Like it or not, it seems like higher interest rates are here to stay. Once we’ve accepted this new reality, the work begins. Here are some necessary adjustments to make to your portfolio in order to best position yourself for the future.
Bank of Canada’s key interest rate
In December 2021, the Bank of Canada’s key interest rate sat at 0.25%. Less than two years later, it stands at 5%. This is a 475-basis point increase and it changes everything. We are now in a tightening cycle meant to combat inflation, reduce consumption, and rebalance the economy. And this is what’s happening.
The implications of higher interest rates
There are quite a few implications to the higher interest rate environment that exists today in Canada. For example, companies that carry a high level of debt will see their profits eaten away by interest expense. This does not have to be a death sentence, but it is pressure that can sometimes sink a company.
Also, higher interest rates will inevitably hit spending, both at the consumer level as well as the corporate level. Simply put, a higher cost of capital, or money, discourages spending. This works in two ways. First, consumers’ disposable income will fall as more money is spent on servicing debts such as mortgages and lines of credit. And we know from the latest data points that this debt exposure is quite high. Secondly, the cost of borrowing to make any purchases is now higher, dampening the willingness to do so.
Get defensive
The environment has drastically changed compared to two years ago. Easy money is a thing of the past, risk tolerance is lower, and the stock market is being hit. With this, we must change our investment strategy. If you haven’t already started doing so, I have a few ideas that should help you preserve and grow your portfolio despite the challenging market conditions.
First, avoid companies that carry a lot of debt. This can include utilities, whose businesses are highly capital intensive and who take on a lot of debt to finance it. But this will vary depending on the financial health and income profile of a utility. For example, Fortis Inc. (TSX:FTS) carries a lot of debt on its balance sheet. With a debt-to-capitalization ratio of 56%, this could be concerning. But in Fortis’ case, the predictability and resiliency of its steadily growing revenue and cash flows can provide us with comfort.
Another way to adjust your portfolio for this higher interest rate environment is to stay away from consumer discretionary stocks. I mean stocks of companies such as Canada Goose Holdings Inc. (TSX:GOOS) and Aritzia Inc. (TSX:ATZ).
While these retailers have an undeniably impressive history and growth story, they are not likely to fare well in an environment where consumers need to cut their spending. This type of spending is among the first to be cut in this environment.
Lastly, I would focus on stocks that are undervalued, provide an essential product or service and/or have a competitive advantage. This brings me back to Fortis, a stock that I think will be the calm in the upcoming storm. Fortis is not only an essential utility, but it also has a competitive advantage, with unmatched scale and reach, and an untouchable position in the industry.
And this leads me to my last idea, Cineplex Inc. (TSX:CGX) stock. As a clear leader in the movie exhibition and entertainment industry in Canada, Cineplex stock remains undervalued. Yet, the company continues to recover nicely, with rapidly improving fundamentals. We can’t run from high interest rates, but a good movie at the theatre is a nice escape. Interestingly, Cineplex’s business has been quite resilient in past recessions.
The bottom line
The reality of high interest rates is upon us. It’s increasingly affecting our disposable income, as well as our mortgages and interest expense, and our balance sheets. Naturally, it should affect our investment portfolios and the stocks we invest in as well. Be defensive as this will help you weather the storm.
