Welcome to the ETF Insights newsletter for November.
This month’s edition will be a bit different than most, dedicated strictly to highlighting how investors can take advantage of Canadian equities that are set to benefit from lower interest rates here in Canada.
I’ll cover some sectors that stand to benefit the most and then highlight how one could get exposure to those industries via an ETF.
First, let’s dig into the “why” of how interest rates impact particular market segments.
How rates impact publicly traded companies
The impact interest rates have on publicly traded companies is a complex situation. However, it can be broken down into a few core concepts, making it easy to understand.
Even for a set-and-forget-it investor, I believe it is absolutely critical to understand how policy rates impact the stock market. Understanding policy rates and their impact on the market can give you a better understanding of why stocks and ETFs are moving in the direction they are, ultimately preventing you from making mistakes.
Let’s go over the simple ones, then get into a few more advanced topics.
Borrowing costs
This one is probably the most obvious. Over the last few years, you’ve likely noticed that the interest rate on your line of credit, variable mortgage, or any other floating-rate debt has increased. We have seen financing in terms of newly issued debt or even something like an auto loan go way up.
Publicly traded companies face the exact same headwinds in this regard. As rates go up, financing gets more expensive, whether on their current floating rate debt or new debt they’ll have to issue in the future.
It seems simple to avoid this situation as a consumer, particularly if you’re in good financial health. You can maintain low levels of debt and generally function pretty well. For publicly traded companies, debt is a way of life, especially ones that have to lay out a lot of capital to expand and operate.
Let’s look at a stock that is rate-sensitive, like BCE. Below is a chart of the company’s interest expenses:
As you can see, they’ve increased materially. It is much the same in a consumer situation. If you earn the same salary but the cost of your debt increases, your “bottom line” will decrease. You’ll have to allocate more money to your debt and have less disposable income.
Consumer demand
In the situation above, I explained how fluctuations in policy rates impact consumers. Considering that nearly every publicly traded company relies on the consumer to some degree, it is safe to say that consumer spending is vital to the health of publicly traded corporations.
If a consumer is paying $2000 a month on their variable rate mortgage and rates increase to the point where they’re paying $2500, assuming they make the same salary, they will have less money to spend net. The reverse is also true. If rates decline and that person pays $1500 for their mortgage, they’ll have more discretionary income to spend.
This works with fixed-rate mortgages and other fixed-rate debt as well. Consumers often pre-plan for mortgage renewals at higher/lower costs and spend accordingly.
Consumer discretionary stocks, ones that are more volatile to the overall economy, are much more prone to this type of impact from interest rates. Let’s look at a revenue chart from a high-cost clothing company like Nike to give you an example:
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As you can see, the popularity of the company in a higher-rate environment is being affected as revenues decline. Consumers on a tighter budget find less need to purchase high-ticket clothing items.
On the other hand, the consumer staple sector is not impacted as much by this. This is because these retailers often sell vital goods that people need regardless of the economic circumstances. Case in point, let’s look to a company like Walmart’s revenue over the same period:
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Policy rates drive the entire economy, and as such, companies that make products that are not considered vital for everyday living tend to suffer when rates are high.
Discounted cash flow analysis
This is the element that tends to get a bit complex. I will explain it as clearly as possible.
When buying stocks or ETFs, the end goal tends to be overlooked. Yes, we want our money to grow. However, what is the driving force behind that growth?
The answer is the future earnings of the company we buy or the companies inside the ETF we buy.
The way those future earnings are valued is by reverting them back to what they’d be worth in today’s dollars, and we use a discount rate to do so. In short, the discount rate is a way to make future money comparable to today’s money by adjusting for things like interest, risk, and inflation.
One of the key factors inside of this calculation is what is called the “risk-free” rate. This is often a government treasury bill rate because these are effectively risk-free investments guaranteed by governments – for example, the US 10-year treasury or the 5-year Bank of Canada bond.
The interest rates these fixed-income investments will pay depend on policy rates. As rates decline, so too will the yields provided by treasuries.
Why is this important?
The risk-free rate is one of the most important elements when it comes to judging the value of future earnings.
As the risk-free rate goes down (when interest rates fall), future earnings of corporations become more valuable, and stock valuations typically rise.
As the risk-free rate goes up (when interest rates rise), future earnings of corporations become less valuable, and stock valuations typically fall.
This is why high-growth stocks tend to fluctuate even further. Because they are much more reliant on future earnings growth than a slower, more mature company, they fluctuate much more based on the rise/fall of policy rates.
Now that we know how companies are impacted, how can you take advantage of falling rates?
I’ve had a lot of requests to cover the sectors of the market that I believe will do well in a falling rate environment. However, I’d like to preface it with the fact that much of the “easy money” in terms of profitability from rate declines has been priced into these stocks already.
That isn’t to say they can’t continue to see tailwinds from rate declines and become some of the best-performing stocks on the market.
If you’re looking for a short-term bounce in price, though, it was realized a while ago, as the market tends to price these things in anywhere from 9-12 months in advance.
A chart highlighting this would be the returns of BMO’s REIT ETF and utility ETF, ZRE and ZUT. These are two sectors which are highly sensitive to interest rates:
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Both of these sectors are outpacing pretty much every North American market index over the last year.
If you’re looking to take advantage of rate-sensitive companies on the thesis that rates will continue to decline, it should be done with a longer time horizon.
Let’s dive into some individual sectors and some ETFs for exposure
Utilities
Utilities is arguably one of the most rate-sensitive sectors out there for multiple reasons.
For one, these companies tend to carry a significant amount of debt. This is just the nature of the business. When you think of a utility’s infrastructure, the power generation facilities, distribution networks, staffing, etc, the company wouldn’t be able to lay out all of the cash it needs to expand this infrastructure. It just wouldn’t make sense.
For that reason, they finance a lot of it, and generally, the rates of return on those assets are higher than the debt they need to pay.
To reduce the risk of ruin, they have a lot of that debt on fixed rates. Fortis, for example, is a company with less than 5% of its debt on floating rates. Algonquin Power, on the other hand, had 23%. One has a dividend growth streak of 51 years, and the latter has had to cut the dividend twice in the last two years.
The second element of a utility is that they’re often slower growing and higher yielding. So, when rates rise and fixed-income investments become more attractive, money flows out of utilities and into safer options. The market sees little benefit in taking on equity risk to yield similar returns.
Now that rates are falling, the script flips. Debt issuances from utilities are going to get cheaper, and money is currently flowing out of fixed-income HISA ETFs and likely into dividend-paying equities over the next few years.
I’m fairly bullish on utilities moving forward. Prices have been stagnant for years, and despite a 30% runup over the last year, I believe they have room to run.
Solid ETFs tracking the utility sector
One could choose to own a broad-based Canadian index fund, and it would give them plenty of exposure. However, as I’ve mentioned before, I’m not a huge fan of Canadian indexing. I believe we have too many cyclical companies inside our index for me to want exposure to the entire thing.
Many fund managers target high-yielding funds in the utility sector, particularly covered calls. They do this because they know the bulk of their target audience in this regard is seeking income from utilities.
Although many of these covered call ETFs performed well during the utility drawdown, they’ve underperformed quite a bit during the runup. Here is a chart of UMAX, Hamilton’s covered call utility ETF, versus ZUT, BMO’s equal-weight utility ETF:
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My go-to funds in the utility sector?
I believe the BMO Equal Weight Utilities ETF (TSE:ZUT) is a solid option for a standard utility ETF.
However, if you’re really bullish on utilities, you could look to Hamilton’s Enhanced Utilities ETF (TSE:HUTS).
This ETF utilizes 25% leverage and can amplify returns in the case of a runup. Just make note that it can also amplify losses in a drawdown. If that fits within your risk tolerance, it’s certainly a candidate.
REITs
Real estate investment trusts have been beaten down in recent years. Peak property values during a record low rate environment and a subsequent runup in interest rates in 2022 caused them to undergo some of the largest drawdowns in their histories.
However, sentiment is returning, and it is fairly easy to be bullish on REITs moving forward. So, which fund to choose?
We don’t really have all that many options here in terms of REIT ETFs. However, there is one pretty clear standout to me, and that is Vanguard’s fund, VRE.
Although the fund is a capped fund, it is not equal-weighted like the Bank of Montreal’s ZRE is, and I like the overall holdings makeup of the fund.
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Instead of focusing on a higher quantity of REITs and lower allocations towards each, it focuses on the larger-cap players, ones that have consistently maintained strong operating results despite a pretty rough economic backdrop.
If rates continue to decline, we should see bullish sentiment towards Canadian REITs.
Broad exposure
Before I get to a broad exposure ETF to rate-sensitive stocks, I would like to mention that I was going to have a section on telecoms in this newsletter, as they do stand to benefit significantly from rate declines. However, there aren’t enough of them in Canada to construct an ETF that would attract any attention.
For that reason, you’ll have to look to buy them individually or a broad-based ETF like I’m going to talk about next if you want exposure to that sector.
With the TSX being an index that contains a large chunk of rate-sensitive stocks, one could realistically grab a fund, likely one that is more so focused on income, and take advantage of the falling rate environment in a single click.
For that strategy, I am a big fan of XDIV, which is the iShares Core MSCI Canadian Quality Dividend ETF. It is a featured fund here at ETF Insights, and you can read our full report by navigating to the ETF reports section on the website.
It has outpaced XEI by quite a wide margin over the last year and is going head-to-head with VDY as the best income fund in the country.
You may have heard me say before that I’m not a huge fan of income-based ETFs. However, in this rare instance, it isn’t necessarily the income portion that attracts me to the fund but more so the fact these funds contain many rate-sensitive stocks that should likely benefit and perform well in a falling rate environment.
When we look to the top holdings of XDIV, it contains many of the country’s major pipelines, banks, telecoms, and consumer cyclical stocks.
I don’t necessarily view XDIV as a strong long-term buy-and-hold ETF for investors focused on total returns. Still, there is no doubt some tailwinds here in terms of falling rates that could impact returns over the short to mid-term.
