Lexicon Financial Group Weekly Update

Monday, January 31, 2022


Looking Back

Oh, what a week last week was!

Investors and borrowers waited with baited breath as central bankers in both Canada and the United States held meetings. In Canada, it was wildly anticipated that the bank would increase interest rates… except it didn’t. That’s considered a strange move, given that raising interest rates is a good way to combat inflation, and that markets had largely priced in such a rate hike.

In the US, the Federal Open Market Committee met last week and announced that it would be holding interest rates steady… for now. They have pretty much signaled that they will begin increasing rates at their next meeting in March.

The market reaction to the news was… muted. As at the time of writing, markets for the week have been relatively flat but positive, with the S&P500 (as measured by IVV) and the TSX (as measured by XIC) eking out 0.3% and +1.5% returns, respectively.

Interest rates and inflation will continue to dominate the landscape for the time being, but as tactical investment managers we are already making some moves to help defend portfolios in an inflationary environment.

 

Looking Deeper

It’s always useful to revisit some core relationships – in this case, the relationship between interest rates and inflation. These are macroeconomic concepts, although they play out differently in individual’s daily life.

Inflation is the rate at which goods and services rise. Much attention has been paid to certain items that increase the cost of goods like energy (oil and gas) and food. According to figures release by the US Department of Agriculture, between December 2020 and December 2021 “food-at-home” (buy it at the grocery store) increased by 6.5%. (“Food at home” is different than “food-away-from-home” (aka restaurants). Those increased between December 2020 and December 2021 as well, although not by as much.) So in the simplest of terms, if you paid $10 for a pound of cherries in December 2020, those cost 6.5% more -- $10.65 – in December 2021.

So how do interest rates factor in?

As interest rates rise, consumers have less money to spend. For example, more of their disposable income is required to fund their debt obligations and pay their bills. Furthermore, as rates increase flows of capital will be attracted to more conservative investment options that pay returns from savings will increase. Both of these actions effectively remove money from the system. With less money available, there will be fewer people willing to pay $10.65 for the pound of cherries.

 

Looking Beyond

What does this mean for portfolio construction? In order to maintain the appropriate risk level in a client portfolio, we must take into account both the rate of inflation as well as the interest rate. And because these change all the time, we must always evaluate the asset allocation of any portfolio to ensure it still meets the objectives outlined in a client’s investment policy statement.

There is no single investment than can solve the inflation/interest rate dilemma. The best – as portfolio managers – we can do is understand the risks and modify asset allocations accordingly.

For many at the moment, this may mean adjusting the type of duration of bonds held in the portfolio (short-term vs long-term), considering other fixed income alternatives, and adjusting allocation of equities into sectors that have historically been more resilient in inflationary environments.

 

Further Reading

Markets & Investing – Raymond James

Why the stock market hates the idea of rising interest rates

Chinese President Xi Jinping has urged the West not to increase interest rates

 

The opinions expressed are those of Craig Swistun and not necessarily those of Raymond James Investment Counsel which is a subsidiary of Raymond James Ltd. Statistics and factual data and other information presented are from sources believed to be reliable but their accuracy cannot be guaranteed. It is furnished on the basis and understanding that Raymond James is to be under no liability whatsoever in respect thereof. It is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of securities. Raymond James advisors are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax-related matters.

 

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