Rate Hikes Impact More Than Just Mortgages
Interest rates are rising. Here’s what that means for you.
Equities around the world plunged this week after the yield on U.S. 10-year treasuries poked briefly above 3.25%, its highest level since 2011, and investors began to worry interest rates were approaching levels that would prove restrictive to economic growth. Amidst the week’s turmoil, Toronto’s S&P/TSX Composite Index had its worst single-day point drop in more than three years, the Dow Jones Industrials suffered its third biggest one-day point drop in history, and the technology-heavy NASDAQ saw its worst daily plunge in seven years. Weaker than expected inflation data prompted treasury yields to settle back a little, slowing the descent. Then an easing in U.S.-China trade tensions helped allow equity markets to catch their breath and stage a partial recovery on Friday.
As we reminded you after February’s sharp sell-off, days like these are natural and expected during any bull market. Rising interest rates and the ongoing risk of trade war add to uncertainty and market volatility, and naturally bring a reasonable compression of equity valuations. But macro fundamentals remain intact and the global economy remains strong. History is clear that equity markets typically recover such losses fairly quickly.
Stocks were already in retreat as the previous week ended, after Federal Reserve Chair Jerome Powell said that the federal funds rate was probably “a long way from neutral”, heightening expectations of tighter monetary policy. The 10-year yield jumped almost 20 basis points following his remarks. To add to market jitters, as this week began, the International Monetary Fund downgraded its outlook for the global economy, blaming emerging markets’ stress and rising trade tensions. Yields on Government of Canada bonds followed U.S. rates higher, but not by as much, leading to a slump in the Canadian dollar.
In a welcome departure from recent norms, Canada’s stock benchmark held up better than the major U.S. indices, because of relative strength in the materials and health care sectors. Materials were lifted by the safe haven flows that boosted gold prices to a two-month high. With less than a week to go before marijuana legalization, shares of cannabis companies advanced after Altria (the maker of Marlboro cigarettes) was reported to be in talks to buy a stake in a Canadian cannabis producer. Defensive sectors – utilities, staples and real estate – were also outperformers. The information technology sector, especially sensitive to the threat of international trade disruptions and slower global growth, was among the worst performers. Energy shares dropped, alongside falling oil prices. West Texas Intermediate crude (WTI), which touched a four-year high just last week, ignored major production disruptions in the Gulf of Mexico due to Hurricane Michael, and retreated on news of higher U.S. inventories (Canada’s Western Canadian Select crude benchmark plunged to a two-year low). The industrials sector was also hit hard, especially SNC-Lavalin, which fell after news that federal prosecutors won’t negotiate a deal with the company to settle fraud and corruption charges.
In Europe, fears about Italy’s budget plans continue to capture headlines, but aside from higher bond yields in Italy, there is still no serious contagion to other major markets. In economic data, German exports and industrial production fell unexpectedly, and the German government cut its growth forecasts for both this year and next. But across the euro area, industrial production grew at double market expectations. Asian equity markets fell even more sharply than those in Europe and North America. Even with Friday’s advance, the MSCI AC Asia-Pacific ex Japan Index is at 17-month lows, and has now dropped more than 20% since January, under the twin strains of trade uncertainty and a higher U.S. dollar.
Although the markets ended the week on a more stable note, the increased volatility may be with us for some time. It is important to remember that pullbacks of this magnitude are frequent and normal. The S&P 500 experiences declines of more than 5% more than three times a year on average. Rising bond yields and increased volatility will continue to create headwinds for equity valuations, but the path of corporate earnings is higher, and earnings growth is the fundamental driver of stock prices. U.S. and Canadian economic activity remains firm, and the likelihood of a recession in the near term is minimal. Focus on your long-term objectives and stay disciplined. Time in the market, not timing the market, is what builds wealth.
What’s ahead next week: