Midyear Outlook: How Rising Canadian Interest Rates Could Impact Investors

by: BlackRock

By Aubrey Basdeo and Kurt Reiman

The Bank of Canada has raised its key lending rate for the first time since 2010. Kurt and Aubrey discuss what may be in store for investors during the second half of the year.

Conditions are now in place for Canadian stocks to potentially stage a comeback over the balance of 2017 after underperforming global equities during the first half. By contrast, Canadian fixed income still looks challenged as central banks take steps to normalize policy.

Canada has recently experienced the strongest growth expansion within major developed economies. Importantly, the synchronized and sustained recovery around the world that we describe in our global outlook will likely reinforce Canada's growth momentum and reduce spare capacity as the output gap narrows. The economic outlook is not entirely without risks. Over-indebted households, overheated housing markets, historically low energy prices, trade skirmishes with the U.S. and lacklustre non-energy exports are potential trouble spots.

Against this backdrop of firming economic activity, the Bank of Canada (BoC) is poised to join the ranks of global central banks in the removal of crisis-era monetary stimulus over the second half of 2017. This is a radical departure since our last update when we thought the BoC would remain on hold until 2018. Fears of deflation have faded from view, although inflation may still be well below the bank's target. Moreover, the resilience of the natural resource sector in the face of weak prices for energy and other industrial commodities augurs for less monetary juice. The Canadian dollar, reflecting much of this recent shift in the BoC's stance, is now trading at the upper end of its 12-month trading range.

The outlook for tighter monetary policy both globally and locally means that, in our view, investors may want to reduce interest rate risk in their portfolios. We favour shorter maturity exposures within fixed income, an underweight to government bonds, and a preference for credit risk through short-dated provincial and corporate bonds. The steady decline in bond yields throughout 2017 has led to increased interest rate risk and more expensive valuations in the bond market. We suggest taking an active approach that also includes global exposures to manage risk and return in bonds, given the low level of income and limited total return opportunities available in Canadian fixed income.

Shifting our attention to stocks, as we outline in our midyear outlook, we favour eurozone, Japanese, and emerging market equities given still strong economic data, relatively more accommodative monetary policy and more attractive valuations than U.S. peers. We see value re-emerging in Canadian equities following this year's sizeable underperformance. As measured by forward price to earnings, Canadian stocks stand at one of the cheapest levels versus U.S. equities since 2004.

Our preference for value supports low-cost producers in the energy sector. Likewise, another darling of the value approach - financials - should benefit from higher interest rates and the Canadian banks' broad geographic reach. Given the rather large exposures to these two sectors within the Canadian stock market and the drag on performance so far this year, any turnaround in value would likely have a disproportionately positive effect on Canadian equities.

Aubrey Basdeo is a Managing Director and Head of Canadian Fixed Income for BlackRock. Kurt Reiman is BlackRock's Chief Investment Strategist for Canada. Both are regular contributors to The Blog in Canada.

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This post originally appeared on the BlackRock Blog.