Interest rates have been on the decline in recent quarters, with most central banks around the world cutting rates in a bid to shore up their jobs markets and ensure financial stability. The Bank of Canada has been among the most staunch interest rate cutters of the group, with a current overnight rate of 2.25%, a far cry from the top end of the range in the U.S. right now (at 4%).
One would think that these meaningfully lower rates would have stimulated the Canadian economy to a large extent. By some measures, they have, with housing demand remaining strong and the jobs market not weakening as fast as it otherwise may have.
But for those who are gloomy about economic prospects in the years ahead and who expect more cuts, there are ways to play this shifting policy.
Here are two of the top Canadian stocks I think are the interest rate-sensitive bets investors may want to consider right now.
Source: Getty Images
Killam Apartment REIT
Residential real estate is among the most interest rate-sensitive asset classes out there. That’s simply because those looking to buy a property will be locked into a long-term mortgage. Whether that’s an individual or a real estate investment trust (REIT) like Killam Apartment REIT (TSX: KMP.UN), interest rates matter a significant deal.
Killam’s stock chart above doesn’t show the kind of growth investors may have expected, considering this environment we find ourselves in. And to some extent that makes sense – interest rate cuts typically take place when the economy is weak, and that’s not good for housing-related stocks.
That said, it’s also generally true that coming out of some sort of significant real estate pullback is where most of the gains can be had for long-term investors. And for those looking to capture a current dividend yield of 4.4% (which could go higher if this stock drops further from here), there’s a lot to like about the relative passive income/yield advantage this stock provides compared to bonds, which have yields that are declining.
In this environment, I think going against the grain in a sector like residential real estate can make sense. Though it’s worth pointing out that investors who choose to do so should have a long investing time horizon. That’s because these cycles can last a while. So, strap in for some volatility and reap the gains down the road.
Shopify
On the other end of the spectrum, growth stocks like Shopify (TSX: SHOP) can benefit in an outsized way from interest rates coming down.
Much of this has to do with how longer-duration growth stocks are valued relative to the rest of the market. Most discounted cash flow models (what analysts use to determine the value of a company today) require a key input – the risk-free rate. This is typically the U.S. 10-Year Treasury, but can be an assortment of longer-duration bonds. In Canada, it’s mostly the 5-year government bond rate.
With interest rates coming down, companies that will likely see a greater percentage of their future cash flows coming in five years or further into the future could be valued much more dearly in such an environment.
So, those who are bullish not only on Shopify’s long-term growth prospects, but also the potential for valuation models to shift in this company’s favour, may want to consider adding to existing positions or taking new ones on.
This is a riskier strategy, but one that appears to be playing out for now in a broad way.
