Money supply contraction is rarely a good thing for stocks. It increases companies’ cost of capital, as well as the opportunity cost of investments, and it tends to get investors fleeing to treasuries. This needn’t always be the case. If companies grow enough, the growth can overcome the effects of higher rates. However, if you hold all other factors constant, a contraction in the money supply should yield lower stock prices.
This raises an interesting question: What should you buy if you expect the money supply to contract?
The seemingly obvious answer is treasuries but, as we’ll see, matters aren’t as straightforward as they seem. Money supply contraction causes previously issued treasuries to fall in price. Nevertheless, treasuries and related instruments like GICs are some of your best weapons in the fight against a shrinking money supply.
Why contractions in the money supply are bad for stocks
Money supply contractions are bad for stocks for two main reasons:
- They increase the cost of borrowing, which makes growth harder and existing operations more expensive than before.
- They increase the “discount rate,” which is the number by which you divide each cash flow to arrive at the value of an asset.
These two factors combined tend to put downward pressure on stock prices, which are valued based on the present value of their cash flows.
Consider Fortis (TSX:FTS), for example. It’s a Canadian utility stock that is well known for its long dividend-growth track record. The stock currently yields about 4%, and investors often purchase it for its perceived dividend safety. Indeed, Fortis’s dividend has been safe historically. But the company has billions in debt: if the money supply contracts in the future, then the interest on that debt will go up. That could harm Fortis’s dividend-paying ability. Additionally, FTS stock trades at 17.87 times earnings, which is not overly high but would be a little high if interest rates went into the double digits.
Money supply contraction: What you can do
If you’re concerned about money supply contraction wrecking your portfolio, you could try buying stocks that gain from rising interest rates. Bank stocks typically fit this definition, as they charge more interest than they pay. However, Canada’s yield curve is currently inverted, which means that the banks may have to start paying more interest in the future.
Another alternative you can consider is a Guaranteed Investment Certificate (GIC). GICs are fixed-income instruments offered by banks. They pay you a set amount when they mature. Some are linked to the performance of stock market indexes, but most just pay a set interest rate. GICs are similar to treasuries in that they usually have similar yields (banks need to match the treasury yield in order to retain their depositors). However, GICs do not trade on the open market, so you don’t need to worry about their prices. If you’re an anxiety-prone investor, this may make GICs more pleasant for you to hold than treasuries. The returns if you hold to maturity will be about the same.
If the money supply keeps contracting, then existing treasuries will go down in price. The law of one price dictates that assets with identical characteristics must have the same yield. With GICs, there is not much “market” related shenanigans to get distracted by, so they can be good assets for some people.
The post Canada’s Money Supply Is Shrinking: Historically, This Is a Bad Sign for Stocks appeared first on The Motley Fool Canada.
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