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Traders work on the trading floor at the New York Stock Exchange in Manhattan, on Sept. 13.ANDREW KELLY/Reuters

My high school wrestling coach used to make us run up and down stairs until legs cramped and stomachs rebelled. If we complained, he had a stock response. “Pain isn’t the problem,” he would say. “Pain is the point.”

He would have made an outstanding central banker. Policy makers are grappling with how much pain to inflict on the economy. They want to slow the economy to reduce inflation. This will involve some distress. But how much? Maybe enough to impress even an old wrestler.

“For [interest rate] hikes to reduce inflation, they need to hurt growth. There is no way around this,” Jean Boivin and Alex Brazier of giant asset manager BlackRock warned in a note this week. “We estimate it would require a deep recession in the U.S., with around as much as a 2 per cent hit to growth in the U.S. and three million more unemployed, and an even deeper recession in Europe.”

Mr. Boivin, who used to be deputy governor of the Bank of Canada before becoming a managing director at BlackRock, is not necessarily in favour of this pain. He worries that killing the global economy right now to crush inflation might be, well, overkill.

If households and businesses still expect inflation to fade back to normal – and surveys indicate they do – there is little risk of a wage-price spiral like in the 1970s. A better, less painful approach might be to go slow on rate hikes and tolerate higher inflation for a couple of years as the cost of maintaining higher growth.

Maybe so. For now, though, central bankers see no more reason for slacking off than my old coach ever did. Jerome Powell, chair of the Federal Reserve, the world’s most powerful central bank, told a gathering in August that the Fed is determined to bring down inflation and “keep at it until the job is done.” This, he acknowledged, will bring “some pain to households and businesses.”

The Bank of Canada and other central banks have voiced similar sentiments. Investors and consumers shouldn’t underestimate their resolve.

Consider the record fall in the real net worth of Canadians in recent months. Matthieu Arseneau, deputy chief economist at National Bank Financial, calculates that “households have seen their real wealth decline by more than 10 per cent in the first half of 2022, nearly twice as much as the previous worst six-month period at the height of the 2008 financial crisis.”

Poor us

The real net wealth of Canadian households declined by a

record amount in the first half of this year. U.S. households

suffered a similar fate. (Variation over the most recent half

year in household net wealth adjusted for inflation)

 

10%

Canada

8

U.S.

6

4

2

0

-2

-4

-6

U.S.

recessions

-8

-10

-12

1995

2000

2005

2010

2015

2020

2025

the globe and mail, source: National Bank

Financial

Poor us

The real net wealth of Canadian households declined by a

record amount in the first half of this year. U.S. households

suffered a similar fate. (Variation over the most recent half

year in household net wealth adjusted for inflation)

 

10%

Canada

8

U.S.

6

4

2

0

-2

-4

-6

U.S.

recessions

-8

-10

-12

1995

2000

2005

2010

2015

2020

2025

the globe and mail, source: National Bank

Financial

Poor us

The real net wealth of Canadian households declined by a record amount in the first half of this year.

U.S. households suffered a similar fate. (Variation over the most recent half year in household net

wealth adjusted for inflation)

 

10%

Canada

8

U.S.

6

4

2

0

-2

-4

-6

U.S.

recessions

-8

-10

-12

1995

2000

2005

2010

2015

2020

2025

the globe and mail, source: National Bank Financial

Some of the decline in real wealth stems from inflation’s corrosive effect. A major part, though, reflects the fight against inflation. Rising interest rates have hammered home prices, stock prices and bond prices.

More pain is likely. Canadians are already a highly indebted lot and rising interest rates are likely to require them to shell out more and more to keep up with their loans.

Claire Fan, an economist at RBC Economics, expects the Bank of Canada to hike its policy rate to 4 per cent by December, up from 3.25 per cent now. If so, the debt servicing ratio – the percentage of after-tax income going to debt payments – will hit a record high around 15.5 per cent by the end of next year.

“We expect labour markets will continue to soften at the same time and look for consumer demand to weaken significantly as lower income, higher borrowing and debt servicing costs squeeze their spending,” she wrote this week. “That will help to lower inflation pressures but at the cost of a ‘mild’ recession in Canada in the middle quarters of 2023.”

The risk for investors is that stock markets may not be fully registering this lacklustre outlook. Analysts continue to see growth in earnings through 2023, although at a much slower pace than in the recent past.

These forecasts may not be too far off the mark if the recession is indeed mild. Analysts – and many investors, too – appear to be betting that central banks will stop short of inflicting genuine distress on their economies. Many also seem to be counting on inflation to fade away quickly as supply chains unclog and oil prices subside.

The danger lies in what happens if inflation doesn’t fade away and central bankers insist on maintaining their chokehold on the economy until inflation is beaten beyond all doubt. That would mean continued pain for both the economy as a whole and stock prices in particular.

The unfortunate reality – which has been amply demonstrated over the past year – is that no one is great at forecasting inflation. So what can investors do to hedge their bets against the possibility of more tumult ahead? One thought is to look at bonds and guaranteed investment certificates. Corporate bonds now yield as much or more than broad stock market indexes deliver in dividends. So do many GICs.

This doesn’t mean these investments are failsafe but it does suggest they could be useful counterweights to stocks over the next year or so. Investors who don’t enjoy pain quite as much as my old coach might want to give them a look.

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