First Quarter 2015

Over the past several months, the capital markets have been focused on interest rates, currencies, and the central bankers who determine them. Most notably, observers are following every nuanced word issued from the new Chairman of the Federal Reserve System of the United States – Janet Yellen.

Continued robust economic growth in the United States has not only propelled their stock market to new heights, but has also contributed to strong employment growth and a strengthening U.S. dollar. This has encouraged the “Fed” to reduce the level of quantitative easing that has been in place since the 2008 financial crisis, and to consider the time when interest rates should start rising again. As a result, there is a growing consensus that the inter-bank lending rate in the U.S. could begin rising before the end of this year, albeit modestly.

The initial reaction to a rising interest rate environment is negative, both in the equity and fixed income markets. A negative reaction in the fixed income markets is normal, and will likely be sustained. It is a simple maxim that higher interest rates reduce the market value of both bonds and preferred shares. Rates and market valuations always have an inverse relationship. Rates go up, the value of bonds falls. Rates go down, the value of bonds goes up.

In our view, an initial negative reaction to rising rates in the equity world is not sustainable. Rising interest rates will be a strong signal that the economy has recovered from the great recession of 2008-2009. A strengthening economy should benefit the revenues, earnings and cash flows in the corporate world, ultimately making these companies more valuable. Some economists like to characterize this stage of the growth cycle as featuring “exit velocity”.

Rising interest rates and a strengthening U.S. dollar do present their challenges. Many of the companies that we invest in the U.S. are truly global in nature, generating more of their revenues outside of the U.S. than in. For example, Colgate-Palmolive generates 80% of its revenues abroad. A strengthening U.S. dollar makes the reported earnings for international operations less valuable when translated back into U.S. dollars, representing a genuine “headwind” for otherwise healthy and growing companies. A rising U.S. dollar also restrains American exports, presenting another economic challenge.

Despite these challenges, we believe that the current U.S. growth cycle will be sustained, and will spread globally. The Asian economies are all moving forward, despite their individual challenges. Europe, led by the U.K., is also continuing to recover. The day will come when these jurisdictions will also have to consider raising interest rates.

What about Canada? Despite all efforts to the contrary, Canada remains a resource oriented economy, and its currency reflects it. Over the past six months, the price of oil has been cut in half, while coal and base metals prices have fared even worse. A weakened Canadian dollar has reflected this reality. In addition, the Bank of Canada moved to cut interest rates recently, in an effort to shore up a seriously weakened economy in western Canada. With regards to its equity market, Canada’s lopsided TSX Index is now delivering positive returns in only the financial services and consumer products areas.

Generally speaking, interest rates will rise globally because of strengthening economic growth, which will be positive for equity investors. We will continue to seek and hold the equities that we think will benefit the most from this unfolding scenario. With regards to fixed income investments, we will continue to favour short term bonds, with an eye to capturing higher coupon rates when these bonds mature and are replaced by better paying ones.



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