Market Buzz – Inflation and Interest Rates – Impact on Stock Market Returns and Income Investing

We often receive numerous questions about the direction of interest rates and how higher or lower rates might impact an investor’s portfolio. Most investors understand that the economy has enjoyed an extended period of low interest rates and also understand that rates move up and down in cycles. The fact is that there is a very strong relationship between interest rates and stock market returns, but before we discuss this relationship, we have to make sure our readers understand two basic economic concepts – inflation and monetary policy. Canada’s central bankers (Bank of Canada) measure inflation on a monthly basis in order to keep core inflation within a band of 1 to 3% per year. They work to achieve this through their control of the overnight rate, which is the interest rate at which banks loan each other money for a period of one day. When the economy is roaring and the labour market is tight, we typically see wages for workers increase and this (along with other factors) has the effect of increasing prices for consumer products and services – otherwise referred to as inflation. If the Bank of Canada determines that inflation is moving past the midpoint of the their target band, they use their tools to increase the overnight interest rate, which in turn lowers the banking sector’s access to capital, reduces the short-term money supply in the economy and hopefully puts a break on inflation – this is referred to as monetary policy. Think of the Bank of Canada’s use of monetary policy in terms of the way a rider will use their reins to control a horse. When the horse (economy) starts to charge forward too quickly, the rider (Bank of Canada) will pull back on the reins (increase interest rates) in order to slow it down.

Most investors mistakenly associate all interest rates with those under the central banks direct influence. The reality is that there is an interest rate on dozens of different types of bonds over dozens of maturities (three months to 30 years) and the central bank has minimal influence over most of them. When individuals and institutions purchase bonds they can select from a range of maturities ranging from less than one year to up to 30 years. Prevailing interest rates (bond yields), which are determined by supply and demand (not directly by central bank decisions), determine the cash payments that these investors will receive from owning the bonds. Higher interest rates therefore typically translate into a better reason to own bonds (relative to stocks). Currently, the average yield for five to ten year Government of Canada bonds is about 2% per year. That same investor can go to the utilities, banking, or telecom sectors and generate a similar (or higher) dividend yield that also provides them with the potential for dividend growth and capital gains. Of course, that investor will also incur higher risk.

So to answer the question…rising interest rates compete with the stock market by making bonds more attractive for new investors. However, it is not the central bank rate that investors need to focus their attention on, but more so on bond market yields and particularly yields in five to ten year bonds. Some investors will attempt to time interest rates and shift in and out of the stock market to take advantage of the cyclical changes. The problem with this strategy is that interest rates are extremely difficult, or even impossible, to forecast accurately over time. In addition, major changes in bond rates typically do not happen overnight, as cycles can take months or years to complete. This can result in investors trying to time the market for profit, but missing the correct entry points by very large time margins. As well, although the link between bond rates and stock market returns is adverse, income stocks still possess qualities that bonds cannot replicate – namely dividend growth and share price appreciation.

Looniversity – Authorized vs. Outstanding Shares

Authorized shares are the maximum number of shares that a corporation is legally permitted to issue under its articles of incorporation. This figure is usually listed in the capital accounts section of the balance sheet.

This number can be changed only by a vote of all the shareholders. Management will typically keep the number of authorized shares higher than those actually issued. This allows the company to sell more shares if it needs to raise additional funds.

Also known as “authorized stock” or “authorized capital stock.”

Outstanding shares are naturally the best to own as they are, after all, “outstanding”. All kidding aside, outstanding shares refers to the number of shares that are currently owned by investors. This includes restricted shares (shares owned by the company’s officers and insiders) and shares held by the public. Shares that the company has repurchased are not considered outstanding stock.

This number is more important than the authorized shares or float. It is used in the calculation of many metrics, including market capitalization and EPS.

Put it to Us?

Q. A friend of mine who recently bought stock in a company was complaining about its “liquidity”.  What does liquidity refer to in reference to investing?

Lindsay Montador; Halifax, Nova Scotia

A. A.  Liquidity and or ‘marketability’ refers to whether you can sell or redeem your investment quickly at or near the current market price.

Term deposits are an example of an illiquid investment, since you generally can’t withdraw your money before the end of the term without paying a significant penalty.

Many other investments, such as mutual funds or listed securities (stocks), in relative terms, are very liquid because they can be quickly sold or redeemed on short notice and at low cost.

In your friend’s specific case, she may have been referring to a stock which does not trade a great deal on a daily basis.  This can happen, particularly in the small-cap arena.  If this is the case, then a patient approach is often key.  Set your price and be prepared to wait a couple days or trading hours to get it.

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