Dustin’s a doubter. He wrote me yesterday from a prairie somewhere. “I’ve been following you for some time now, along with other “contrarian” personalities,” he says. “I think we all know that with rising interest rates that assets such as housing will obviously go down. But is your strategy of investing in the stock market during the time of rising interest rates a sound one?
“How about preferred bank shares? I’m going to say that these banks will suffer when housing prices decline and people are unable to renew mortgages, walk away etc. In general though, the stock market as a whole would essentially suffer. An echo of the American financial crisis per se, although not as grand in scale. My take on this is that housing will not be the only dog in this “show” and that other assets will not be immune to the punchbowl being taken away.”
Well, Dustin is right about one thing. Rates will rise. The Fed made that clear yesterday, and we’re still on track for the first hike in years to take place in September. As I said yesterday, our poodles will eventually follow suit. There will be no more 2.6% five-year mortgages this autumn.
As rates rise, real estate cools. How much sales and prices are affected will vary by market and other factors we don’t yet know. But the long-term direction is obvious. Just take a look at the latest StatsCan numbers hatched Wednesday – Canadians have been on a borrowing binge for the last ten years with indebtedness growing by 64%. By 2012, 71% of us were in hock – no surprise, since almost the same percentage own houses.
So, family debt and real estate values have been moving in lockstep – about what you’d expect. That means stability, even if incomes don’t swell at the same pace, so long as interest rates stay in the ditch. Hard to overstate the importance of cheap money, because once rates creep higher, house values (and net worth) inch lower, but debt levels remain the same. Ouch.
Now, what of Dustin’s fear that financial assets will also tank?
Could happen, of course, but history suggests otherwise. Interest rates were coursing higher between 2004 and the financial crisis of 2008. Then we suffered the worst market decline in 80 years including a global credit crisis, followed by six years of emergency rates and one of the slowest recoveries in modern history, complete with a US debt ceiling scare in 2011.
Despite all that, a portfolio that’s balanced (40% fixed income and 60% growth assets, no individual stocks, no mutual funds) and diversified (across asset classes and geography) averaged 7.41% over the last decade. The five-year number is 10.06%. Last year it was 8.5%. So far this year (four months) it’s returned 4.2%.
In other words, the performance has been remarkably consistent through one of the most volatile and unprecedented decades in the lives of everyone reading this pathetic blog. When rates rose, it did fine. When they fell, it was cool. When crisis hit, it recovered fast. Overall returns have paced or exceeded almost every real estate market. And unlike houses, such a portfolio paid regular income, didn’t need reshingling, avoided property taxes and needed no bozo in a Audi charging 5% commission to sell it.
But what of now? Are things so much worse that little Dustin could be creamed if he invests?
Of course not. There’s so much more risk in buying a bungalow in the GTA with 7% down than there is investing in a rational portfolio. Rising interest rates actually mean economic growth – because central bankers (like the Fed) wouldn’t even consider getting back to normal if they thought the economy might croak. More growth means more corporate profits, more jobs, and more growth. Nothing scary there, unless you have an epic mortgage.
As for preferred shares, they slid about 10% this year as the Bank of Canada foolishly trimmed its key rate, and that is expected to reverse. In fact, rate reset preferreds (now the majority of the market) will bob higher along with the cost of money. (Yes, that means they’re now on sale.)
Banks in trouble? That’s rich. There will be no mass defaults on Canadian mortgages, and no streets-full of people walking away from their indebted homes. Even so, bankers are insured and are now enjoying record profits, even in a soggy economy. But if bank profits were to dip, preferreds would surely retain their value and continue to churn out tax-reduced dividends.
So, higher rates mean an economy’s thriving, just as low rates mean decline. When money costs more, people borrow less, or accelerate debt repayment. How’s that worse than the borrowing binge we’ve been on?
Things are getting better, Dustin, not worse. And if a decent portfolio can deliver 7% over the decade we’ve just had, why would you suddenly expect losses?
True, many homeowners with scant equity will be crushed. The moaning and gnashing will be deafening. But there’ll be no tag day for the balanced. Still time, kid.