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THE FED'S EFFECT ON CANADIAN STOCKS
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By Kurt Reiman  | Friday, June 24, 2016


In recent weeks, market participants have once again begun handicapping the odds that the Federal Reserve (Fed) will hike interest rates for a second time this summer. The debate and anxiety over whether the Fed will move in June, July, or September misses a larger point: The Fed will likely move interest rates slowly and deliberately higher and will have its eyes focused squarely on the global economy and financial market conditions as it normalizes monetary policy. We don't think the Fed is any hurry to raise rates and should continue to keep its options wide open.

There is, however, a tendency to worry that the Fed's efforts to raise interest rates will somehow complicate the outlook for riskier assets like stocks. Perhaps the thinking goes that since monetary accommodation was helpful for inflating asset prices and suppressing volatility, the reverse will prove problematic. While we wouldn't rule out the prospects for further stock market gains, global equity returns are likely to be more modest and volatility more elevated from here, especially because stock markets are more fully valued these days.

But what about the effect on Canadian stocks? Could the Fed's rate increases spell trouble for Canadian equity investors and what could it do to the Canadian dollar? I took a look at the historical precedent to get a sense of what the early stages of Fed rate hikes mean for Canadian investors. While there is admittedly a limited sample size of only four comparable episodes in 1994, 1999, 2004, and today's, the data are modestly encouraging.

For starters, the Fed's current rate normalization campaign is incredibly modest by historical standards (see the chart below). While it's far easier for short-term interest rates to double given their low level today, the pace of rate hikes since December has been and is likely to be far more modest than at any time in the past 25 years.

Second, despite all the predictions for a stronger U.S. dollar as the Fed raises rates, the historical experience has been rather the opposite from the standpoint of a Canadian investor (see the chart below). In the four episodes dating back to 1994, the Loonie has held up rather well heading into the Fed's first rate increase. In other words, if the past is any guide, we can't expect the Loonie to suffer just because the Fed is raising rates and the Bank of Canada is holding rates steady. If oil prices continue to firm as the Fed pushes rates higher (a reasonable assumption), then any downward pressure on the Loonie from higher short-term U.S. interest rates could be partially or fully offset by the move higher in oil prices.

Third, Canadian stocks have historically held up well in both absolute terms and relative to the U.S. when the Fed is raising interest rates. With the exception of 1994 when the Fed doubled short-term interest rates from 3% to 6% in the span of a year, Canadian stocks have outperformed U.S. stocks (substantially so in two instances) during periods of Fed rate normalization (see the chart below). In each of these four periods, Canadian equities were either flat or higher during the 12 months after the Fed began its tightening cycle.

Given the potential for a slow and deliberate reversal of short-term interest rates in the U.S., we think global equities will deliver more muted returns against a backdrop of higher volatility. We think the Fed is poised to raise rates once this summer. However, to the extent that the Fed raises rates as it sees confirmation of a steady reflation of the economy and either stable or higher commodity prices, this can favor Canadian equity markets and is unlikely to put undue downward pressure on the Canadian dollar.

Source: BlackRock Investment Institute and Bloomberg.

Kurt Reiman, Director, is BlackRock's Chief Investment Strategist for Canada and is a member of the BlackRock Investment Institute (BII). He is responsible for creating value added Canadian financial market and investment insights and communicating them, alongside our global views, to our clients as well as to investors and our client-facing professionals throughout Canada. This article first appeared on the BlackRock Blog © 2016 by BlackRock Asset Management Ltd. Used with permission.

NOTES AND DISCLAIMER

Past performance is not guarantee of future results. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain "forward-looking" information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

© 2016 BlackRock Asset Management Canada Limited. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. Used with permission. iSC-2351

 
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