Canadian firms in an era of a higher cost of capital

Even with the recent uptick in hiring, the Canadian economy remains in a slump, with sparse activity in the financial markets, slow hiring and lacklustre investments.

In response, the Bank of Canada has been cutting interest rates—three times since June, with more reductions on the way. It’s only a matter of time before the cuts spur more hiring and investment by businesses.

But rates aren’t going back to where they were. We estimate that the Bank of Canada will reach a terminal rate of around three per cent next year, which is notably higher than much of the past 20 years.

Money, once again, has a price.

This new era will lead to fundamental changes in how businesses operate. No longer can they coast on the low cost of borrowing to improve their bottom lines.

Instead, firms will have to focus on adding value and boosting productivity to grow, remain competitive and increase profit.

The Canadian economy, after all, has had little productivity growth over the past decade. Productivity gains are a key recipe for growth, without which businesses would lose out to competitors.

In addition, Canadian businesses and households also have high debt loads, which makes them even more vulnerable to high borrowing costs. 

Weighted average cost of capital: A definition

To understand this new era of higher interest rates, consider the weighted average cost of capital, the average rate a business pays to finance its operations. It is calculated by averaging the costs of all sources of capital—such as debt and equity—weighted by the proportion of each source.

The weighted average cost of capital serves as a way to determine the required rate of return on investment. For instance, a company would only invest in a new technology if the expected rate of return exceeds its cost of capital; otherwise, it would be losing money on the investment.

We examine the weighted average cost of capital for businesses in the S&P/TSX composite index. The index comprises about 250 of Canada’s largest firms, encompassing over 70 per cent of total market capitalization on the Toronto Stock Exchange, and is a barometer of the Canadian economy. It will reveal how interest rate changes might affect businesses across sectors.

Implications of rate cuts

When rates fall, so does the weighted average cost of capital, which, in turn, lowers the required rate of return on investments and increases the risk appetite.

Businesses will be more inclined to hire and invest in productivity-enhancing projects when the benchmark for required returns is lower—restoring previously postponed projects due to restrictive rates back into the pipeline.

It might be hard to see that looking at today’s data. Despite three rate cuts, the impact has been slow to materialize.

The economy remains at a standstill. Although some firms might have begun hiring again, the unemployment rate is still elevated. Consumer spending slowed even more. Investors and entrepreneurs are sitting on a mountain of cash reserves, potentially waiting for further rate reductions before deploying capital.

This behaviour reflects a cautious stance as interest rates remain in restrictive territory. But this risk aversion comes with opportunity costs. The economy will unlikely return to the near-zero interest rate environment that ruled the past decade.

In the upcoming months, rate cuts will bring capital inflows into the market, and with those come opportunities. Businesses that act quickly to capitalize on this shift will benefit, especially as pent-up demand is released.

In addition, businesses cannot afford to wait indefinitely. Canada is already well behind in the productivity curve, with productivity flattening over the past decade and falling further and further behind the G7 countries at a time when the U.S. is undergoing a productivity renaissance.

Waiting too long to invest in productivity-enhancing measures could result in a loss of market share to competitors, domestically and globally.

Of course, rate cuts through early next year will not affect all industries equally.

Information technology has the highest WACC because businesses in this sector are seen as harbouring higher risk. In contrast, communication services and utilities have the lowest WACC as oligopolies dominate these sectors and are thus seen as low risk by lenders.

Rate-sensitive sectors, including technology, energy and materials, will benefit the most from rate cuts. The financial services sector and real estate will also have a substantial uptick in activity.

Since the largest sectors by revenue are financial, energy and industrials sectors, some of those with higher costs of capital, a drop in interest rates will awaken the recovery come 2025.

The outlook

The Canadian economy is rather rate-sensitive given its high debt load. By the end of this fiscal year, Canada’s total market debt is expected to surpass $1.4 trillion. Household debt exceeds 100 per cent of gross domestic product, largely driven by high housing prices and mortgages.

Mortgage rates reset every five years in Canada, making households vulnerable to fluctuating interest rates. In contrast, in the U.S., two-thirds of mortgage holders have locked in their rates for 30 years at below four per cent, making them essentially immune to rate changes. Businesses face similar challenges, as many loans often have rates fixed for five years.

As rates fall, this rate sensitivity will translate into a quicker recovery in consumer spending, business investments and growth.

Since inflation already returned to two per cent ahead of expectations, rate cuts are also happening at a faster pace. That will smooth out the debt renewal path for businesses and consumers alike.

Nevertheless, the new era of higher cost of capital will force Canadian businesses to invest more in innovation and productivity growth.

The Bank of Canada has referred to Canada’s productivity drag as an economic emergency. The decade-long productivity drag might have been acceptable in an era of cheap money. Now, firms are under pressure to improve efficiency, reduce costs and increase margins to stay competitive.

As immigration rules tighten, companies should no longer rely on cheap labour to fuel growth. Couple that with an aging workforce means businesses must prioritize investments to improve productivity to remain competitive.

The takeaway

The era of cheap money allowed firms to grow despite weak productivity gains. As rates fall but remain above pre-pandemic levels in the upcoming months, businesses must harness opportunities to create and deliver value through strategic investments to boost productivity.

In a world of more volatility, firms will need to adjust to the reality of a long-term, high-cost capital environment. Innovation, automation and strategic investment in long-term growth will be critical ingredients in a recipe for success.