Once things had cooled down, central banks loosened monetary policies and lowered interest rates. It was termed the ‘business cycle,’ and usually lasted about four years. We really haven’t seen a business cycle in over 20 years as inflation has remained low. The causes of low inflation include globalization, importation of cheap goods, as well as computerization and automation of business practices leading to wage pressure deflation. Over the past 20 years, central banks did attempt to cool speculative behavior by beginning to tighten monetary policy even though inflation was benign. In 2000-2001 the ‘dot com’ bubble burst because this. The damage of the dot com bursting caused the central banks to lower interest rates and inject monetary liquidity into the economy. Disaster was averted, but the low interest rates and ample liquidity created another bubble – housing. By 2006-2007, it was apparent that runaway speculation in housing and financial instruments related to it were out of control and headed for a crash. Central banks ‘tapped the brakes’ by trying to raise interest rates, which burst the speculative bubble centered in housing. The great financial crisis of 2008-2009 ensued. In each of the above crashes, and in hindsight, central banks were too focused on headline inflation and not focused enough on the speculative collateral behaviors created by their policies.
In early 2020, the Covid-19 pandemic hit the world just as it was beginning to normalize after the financial crisis. We all know the shock it created – from unemployment due to lockdowns, supply chain disruptions, and online purchasing surges due to people being confined at home. As before, central banks responded with monetary stimulus created by money printing and pushing interest rates to near zero – and in some instances, below zero. They needed to do it this time as the pandemic affected the broad economy and the lives of everyday people – not just-dot com speculators or real estate players with dubious financial products. However, the amount of money creation involved was of biblical proportions. In Canada, for example, the average wage went up during the pandemic.
The problem with central bank policies is that they can’t pinpoint parts of the economy in need, but are restrained to flood the entire monetary system with stimulus. Like spraying your garden with fertilizer on the spray nozzle, you’re stimulating the plants you want as well as the weeds you don’t want to stimulate. So, while the two-year pandemic caused disruption and hardship, we have mostly survived. Work from home will likely survive as a hybrid and viable alternative, but the $3,000 exercise bike trend will not. The massive monetary stimulus created during the pandemic correctly stimulated the broad economy, but also fostered asset inflation in real estate and some stock prices. As we emerge from the worst of the pandemic, it is high time for central banks to remove the monetary stimulus. Interest rates are being raised, money is being withdrawn from the financial system and as a result the froth is being removed from the economy. Speculators are unwinding positions in the stock and real estate markets and other areas of unintended speculation caused by the overspray nature of monetary policy.
Central bankers are beginning to do what they should. It’s a good thing they are now trying to take control all of the broad economy rather than just focusing on consumer inflation. Markets are almost as much about human emotions as about fundamental values in the short term.
Needless to say, it has been a volatile and miserable time for investors. With inflation springing up and interest rates rising, bonds, stocks and other assets fell. Fears of a recession ahead, as well as the war in Ukraine and its effect on Europe, added to the gloom in asset prices.
The tough talk by central bankers about quashing inflation through monetary tightening and higher cost of money is part of their process in cooling things off in the economy. Whether they follow through with these policies to bring inflation to their 2% target or settle with a higher target remains in question. I think that the pain inflicted to do so will be too great and they will raise their target at some point.
Volatility has returned and will likely be with us for the years ahead. While uncomfortable for investors, it is somewhat a return to more normal conditions where we have business cycles together with monetary policy swings. We are focused on quality companies that have long-term good prospects. Studies that date back decades show that owning stocks over a long term far outstrips inflation, bonds or cash (see chart below). Separate studies show that trying to time the market is a loser’s game, although many investors persist.
I welcome the central banks as they try to reign in inflation and speculation. An economic slowdown or perhaps a recession is a small price to pay given the menace that firmly-rooted inflation can be. Furthermore, a purge of the speculation in some asset prices would be a good thing.
With our short-term fixed income investments, good cash holdings and high-quality stocks, we are in a good position to weather any storm ahead. And, with cash on hand, we will be looking forward to good buying opportunities.
As always, we will protect your interests.
Tony Pringle, CFA
September 30, 2022
This information is not investment advice and should be used only in conjunction with a discussion with your RBC Dominion Securities Inc. Investment Advisor. This will ensure that your own circumstances have been considered properly and that action is taken on the latest available information. The strategies and advice in this report are provided for general guidance. Readers should consult their own Investment Advisor when planning to implement a strategy. Interest rates, market conditions, special offers, tax rulings, and other investment factors are subject to change. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers is to be under any responsibility or liability whatsoever in respect thereof. The inventories of RBC Dominion Securities Inc. may from time to time include securities mentioned herein. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member-Canadian Investor Protection Fund. RBC Dominion Securities Inc. is a member company of RBC Wealth Management, a business segment of Royal Bank of Canada. ® / TM Trademark(s) of Royal Bank of Canada. Used under licence. © 2022 RBC Dominion Securities Inc. All rights reserved. 22_90421_JTE_002 (06/22)