Inflation or recession: which is worse for investors?

The surging cost of living is more damaging as it erodes purchasing power and could trigger a wage-price spiral as workers demand more pay, analysts say

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Central banks have a choice of two poisons as they battle to fight inflation without triggering a full-blown recession.

It’s hard to feel much sympathy for them, after they spent the past decade or so playing fast and loose with monetary policy, then dismissed the resulting inflationary surge as “transitory”.

Yet, they now face a bleak choice between allowing inflation to run hot or forcing the economy into recession by raising interest rates.

So, which poison will they choose — inflation or recession? Both could prove toxic for global markets.

A huge amount depends on which option they choose. The signs are mixed.

The US Federal Reserve, European Central Bank and Bank of England are all trapped by the policies they have pursued since the financial crisis, says Mike Hollings, investment director at asset manager Shard Capital.

Twelve years of near-zero interest rates and loose monetary policy have left economies loaded with debt and reliant on easy money to survive.

This has deprived central banks of their prime weapon in the war on inflation, higher interest rates, he says.

“Central bankers are like lions that can still roar, yet have no teeth,” Mr Hollings adds.

Driving up borrowing costs will do little to slow inflation, which is largely being driven by the war in Ukraine and global supply chain disruption.

They will have to act anyway, if only to convince markets they are still king of the jungle.

Last week, the Fed acted tough by increasing the benchmark funds rate by 0.75 per cent, to between 2.25 per cent and 2.5 per cent.

A few days earlier, the ECB showed some muscle by raising its marginal lending rate by 0.50 per cent to 0.75 per cent.

The BoE is expected to follow suit by increasing base rates for the sixth meeting in a row on August 4, by 0.5 per cent to 1.75 per cent.

Yet, these rates remain incredibly low by historical standards, especially with US inflation hitting 9.1 per cent in June.

The Fed may hike again in September and in November, pushing the funds rate to a range of 3 per cent to 3.25 per cent by year end, but that may be it.

The US economy shrank by 0.9 per cent in the second quarter and is weaker than people realise, Mr Hollings says.

“The Fed may talk tough, but it will prioritise protecting the economy against recession over fighting inflation,” he adds.

The ECB is in an even tighter spot as Russian President Vladimir Putin threatens to halt gas exports and plunge the continent into an energy crisis.

It is “impotent” as eurozone inflation hit a record 8.9 per cent in July because many EU member countries, including Italy, are almost buried in debt.

“Any serious attempt to fight inflation would effectively bankrupt those countries,” Mr Hollings says.

Central banks may have already chosen their poison – and it is the bottle marked inflation.

Recession fears have now eclipsed inflation concerns and markets expect a more dovish central bank response, says Jason Hollands, managing director at wealth adviser Evelyn Partners.

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“We can see this in the bond markets, where the yield on 10-year US Treasuries has fallen from 3.49 per cent in June to 2.78 per cent today,” he adds.

The Fed could even start cutting rates again early next year, according to Sam North, personal finance expert and trading school lead at eToro.

“Its long-term inflation expectations are closer to 2 per cent than the 9.1 per cent we saw in June.”

However, Mr North sees grounds for optimism.

“If the Fed believes it can get inflation under control in a shorter, sharper cycle than in the 1970s, that is ultimately positive for global markets.”

If that scenario plays out, it might soon be time to start thinking about what a market recovery could look like, Mr North says.

“If you’re acting too defensive in this environment, you may miss out on the early days of the next bull market.”

When it arrives, gold and copper could rally, while the safe-haven US dollar could plunge from today’s highs.

Mr North suggests being prepared for all scenarios. “Keep a very close eye on inflation, gross domestic product and the jobs numbers.”

Investors can still make money despite current uncertainty as some companies are weathering the inflation storm better than others, says Victoria Scholar, head of investment at Interactive Investor.

“Oil companies are doing well out of high energy prices, with London-listed Shell posting record second-quarter profits of $11.2 billion,” she adds.

Banks also benefit from rising interest rates as it lets them widen their net interest margins, the difference between what they charge borrowers and pay savers.

“Their capital markets desks can benefit from increased trading activity when financial markets are volatile. The downside is that M&A and initial public offering activity have declined this year,” Ms Scholar says.

British banking giant NatWest Group posted a 13 per cent rise in first-half pre-tax profits to more than £2.6bn ($3.14bn) and declared a special dividend totalling £1.75bn.

Utilities, telecommunication companies and consumer staples can also help investors survive current uncertainty, Ms Scholar adds.

Yet, central banks are taking a chance by accepting more inflation as a price to pay for less recession.

Both options are “ugly”, but inflation is the greater evil, Chaddy Kirbaj, vice director at Swissquote Bank, says.

“While recessions hurt, inflation can trigger a systematic decline in the economy and its efficiency,” he adds.

Inflation is so damaging because it erodes purchasing power, punishes the poor and may trigger a destructive wage-price spiral as workers demand more pay to keep up.

Higher wages also eat into company profits.

“Uncontrollable skyrocketing inflation would be the worst-case scenario of all for everyone — investors, central bankers and consumers,” Mr Kirbaj says.

Central banks cannot afford to make a mistake now. Instead of a choice of poisons, we may end up with both.

Updated: August 02, 2022, 5:00 AM
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