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Investing in stocks when interest rates decline

Dive into stock investing basics, understand the impact of low interest rates on stocks, and identify booming sectors.

Updated

12 min. read

Though rising interest rates have been the common narrative over the past few years, it shouldn’t be long before the story changes, with rates being expected to start dropping. To wit: the Bank of Canada recently cut its overnight rate by 25 basis points, putting its policy rate at 4.35 percent. The move - the first of its kind since the beginning of the pandemic – will, no doubt, spark fresh conversation.

The drop is a welcome relief to many, though it leaves some questions unanswered. When will further cuts come? How will they affect inflation? But one thing should be clear: if past behaviour is a good predictor of future behaviour, declining interest rates will likely prove to be a win for investors.

Stocks have historically performed well (or better, at the very least) when interest rates fall. Which is why now may be a good time to invest in stocks, to reap those future rewards. In fact, equity investing – purchasing stocks to gain shares in a company – can be a smart approach for investors looking to carve a solid path to long-term wealth building.

Understanding equity investing

Let’s start off with the basics: what exactly are stocks? When someone wants to invest money in a company, they typically purchase shares of that company on the stock market. Those stocks, often traded on a stock exchange, represent ownership in the company. They also represent potential for growth through capital appreciation, a rise in an investment's market price. Effectively, capital appreciation is the difference between the purchase price and selling price of an investment – in this case, a stock.

Why invest in stocks?

If you’re looking to establish a strong investment portfolio, stocks can be your loyal friend. Equity investing can help you build savings and typically sees better returns than cash and other investments. Moreover, investing in stocks can shield you from taxes and inflation. It may seem counterintuitive, but historical data has found that inflation won’t hinder stocks. On the contrary, stocks have demonstrated they can outpace inflation over the long-term.

And let’s not forget about the dividend. If a company pays shareholder dividends, investors receive a regular income. Along with the favourable tax treatment, stocks have benefits worth exploring. But don’t forget that stocks have a tendency to fluctuate. That’s why a longer-term approach would be advantageous for any investor.

Types of stocks

There’s a large variety of stocks to choose from. Here’s a simple breakdown of the more popular ones:

Common stock: The most basic type of stock, common stock provides the investor with an ownership stake in the company. They also can vote on major decisions pertaining to the business.

Preferred stock: Considered to be more like a bond than a stock, a preferred stock seldom provides investors with voting rights, but it allows them to receive dividend payments before common stockholders.

Large-cap stock: Common stocks fall into different categories based on their market capitalization. Large-cap stock refers to a company with a market capitalization value of more than $10 billion. These companies are usually well-established, some are even referred to as blue-chip stocks.

Mid-cap stock: These companies are the next step down in market cap, between $2 billion and $10 billion, on average. Though not as established as the large-cap stocks, the companies are on their way. They often represent less risk than small-cap (see below) but more than large-cap stocks.

Small-cap stock: With caps at less than $2 million, small-cap stocks are often in their early growth stage. But they offer investors the potential to find hidden gems which could be promising investments in the long-term. Just remember they come with risks too, as they will be most sensitive to economic downturns.

Growth stock: With strong potential for high returns, growth stocks are the favourite choice of stock for many. But that also means their stock will come at a high price (and overvalued levels) which can sometimes translate to disappointment for investors. If you find one with a good price, however, there can be much to gain in a growth stock.

Value stock: These otherwise-stable companies are trading for less than they’re worth, for any number of reasons.

Dividend stocks: These companies pay dividends to shareholders, often in the form of cash but can also be in the form of shares.

“Stocks have historically performed well (or better, at the very least) when interest rates fall. Which is why now may be a good time to invest in stocks.”

How falling interest rates affect stocks

With interest rates finally in decline, it’s assumed to be a good time to be an investor in stocks. Not convinced? Let’s look at how, and why, that drop can affect stock valuations over time.

The inverse relationship: Though there are exceptions to the rule, historically we’ve seen that when interest rates rise, stock prices decrease – and vice versa. If you look at it logically, it makes sense. With lower interest rates, it’s easier for a company to raise capital. Which impacts future growth prospects and earnings. Which can, in turn, raise the price of the company's stock. When many companies experience the same increase in stock prices, stock markets tend to go up. Investors will also feel more optimistic about their equity investments, making them more desirable.

Cheaper borrowing: Companies must pay more to borrow money when interest rates go up. This will have a domino effect on the costs of raw materials, equipment, upgrades to their operations, as well as their ability to pay employees. Ultimately, those rising costs reduce a company’s profitability, often lowering the stock price. But when companies can borrow money at lower rates, they can see growth in earnings, profitability - and stock prices.

Increased consumer spending: When consumers pay less in interest, they have more cash to spend. They’re also more willing and able to borrow money for big purchases, like a new home. That, in turn, will influence stock prices to rise. Conversely, rising interest rates will cause businesses and their customers to cut back on spending. Their spend-thriftiness will lead to a dip in earnings and stock prices.

Discounted cash flows: A discounted cash flow (DCF) estimates the value of an investment today based on its expected cash flow in the future. If the DCF value is higher than the current cost of the investment, it’s an opportunity worth considering. If stock prices represent the present value of a company’s expected future earnings, the argument logically follows that lower interest rates can make future earnings more valuable in the present, leading to higher stock valuations.

Sectors that benefit from lower rates

As rates drop, some sectors may benefit more from the changing economic landscape. There’s no guarantee but, were they to follow past behaviour, companies representing the following sectors would find much to appreciate from lower rates.

Technology: To remain competitive, IT companies must always be innovating. To do so, they need intensive investments in research and development. They would also need to pursue expansive strategies including acquiring other companies. Achieving those goals requires a lot of capital. Which is why tech companies rely heavily on debt. Lower interest rates allow them to secure funding at more affordable rates to make their R&D activities possible. Those most likely to gain from the situation are mid-cap tech stocks and tech stocks with high debt balances. Huge companies like Apple may not find as much of an advantage.

Consumer Discretionary: When we talk about the consumer discretionary sector, we’re referring to non-essential goods and services, including cars, designer clothes and entertainment. Lower interest rates tend to inspire consumers to up their discretionary spending. The reality is especially true when customers emerge from a period marked by overly restrictive purchases (i.e. buy only what is necessary). When pent-up demand meets low interest rates, retailers, restaurants and entertainment companies will typically see their sales spike.

Real Estate: Lower interest rates translate to more affordable mortgages which, in turn, stimulates demand for housing. Those lower mortgage rates can also boost the value of real estate assets. With demand rising for properties, companies working in the real estate sector will be able to invest more in inventory and building their portfolios. Which results in more consumer spending, sales and profit. And on and on it goes.

Alternatively, some other sectors may be impacted by lower interest rates in less-than-positive ways. The financial services sector, for example, usually finds its profitability increase when interest rates rise, not fall. Interest income from loans tends to increase faster than interest paid on deposits, leading to those greater profits. That said, higher rates can also reduce demand for loans and borrowing, which can also affect a financial institution’s performance.

ETFs: A simplified approach to sector investing

For those looking to invest in the stock market, there are other options aside from individual stocks. An exchange-traded fund (ETF) is a pooled investment vehicle that owns a basket of stocks, bonds, commodities or other securities. Just like stocks, ETFs can be traded throughout the day. Unlike stocks – which represent ownership in a single company – an ETF holds many securities (similar to mutual funds, except those are traded only once per day).

The benefits of ETFs are many, including:

Ease of trading/liquidity: As mentioned earlier, ETFs can be traded any time of day. And since they’re most likely to be traded on stock exchanges, they can be bought and sold whenever the exchange is open (even if the geographical market is closed).

Instant diversification: When you invest into an ETF, you buy into a basket overflowing with hundreds or thousands of securities. You can track the performance of an array of indexes, sectors and companies. Diversification ensures greater protection against market volatility, an especially valuable feature if a company or industry is facing economic challenges. It’s been said that a well-diversified ETF, such as one based on the S&P 500, can beat most investors over time.

Transparency: ETFs typically disclose their holdings publicly on a daily basis, so you know exactly how your fund is doing.

Lower fees: Generally speaking, ETFs come with lower management expense ratios. Lower costs mean a higher percentage of returns end up in the investor’s pocket. That said, there will be transaction costs you’d need to weigh over the others before jumping in.

Practical tips for getting started with stock investing

For a successful experience with stock trading, the following tips can help.

Start small: It’s important not to invest more than you can afford to lose. So, before you get started, check your personal finances and make sure they are in order. Create a budget that ensures your basic expenses are covered and an emergency fund is in place for any unexpected events. Only once you’ve established the above and adopted a diligent mindset should you set aside an amount each month for your investments.
Do your research: Knowledge is power, whether you’re investing in stocks or trying anything new in life. If you invest in companies you’re not familiar with, you’re opening yourself up to avoidable risks. With enough research and due diligence, however, you can better understand what companies do, how they’re performing – and decide whether you want a piece of the pie. That knowledge will help you make more informed (and smarter) buying decisions.
Diversify: To minimise risk, it’s best not to invest all your allocated funds in one stock. It’s much more effective to spread your money across different sectors, companies and geographic regions. Diversification gives your portfolio an important level of protection should an investment not perform according to plan.
Pursue dollar-cost averaging: Dollar-cost averaging is a strategy to manage price risk. If you invest haphazardly, all at once, you’ll need to worry about timing the market perfectly to get the best price. That’s a difficult ask. With dollar-cost averaging, you invest a fixed (smaller) amount on a regular basis, regardless of the share price. The approach helps decrease the risk of paying too much before the market drops.
Adopt a long-term perspective: Investors will do best when they embrace patience. Understanding that stock investing is a marathon—not a sprint— will help you appreciate the importance of a long-term vision. It’s not about pulling your funds at the first drop in the market. It’s about staying invested for the long haul, acknowledging that only then can you truly reap the rewards.
Consider professional advice: While research and due diligence are essential, sometimes it helps to seek guidance from a professional. A financial advisor can provide informed opinions and advice that can prove valuable.
Never stop learning: Investing is an ongoing journey, one that will keep you on your toes, always learning something new. To make the most of the journey, check out as many resources available to you. BMO’s Investment Learning Centre, for example, offers articles, podcasts, videos, and free courses to help every investor discover new strategies, enhance their understanding of the markets and adapt their investment approach for success.

Final thoughts

If you’re thinking of dipping your toes into stock investing, there’s no better time than now - when interest rates start to decline. From cheaper borrowing to increased consumer spending and greater profitability for companies, a decrease in rates has historically proven to be a boon for wanna-be stock investors.

With an abundance of individual stocks to choose from, sometimes investing in a basket of securities – ETFs – is a less overwhelming approach. Regardless of how you begin your stock investing journey, though, be sure to do so thoughtfully, with patience and a long-term outlook.

Ready to take your first steps toward building your stock portfolio? Check out BMO’s Investment Learning Centre for valuable tips and advice. Then head over to BMO InvestorLine for our trading tools and research. Don’t forget to explore BMO's Investment Payout Calculator to help you determine how much income your investments could earn. It’s easy to open an InvestorLine Self-Directed account to start your equity investing on the right foot. If you need more help, a BMO advisor, will be happy to show you how.