Managed Money Reporter Newsletter — Issue 143, January 1999

Editors: Carl Spiess & Allan McGlade

How Interest Rates and Inflation Affect Investments

An Insight to the Markets of 1999

Interest rates are the cost of money, and simply put when you have a greater supply of money than demand, you have very low interest rates; when you have a shortage of money interest rates climb. If you are looking at rising and falling interest rates over market cycles, as opposed to short-term fluctuations, it's really just a case of supply and demand. In the last few decades money has been very expensive and that can be attributed to the fact that baby boomers have comprised the largest segment of the population, and they have required large sums of money to buy homes, cars, furniture etc. We saw interest rates soar as every baby boomer had a $100,000 to $300,000 mortgage.

In terms of how this affects the markets, when interest rates are low there is a large excess of cash available to invest. Fixed income securities become an unattractive place to put money because their return is low, however equity markets become very attractive because conversely their returns are rising. The TSE for instance has averaged a 12% rate of return since inception, so investors look at this and say why should I take a 4% return when, if I put up with a little more volatility, I could get 12%. Money starts to flow into the stock market and pushes prices even higher. Corporations of course tend to do much better during periods of low interest rates because money is very cheap for them to borrow, their outstanding debt servicing is much lower, and therefore more money is going to the bottom line. Consumers also benefit from low interest rates because it's cheaper to borrow to buy consumer goods. So the net result is that the economy is doing better, corporate stocks are doing better and therefore the stock market is reaping the benefits.

Bond markets also do quite well during periods when interest rates are falling, because bonds go up in value as interest rates fall. Another factor that is affecting bond markets currently is the fact that as provincial and federal governments in Canada have started to decrease debt, and experience very positive cash flows through taxation revenue etc., less bonds are being issued to replace bonds that are being cashed in. We are starting to see bonds being taken off of the market, and a shortage in bonds tends to drive their prices up and interest rates down. Over the last year the Government of Canada has taken approximately 12 billion dollars worth of bonds off the market because of greatly improved cash flow. This shortage of bonds could continue to drive bond markets higher and interest rates lower.

Low interest rates also help to keep inflation in check: the two go hand in hand. Low inflation allows interest rates to come down and still give investors a positive real rate of return, whereas when interest rates were high with Canada Savings Bonds at around 19%, real rate of return was actually closer to zero, or sometimes even a negative real return because the inflation rate was also extremely high. Naturally, if interest rates spike up in the short term, or inflation spikes up, that will have a detrimental effect on both stock and bond markets. Bond markets because it's such a simple relationship: when interest rates start spiking up bonds are worth less than they were purchased for. In terms of the stock market, when interest rates are on the rise people tend to pull their money out of the equity markets and place their money where there is a guaranteed rate of return offering them less risk and volatility.

So what can we expect for the near future? This past summer, Alan Greenspan went on record to say that interest rates in the U.S., which were then at 5 1/2%, would not be raised. In fact they have since dropped to 4.75%. Here in Canada the Bank of Canada had been getting some pressure to raise interest rates to support our dollar. The Canadian economy however is not in as great a shape as its U.S. counterpart. So while we briefly saw rates as high as 6.00%, there is concern that raising the interest rate to stabilize the dollar will also have an adverse affect on the economy in general. The Canadian Bank Rate has since been pulled back to 5.25%. With this in mind, it is our view that you can expect that the Bank of Canada will continue to minimize interest rates wherever possible for 1999.

What does this mean to you as a long-term investor? The key is balance. Every investor should have a balance between the two main types of investments; equity (stock) and fixed income (bonds). The correct mix will vary from person to person. Your mix will depend on the time horizon of your investment portfolio along with your tolerance for risk. As a general rule of thumb, we recommend the guideline of 100 minus your age equals the percentage of equity in your portfolio. For instance, a 45-year-old investor would have roughly 45% of his portfolio in fixed income and 55% in equity.

Investment ideas for equity include equity based mutual funds while fixed income include bonds funds as well as stripped coupon bonds and GICs. For a combination of the two, we look to a good quality balanced fund.

For more information, or a review of your investment portfolio, call our Service Centre at (416) 863-7777 or 1-800-387-9273 or email us.

January 1, 1999 Marks an Historical Change to Canadian Stock Indices

In the New Year, the Toronto Stock Exchange is introducing a new market index. This new index, the TSE 60 will, as the name implies, be made up of 60 of Canada's largest companies. The new index will be operated by Standard & Poors, a company noted for the management of one of the largest American Indices, the S&P 500.

The TSE 60 will be replacing the Toronto 35, the TSE100 and TSE 200. The TSE 300 however is expected to remain intact.

Holders of both TIPS 35 and TIPS 100 (formerly known as HIPS) can expect their units to be combined into a new unit. The new unit probably will be called SIPS 60. Just like the TIPS units, this clone will represent a basket of stocks trading at a multiplier of the underlying index. It is expected that the transition would be seamless, and specific details will be provided to holders of these securities once they are finalized.

While there is a chance that this change will also affect holders of Equity Linked GICs, it is expected that the exchange may choose to continue to calculate and quote the Toronto 35, TSE 100 and TSE 200 on an ongoing basis.

Fund News

Dundee Bancorp has announced the resignation of Norman Bengough who formerly assumed the responsibility for the company's fixed income portfolio, including the bond portion of the Dynamic Partners Fund. David Goodman, along with the other existing members of the investment team will take over his responsibilities

O'Donnell Group of Funds has announced that Wally Kusters is no longer the fund manager for the O'Donnell Select Fund or O'Donnell Balanced Fund. The funds will now be managed by Glenn Inamoto, who has been managing the O'Donnell Canadian Fund.

C.I. Fund Management Inc. has announced that Wally Kusters has joined the company with a multi-year contract as the lead manager of two new Canadian mutual funds - a Canadian equity fund and a Canadian balanced fund.

For additional information on these or other mutual funds, please call our Service Centre at (416) 863-7777 or 1-800-387-9273 or email us.


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