Highlights of Benjamin Tal Weekly Market Insight

The Bank of Canada is very clear about its intention to raise rates as early as June. The key question is not
about timing but rather of magnitude. At this point, it appears that the market is in a process of pricing in a
significant rate increase by the Bank, with many observers suggesting that the Bank rate will reach 4% or 5%
by the end of 2011. It appears that the Bank of Canada itself is uncomfortable with this recent move by the
market to discount an aggressive tightening program. The Bank knows very well that this recovery is going to
be extremely non-linear with an array of factors limiting growth and inflation in the second half of the year and
into 2011. These factors include a strong dollar, the end of fiscal stimulus, a significant softening in real estate
activity following this spring, a slower pace of economic activity in the US in the second half, and the impact of
higher interest rates on over-extended consumers. In fact, our consumer capability index is at a 15-year low
and we estimate that consumers are now 40% more sensitive to higher rates compared to the last times the
Bank of Canada raised interest rates. This environment is consistent with a gradual approach towards removing
liquidity from the market with the Bank rate likely to rise to only 2.5%-3.0% by the end of 2011.

What does the coming rate hikes mean for the stock market? The common thinking is that higher rates are
negative for stocks, but history does not support this claim. Looking at data going back to the 1950s we found
that in the six months before the Bank started to lean into the wind, Canadian stocks historically provided, on
average, a 22% annualized return (dividends plus capital gains) measured by the total return index for the TSX
Composite. In the six months after a rate trough, Canadian stocks in comparison returned 8.3% in annualized
terms. That’s less, on average, than in the pre-hike period, but within a per cent of the TSX’s longer term
performance. Total returns were significantly negative in only one of the thirteen half-year periods after a rate
trough. Stocks outshone bonds, the main competing asset class, about 70% of the time in the half year before
the trough in rates and over 85% of the time in the half year after.

Along with the expected limited monetary tightening, this historical observation suggests that the coming rate
hikes may well be an annoyance but are unlikely to deliver a knockout blow to equity markets.
Benjamin Tal
CIBC Senior Economist