Could trade deal signal faster interest rate hikes?

The sense of comfort gained from the newly signed trade deal could see the Bank of Canada raise interest rates twice before the year is out, according a portfolio manager.

A new NAFTA deal was reached yesterday – rebranded as the catchy US-Mexico-Canada Agreement (USMCA) – improving access to Canada’s diary market for US farmers and tightening rules of origin for car production. The loonie responded positively, hitting a four-month high, at one point up 0.7% to $1.2814.

Grant White, of White Hewson Advisory Group at National Bank Financial, said there was relief around the removal of uncertainty but that it was important to keep clients posted about what this means.

The Winnipeg-based money manager sent out a note outlining how he expected a currency boost and potentially quicker interest rate increases.

He said: “I think we’re all expecting a hike this month but we might see another one before the end of the year.”

He added: “I think the Bank of Canada was comfortable with where the economy was and where it was heading. The only thing they were uncomfortable with probably was trade. Just a personal thing, but I think they may have been holding back … just to keep the gas on the fire, if you will.

“Now that the deal is being settled, they might feel more comfortable that they can raise rates again. I think it’s just more of a comfort thing. This doesn’t change a whole lot from the economic perspective but it gives a little more certainty to where things are.”

White added that it’s important to prepare portfolios for what lies ahead. When it comes to rate hikes, he said his firm has been working on debt management and, on the investment side, focusing on clients’ fixed-income flexibility.

He said: “That’s the part that’s most challenging – we need to be careful there and make sure we’ve got low duration debt and we’re not overexposed to higher risk debt – not in terms of higher default – but in terms of interest-rate risk.

“People need to be really careful around high yield investments. We’ve seen a lot of high yielding dividend stocks and we have a lot of high-yield real estate. A lot of that can be fuelled by debt and if the debt rates are higher, it makes it more difficult for those companies to pay those dividends.”

Zach Davidson, investment advisor, JMRD Wealth Management Team, National Bank Financial, said the new trade agreement should be a positive for Canadian equities and a “pro-growth” signal for the global economy. Given the number of other concerns in the Canadian market – a potential housing slowdown, loss of corporate tax advantage and competitive versus the US and lack of pipeline expansion – he said any positive news is helpful for sentiment.

He added: “However, many Canadian companies expanded into the US over the last few years so a stronger Canadian dollar may mitigate some of the positive effects. I don’t think it should change an investor’s strategy or allocation. There are always ‘events’ that happen in the markets and many are a blip on the screen when we look back over time. The key is to stay with one’s asset allocation, rebalancing periodically but not reacting to events.”

Davidson said he expects the BoC to go ahead with a rate hike this month now the NAFTA obstacle has been cleared but questioned whether it will necessarily mean a more aggressive approach from Governor Stephen Poloz.

However, he agreed with White that higher dividend promises need to be treated with caution.

He said: “As central bankers are often heard to say, they’ll remain ‘data dependent’. Bond yields have been trending higher for over a year in Canada. As a result, more interest rate sensitive sectors such as utilities and telecoms have not performed as well. In addition, many of these stocks traded at expensive valuations as investors gravitated from fixed income that was offering meagre income and bid-up dividend equities with low growth.

“Some of these low growth companies are still not ‘cheap’ in a higher interest rate environment. Companies with elevated debt levels and high payout ratios may be overextending themselves by promising a certain level of dividend growth. Focus on growing businesses with low debt levels and lower payout ratios.”

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