The global financial landscape is undergoing a significant transformation, moving decisively away from the prolonged period of "free money" characterized by near-zero interest rates. This seismic shift, driven by a confluence of factors including persistent inflation, escalating government debt, and robust economic growth, is fundamentally altering the economic calculus for businesses, consumers, investors, and governments worldwide. Capital, the very engine of capitalism, is becoming more expensive, and its impact, though sometimes slow to permeate, promises to be far-reaching.
David Stonehouse, Senior Vice-President and Head of North American and Specialty Investments at AGF Investments Inc., offers a critical perspective on this evolving environment. His insights provide a roadmap for understanding the forces shaping the U.S. and Canadian economies, identifying competing pressures that may temper the impact of higher capital costs, and equipping financial advisors with the knowledge to guide clients through this challenging period.
A Reshaping of the Economic Landscape
The era of ultra-low interest rates, a defining feature of the post-Global Financial Crisis and COVID-19 pandemic economies, fostered an environment of readily available and inexpensive capital. This fueled asset appreciation, encouraged borrowing for investment and consumption, and generally supported economic expansion. However, the subsequent surge in inflation, beginning in earnest in 2021, forced central banks globally to embark on aggressive monetary tightening cycles. This has led to a significant increase in bond yields, signaling a fundamental repricing of risk and a higher cost of borrowing.
Stonehouse observes, "We had a massive reset [in 2022] and it had an impact at the time, but since then we’ve been range bound. Now we’re breaking out." He cautions against viewing the current situation as merely a delayed reaction to past events. Instead, he suggests a more complex, potentially multi-wave inflationary dynamic. "The world adjusted to a new interest rate environment four years ago, so I don’t think we’re seeing a delayed reaction to what happened four or five years ago. There are a lot of people who think that inflation comes in waves, citing the 1970s as an example. We could be going through another aspect of that where we had the first wave five years ago and we have the second wave now." This perspective highlights the enduring nature of inflationary pressures and the possibility that the current uptick in yields is part of a broader, more persistent inflationary cycle.
Unpacking the Drivers of Rising Bond Yields
Understanding the specific catalysts behind the ascent of bond yields is crucial for navigating the current market. Stonehouse identifies a multifaceted array of contributing factors, moving beyond simplistic explanations.
-
Energy Prices and Inflationary Pressures: While elevated energy prices are a recognized contributor to the current inflationary environment, Stonehouse suggests their impact may be less encompassing than initially perceived. "High energy prices are a factor in the higher rate environment a fall in energy prices ‘won’t fix everything.’" He elaborates that if energy-driven inflation were the sole culprit, the impact would be most pronounced in inflation breakeven bonds, which have remained relatively range-bound. This indicates that other, more structural factors are at play.
-
Robust U.S. Economic Growth and Debt Levels: A significant driver of higher yields, particularly in the U.S., is the combination of strong economic growth and substantial debt accumulation. Stonehouse points to real U.S. GDP growth hovering around three percent and nominal growth at approximately six percent. This expansion is fueled, in part, by considerable investment and capital expenditure. Such robust economic activity, coupled with increasing government borrowing to finance its operations and a growing national debt, naturally exerts upward pressure on interest rates as demand for capital intensifies. As of the third quarter of 2023, the U.S. national debt surpassed $33 trillion, a figure that continues to grow, necessitating substantial borrowing at potentially higher interest rates.
-
Global Debt Crises and Market Contagion: The interconnectedness of global financial markets means that challenges in one region can ripple across others. Stonehouse notes that "worsening debt crises in France, the UK, and Japan all contribute to the shape of global bond markets and the yields on key instruments like the U.S. 10-year treasury bond." Sovereign debt concerns in major economies can erode investor confidence, leading to higher borrowing costs for those nations and influencing global yield benchmarks as investors seek perceived safe havens or adjust their risk premiums. For instance, the persistent budget deficits in France and the UK, coupled with Japan’s aging population and high public debt, create an environment of uncertainty that impacts global fixed-income markets.
-
Normalization of Term Premium: The term premium, which compensates investors for the risk of holding longer-dated bonds, had been historically low for an extended period. Stonehouse explains, "The fifth factor that Stonehouse identifies is the relatively low starting point for term premium. Despite a big move up in 2022, term premium was not fully normalized until more recently. Now, finally, longer-term yields are moving higher." This normalization suggests that the market is more adequately pricing in the risks associated with holding debt for longer durations, contributing to higher long-term yields.
-
The AI Buildout and Capital Competition: A novel and increasingly significant factor influencing bond yields is the massive capital expenditure associated with the artificial intelligence (AI) revolution. "The sixth and final factor driving bond yields, Stonehouse says, is the AI buildout. The scale of borrowing now being undertaken by the hyperscaling AI companies has created a competition for capital which has driven up credit and bond yields on the longer end of the curve." Companies at the forefront of AI development, requiring substantial investments in data centers, computing power, and research, are actively competing for a finite pool of capital. This heightened demand from a rapidly expanding sector directly contributes to higher borrowing costs across the market. The projected investment in AI infrastructure alone is expected to run into trillions of dollars over the next decade, underscoring the magnitude of this capital demand.
The Multifaceted Impact of Higher Interest Rates
The consequences of a higher cost of capital are far-reaching, affecting various economic actors in distinct ways.
-
Consumers and Refinancing Burdens: The most immediate impact of rising interest rates is felt by consumers facing the prospect of refinancing existing debt. "This new rise in interest rates is coming as many borrowers who had locked in low rate financing before the end of the pandemic have been forced to refinance," Stonehouse explains. This includes corporations renewing five- and ten-year debt issuances, Canadian homebuyers facing renewals on their five-year mortgage terms, and even U.S. homeowners navigating the natural churn of the housing market into higher-rate mortgages, despite the availability of 30-year fixed loans.
This increased debt servicing cost inevitably leads to a pullback in other discretionary spending. Stonehouse notes the precarious financial position of many consumers: "many U.S. and Canadian consumers lack a strong wealth or savings cushion to deal with this cost." While higher net worth individuals may see their investment income benefit from higher rates, those with lower incomes face more difficult choices. The continued low volume of transactions in the U.S. housing market serves as a stark indicator of this new rate regime’s dampening effect. In Canada, where housing markets have experienced more significant declines despite relatively lower rates compared to the U.S., Stonehouse attributes this sensitivity to shorter mortgage renewal terms and a more acute consumer awareness of borrowing costs.
-
Businesses and Investment Decisions: For businesses, a higher cost of capital directly impacts investment decisions. Projects that were viable at lower borrowing costs may now be shelved or postponed. This can lead to a slowdown in capital expenditure, potentially impacting economic growth and job creation. However, Stonehouse points out that some sectors, driven by compelling competitive imperatives, remain undeterred. "AI debt issuance, too, hasn’t been derailed by high borrowing costs. Companies building AI infrastructure are still more motivated by existential competitive risk than managing the cost of debt." This highlights how strategic necessity can override financial considerations for certain forward-looking industries.
-
Shareholder-Friendly Behavior and Corporate Strategy: The elevated cost of capital also disincentivizes certain shareholder-centric corporate strategies. "Higher cost of capital means companies are more likely to spend on R&D and growth-generating enterprises rather than share buybacks and dividends," Stonehouse observes. This shift reflects a prioritization of long-term value creation and innovation over short-term shareholder returns. While this may lead to less immediate shareholder payouts, it could foster greater corporate resilience and long-term growth potential. He notes, however, that "the largest technology companies are still engaging in significant share buybacks," suggesting that established, cash-rich firms may still leverage their financial strength to reward shareholders.
-
Government Finances and Debt Management: Governments are not immune to the effects of higher interest rates, particularly those with significant debt burdens. The U.S. government, which has relied on short-term Treasury bills for much of its financing in recent years, is now facing higher costs as these instruments mature and need to be refinanced at elevated rates. The Congressional Budget Office (CBO) projects that net interest payments on the U.S. federal debt will more than double over the next decade, reaching $1.4 trillion annually by 2033, largely due to higher interest rates. This increased debt servicing cost can constrain government spending on other critical areas, such as infrastructure, social programs, or defense.
Implications for Canadian Investors and Advisors
The current environment presents both challenges and opportunities for Canadian investors and their advisors.
-
Fixed Income Re-evaluation: Despite a challenging period for fixed income investors in 2022, Stonehouse emphasizes the renewed attractiveness of bonds. "the relatively higher starting point in yields as well as the income cushion those yields provide should offset any sense that we’re repeating the 2022 bear market." The higher yields now available offer a more compelling income stream and a greater buffer against potential price declines. As of early 2024, yields on Canadian government bonds across various maturities offer significantly higher returns compared to just a few years prior, presenting a more attractive risk-reward profile for income-focused investors.
-
Equity Market Dynamics and Valuation: In equity markets, the higher cost of capital has led to "multiple compression." Stonehouse explains, "a high cost of capital and the uncertainty that causes it has also resulted in multiple compression. Profits remain high among S&P 500 companies, but share prices aren’t moving up as rapidly. Investors are discounting earnings against those high capital costs." This means that investors are valuing earnings more conservatively due to the increased cost of financing and the potential for future economic slowdowns. This dynamic is particularly pronounced in less profitable, smaller-cap, and more highly leveraged companies, which have "struggled in the past few months… largely due to this rate overhang."
-
Strategic Positioning for Advisors: Stonehouse advocates for a disciplined and forward-looking approach for advisors. "We would still be encouraging investors to stay the course," he advises. While acknowledging the challenging environment, he believes that yields are approaching "a more attractive sustainable level." This suggests that now may be an opportune time for investors to increase their allocation to fixed income and carefully consider equity investments, given the recent corrections in both markets.
He adds, "we do think they’re getting closer to a more attractive sustainable level, then we would anticipate that the setup is actually fairly attractive for investors to step in here given the correction that we’ve seen in bonds and a lot of the stock market." This perspective underscores the importance of viewing market downturns as potential buying opportunities for long-term investors.
Looking Ahead: Navigating Uncertainty
The transition away from an era of abundant, cheap capital is likely to be a prolonged one. While the precise trajectory of interest rates and inflation remains uncertain, the underlying drivers suggest a sustained period of higher borrowing costs. Factors such as ongoing geopolitical tensions, the continued need for government borrowing to manage deficits, and the significant capital demands of technological advancements like AI will likely keep upward pressure on yields.
For advisors and investors, the key lies in adaptability and a focus on fundamental financial principles. Diversification across asset classes, a prudent approach to debt management, and a long-term investment horizon will be paramount. As Stonehouse’s insights suggest, understanding the complex interplay of economic forces, recognizing the enduring impact of higher capital costs, and maintaining a disciplined investment strategy are essential for navigating the evolving financial landscape and achieving long-term financial success. The age of free money may be behind us, but a well-informed and strategic approach can still unlock significant opportunities in the new economic reality.
