If you’ve loaded up on GICs over the past 18 months, I understand. I’ve bought a couple myself. The thought of a 5-per-cent yield is intoxicating after years in which payouts were often half that.
But do GICs still make as much sense as they did a year ago? They had massive appeal back when inflation was raging and central banks were hiking interest rates at a frantic pace. Compared with risky stocks and falling bonds, GICs were an island of safety.
Now, though, the picture has changed. Inflation has tumbled in recent months. Both the Bank of Canada and the U.S. Federal Reserve are hinting they’re done with raising interest rates. Meanwhile, forecasters are turning more optimistic, particularly on the outlook for the U.S. economy.
This suggests it is time to start taking on a bit more risk. The question is what type of risk. Let’s look at the top candidates.
Bonds: The past couple of years were hellish for bond investors. Bond prices move in the opposite direction to interest rates, so as central banks drove interest rates relentlessly higher, bond prices nosedived.
Bond enthusiasts think this process will reverse itself over the next couple of years. If they’re right, interest rates will tumble, bond prices will soar.
In fact, the turnaround may already have begun: A broad index of Canadian bond prices jumped 3.2 per cent over the past month, according to Bloomberg.
More gains could be in store. The market expects both the Bank of Canada and the U.S. Federal Reserve to slash overnight interest rates in the coming months as economies slow and inflation fades back to target. Everything else being equal, lower central bank rates should lead to lower rates for longer-term bonds and light a rocket under bond prices.
The catch? This process may not be quite as speedy as investors would like.
Central banks’ willingness to cut interest rates will hinge on inflation continuing to fall. If inflation proves unexpectedly sticky – or even resurges, perish the thought – central banks could keep rates higher for longer than the market now thinks likely.
Stocks: The prospect of interest rate cuts over the next year has already reinvigorated global stock markets. The MSCI All Country World Index jumped 9 per cent in November, its best month in three years.
Strategists at Deutsche Bank, BMO Capital Markets, Bank of America and Royal Bank of Canada think this happy trend can continue, particularly in the United States. They are calling for the S&P 500 index, now around 4,600, to surge to record highs in 2024 of 5,000 or more.
On the other hand, the folks at J.P. Morgan predict that Wall Street’s favourite benchmark will finish 2024 at 4,200, about 9 per cent lower than it is now.
Why such a big divergence in outlooks? Much of it comes down to differences in opinion about whether the U.S. economy will slide into a recession next year and, if so, how deep that recession will be.
Optimists, such as Goldman Sachs, argue that most developed nations will escape recession. Skeptics, though, ask whether stocks are offering enough extra payout over bonds to justify taking on all the extra risk and volatility that goes along with equity investing.
To attract investors, stocks typically have to generate substantially more in earnings than bonds are producing in yield. Right now, there isn’t much of a gap, at least in the U.S. market.
Pimco, the giant bond investor, argues that U.S. stocks have not been this expensive relative to bonds since 2007. It calculates the equity risk premium – the extra return you get for holding stocks rather than long-term government bonds – at a mere 1 per cent, far below the historical average of 4.2 per cent.
Investors who want a cheaper alternative to the broad U.S. market may want to look at Canadian stocks, particularly big, reliable companies with large dividends. Several such companies – including giants such as BCE Inc., Telus Corp. and TC Energy Corp. – are paying out 6 per cent or more.
If interest rates do fall over the next year, the supersized yields on these stocks are going to be outrageously tempting. That should drive their share prices higher.
The bottom line is that GICs still hold considerable appeal for cautious investors. However, GICs have historically not been a great investment. Over the past 20 years, they have barely kept pace with inflation.
Right now, other assets seem poised to produce superior returns.
Bonds, for instance, look like a low-risk way to play the probable fall in interest rates over the next year. Investors who buy cheap exchange-traded funds (ETFs) that track the broad Canadian bond market should do well if bond yields slide as much as expected.
Many Canadian dividend stocks also look tempting. Their yields are generous and they are insulated, to some degree, from the political turmoil that could shake U.S. markets in the upcoming election year.
Can’t decide? Consider the balanced ETF portfolios offered by the likes of iShares and Vanguard. They hold 60 per cent stocks and 40 per cent bonds. That classic mix has a long track record of success and has produced solid returns of about 7 per cent so far this year. No, they’re not quite as predictable as GICs, but they will probably perform better over the long haul.