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Market reaction to recent inflation scare provides roadmap for defensive portfolio changes

by Wayne Cheveldayoff, 2004-04-22

During the recent inflation scare, the markets reacted in textbook fashion. Bond yields started to rise as traders dumped bonds and this triggered a sell-off in interest-sensitive equities like utilities, banks, income trusts and real estate investment trusts (REITs).

These developments provided a roadmap for investors who may want to protect their portfolios against the future ravages of inflation and rising interest rates.

The sequence of events started with the dramatically better-than-expected U.S. job numbers on April 2. Market participants began worrying that the U.S. Federal Reserve might start to raise short-term interest rates sooner than had been previously expected. Bond yields started to edge up.

Then, on the morning of April 14, the U.S. government reported surprisingly strong consumer inflation numbers. Sentiment swung further towards expecting an imminent Fed rate increase and interest-sensitive equities plummeted. The rout continued into the next day.

The biggest impact among equities was felt in the income trust sector. (As bond yields rise, the trustsí cash distribution yields become less attractive on a relative basis.)

For instance, in the business trust sector, the popular Yellow Pages Income Fund dropped from a high of $11.80 per unit on April 14 to a low of $10.75 per unit on April 15, a decline of 8.9 per cent. As its units fell, its cash yield went from 7.5 to 8.2 per cent.

Bell Nordiq Income Fund units similarly fell 7.7 per cent within 48 hours and the Davis and Henderson Income Fund, which supplies cheques to bank customers, saw its units drop by 10.8 per cent.

Power and pipeline trusts were also hit by the interest rate fears. TransCanada Power LPís units fell 6.1 per cent and Gaz Metís units sank 8 per cent over the two days.

Price weakness had shown up earlier in the month for the REIT sector and continued in the two-day period. Retirement REIT, which closed at $13.04 per unit on April 1, touched a low of $11.35 on April 15, a slide of 13 per cent over two weeks. Similarly, Residential REIT, which was $18.43 per unit at the beginning of the month, was 10.1 per cent lower at $16.56 per unit by the middle. H&R REITís units fell 20.4 per cent over the same two-week period.

During the mid-April panic, shares of utilities and banks also fell, but to a lesser extent. For example, Enbridgeís shares fell 4.7 per cent and TransCanada Pipelinesís shares sank 4.1 per cent. CIBCís shares slid 3.3 per cent while Royal Bankís shares declined by 2.8 per cent.

Keep in mind that this sell-off occurred before any action by the Fed or the Bank of Canada to raise interest rates. In fact, the Bank of Canada lowered its key rate by a quarter of a point on April 14 and a decision to raise rates is at least several months off in either country.

But it clearly shows that the markets anticipate central bank interest-rate actions well before they happen.

Thus, if you want to protect against the impact of rising interest rates, you will need to make changes in your portfolio well before the Fed or the Bank of Canada begin to push up rates.

If you own bonds, you may want to consider shortening term to minimize the price decline. With an approximate 50-basis-point rise in yields, a 10-year bond will go down about 4 per cent in price, while a 30-year bond will drop by 7.25 per cent.

If you own bond funds, which normally perform the same as a 7 to 10-year bond and are vulnerable to price decline as yields rise, you may want to switch into a money market fund where the yield will be lower but so will be the risk of a decline in value.

In the income trust sector, defensive action would include switching away from REITs, pipeline and power funds, and any trusts with high debt levels to funds with low debt and good growth potential.

In fact, besides retreating to short-term money market investments, investing in companies and trusts with strong profit growth prospects may be the only way to escape the impact of rising rates.

An increase in rates can be expected to lower average Price/Earnings multiples for stocks, just as falling interest rates helped increase P/E multiples. This happens because analysts use market interest rates to discount future expected corporate cash flows. The higher the market yield (discount factor), the lower the present value of the stock.

In a climate of falling P/E multiples, the only stocks that will hold their ground or increase in value are ones that are rapidly growing their earnings.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2004 Wayne Cheveldayoff