Investors have plenty of reasons to worry. But, at least for now, a new financial crisis isn’t one of them.
The reasons for worry are obvious. U.S. core inflation hit a four-decade high this week. British Prime Minister Liz Truss fired her treasury chief, spurring more instability in government debt markets. Royal Bank of Canada warned that Canada should brace for a recession that could start within months.
What is less obvious is that financial markets are continuing to function relatively well. They are registering concern, yes, but not alarm.
Consider, for instance, the financial stress index compiled by the U.S. government’s Office of Financial Research. This gauge of tension in global financial markets has ticked up sharply in recent months, but remains far below the levels it reached in previous crises, such as the onset of the pandemic or the great recession of 2008.
Bond markets, too, appear calmer than you might expect. In times of crisis, the yields on the lowest-rated, riskiest types of corporate bonds usually jump in comparison to the yields on safe government debt. The current yield spread has not reached anywhere near crisis proportions. It is considerably higher than it was a year ago, but still well below the levels it reached during previous emergencies.
It may be that stress indexes and bond markets are simply slow to register the world’s developing problems. However, another way to interpret the disconnect between headlines and markets is as a sign that a great deal remains in doubt. Despite all the research being performed at central banks and Wall Street investment banks, nobody seems to have a great handle on some fundamental questions – such as what lies ahead for inflation.
For years, economists declared that increased globalization, falling rates of unionization and independent central banks made a recurrence of the high-inflation 1970s nearly impossible.
The past year has proven the experts wrong. This has undermined other key assumptions – notably the idea that interest rates are destined to stay lower for longer than they did in previous decades.
The outburst of inflation over the past year has sent interest rates soaring. Higher rates have chilled home sales, hammered stock prices and gutted bond portfolios.
Optimists can argue that this is just a pandemic thing. Maybe today’s high inflation is simply the result of too much stimulus money running up against sharply reduced supply caused by a once-in-a-generation health crisis. If so, central banks will raise interest rates high enough to crush this unusual bout of inflation and by, say, 2024 we will be back to something like prepandemic normalcy.
But pessimists are correct to emphasize that a return to low inflation can’t simply be assumed. There is a chance that inflation will run consistently higher in the future than it did in the past. Political tensions between the U.S. and China could splinter the global economy. Cost-of-living crises in multiple countries could turn workers in search of wage increases more militant. If so, higher inflation and higher interest rates could be the new normal.
What should investors do in this uncertain environment? One good idea is to recognize that every downturn is different.
The great financial crisis of 2008, for instance, seems unlikely to stage a repeat. Back then, the financial sector blew up because of dimly understood problems deep in the innards of the system. Central banks had to come rushing to the rescue, improvising first-aid plans as they went.
Now, the situation is nearly exactly reversed. Central banks aren’t providing the aid – they’re generating the pain by aggressively hiking interest rates. The problem they’re addressing isn’t at all murky. It’s obvious: high inflation.
All of this sounds more like the 1970s than 2008. But it does contain a nugget of hope. If central banks’ rate hikes are the primary reason for today’s market pain, then policy makers can always ease back if something does break.
The question is how far they will choose to go in hiking rates. In Canada, stratospheric home prices and high levels of household debt are obvious points of vulnerability. In the U.S., stock prices and political instability seem like more glaring risks. In Europe, the key issue is soaring energy prices caused by Russia’s invasion of Ukraine.
If central banks are truly determined to beat inflation to the ground, things could get ugly, according to analysts at BlackRock Inc., the giant institutional investor. In their recent market outlook, the analysts argue that markets are still underestimating the dangers. Forget about a mild recession, they say. A deep downturn will be required to tame inflation.
But will central banks choose to stay the course against inflation if their economies crater? That is unknowable. For now anyway, guaranteed investment certificates and similarly safe investments are looking more attractive than a bet on beaten-up stocks – not because a new financial crisis is imminent, but simply because of all the things we don’t know.