The Canadian Press

Rising interest rates this summer should not derail the stock market recovery because higher borrowing costs won’t damage the economy, says a report from CIBC World Markets.

“Higher interest rates are not yet a reason to hit the sell button,” chief economist Avery Shenfeld said Monday in the investment bank’s latest Economic Insights report.

The report said stocks have historically outperformed bonds — competing securities that are extremely sensitive to interest rates — in the early months of 13 previous periods of rising interest rates studied by the investment firm.

The results show that in the six months before the central bank started to raise rates, Canadian stocks historically provided, on average, a 22% annual return (dividends plus capital gains) measured by the total return index for the TSX Composite stocks.

In comparison, Canadian stocks returned 8.3% in annualized terms in the six months after a rate trough –far less, on average, than in the pre-hike period, but within a percentage point of the TSX’s longer term performance.

“History shows that the half-year in the lead-up to the first Bank of Canada rate hike tends to coincide with a very strong run for stocks, and stocks still outperform bonds in the early months after that first tightening (interest rate hike) move,” Shenfeld said.

Canada’s central bank is widely expected to begin hiking its key interest rates in late June or July after lowering them to historic lows to counter the negative impact of a global financial crisis. The Bank of Canada’s key rate has been at 0.25% since April 21, 2009.

The Bank of Canada has signalled that it intends to begin tightening credit, which could lead to interest rate jumps of between half a percentage point and a full point by the end of the year, in order to keep a lid on inflationary pressures in the economy.

“Rate hikes tend to be more damaging later in the cycle, when the central bank is more willing to risk a stall or recession to create anti-inflationary slack,” Shenfeld said.

“At this point, we are a long way from the demand-driven wage-price spiral that would see the central bank willing to seriously sacrifice growth. Rate hikes are coming, but not at the growth-crushing pace that should at this point strike fear in the hearts of equity investors.”

The main stock indexes have recovered much of the ground they lost during the 2008-09 global downturn. On Monday, the TSX closed at just under 12,030, but that’s still about 3,000 points or 20% below where it was in mid-2008 when it hit an all time high just over 15,000.

In Shenfeld’s report, the CIBC says that in the half-year periods that follow rate hikes, the transportation and durables sectors of the market were among the best places to invest.

Those sectors, which include the major railways CN (TSX:CNR) and CP Rail (TSX:CP), are not as strongly sensitive to higher interest rates and still benefit from a recovering economy because they will haul more goods to market.

Kate Warne, Canadian markets specialist with the Edward Jones brokerage in St. Louis, said the Canadian equity market is up about 2% this quarter and could rise between eight and 10% for the year.

“The Canadian economy clearly came out of recession last fall,” Warne said. “So if you look at a 14% gain, that’s good but not the 30% we saw in 2009. Using the long-term average of nine to 10% is probably a good estimate for what you would expect stocks to do this year.”