<\/p>\n
Despite the Canadian stock market\u2019s heavy weighting in financials and other high-dividend yielding sectors, investors should not cut their exposure to domestic stocks in a response to the increased likelihood of higher interest rates, says a new report from CIBC World Markets.<\/p>\n
With the Bank of Canada expected to raise its key lending rate at its July 20 meeting, investors may be worried that dividend stocks will suffer as a result of bond-like characteristics. However, senior economist Peter Buchanan looked at previous Bank of Canada tightening cycles and found that the positives typically outweight the bad news related to higher rates.<\/p>\n
\u201cStock prices respond to a variety of factors, including earnings and growth prospects\u2014not just interest rates,\u201d he said.<\/p>\n
While there should be a clear inverse correlation between rates and valuations, central bankers muddy the relationship by frequently raising rates as the economic signals are improving. It also takes time for the economy\u2014and by extension, sales and corporate revenues\u2014to respond to higher rates, Mr. Buchanan explained.<\/p>\n
In the six months prior to the last 13 tightening cycles (between 1956 and the middle of 2004), he found that Canadian stocks historically provided average annualized returns of 22% (including dividends and capital gains). In the six months following a rate trough, Canadian stocks returned 8.3% in annualized terms.<\/p>\n
While higher dividend sector do tend to be more impacted by rising rates, the economist noted that telecom stocks are an exception.<\/p>\n
\u201cIt appears that investors have come to see the sector increasingly as a growth play, due the rapid proliferation of a range of new media services,\u201d Mr. Buchanan said. \u201cThat has reduced its traditional \u2018bond-like\u2019 behaviour.\u201d<\/p>\n
He added that long-term rates have much more of an impact on equity valuations than short-term rates do.<\/p>\n
\u201cAlthough we expect the Bank of Canada to start tightening before the Fed, Canada\u2019s low inflation and better fiscal fundamentals leave somewhat more room for the curve to flatten and that could, in turn, help to cushion bonds and equities from an overly rough ride.\u201d<\/p>\n