As we fight inflation, look for long-term investment opportunities

Falling inflation and interest rates are beneficial for long-term assets such as equities. Why? Because equities tend to rise when interest rates fall. Lower interest rates can reduce a company’s cost of financing, affect valuations, improve profitability and increase customer buying power, positively affecting its share price.

History supports this trend. Based on 74 years of data, the S&P 500 historically returned 13% in calendar years following a decline in inflation. In comparison, it returned only 8% in calendar years following a rise in inflation.

In addition to equities, declining interest rates also boost bond returns. As rates fall, the coupon on newly-issued bonds also declines. Since previously-issued bonds pay a higher coupon than new issues, the value of older bonds rises.

Attracted to higher short-term interest rates not seen in a generation, Canadian investors have added over $20 billion to money market funds over the past two years.

The allocation to short-term assets is even greater if you include GICs, HISAs and similar cash or near-cash products. Investors have come to see these investments as a lower-risk way to generate income during periods of higher interest rates. However, this could soon change.

If interest rates have peaked and are soon going to be on the decline, the appeal of these short-term, near-cash investments may soon erode. Interest rates on money market funds, GICs and HISAs fluctuate — among other reasons — whenever the BoC makes a change to the overnight rate. As inflation and interest rates decline, the income earned by money market funds and similar investments will also decline — while the total return potential for stocks and bonds should increase.

This is one of the many reasons why it’s always important to regularly review your portfolio’s strategic asset allocation. Because the investing paradigm may be shifting as interest rates are expected to start lowering this year, it may be time to consider reviewing your portfolio to identify overexposure to short-term investments.

To learn more about inflation and interest rates and how they impact your portfolio — and how CIBC Asset Management responds to and anticipates these factors in managing the investment products we offer — please contact your advisor or CIBC representative anytime.