InvestorsFriend Newsletter February 25, 2023

The Investment Outlook for 2023

2023 began with stocks and longer-term bonds ripping higher in January as long-term interest rates backed off somewhat from earlier peaks. Then in February, stocks and long-term bonds gave back some of those gains. Still, the S&P 500 remains up 3.3% and the Toronto stock exchange remains up 4.3% for the year to date.

The outlook is always uncertain and so most investors should probably hedge their bets by holding not only equities but also fixed income and cash.

The great news is that cash in investment accounts is now earning just over 4%. And you can easily get over 4% in short-term GICs. The yield available on all forms of fixed income has risen. In 2022, most fixed-income investors suffered capital losses as longer-term interest rates rose. (Investors learned or re-learned that fixed income does not mean fixed value.) But that’s far less likely to be a concern in the rest of 2023 since long-term interest rates have already risen very significantly and may be more likely to decline modestly by the end of this year rather than increase much. So, an allocation to fixed income should do reasonably well this year.

Equities are always a tough call in any given year. They rise in the long term and so it’s wise to have a fairly heavy allocation to equities. But current stock valuations on average are not cheap and could be driven down as many investors may tend to sell shares in favor of fixed income. Other investors will buy those shares but the share prices would be “bid down”.

In addition to a lot of free information, InvestorsFriend has a paid Stock Picks service which includes a good selection of stocks as well as fixed income. This also includes short daily comments on the market each weekday. The cost is a modest $15 per month or $150 per year. Click here or on the Stock Picks link at the top of every page on this web site to see the page where you can subscribe to that service if you wish. [Notice my “hard sell” approach here.] And you can see full details of our past track record by clicking the “Performance” link above.

Not everyone is interested in owning individual stocks and so we also provide (for free) information on building a portfolio using Exchange Traded Funds.

These Higher Interest Rates are a Massive Game Changer

Higher interest rates have already cooled off the Canadian housing markets significantly. Single-family home prices in the highest priced areas like Toronto and Vancouver have apparently declined over 20%.

Let’s take a look at some of the rather shocking math here.

Just 14 months ago on January 1, 2022 the interest rate (or yield) on a 30-year U.S. treasury bond was 2.01%. Today it’s 3.88%. The value of a $1000 U.S. treasury bond purchased 14 months ago has plummeted to $678. That’s a 32% capital loss on a so-called risk-free bond! This investor is locked into to getting $20.10 per year in interest while newer 30 year bonds issued today are paying $38.80. So, the value of that lower interest rate bond had to plummet.

And let’s look at how the payment on a $400,000 mortgage changes as a 5 year mortgage rate has jumped from about 2.0% to about 5.0% in the space of about 14 months.

The monthly payment at 2.0% is (was) $1694. Furthermore, and very importantly, $1,030 or 61% of the first payment was going to pay down principle and only $664 or 29% of the payment was going towards interest. And after 10 years, 34% of the mortgage was paid off.

But at a 5.0% interest rate the payment increases by 37% to $2,326. And there’s more bad news. Now only 29% or $677 of the first payment is going to pay down principle. 71% or $1650 is going just to pay interest. So your payment is 37% higher and yet you are paying far less towards the principle. After 10 years this mortgage is only 26% paid off.

To run the numbers for a different mortgage amount or interest rate, use this handy link.

So mortgage payments for home buyers have just shot up by about 37%. And not only that but the amount going to principle in the first payments drops by 34% despite the higher payment. So, it becomes harder to pay off the mortgage earlier.

This is a game changer and all else equal has to lead to lower home prices and this has already occurred especially in Toronto and Vancouver. But, all else is never equal and there may be other factors such as immigration that could offset some of the decline.

Next, consider that just 14 months ago, cash bank account products in self-directed investing accounts were paying just 0.05% (not a typo!). Now these same accounts are paying 4.0 to 4.35%. That’s another game changer.

Many fixed income investments that might have looked reasonable 14 months ago at 5% suddenly do not look attractive in comparison to getting 4% in a daily interest account. The prices of most preferred shares fell hard in 2022 as their prices came down to “compete” with the higher interest rates and yields suddenly available on other fixed income investment options.

Equity valuations also came under pressure due to higher interest rates. a A P/E of 20 that seemed reasonable when cash was paying 0% suddenly is less attractive when cash is paying 4% and when there are suddenly many options to earn 6% or more in dividends.

Higher interest rates also lead to higher expenses for corporate debt. And that can push stock prices down. But the bigger impact is that the required higher “discount” rate on future cashflows pulls down the P/E ratios that stocks trade at – meaning stock prices decline, all else equal.

Yep, it’s a game changer!

Marginal Income Tax Rates

With a few days left in RRSP season and with tax filing season upon us, it’s a good time to take a look at marginal tax rates.

I’ll look at Ontario because it is the largest province but I also have a handy link where you can find the marginal tax rates for all the other provinces.

For the 2022 tax year, the marginal tax rate on regular income such as wages and interest in Ontario is 20.05% up to a taxable income of $49,231. People in that tax bracket should probably not make an RRSP contribution since the marginal tax rate at withdrawal time could easily be higher. It’s interesting and shocking to see that in that first tax bracket the marginal tax rate on eligible dividends is negative 6.86% Eligible dividends are dividends from almost any Canadian company on the stock exchange including their preferred shares. These dividends are “eligible” for the dividend tax credit. For this tax bracket, it seems that the dividend credit in Ontario is higher than 20.05%.

Of course, the vast majority of people, especially those with lower taxable incomes have no eligible dividend income, or very little at most. But a small percentage of people are in a position to take big advantage of the low tax rate on eligible dividends.

Investors should be aware of their tax bracket and the marginal tax rate that they face on regular income (including wages, interest, non-Canadian dividends, pensions and RRSP withdrawals), capital gains (half the tax rate on regular income), eligible dividends, and Non-eligible dividends (which are dividends from Canadian small businesses).

Here’s a link to a great web site that gives the marginal tax rates for all the different tax brackets with a page for every province and territory in Canada.

More useful links

Click the “links” button at the top of every page on this web site. There are links there to a lot of sites that are very useful for investors.


Shawn Allen

InvestorsFriend Inc.
February 25, 2023




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