We’re more than two months into 2023, and no one can say with any certainty how it will turn out.
It’s not that we’re lacking predictions. There are lots of those, from central banks, economists and brokerage analysts. But I sense uncertainty and a lack of conviction. There’s an on-the-one-hand, on-the-other-hand attitude that, rightly, makes investors nervous.
For example, the Bank of Canada raised its target rate by a quarter-point in January and then announced a pause while it assesses the impact of its increases over the past year. If the result isn’t a steady decline in inflation toward the desired 2-per-cent level, more rate hikes will follow.
In short, the Bank implies it does not know how this will play out. We’ll tell you more when we can. Meantime, other central banks are still raising rates, including the Federal Reserve Board, which announced another quarter-point hike on Feb. 1.
With both the Canadian and global economies doing better than expected so far this year, how long will the Bank of Canada’s pause last? As we’ve seen, the Bank doesn’t have a sterling record of projecting the future – remember “transitory inflation”? But history tells us that interest rate hikes take many months to work their way through to the broad economy so it’s too soon to judge.
At this point, I suggest you take any projection of how the year will unfold with a degree of skepticism. No one really knows.
I think there are three possible scenarios that we could see over the next 10 months. Here they are.
The Goldilocks scenario
Inflation continues to trend lower, enabling other central banks to follow the BoC’s lead and put rate hikes on hold. We avoid a recession, or experience a minor, short-lived one. Employment remains strong, but not to the point of escalating wage inflation. By mid- to late-2024 inflation drifts down to the target range.
Who wins? The stock markets, as increasing certainty boosts investor conviction. There’s a risk of a return to irrational exuberance in this scenario as stock p/e ratios are still high, despite last year’s sell-off. Bonds should stabilize as the prospect fades of more rate increases. Holders of variable rate mortgages will breathe a sigh of relief as the monthly increases in their payments stops.
Who loses? Conservative investors, who right now are enjoying better returns from GICs and high-interest savings accounts than they’ve experienced in years. We’re already seeing signs that commercial rates are pulling back. Gold will probably be another casualty. It’s a safe-haven investment at a time when no one will think they need a safe haven.
The Flatline scenario
Disinflation stalls. Inflation flattens out at around the 4-5 per cent level. Sure, it’s a big improvement over last year but a long way from the 2-per-cent target. Central banks have no choice but to start hiking rates again. The squeeze pushes the economy over the brink, into a recession.
Who wins? The GIC and cash investors who lost out in the Goldilocks scenario will like this outcome. Savings rates will rise to highs unseen in many years.
Who loses? Bonds will go into another slump as rising yields push down prices. Stock markets will be volatile, with interest-sensitive securities coming under renewed pressure. Variable-rate mortgage holders will start to panic. Drivers will be shocked to find a huge cost escalation when renewing leases due to higher interest rates.
The Nightmare scenario
Inflation stages a resurgence as oil prices rise and groceries continued to get more expensive – we’ve already heard from Loblaw that suppliers want to push up prices on a wide range of items. The central banks are forced to resume rate hikes at the aggressive pace we saw in 2022. Wage demands escalate as household expenses rise. The economy plunges into a deep recession. Mass layoffs result. Observers warn of a replay of the early 1980s. Stagflation becomes a household word again.
Who wins? Short-sellers profit as stocks dive. GIC investors rejoice.
Who loses? Almost everyone else. Bonds are clobbered and some people swear they’ll never invest in them again. Stocks tumble, with interest-sensitive companies especially vulnerable (REITs, utilities, etc.). Mortgage defaults escalate as already stretched home-owners crumble under the burden of ever-higher rates.
There’s also an Armageddon scenario, thanks to Mr. Putin, but if that should transpire, we’ll have a lot more to worry about than our money.
Goldilocks is clearly the most desirable outcome. But it would be foolhardy to ignore the other possibilities. Hope for the best, plan for the worst.
Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to www.buildingwealth.ca/subscribe