According to Statscan, more than 50 per cent of all financial assets in Canada are tied up in equities and investment funds.Aaron Vincent Elkaim/The Canadian Press
Declining interest rates were a fixture for so long that it was natural to assume they were just part of the order of things. Like the Gulf Stream. Or $1.50 hot dogs from Costco.
For roughly four decades, rates headed steadily downward, conditioning an entire generation of investors to the comforts of cheap money.
They piled into the stock market as it thrived through years of ultralow interest rates. Eventually, they learned to ignore bonds as well, when rates descended to near zero and remained there for nearly a decade.
And that’s about where the average investor sits today – heavy on stocks, light on bonds and wholly unprepared for the great rate reset now upon us.
The downward pressure on interest rates that once seemed permanent has lifted. Gone are the easy-money policies and stagnant investment that defined the global economy of the 2010s.
In its place, we have inflation, deglobalization and a global arms race for scarce capital. It’s the new normal. The synchronized rise in global bond yields is just the beginning.
“Higher yields are here to stay for a reason,” Jean Boivin, head of BlackRock Investment Institute, said in a recent report. “Sticky inflation, heavy government borrowing and growing private investment needs give little reason for pressure on yields to fade.”
The game has changed and investors need to adapt. They are still positioned for the old normal.
The household balance sheet has never been more heavily skewed toward stocks. More than 50 per cent of all financial assets in Canada are now tied up in equities and investment funds, according to Statistics Canada.
The bulk of the Canadian nest egg is held in mutual funds – more than $2.5-trillion as of the end of last year, according to the Securities and Investment Management Association. Just 13 per cent of that is held directly in bond funds. Since balanced funds also include a fixed-income component, the true weighting would be higher, but still well short of the traditional 40-per-cent allocation.
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It’s not just Canadians shunning bonds. Bond allocations in U.S. portfolios are close to 40-year lows.
“After the financial crisis, I spent a decade convincing investors they needed to take more risk. Now I have to convince people to take less risk,” Blair duQuesnay, an investment adviser and author of The Belle Curve blog, wrote in a recent post.
It’s great that more Canadians are participating in the stock market. It’s the best way to build wealth over the long term. Financial markets have never been easier to access and the costs of doing so have never been lower. Today, you can buy into the entire stock market for nothing on your smartphone.
Some of the rise of stock ownership in Canada is structural. Traditional pensions have been replaced in large part by defined-contribution plans and group RRSPs, which direct retirement savings into stock-heavy portfolios.
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But investor optimism and speculation are clearly at play as well. By all accounts, Canadian investors have developed a serious appetite for risk through this bull market. In the past year alone, Canadian households have added $275-billion worth of stocks to their holdings, according to Statistics Canada data up to the end of the second quarter. Those are net purchases, by the way, over and above total sales of stocks in the same period.
You can’t really blame investors. The S&P/TSX Composite Index TXCX is up by 18 per cent in just the past year. The broader uptrend has overcome every possible shock the world could throw at it – wars, both real and economic, runaway inflation, a global pandemic.
Let’s say you put your entire savings into the TSX at the worst possible moment of the past decade – the market peak in February, 2020, just prior to the COVID-19 outbreak. Left alone, that money would have more than doubled by now.
The bond market experience in recent years, on the other hand, has not been a positive one. Measly yields through the 2010s taught investors to look for income in the stock market instead. And then bonds had their worst year in history in 2022, cementing their reputation as dead money. The latest run-up in yields has made bonds feel even more dangerous to an investing public already inclined to disregard them.
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But this is exactly the moment when everyday investors should be giving bonds a fresh look. With meaningful income and a valuation cushion courtesy of the recent selloff, parts of the bond market now look more attractive than they have in years.
The risk-return profile for stocks is also undergoing major shifts, but in sneakier ways. If higher bond yields are here to stay, that meaningfully changes the math for equity investors. No longer can investors afford to be so tolerant of high valuations, long-duration stocks, and companies that need cheap credit to thrive.
The only reason we haven’t seen these things come to the fore yet is because corporate earnings have been off the charts. Had that not been the case, stocks would probably be correcting as we speak. In the U.S., stock valuations have been declining for the past year. It’s just been masked by an extraordinary profit cycle.
The truth is, it’s a new world. Don’t get stuck in the old one.