As anyone who has read a bear-market headline has gathered by now, the economic outlook is turning ugly. The question that lingers is just what form of ugliness it will take.
In one scenario, soaring interest rates and climbing oil prices clobber the economy, leading to a painful but short recession that stamps out today’s roaring inflation.
In another scenario, a recession may be averted, but inflation isn’t. The economy stumbles along in a stagflationary funk as rising prices continue to ransack consumers’ wallets.
Both scenarios are ugly, but they have different implications for investors.
If we fall into a recession that crushes inflation and eventually takes us back to normality, 10-year Government of Canada bonds are an excellent place to be. At current yields, around 3.5 per cent, they deliver a decent and safe return, no matter how bad the downturn gets, how much corporate profits slump or how far the stock market falls.
Bonds also hold out the possibility of capital gains down the road, because bond prices and interest rates move in opposite directions. This implies bonds should gain in value whenever central banks finally feel confident inflation is under control. At that point, policy-makers will presumably start to cut interest rates to support their ailing economies. Bondholders will prosper.
But if we get stagflation? Then none of the above applies.
In a stagflationary scenario, like the 1970s, inflation goes hand in hand with economic stagnation. Bonds bleed because persistent inflation eats away at the real purchasing power of the yields they deliver.
Stocks don’t do well in a slow-growth stagflationary world either, but at least they have the ability to keep pace with high inflation and protect the real value of your investment. The ideal investment in a stagflationary world is a dividend-paying stock from a company that has the ability to raise prices to stay level, in after-inflation terms, with whatever inflation occurs.
Reasonable people can come up with good reasons to expect either recession or stagflation.
The strongest argument for why we should brace for a recession is that the 1970s taught policy-makers that the best time to break an inflationary cycle is when it is just getting started.
Half-measures didn’t work in the 1970s. They allowed inflation to fester for years and those problems eventually required extraordinary action – notably, the 20-per-cent-plus interest rates that central bankers imposed in the early 1980s. Those stratospheric rates plunged North America into a brutal downturn, but finally brought inflation to heel.
If the memory of the 1970s still hangs over central banks, policy-makers are unlikely to let up on the current rate-hiking cycle until inflation is falling back close to their 2-per-cent-a-year target.
There is a long way to go. Consumer price inflation in the United States ripped ahead at an 8.6-per-cent annualized pace in May, while in Canada it sizzled along at a 6.8-per-cent clip in April. Both are multidecade highs.
Red-hot inflation like this leaves central banks with few options but to raise rates high enough to put the entire economy into a deep freeze. Nearly 70 per cent of leading academic economists expect the United States to fall into a recession next year, according to a survey conducted a week ago by the Financial Times and the University of Chicago.
This is not a pleasant prospect. The greater danger, though, is that the economy cools, but it’s not enough and inflation persists. Then the situation would begin to look uncomfortably like the stagflationary 1970s, when high inflation hit investors from one direction while an underperforming economy walloped them from the other.
This could happen if oil prices continue to run high, the Russian invasion of Ukraine keeps pressure on food prices and COVID-19 continues to disrupt Chinese production. About 47 per cent of the economists in the Financial Times/University of Chicago survey thought it “somewhat likely” or “very likely” that core inflation would still be running above 3 per cent a year in 2023.
The World Bank, too, sees risks. In its most recent report on global economic prospects, published earlier this month, the bank warned “the danger of stagflation is considerable today.” It sees global growth falling in the years ahead and “a risk that inflation will remain higher for longer than currently anticipated.”
Clearly, investors should focus on playing defence at a time like this. Both bonds and dividend-paying stocks have their attractions. The problem is that we can’t know which option will do best until we have a better idea of how persistent inflation will be. Until this becomes clearer, maintaining a portfolio that holds both bonds and dividend payers looks like the best course of action in an increasingly ugly economy.
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