Skip to main content
subscribers only

Investors have good reason to be confused.

Central banks have taken monetary intervention to unprecedented levels since the financial crisis, and thereby prompted worried markets to paint two entirely contradictory scenarios for what may lie ahead.

One scenario, repeated ad absurdum by the hard money crowd, holds that crippling inflation – or even hyperinflation – is lurking just around the corner. If that's the case, it makes sense to dump your bonds, buy gold and wait out the ensuing disaster.

The second scenario, trumpeted most dogmatically by Princeton economics professor Paul Krugman, is that current government intervention is insufficient to prevent the developed world from sliding into a 1990s-Japan-style slow growth malaise. If that's what lies ahead, it makes most sense to hunker down in bonds even at today's laughable yields.

So which is it – hyperinflation or stagnation? Right now, it looks like the latter but this year has already seen economic data swing wildly from positive to abysmal. Which means it's a fine time for investors to get comfortable with the security of extra cash.

Inflation fears are understandable after the $2-trillion (U.S.) expansion of the Federal Reserve balance sheet in recent years. But this isn't 1975. In the 1970s, crippling inflation was driven by unions' ability to put an ever higher price on labour. To defend profits, companies kept raising prices, which led to further demands for higher wages.

Today, not only is wage pressure non-existent, but the hollowing out of middle class wealth is widely viewed as our biggest economic challenge – until consumers feel wealthier, they're not going to consume at levels that could spur a recovery. With corporate profit margins at record levels, the balance of power has shifted 180 degrees from employees to management.

But if a 1970s-style wage-price spiral is unlikely, the hyperinflation of 1920s Germany is also not in the cards. Back then, the German government felt forced to print marks in order to make reparations payments following the First World War. Importantly, these debts were in foreign currencies. As the value of the mark fell, the size of the debt obligation – denominated in French francs, U.S. dollars and British pounds – climbed.

In the contemporary United States, the giant bills ahead for Baby Boomer Medicare and Social Security are in U.S. dollars. This means that unlike the Weimar Republic, the size of the debt obligations will not rise as the foreign exchange value of the currency falls. The Treasury can simply print more dollars to pay for entitlements. This would be somewhat inflationary, but hyperinflation seems unlikely since government has no reason to tolerate rising prices past a certain point.

For investors in 2013, the primary risk remains that the U.S. and Canadian economies will fail to respond to the ocean of new money supply and just stagger slowly forward. In light of the disappointing U.S. and Canadian employment data Friday, these concerns are staring investors right in the face.

So where to hide? Ordinarily, beaten down Canadian mining and energy stocks would provide a tempting refuge: they're both cheap and an inflation hedge. But slower Chinese commodity imports and the increasingly visible cracks in the Asian giant's credit markets suggest that cautious investors might want to steer clear of the mining and energy sectors right now.

Which leaves cash.

With interest rates near zero, the opportunity cost of holding cash is low. Yes, it's boring but investors should remember that losing big chunks of their investing principal is far worse for their long-term health than trailing the equity benchmark for a year or two.

Right now, the global economy and central bank policy are in uncharted waters. Even the scourge of inflation pales in comparison to two plausible investment threats we haven't mentioned – a disorderly unwinding of the European Union or a credit collapse in China.

Investors work hard for their savings. They should make sure that all their money is still there for 2014.

Follow related authors and topics

Authors and topics you follow will be added to your personal news feed in Following.

Interact with The Globe