 0.9 per cent, respectively, the dividend yields on both these companies are a little lower than I’d like to see.

But at 14.9 and 4.8, respectively, their price-to-earnings ratios are good, enabling them to weather any financial storms.

In sum, we’re overdue for a market correction. So, all I can now recommend is that you hold fast to a portfolio of good dividend-paying stocks, although the share prices are likely to drop five to 20 per cent. You should also keep plenty of cash on hand for bottom-feeding.

In the meantime, keep hoping that the world’s central banks will wake up and start allowing the market to have more control over interest rates.

 

T. Edward Gardiner, a keen observer of the markets, is a Bell Canada retiree. He lives in Ottawa.

 

 

Investor’s Digest of Canada, MPL Communications Inc.
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