Yesterday, Wall Street reported its biggest loss in two years after the official data showed that U.S. inflation reached 8.3% in August from 8.5% in July. The S&P 500 Index fell 4.32% as all 11 sectors ended the session in the red. This selloff came, as investors priced in a 75-basis-point interest rate hike expected in the September 20-21 Fed meeting.
This interest rate and equity prices tug-of-war has been an ongoing phenomenon for the last six months. How can you benefit from interest rates and stock price correlation?
Interest rates and other things
The economy was growing fast, as there was ample money supply from the stimulus package. But supply chain bottlenecks have created inflation that the Fed has to tackle, even if it means slowing the economy.
The interest rate is the lever for the central bank to control the money supply (engine power) in the economy. Steep interest rate hikes impact demand, as consumers don’t have ample money to spend on discretionary items and they have to prioritize. Higher interest rates reduce money supply, strengthening the U.S. dollar (when supply is tight, the dollar rises).
When the U.S. dollar strengthens, oil and gas prices fall, as commodities are priced in U.S. dollars. A strong U.S. dollar makes oil and gas expensive to holders of other currencies and impacts demand. Hence, the U.S. Fed’s interest rate hike impacts global economies.
(The U.S. dollar became the world’s reserve currency because of the 1944 Bretton Woods agreement, which pegged the US. dollar to gold and other currencies to the U.S. dollar. Although the system collapsed in the 1970s, the U.S. dollar had already become the global currency.)
Why do Canadian stocks fall when the U.S. interest rate rises?
Canada is a leading exporter of oil and gas to the United States and trades other goods and services. When the U.S. dollar strengthens, exchange rate gains mitigate the impact of weak U.S. consumer demand. So, the TSX Composite Index fell 1.7%, while the S&P 500 Index fell 4.32% yesterday.
To keep the value of the Canadian dollar in sync with the U.S. dollar, the Bank of Canada increases interest rates in sync with the U.S. Fed. If the interest rate continues to rise, it could lead to stagflation and recession. Stagflation is when consumer demand weakens, but inflation continues to remain high.
The U.S. August inflation showed just a 20-basis-point ease from July, which is lower than economists’ expectations. Moreover, the real gross domestic product (GDP) growth was negative for two straight quarters. There is now a greater likelihood of a recession. A recession occurs when weak consumer demand affects the business environment and companies downsize, affecting supply.
When the economy reaches the level of recession, inflation and the U.S. dollar fall to a point where demand is higher than supply. At this point, recovery begins.
How to make money in a recessionary environment
You can invest in different types of stocks for the three stages of the economy: inflation, recession, and recovery. High inflation leads to higher rent. Now is a good time to buy a real estate investment trust (REIT), as the rising interest rate is easing property prices and REIT’s stock prices are falling while rising inflation is increasing rent renewals.
You can lock in a higher distribution yield of 6.5% with SmartCentres REIT. Its stock price has dipped 14% since the Fed’s first interest rate hike in March. The REIT can earn you a stable dividend during a recession and a 15-20% growth during economic recovery when property prices rebound.
Another good investment is an index ETF like iShares Core S&P 500 Index ETF (CAD-Hedged). It gives you exposure to the top 500 stocks by market cap, thereby giving market returns. A few stocks may perish, but the market will recover.
