Investing, interest rates, and the inflation correlation
(Reading time: 3:15)
Your investments are affected by interest rates, which, in turn, can be influenced by inflation.
As for how those two market forces potentially impact your portfolio, well, that naturally depends on the types of assets you have and where we are in our economic cycle.
This is where cause, effect, and the Bank of Canada (BoC) all come into play.
“If the economy is growing too fast, this can lead to rising inflation. This is when the Bank of Canada may step in and raise interest rates to cool down spending (by making it more expensive to borrow),” explains Educators Certified Financial Planner professional Robert Johnston. “Whereas if the economy is growing at a snail’s pace, the BoC will lower rates to encourage spending. However, a booming economy isn’t necessarily the only contributing factor to rising inflation. In the case of the past year, global supply issues (due to the pandemic) and high energy costs have played a part in Canada’s inflation rate rising to the highest it’s been in 18 years.”
So, what does it all mean when it comes to your investments?
First, inflation (if higher than zero) will always reduce any investment’s return. If an investment has a return of 3% and inflation is 2%, then that investment’s ‘real rate of return’ is 1%. The higher inflation is, the less the ‘real rate of return’ an investment provides.
“If inflation has taught us anything, it’s that putting all of your money in a savings account will actually erode your savings year-over-year. Equities, on the other hand, have delivered returns that have been historically higher than inflation. In fact, during the past two decades, the average inflation rate in Canada has been 1.93%*, while the average annual performance of the S&P/TSX Composite Index was 5.74%**.
And what about interest rates?
Well, as mentioned earlier, inflation can lead to higher or lower interest rates, as directed by the BoC. If inflation creeps up too high, the BoC may raise rates. And interest rates can affect equities and fixed income.
“For equity (i.e. stock) prices, rising interest rates typically have an adverse impact,” continues Robert. “Higher borrowing costs usually mean that companies have to spend more to service debt and less on capital investments, which can affect future earnings growth. If consumers are spending less money because of higher interest rates (and debt levels), it can cause corporate revenues and profit growth to shrink, affecting a company’s stock performance in the process.”
When considering (equity) asset holdings, Robert has a few tips.
“Equities, though volatile, offer great protection against inflation,” says Robert. “And while interest rates can have an impact, some sectors respond better to interest rate movements. Ensure you have exposure to a diversified mix of sectors. And remember, the amount you hold in equities must be aligned to your ability to handle the increased risk.”
If you hold fixed-term investments, such as bonds and GICs, you’ll need to employ different strategies.
Robert goes on to explain, “In the case of bonds, prices and interest rates move like a seesaw—when one goes up, the other goes down, so fixed income returns may be affected in the short term. In times of rising interest rates, bond prices will fall. Like equities, some bonds will respond better to interest rate movements and it’s important to diversify.”
Where GICs differ from bonds, is down to a few factors:
- They offer yields that are typically higher than government bonds (and don’t show price fluctuations once purchased)
- Can be insured against default by the Canada Deposit Insurance Corporation for up to $100,000
- Plus with an investment technique called laddering, you can keep equal amounts in GICs with terms of one, two, three, four and five years, so you won’t be strongly affected by modest moves in interest rates up or down
While inflation is a market force impossible to avoid, there are steps you can take to minimize its impact on your long-term financial plans.
That’s where Educators Financial Group comes in.
We can provide you with the expert, educator-specific advice you need to create a diversified investment portfolio that reflects your financial goals, time horizon, and risk tolerance. Plus we’ll go the extra mile to keep your portfolio on track—even during times of economic change.