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Market forecasters are facing an unusual problem – too much good news.

It wasn’t supposed to be like this. Over the past year, the Bank of Canada and the U.S. Federal Reserve hammered their economies with the most aggressive interest rate hikes in four decades. Many economists expected the soaring rates to bring the Canadian and U.S. economies to a screeching halt.

Except they haven’t. Both countries recently reported that jobs growth surged in January at a frantic pace that blew past market expectations. Unemployment in both Canada and the United States continues to hover near its lowest levels since the early 1970s.

This is where things start to get murky.

At first blush, a booming jobs market would seem to be great news – for households, for companies that depend on consumer spending, and for stocks in general.

Look closer, though, and the picture gets more complicated.

For one thing, the current strength in hiring could be one big head fake. Higher interest rates typically take 18 to 24 months to exert their full effect, according to the Bank of Canada. This means the big, abrupt hikes of the past year are still winding their way through the economy. Maybe we’re enjoying a last hurrah before an imminent slowdown.

For another thing, the good news on jobs translates into bad news for inflation fighters. A drum-tight labour market has historically pushed up wages and often inflation as well. If current trends continue, central bankers might have to impose even higher interest rates to tame today’s still-lofty inflation.

This would not be good for stocks, because higher interest rates make bonds a more compelling alternative to equities. Higher interest rates also have a habit of pinching corporate bottom lines.

Company profit margins swelled as inflation spiked over the past couple of years, points out Eric Lascelles, chief economist at RBC Global Asset Management. A fall in inflation could have the opposite effect, pulling down profit margins and thereby exerting a drag on stock prices.

For now, trying to figure out how all these pieces fit together is creating lots of employment for economists and market strategists. Some forecasters see a hard landing, or recession, ahead. Others see a soft landing in which the economy slows but avoids an outright recession. Still others are arguing for a no-landing scenario in which growth reaccelerates over the coming year, while inflation and interest rates remain high.

You can find smart people on every side of this argument. For instance, the fine minds at giant money manager BlackRock argue that “central banks are deliberately causing recession by overtightening policy to tame inflation.”

The equally outstanding intellects at investment bank Goldman Sachs declare just the opposite. They say household finances are in unusually good shape right now because of savings built up over the pandemic. They also argue that some sources of inflation are likely to fade away painlessly as supply chains unclog. Given all those positives, Goldman Sachs insists there will not be a recession this year in North America or in continental Europe.

Rather than betting everything on one of these forecasts, investors may want to think in terms of probabilities. In an essay last week, Mohamed El-Erian, the economist and former money manager who now serves as president of Queen’s College at the University of Cambridge, put the chance of a painless soft landing for the economy at around 25 per cent

Equally likely, he writes, is a scenario in which inflation takes off again this year as China reopens its economy and U.S. labour shortages persist.

Most likely of all is a scenario in which inflation proves sticky. This outcome, on which Mr. El-Erian puts a 50-per-cent probability, would see inflation fade from its current level just over 6 per cent but remain stuck at 3 to 4 per cent.

“This would force the Fed to choose between crushing the economy to get inflation down to its 2-per-cent target, adjusting the target rate to make it more consistent with changing supply conditions, or waiting to see whether the U.S. can live with stable 3- to 4-per-cent inflation.” he writes.

Be careful what you wish for

Rising inflation in recent years has been good for companies’ profit margins. Investors may want to contemplate what will happen if this process goes into reverse.

13

11

9

Historical

average

7

5

3

1980

1986

1992

1998

2004

2010

2016

2022

Note: As of Jan 2023. Shaded area represents recession.

the globe and mail, source: RBC Global Asset Management

Be careful what you wish for

Rising inflation in recent years has been good for companies’ profit margins. Investors may want to contemplate what will happen if this process goes into reverse.

13

11

9

Historical

average

7

5

3

1980

1986

1992

1998

2004

2010

2016

2022

Note: As of Jan 2023. Shaded area represents recession.

the globe and mail, source: RBC Global Asset Management

Be careful what you wish for

Rising inflation in recent years has been good for companies’ profit margins. Investors may want to contemplate what will happen if this process goes into reverse.

13

11

9

Historical

average

7

5

3

1980

1986

1992

1998

2004

2010

2016

2022

Note: As of Jan 2023. Shaded area represents recession.

the globe and mail, source: RBC Global Asset Management

To be sure, Mr. El-Erian’s exhaustive catalogue of possibilities just underlines how uncertain things are out there. The one-sentence summary is that you can make a case for just about any outcome you want.

So what should investors do? To my mind, the key question is how much risk you want to take on when the range of potential outcomes is so large.

Playing it safe sounds like a very sensible idea. Peter Oppenheimer, chief global equity strategist at Goldman Sachs, told a seminar this week that stock markets have priced in the recent flurry of good news. “Valuations are really quite full, especially in the U.S.,” he said.

He expects stock market returns to be quite restrained so long as investors can get a guaranteed 5-per-cent return on their cash. For Canadian investors, that suggests a simple strategy: Lean toward guaranteed investment certificates so long as their yields remain at or near current levels. Good news or bad news, your portfolio will survive to see more stable times.

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