By John Cunnison, Chartered Financial Analyst®, Chief Investment Officer,  Baker Boyer

Often fascinating and counter-intuitive, historical data of consumer sentiment can powerfully foreshadow market behavior and its impact on investment market performance.

As fear of recession rises, a review of consumer behavior during recessions of the past gives us a pretty good idea of how financial institutions and markets may fare during the coming year.

For example, concern about an uncertain future typically motivates consumers to hold on to cash assets and take refuge in safe investments.

For financial institutions during the pandemic, this has meant soaring deposits as consumers sought security in saving against the potential for unexpected financial hardships that could arise from this unprecedented (in our lifetime) global occurrence.

At the same time, interest rates remained low throughout the pandemic, until recent hikes by the European Central Bank and the U.S. Federal Reserve. This has meant that financial institutions are beginning to enjoy a wider spread between what they pay on deposits and what they make on the loans that they underwrite.

Now what?

Now that interest rates and the Consumer Price Index (CPI) are on the rise, will consumer behavior follow the same pattern as it has in the past?

Interestingly, the answer may be “no.” Usually when interest rates are high, deposits decline as people look for higher yields through stocks or other investment options. However, because the Central Bank and the Fed are trying to cool the economy to bring inflation down, prompting fears of recession, and people are nervous.

It’s entirely possible that people will stick with the safety of their FDIC-insured or European Banking Authority-insured bank deposits rather than take the risk of betting on a potentially higher yield, simply because they’re scared of a recession. Consumers may be seeking a return of their savings more than a return on their savings.

This will be a particular challenge for people in or nearing retirement, who will be hit particularly hard by inflation. They’ll be looking for strategies to protect their savings and investments while covering increased costs caused by inflation.

An unfortunate and truly unprecedented market anomaly is complicating matters for them, however: both stocks and bonds have declined simultaneously. Usually, when one goes down, the other goes up. So, this is really disorienting for a lot of people who would normally be shifting from more stock-heavy portfolios to more bond-heavy portfolios.

Fortunately, there are strategies for mitigating the risks of inflation, such as low-risk government-issued I bonds that currently offer a yield in the 9% range (but investment amounts are limited), Treasury Inflation-Protected Securities (TIPS) that increase or decrease with changes in unexpected inflation, or inflation swaps that can be easily accessed in a mutual fund format. Of course, another tactic is to invest in shorter-term bonds so that every year or two you can reinvest maturing bonds at a potentially higher rates.

As with any investment, the key is balance. There can be a cost to protecting against inflation.

For example, a two-year treasury bond may have a 4% yield today. If you buy a two-year TIPS bond, which has inflation protection built into it, you’ll get a lower yield. Accepting the lower yield is the price investors pay for protection from unexpected inflation. But if inflation is lower than expected, you would’ve been better off getting the 2-year treasury without inflation-protection at 4%.

A Buyer’s Market

The best inflation hedge over time is stocks.

For people who are still saving toward retirement, the decline in the stock market can be viewed as good news: stock prices just got a lot cheaper than they were at the beginning of the year.

The paradox is that the time for strong value creation is when things feel the worst. Existing value is going down now, but that gives us the opportunity to buy at a tremendous discounts with the expectation that we’ll see a rebound in returns in a year or two.

There’s nothing to indicate that we should be expecting an economic downturn that is greater than what the market has already priced. But, in this time of unprecedented occurrences, if the economy sinks further than expected, it’s good to remember that for disciplined investors it can represent another opportunity for buying stock at a discount.

Inflation Destination More Important than the Journey

Month-to-month inflation data during a time of market volatility will always generate a lot of noise, with analysts and traders interpreting the meaning of each single inflation reading.

But when we look back five years from now, we’re unlikely to remember what inflation did in September of 2022. We will be talking about the overall trajectory and, perhaps most importantly, the Fed’s determination of the “neutral rate,” which is the rate that provides the optimal balance between price stability (inflation) and full employment.

It’s important to remember that while monetary policy can affect the demand side of the inflation equation, it has relatively little effect on the supply side. Improvement or deterioration of supply conditions will have a material impact on both the trajectory of inflation and the final destination (or “neutral rate”). There are good reasons to expect some improvement to supply as China’s zero COVID policies ease and Europe adjusts to the ongoing war in Ukraine.

Beware Concentration, Be Diversified

There is an old saying: “If you don’t know your tolerance for risk, the market will teach it to you.” I would like to suggest modified version of this: if you don’t know the benefit of diversification, the market will teach you.

Periodically, markets recalibrate. It’s a healthy process, akin to periodic forest fires clearing underbrush and preventing the kind of devastating wildfires that come with excess fuel. The current environment is a healthy recalibration of markets, and those with diversified portfolios are weathering the volatility well.

It’s even important to diversify your diversifiers. Some investments just feel safe. Gold is a good example. At the risk of raising the ire of investors who favor gold, this is what we call “imperfect hedge.” There’s a saying about gold, for instance, that you could buy a decent suit for an ounce of gold in the 1800s, and you can still buy a decent suit for an ounce of gold in the 2000s. If you had invested the same amount of money in stocks over that same time period, you could buy many more suits with the resulting performance above inflation.

There’s certainly nothing wrong with gold or other securities that offer a measure of inflation protection, but there is a risk during volatile periods that investors will abandon diversification for assets they perceive as “safer.”

Building a resilient, diversified portfolio begins with a clear assessment of the risks that need to be managed. Remember that inflation, for example, isn’t the same for everyone. If you commute, you’ll feel rising gas prices more. If you’re a vegetarian, you may not feel as much pain at the checkout counter as other consumers when meat prices go up.

So, it’s important to assess your inflation exposure when deciding how much of your asset base to protect to ensure that you continue to have strong purchasing power through a period of inflation and/or recession.

About the Author

John Cunnison is Vice President of Baker Boyer and Chief Investment Officer of D.S. Baker Advisors. He is a national financial markets expert and Chartered Financial Analyst.