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Rising Interest Rates and Inflation – What Does This Mean for the Equity Markets?

Despite a global pandemic the likes of which we have not seen since 1918, the S&P 500 returned +18.4% in 2020 (in USD). Underneath the surface, the distribution of returns paints a much more detailed picture. 77% of the return in the index was attributed to 10 stocks (primarily mega-cap tech names). Our previous blog highlighted what short-term strategies have worked in the markets in 2021 thus far. Companies with low quality, low growth, and high volatility characteristics have outperformed and now must deliver after largely pricing in a recovery in our minds. These are not candidates for inclusion in Bristol Gate portfolios.

The trends in the market appear to be shifting – rising rates and fears of inflation have given investors pause. What do these trends mean for the markets moving forward?

As seen below, rising interest rates do not necessarily mean equity market weakness in the near future. In fact, the opposite has been true historically over the past three decades. The biggest risk by far of rising rates lies in the fixed income market where yields have been compressed, even small changes in rates will have a big impact on bond prices. Some of that fixed income money could find its way into equities providing support to the markets.

Source: “Rising Interest Rates are a Good Sign for Stocks”, Sam Ro. Yahoo Finance.

Within equities, we believe much of the recent underperformance of dividend stocks through the pandemic and recovery thus far can likely be attributed to the low interest rate environment. The low discount rates applied to future earnings of non dividend paying high growth stocks made growth an attractive segment of the market. As this trend in interest rates reverses and discount rates increase, the non dividend paying growth universe may give back a substantial amount of its relative gains.

Data Source: Ned Davis Research Inc. Past performance is no guarantee of future results. Data shown is based on the average 36-month performance after all rate hikes since 1972 which occurred on the following dates: 1/15/73, 8/31/77, 8/31/80, 9/4/87, 2/4/94, 6/30/99, 6/30/04, 12/16/15.

The chart above shows that in previous rate hike cycles, high dividend growers have historically performed well and provided a strong hedge in equity portfolios against rising rates and inflation. We believe companies that are growing dividends off strong fundamentals will once again be rewarded through this uptick in interest rates moving forward, particularly if they are attractively valued and can grow cash flows above inflation.

Important disclosures

Gross returns in this report refer to the Bristol Gate US Equity Strategy Composite and Canadian Equity Strategy Composite. No allowance has been made for custodial costs, taxes, operating costs, management and performance fees, which will reduce performance. Past performance is not indicative of future results. Allowance for withholding tax in the US strategy composite is partially reflected in the composite returns for periods commencing January 2017 and after. The Net returns for the Bristol Gate US Equity Strategy Composite and Canadian Equity Strategy Composite are reflective of the maximum management fee charged by Bristol Gate of 1% and 0.70%, respectively. Past performance is not indicative of future results.

The Bristol Gate US Equity Strategy Composite was formerly known as the Bristol Gate US Dividend Growth Composite until April 1, 2015. The Composite inception date was May 15, 2009. The Composite consists of equities of publicly traded, dividend paying US companies and is valued in US Dollars.

The Bristol Gate Canadian Equity Strategy Composite was formerly known as the Bristol Gate Canadian Dividend Growth Composite until April 1, 2015. The Composite inception date was July 1, 2013. The Composite consists of equities of publicly traded, dividend paying Canadian and US companies and is valued in Canadian Dollars.

The S&P 500® Total Return Index measures the performance of the broad US equity market, including dividend re-investment, in US dollars. The S&P/TSX Composite Index measures the performance of the broad Canadian equity market, including dividend re-investment, in Canadian dollars. This index has been provided for information only and comparisons to the index has limitations.

There is the opportunity to use leverage up to 30% of the net asset value. Leverage is not used as an investment tool to enhance returns, but for cash management needs of certain composite portfolios.

This Report is for information purposes and should not be construed under any circumstances as a public offering of securities in any jurisdiction in which an offer or solicitation is not authorized. Prospective investors in Bristol Gate’s pooled funds or ETF funds should rely solely on the fund’s offering documents, which outline the risk factors associated with a decision to invest. No representations or warranties of any kind are intended or should be inferred with respect to the economic return or the tax implications of any investment in a Bristol Gate fund.

Bristol Gate claims compliance with the Global Investment Performance Standards [GIPS®]. To receive a list of composite descriptions and/or a presentation that complies with the GIPS® standards, please contact us at info@bristolgate.com. Bristol Gate Capital Partners Inc. has been independently verified for the periods commencing May 2009 until December 2015 by Ashland Partners International PLLC and from January 1, 2016 – December 31, 2019 by ACA Performance Services.

A Note About Forward-Looking Statements

This report may contain forward-looking statements including, but not limited to, statements about the Bristol Gate strategies, risks, expected performance and condition. Forward-looking statements include statements that are predictive in nature, that depend upon or refer to future events and conditions or include words such as “may”, “could”, “would”, “should”, “expect”, “anticipate”, “intend”, “plan”, “believe”, “estimate” and similar forward-looking expressions or negative versions thereof.

These forward-looking statements are subject to various risks, uncertainties and assumptions about the investment strategies, capital markets and economic factors, which could cause actual financial performance and expectations to differ materially from the anticipated performance or other expectations expressed. Economic factors include, but are not limited to, general economic, political and market factors in North America and internationally, interest and foreign exchange rates, global equity and capital markets, business competition, technological change, changes in government regulations, unexpected judicial or regulatory proceedings, and catastrophic events.

Readers are cautioned not to place undue reliance on forward-looking statements and consider the above-mentioned factors and other factors carefully before making any investment decisions. All opinions contained in forward-looking statements are subject to change without notice and are provided in good faith. Forward-looking statements are not guarantees of future performance, and actual results could differ materially from those expressed or implied in any forward-looking statements. Bristol Gate Capital Partners Inc. has no specific intention of updating any forward-looking statements whether as a result of new information, future events or otherwise, except as required by securities legislation.

[1] https://www.eea.europa.eu/publications/covid-19-and-europe-s/covid-19-and-europes-environment

[2] https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7498239/

[3] A universe consistent with our investment process (three years dividend history, investment grade rating, etc.) was used for this analysis.

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