By Tania L. Haas
Published May 26, 2010
TORONTO (MarketWatch) — As investors await the Bank of Canada’s likely decision to raise interest rates next month, market strategists anticipate stocks of financial companies, commodity-based products manufacturers, and consumer goods firms will be those hardest hit by tighter monetary policy.
Higher interest rates can be problematic for some companies, but the Bank of Canada’s actions reflect a stronger-than-expected economic recovery characterized by somewhat higher-than anticipated inflation and a lofty Canadian dollar. Those factors have pushed the central bank to consider tightening sooner than many expected.
The Canadian market started buzzing about an impending rate hike last month after the Canadian central bank announced that it had removed its conditional commitment to keeping its key lending rate at 0.25% until the end of June. That triggered forecasts the bank would start raising interest rates about six weeks earlier than previously expected.
Analysts said that while all companies have to adjust when rates go up, financials would be among the most directly affected.
“In the financials, it’s mainly the banks that are susceptible to movements in the cost of short-term funds. The implied flattening in the yield curve, which comes from that, starts to take away some of the net-interest margin,” says Jack Johnston, chief strategist at The Harbour Group RBC Dominion Securities in Toronto.
“In terms of the direct areas that seem to be getting hit, they seem to be the banks, utilities, and consumer discretionary,” says Johnston.
In those sectors, the companies that fare well in the face of interest rate hikes are those with the most cash and least amount of debt.
“Companies, if they have existing floating debt, are going to be hurt. But if a company has fixed debt, as inflation goes up the value of that debt becomes less in current terms,” says Allan Nichols, international equity strategist at Morningstar in Chicago.
Nichols says companies with large cash holdings, like Research in Motion (NASDAQ:RIMM) , Fairfax Financial (OTN:FRFHF) , and Sierra Wireless(NASDAQ:SWIR) should do well.
“Now for companies with a lot of debt,” says Nichols, “Angiotech Pharmaceuticals is massively leveraged, but very small. On a larger scale Telus (NYSE:TU) also has a large debt position compared to its market cap.”
While Telus holds a lot of debt, the telecom sector in general will likely withstand a hike. “The interest rate really doesn’t affect whether I’m going to use my cell phone or not,” says Nichols.
Peter Buchanan, senior economist at CIBC World Markets in Toronto, says investors don’t need to make drastic changes to their portfolios just because interest rates go up a bit, but suggested a look at previous rate-hike cycles could help provide some guidance on how to position a portfolio.
Buchanan and his peers analyzed the sensitivity of different sectors to rising yields based on data for the last 20 years. The most sensitive were banks and diversified financials. Following those in terms of sensitivity, Buchanan found, were capital goods producers – partly because of balance sheet effects, but also because higher rates tend to hurt corporate investment. Moving down the list, he found materials, stocks, and energy were also susceptible to a rise in interest rates.
“I know it may seem surprising that energy is there,” says Buchanan, “But of course, the oil industry is tremendously capital intensive, and producing the oil involves long waiting periods between when the actual exploration is undertaken and the time the firm receives its cash and net back.”
Utilities are vulnerable, according to Nichols at Morningstar, because shareholders buy them for the yield. If interest rates go up, the relative yield isn’t as good, and so people might look elsewhere.
Nichols also points out that the soaring Canadian dollar can have a negative effective on Canada’s export-based economy. “While the Canadian dollar strengthens, it hurts the commodity producers like oil, natural gas, timber, and other mining products.”
Finally, there’s gold. Will it still sparkle in the face of the impending interest rate hike?
“Gold also seems to fare poorly in the aftermath of central bank interest rate hikes;” says Johnston. “But gold is global commodity and the Bank of Canada is one of the earlier movers on the interest rate front, so it’s more of a global tightening and monetary policy that is the issue for gold.”