Predicting the seasons is easy compared with economic forecasting but is either of use to investors?

It sounds almost biblical: inflation begets higher interest rates which begets a recession which begets falling stock markets. In the US, the story so far (June 2022):

Inflation 9.1%[1]
U.S. stocks fall, -21.10%[2]
U.S. Bonds fall, -10.29%[3]
Interest rates rise to 2.5% (July 2022)
Is recession already here?

It is easy to construct a propulsive story that has the sense of inevitability and ignore the warning attributed to Mark Twain,

“What gets us into trouble is not what we don’t know. It’s what we know for sure that just ain’t so.”

Let’s dig into this narrative and consider whether it holds together.

Inflation: storm surge or climate change?

To stretch the analogy, do we need sandbags, or do we move to higher ground? In other words, is inflation temporary or does it signal, as asset manager Blackrock suggests, a new regime with “Persistent inflation amid sharp swings in economic activity”

At first glance inflation is a simple idea – it is a measure of the general increase in prices. Economists rely on a basket of goods and services and weight price changes to arrive at an overall index, the Consumer Price Index (CPI), for example, as a general measure of inflation. The Bank of Canada offers a brief overview of inflation and how it is measured. Key takeaways are:

constant inflation requires constantly rising prices. For example, if gas prices rise from $1.20/litre to $1.80/litre and then remain constant, then gas inflation will spike and then decline to zero.
Inflation is backward looking, comparing current prices with past prices.

By July 2022, inflation in Canada had risen to 8.1% year over year – the largest yearly increase since January 1983. In February 2021, inflation was 1.0%.

Prices and inflation behave differently. Consider the following:

Commodity prices rose as demand rose as Covid restrictions eased in late 2021 and early 2022. Commodity prices rose again after the Russian invasion of Ukraine on Feb 24th, then fell back to pre-invasion levels, before rising again in July.
- Copper prices have fallen 28% from March highs.
- Wheat prices have fallen 37% from May highs.

Another contributor to inflation has been the rapid rise in goods and the associated pressure on supply chains to keep up with demand. Canadian consumer spending now exceeds pre-pandemic levels .
The cost of shipping a container has fallen by 35% from the post-covid high in September last year.
Major retailers are reporting high inventory with the expectation of decreasing prices to unload excess inventory. The US retailer, Target, for example, in a recent profit warning said it had ordered too many TVs and home appliances and that it will be reducing inventory by offering discounts.
In contrast, if you feel you need a break and are planning a few days in a luxury hotel, be prepared to pay twice what you paid pre-covid.

A recent study by the “bank of central banks”, the Bank for International Settlements (BIS), examined the interaction of prices and inflation and how this changes as inflation increases. Some highlights:

Individual price changes may not lead to changes in inflation when inflation is low. Such price changes tend to be independent and may cancel each other out as much they add to generally rising prices. Gas prices would be a good example of prices that show a lot of variation but, on their own, do not signal wider inflationary concerns.
As inflation increases, price changes become more synchronized and takes off in advanced economies once inflation rises above 5%.
As price rises become widespread, differences in consumption patterns between consumers matter less and the link between price increases and wage increases becomes stronger.
Employees will try and make up for the loss of purchasing power already incurred as well as anticipate future changes.

The trend is clear: individual price changes become broader and more coordinated and alert wage earners to the necessity of seeking higher wages to offset their loss of purchasing power. Left unchecked, higher wages feed through into higher prices. Wages are the price of labour, but unlike commodities, wages are sticky and don’t tend to fall when demand falls. Central banks are moving swiftly with interest rate rises to pre-empt sustained wage inflation that might be difficult to unwind.

For a current view of where unchecked inflation can end consider Turkey where interest rates have been kept low despite 79% or 160% inflation (depending on whether we use official or unofficial data). Persistent high inflation leads to underinvestment and impacts the poorest disproportionally. Central banks outside Turkey aim to break the cycle by raising interest rates which discourages borrowing (e.g., mortgages), lowers demand and tempers inflation. Lower demand reduces economic growth and risks rising unemployment: the hard landing. Negative inflation, or deflation, is also undesirable as it reduces future spending power and makes it more difficult to pay off debt, reduced spending, and reduced economic activity.

The goldilocks economy?

Central banks such as the Bank of Canada or the U.S. Federal Reserve attempt to maintain economic stability by keeping inflation at a low, steady rate. Neither inflation nor deflation is the goal, but rather, a steady and predictable situation. Central banks generally target an inflation rate of about 2% to allow some room for companies who may have temporary productivity problems from slipping into a deflationary cycle and raising unemployment.

What’s an investor to do?

Interest rates controlled by central banks are only one factor influencing inflation. Other factors are the Russian invasion of Ukraine, Covid related supply chain interruptions, and firms that exploit their pricing power as summarized in a recent research paper (full disclosure: the finance and insurance industry is revealed as one of the worst culprits). Even climate change adaptation has been cited as a long-term inflationary factor.

Inflation is only one risk for an investor, but is instructive because it has some common characteristics:

Inflation, like many economic measures, is retrospective. Markets look forward.
Inflation cannot be isolated from other economic factors. Lower taxation to alleviate rising energy costs may boost consumption and risk higher inflation (a point of debate in the UK contest for their next Prime Minister). Inflation in one country can be influenced by the action of another country through exchange rates, tariffs and supply problems.
A non-linear response. As noted above low inflation has different characteristics to high inflation and left unchecked can be self-reinforcing.

This should make us cautious of scenarios based on linear extrapolations of recent data. If we turn to historical research about investment performance during periods of high inflation, we find that average annual returns after accounting for inflation, are positive for stocks and bonds. The only exception is one-month T-bills (a proxy for a high interest savings account). This is good news for long-term investors although clearly not our experience for the first half of 2022, which only encourages us to view this period as uncharacteristic and a poor basis for long-term decision making.

If current inflation is not a useful guide to future market returns, can we look at current markets for information about future inflation? Comparing the returns from nominal bonds and inflation linked bonds provides an estimate of future expected inflation. For example, the break-even inflation rate for 5-Year U.S. government bonds is currently 2.72%. This is the expected average inflation rate over the next five years which is considerably less than the current rate of 9.1%. The break-even inflation is not a reliable forecast of actual future inflation. As discussed above, many factors can arise in the future, not accounted for in current bond prices.

Was that a recession?

A recession is a period when the economy is shrinking. The stock market is a narrow slice of an overall economy so the two may not behave the same.

In the 15 US recessions in the past century the average annualized return in the two years following the start of a recession was 7.8%. That is an average return so on some occasions the annualized return was negative, but it was positive 73% of the time.
Recessions are decided by committee (in the US it is the Business Cycle Dating Committee) assessing data on employment, industrial production and other factors. This can take a while – the recession that is now considered to have begun in December 2007 was only decided by committee in December 2008. To get a more immediate assessment commentators have used two quarters of GDP decline as a proxy, but their narrow focus can lead to subsequent revisions.

Identifying recessions may help economists understand similar historical periods, but it lacks any predictive power of use for investors. Because recessions are proclaimed with a delay, rather than in real time, markets are often on the way toward a recovery by the time of the announcement. In 2020’s recession, for example, the market’s low point came in March, three months before the announcement of a recession in June 2020.

Here is an interactive tour of the U.S. stock market during past periods identified as recessions.

Much ado about nothing?

Is knowledge of economics (interest rates, inflation and recessions) for naught to the investor?

I recently wanted to improve the quality of my music listening at home. I read a lot about stereo amplifiers, the advantages of different designs and whether I needed a phono stage, DAC, streamer and other features. Eventually I came across a review that distilled what I was looking for into a single sentence: “The sound of the entire band was palpably realistic, the XXXX stayed out of the way and let the music shine.” The amplifier offers nothing I did not need, comes with a 20-year warranty (unheard of in the audio business) and sounds wonderful. My newly acquired knowledge of amplifiers enabled me to understand what I needed to achieve my music listening goals[4].

A power amplifier is simple compared with markets. Both can generate noise that can mask the signal. Current prices of stocks and bonds are based on assumptions about the future state of the economy and unlike amplifiers the output, as measured, by investment return, is never certain even if the design is robust (sadly no 20-year warranty). We live in communities embedded in an economy. Our lives are influenced by the state of the economy; whether we can take a vacation, a dinner with friends or save regularly. In the broadest sense, we want to understand our economic future and prepare ourselves for it. The best way to do that is to learn what we can from economic history and embed that into the design of portfolios before the inevitable storm clouds gather.

[1] U.S. Bureau of Labor Statistics

[2] PWL Capital Market Statistics

[3] Bloomberg US Aggregate Bond Index

[4] I can’t say for certain because supply chain issues mean a few months delay before delivery of the amplifier, but that too will pass.