Rising interest rates and soaring inflation – along with the lingering affects of the COVID-19 pandemic – are affecting every aspect of the Canadian economy, from prices at the pump and in the grocery store to higher shipping costs and a tighter labour market. In this Q&A, Dean Proctor, CWB’s Calgary-based Vice-President and Market Lead, and Samuel Cummings, Associate Vice-President and Market Lead for CWB in Ontario, share their thoughts on the challenges facing clients today, how businesses and investors can deal with volatility, and how CWB can help.
- Rising interest rates and inflation are the result of the Canadian economy emerging from the pandemic and returning to normalcy.
- Higher prices impact the ability to obtain supplies and deliver products and services on time – but it’s also creating new opportunities for acquisitions. Many business owners are wisely keeping a long-term view.
- The most prudent approach is to create a plan that accounts for potential downturns. Consider your investment and retirement goals, then reverse-engineer your strategy.
- More business owners are thinking about limiting risk by choosing fixed rates, but not necessarily for the long term.
- To absorb higher costs, consider passing on the increase to customers or reducing your internal costs.
Background: Rising interest rates and what they mean for the economy
The CWB Wealth Management Investment Team explains:
Central banks will look to combat persistent inflation by raising interest rates at a faster pace, and to a higher level than previously forecast. Rates were cut to near zero due to the pandemic, and it was always expected that central banks would look to normalize once the global economy was back on its feet. But, instead of perhaps a 1% interest rate increase this year, the Bank of Canada is now expected to raise rates by around 2%. That’s a big increase in a short period of time. Higher inflation and interest rates are a double whammy for the economy. Higher inflation, especially for essentials like food and fuel, acts as a tax on our disposable income. Similarly, higher interest rates increase our costs of borrowing on lines of credit and variable mortgages, for instance, and limit what we can spend elsewhere. Both will lower the growth forecast of the economy and, indeed, we are seeing economists start to talk about a more “normal” year of economic growth for 2022 in North America instead of the strong growth once anticipated. Read more in CWB Wealth Management’s Q1 Investment Commentary.
Q: There is a lot of doom and gloom about inflation and rising rates in the media these days. Is the concern warranted?
Dean: From my perspective, I don’t think any of it has really come as a surprise. We had been in a low-rate environment for years, and I think many of our clients had anticipated rising rates even before the pandemic put a pause on normalization of monetary policy. Neither is inflation much of surprise. When you have supply chain constraints like the ones we’ve seen over the past two years, and demand remains constant or increases, the one thing that’s got to give is pricing. I guess the question is, if we work through those supply chain issues, do we see inflationary pressures ease and some balance restored? That is still an unknown.
Samuel: Ultra-low interest rates were a response to the pandemic, and now we are seeing a normalization of rates. In other words, we have come far enough out of the pandemic to be in a place of normalization.
From a long-term perspective, this is just another example of news – not necessarily bad news – and the message for client is, “This too shall pass.”
The important question is what we can do from an advice perspective and from a risk-management perspective to help clients weather this inflationary pressure. And that’s where I think the power of advice comes into play, because clients can really capitalize on advice in periods of volatility like we have now.
Q: How is inflation impacting your clients now?
Samuel: There’s an element of sector specificity to this. For certain clients, higher prices are impacting their ability to obtain supplies and deliver their products and services on time. Inflation is also affecting their ability to forecast profitability and revenue. On the other hand, some sectors – insurance, for instance – are very comfortable with higher rates and the improved profitability outlook they bring.
Dean: Here in Alberta, the energy sector faced some significant headwinds for several years, and companies focused on improving operational metrics and reducing their debt. Now, with the increases in oil and natural gas prices, they are churning out historic cash flows and building up their capital positions. That’s creating interesting opportunities – for acquisitions, for instance.
Q: The Bank of Canada has responded to higher inflation by raising rates for the first time in years. How far do you think the tightening trend will go?
Samuel: Obviously, the consensus is that rates are going up from where we are today, but I think monetary policymakers will be very careful to avoid shocking the economy in a short period of time. There are so many questions: Is this inflation more of a short-term supply chain issue? How will the war in Ukraine unfold and what will its long-term impact be? I expect central bankers will slowly and consciously monitor conditions and not make any rash decisions. That said, we know the concept of “lower for longer” does not apply anymore when it comes to rates.
Dean: I would think policymakers will also want to hedge against any material impact on the Canadian dollar. They seem to be fairly comfortable with an 80-cent [to the U.S. dollar] loonie right now, given supply chain challenges and some of the long lead times required when purchasing goods and services from abroad.
Again, the hikes have not really been a shock to anyone. Even now, rates are essentially back to the levels of late 2019 or early 2020, before the pandemic.
From our perspective, demand for lending has not really changed. Most of our clients have a longer-term view of things. They are looking at this tightening cycle as a shorter-term blip on the radar to a more normalized interest rate environment.
Q: So you don’t foresee the double-digit interest rates we saw in the 1980s in the face of mounting inflation? Or even legislative moves like wage-and-price controls?
Samuel: I think we’ve learned from the past, so I don’t think we’ll see those crushing interest rates again. There are more creative ways for the Bank of Canada and the U.S. Federal Reserve to use monetary policy to control inflation. I don’t see us going down the path of the late ‘70s and early ‘80s and all the challenges that would bring.
Dean: If you look at history, there are plenty of examples that suggest wage-and-price controls lead to hyperinflation when the controls are lifted. Today, there are other ways to manage inflation that reduce the need for those drastic measures.
Q: The U.S. yield curve inverted briefly this spring, raising the spectre of a recession. Do you think that’s likely?
Samuel: Well, an inverted yield curve can be a leading indicator of recession, but not always, and even when it is, you can’t time these things. The most prudent approach is to create a plan that takes the potential for downturns into account. That’s why I go back to advice. The foundation is a financing plan, or an investing and retirement plan, that is built around your goals and then reverse-engineers a strategy that factors in what might happen. It’s not that I’m not concerned about recession, but I’m a big believer in planning for potential volatility.
Q: How are your commercial clients dealing with rising rates and higher inflation?
Dean: Clients are definitely more interested in having a conversation about fixing rates on their debt as opposed to sitting in variable, where you run the risk of your debt servicing costs literally resetting overnight. So we’re seeing more clients trying to get ahead of rate risk and thinking about fixed, but not necessarily for the long term – more like two to three years. We’re seeing that on the depository side as well. After all, there’s not a lot to gain from locking in a GIC for a long time when there’s not much difference between one-year and five-year rates.
Samuel: For many companies, the challenge right now is how much of their increased costs – whether because of higher interest rates or input costs for materials or services or labour – can they pass along to their customers. We have had some clients who have decided to lock in, but others are taking a more wait-and-see approach. Even if companies have to absorb rising costs, some see fixed rates as tying their hands. And remember: if a recession is in fact on the horizon, the Bank of Canada could lower rates again.
Q: What can businesses and individuals do to weather this period of uncertainty?
Dean: Planning is so important. A lot of businesses have begun to forecast a base-case scenario and then build in sensitivities around various inputs, like decreases in revenue or increased labour or material costs. That allows them to model financial performance under different conditions. Another thing is, if you cannot transfer higher costs to customers, are there stones that have been left unturned in your business? You can’t control higher rates or inflation, but what about internal costs? Are there other things you can look at to help you absorb higher costs and get you through this period?
As for individuals, we saw a flight of capital to equity markets over the past couple of years, and anyone who remained invested after March of 2020 is probably pretty happy. Now, with rates rising, we’re starting to see capital move back to maybe less risky investments. People are a little bit more willing to put money into savings accounts, GICs – those traditional vehicles that have different levels of security around them.
Samuel: It comes down to risk. How are you managing it? On the investment side, asset allocation is king, and the key is to reverse-engineer your portfolio allocations based on your goals. And the last thing on investments is diversification, so it’s not all-or-nothing. In periods of volatility, those foundational strategies for managing allocation and diversification can make all the difference.
Q: In this changing environment, does it make sense for businesses to change the way they approach capital expenditures?
Dean: I think there’s a couple factors. For every company we’re talking to where capex is a normal line item, we’re not getting the sense the foot is coming off the pedal. The challenge is with the things they are spending the money on. Is it to buy more services, to buy materials, to drill more wells [or] to buy real estate? Depending on the answer, companies might be facing longer lead times and exposure to cost increases over the waiting period. If they order the material or service today but don’t receive it for six or 12 months, is the price locked in? Or are they subject to an escalation clause? Those are things that need to be nailed down to avoid nasty surprises.
Q: Same question with real estate: with rates rising, is it just too risky an asset class now?
Samuel: I wouldn’t say “too risky.”
From a macroeconomic perspective, the growth we’ve seen in real estate over the past few years may not be sustainable during a period of higher cost of capital and inflation. But you need to understand what the goal is.
Over the long term, the fundamentals for real estate are strong, so does it make sense as a long-term investment? I think so, for the right investors. But real estate can be relatively illiquid, so if you’re thinking of it as a short-term play with, say, a 12-month time horizon, then you could argue that it’s a risky proposition.
Q: What other concerns do your clients have right now?
Dean: For our commercial clients, I would say No. 1 is labour – attracting and retaining key personnel. Second is the supply chain environment – nobody has a good handle on that yet. And third is, how much of the increased costs they’re facing can they absorb? Some clients have had a very good couple of years despite the challenges, but how long can that go on? There are only so many levers for them to pull.
Samuel: I would add succession to the talent conversation. Some businesses did not have a clear succession plan, but the pandemic brought the issue to the forefront for many of them. It has made owners think more deeply what’s important in their lives, and about what the business might look like when they are not there. That ties into talent. Who leads when the owner is gone? Family? Workers? The executive team? Along with discussions about the other issues Dean mentioned, those are the types of conversations our relationship managers are having with clients, giving them a sounding board for ideas and leveraging the power of advice.