Protect your portfolio from negative interest rates

A few years ago, the notion of negative interest rates was a purely academic discussion. But after the Bank of Canada said in December that its overnight rate could fall below zero—and some European countries did indeed go negative—the prospect of seeing minus signs became real. Bad enough for savers—people in Denmark pay banks to hold their money, as if it were stored furniture—it could prove still worse for equity investors.

Typically, markets rise when rates fall. That’s what we’ve seen in most developed economies since 2009. Essentially, by lowering rates, central banks encourage investors to get out of fixed income and buy stocks, which will earn them a higher return. However, this has made certain safe income-generating sectors, like utilities and real-estate investment trusts (REITs), more expensive. As well, the rotation to equities has largely played itself out, says Craig Fehr, an investment strategist at Edward Jones.

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Here’s the idea behind negative rates: Banks get charged a fee to store cash at the central bank. No institution wants to do that, so they take that money and invest it or loan it to consumers and businesses instead. Also, the lower borrowing rates go, the more consumers opt to buy stuff. The alternative is keeping money in an account that’s costing them. If everyone does as they should, then more dollars flow into the economy.

The reality, though, says Fehr, is that negative rates can spook markets. Below-zero rates suggest something’s very wrong with the economy. Every country that has gone negative, save Denmark, has seen its market fall. After Japan slashed its rates on Jan. 29, the Nikkei 225 dropped 6%. Meanwhile, companies have been reluctant to borrow and invest in their operations. Why? Because they’re still nervous, says Fehr, and that may not be alleviated with negative rates.

However, even if markets react on the downside, there are equities that could benefit. Utilities and REITs, already the go-to sectors for yield-seeking investors, may still be the best bet, says Ryan Crowther, a portfolio manager at Franklin Bissett Investment Management. They have long-duration cash flows—in the case of utilities, those come from mandated rates of return. “They’re still the most bond-like equity you can buy,” he says. Crowther also notes that lower rates make stocks more attractive from a valuation perspective. Their debt costs go down, so growth is less expensive.

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Another way to play negative rates is to buy dividend-paying stocks that will benefit from economic growth. If the central bank’s goal is to kick-start the economy, then a technology stock or even some small-cap names might be the best choice, says Fehr. Many pay dividends these days, so not only can you get the yield you wouldn’t in a savings account, but you’ll also benefit from corporate growth. “You want companies that have the ability to weather slower economic conditions and thrive in improving ones,” he says. “Cyclical names could be good.”

It’s hard to know what will happen to the financial sector if rates go negative, says Crowther. Banks would have to pay the central bank to hold their money overnight, but people might borrow more, which would be a positive. “It’s complicated because there are so many different variables at play,” he says.

This article was originally published on Canadian Business.