What Will Be The Consequences If Interest Rates Rise?

Last update on Feb. 5, 2018.

Image Credit: Mr.Whiskey / Shutterstock.com

 

At the beginning of every month, I brief members on how MoneyGeek's Regular portfolios have performed and comment on the state of the financial markets. In this update, I’ll also talk about the recent rise in interest rates, and potential consequences if rates continue to increase.

 

January Performance of Regular Portfolios

The performance of MoneyGeek's Regular portfolios for the month of January 2018 were as follows. (Please note that we’ve changed the names of the portfolios to be more in line with the conventions of our competitors, but the contents of the portfolios haven’t changed.)

 

Last Month

Last 12 Months

Since Apr 2013

Aggressive

+1.6%

+15.6%

+99.8%

Growth

+1.4%

+13.6%

+82.6%

Balanced

+1.1%

+11.6%

+66.4%

Conservative

+0.8%

+9.5%

+51.3%

Very Conservative

+0.6%

+7.6%

+37.5%

I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Regular Aggressive portfolio.

 

Last Month

Last 12 Months

Since Apr 2013

RBC Select Aggressive Growth

+1.4%

+11.5%

+69.6%

TD Comfort Aggressive Growth

+0.3%

+9.4%

+52.9%

CIBC Managed Aggressive Growth

+1.7%

+11.5%

+60.4%

Canadian Couch Potato Aggressive

+1.6%

+14.5%

N/A

In contrast to our competitors, MoneyGeek’s Regular portfolios employ stocks/ETFs that follow the value investing strategy (QVAL, IVAL and BRK-B), and also allocate a larger percentage of the portfolios toward Canadian oil and gas stocks (XEG.TO) and gold (CGL-C.TO). If you would like to take a look at our portfolios, I invite you to sign up for our free membership.

MoneyGeek’s portfolios generally outperformed our competitors in January. BRK-B especially had a good month, rising by 5.8% in Canadian dollar terms. I’m not entirely sure why BRK-B outperformed in January. The company did announce a joint deal with Amazon and JP Morgan to form a healthcare company, but the stock had outperformed prior to that announcement.

The U.S. stock market had yet another banner month. The S&P 500, which tracks the largest 500 stocks in the U.S., rose by 5.7% in U.S. dollar terms. Note that because of the weakening U.S. dollar, this translated to a 3.5% gain in Canadian dollar terms. Early last month, Warren Buffett stated that the recently enacted corporate tax cuts were not “baked in” to the stock market. Perhaps investors agreed with Buffett.

But while the stock market continued from strength to strength, the bond market has started to show signs of weakness. The iShares 20+ Year Treasury Bond ETF (Ticker: TLT) lost 3.3% in January in U.S. dollar terms as long term interest rates rose.

Many investors, including myself, expect rates to continue to rise. The Republican tax cut will leave more money in the hands of its citizens, who will then go out and purchase more goods and services. More demand for goods and services will drive up prices (i.e. increase inflation), and increased inflation will force central banks to raise benchmark interest rates.

Interest rates will probably increase faster than inflation. Inflation has momentum, so if central banks merely match the rise in interest rates to that of inflation, they risk having inflation continue to soar higher. This is precisely what happened in the 60s and 70s, as the following chart shows:

Image credit: The Market Oracle

Inflation’s continual rise during that period was finally stopped in the early 80s when interest rates were set some 6% per year higher than inflation. So how would higher interest rates affect us personally? I have a few thoughts on that.
 

Potential Effects of Higher Interest Rates On Investments

One, I believe higher interest rates may lead to lower housing prices, as fewer people will qualify for mortgages. Perhaps this will be the trigger that finally pops the housing bubbles in Toronto and Vancouver.

Two, I believe highly indebted stocks will struggle. Because interest rates have been so low for so long, even a relatively small increase in interest rates will have a noticeable impact on dollar amounts paid to service debt. For example, if interest rates on a company’s debt go from 4% to 6%, then the dollar amount on interest payments will go up by 50%. For heavily indebted companies, such increase might be enough to push them over the edge to bankruptcy.

Three, I believe growth stocks will struggle. By growth stocks, I don’t mean companies like Google that continue to increase their earnings year after year. Rather, I mean those companies that are losing money in pursuit of growth in other metrics, such as number of active users. Companies like Snapchat and Uber come to mind.

The problem with growth stocks is that they continually need fresh injections of money in order to stay alive. When interest rates are low, investors are more willing to hand money to such companies, because they might see the alternative as having money sit in some bank account earning hardly any interest. But if interest rates increase, some of these investors may be content to park their money in a safer investment that now generates decent rates. If fewer investors are willing to finance growth companies, those companies may not be able to raise enough cash and may eventually go bankrupt.

This greater allure of safer investments could also lead other bubbles to pop. For example, some people may have been more willing to speculate in things like cryptocurrencies because interest rates are low. But with higher rates, some may decide to pull money from cryptocurrencies and leave it in their bank instead. Perhaps this is the reason cryptocurrency prices have been going down recently? It’s hard to say, but I think it’s one plausible explanation.

Now, if these things come to pass and multiple bubbles pop, we will have a problem on our hands because that means we will almost certainly enter an economic recession. But that’s a step too far to predict. In the meantime, I think it’s wise to monitor the situation, and to be ready to react if interest rates do start to have an impact on some of the above-mentioned outcomes.

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