While the Federal Reserve tries to tame inflation without causing a recession, investors should gird for the possibility of failure—potentially on both fronts.
The central bank raised interest rates by 0.75 percentage point on Wednesday for the second time in a row in policy makers’ effort to cool demand and slow price growth, but so far inflation remains near 40-year highs. And now investors are increasingly worried that the Fed will be unable to achieve a “soft landing,” and that rate hikes will tip the economy into a recession instead.
In a press conference accompanying the rate hike announcement, Fed Chairman Jerome Powell acknowledged both the risk of doing too little and failing to contain inflation, and the risk of doing too much and forcing an economic slowdown. “We’re trying not to make a mistake,” he said, noting that the path for threading the needle had narrowed.
That means that investors should look to add a recession page to their inflation playbook, even though those two scenarios usually involve opposing strategies, financial pros say. The rare combination of high inflation and slowing growth is called stagflation. While many economists don’t expect the U.S. to see the kind of prolonged stagflation that it experienced during the 1970s, elevated inflation and a burgeoning recession could very well overlap, financial pros say.
“The evidence is stacking up to suggest that the recession might happen before they bring inflation under control,” said Jason Pride, chief investment officer for private wealth at Glenmede, an investment and wealth management firm in Philadelphia.
Here are some stock-and-bond strategies for investors in these uncertain times.
Stay the Course
The first half of the year was brutal for both stocks and bonds, and investors are anxious. While the S&P 500 has edged up off its lows of mid-June, stocks have probably not reached a bottom yet, market watchers say. A bottom would represent “peak fear” in the market, and right now fear is elevated, said Rob Arnott, founding chairman of Research Affiliates in Newport Beach, Calif.
The best time to invest is at peak fear, when assets are cheapest, Arnott said. Because it’s hard to time the precise bottom, investors with strong stomachs can start dollar-cost averaging into the market now, Arnott said.
Emerging market stocks are “stealth inflation fighters” that are particularly attractive right now, he said. Many emerging-market economies are commodity exporters, so they offer investors exposure to the sector without the need to invest directly in commodities, which are expensive right now. A general rule of thumb is investors should allocate about a third of their stock portfolio to non-U.S. equities, and about a third of that international allocation should go toward emerging markets, Arnott said.
Another term for peak fear is capitulation, when everyday investors want nothing to do with stocks. However tempting, that’s not the time to exit the market and lock in your losses. If you need to sell a little to raise cash to tide you through a recession, then that’s OK, said Yiming Ma, assistant professor of finance at Columbia Business School. Just keep most of your assets invested, so you’ll participate in the recovery as soon as it starts. (Investors might be surprised to learn that the market’s best days tend to fall within two weeks of its worst days over a 20-year period, according to research from J.P. Morgan Asset Management).
Embrace Bridge Strategies
Some corners of the stock market are well positioned to weather both inflation and a possible recession. Pride says real estate investment trusts are relatively attractive right now. REITs have a natural tie to inflation through rent escalation and price appreciation of owned real estate, he said. Rent increases tends to trail inflation, but this lag should help REITs outperform other risk assets, like traditional equities, as economic growth declines and inflation moderates, he noted.
Healthcare stocks are also well positioned for high inflation and slow growth. Pharmaceutical companies and healthcare providers are particularly able to pass along price increases, said Gargi Chaudhuri, head of iShares Investment Strategy Americas at BlackRock. Two ETFs that offer exposure to these sub-sectors are the iShares U.S. Pharmaceuticals ETF (ticker: IHE) and the iShares U.S. Healthcare Providers ETF (IHF), Chaudhuri said. What’s more, demand for healthcare doesn’t decline as much during a recession as demand for discretionary purchases.
On the bond side,Treasury Series I savings bonds are a good bet for both inflation and a possible recession. The initial interest rate on new Series I savings bonds is 9.62%, and you can buy bonds at that rate through October 2022.
There are some important caveats to remember with I bonds, said Greg McBride, chief financial analyst at Bankrate.com. For starters, they’re not income instruments. Interest each bond earns is added to its principal value, and you get access to it when you cash out the bond. Second, they’re not very liquid. You can’t cash them in the first year, and if you redeem them within the first five years, you’ll lose your last three months’ interest. Lastly, consumers can only buy up to $10,000 of electronic I bonds each calendar year (couples can buy $20,000 between them).
So they’re a good fit for longer-term savings. “When you can get 9%-plus risk-free, there’s nothing else like them,” said Eric Diton, president and managing director of the Wealth Alliance in Boca Raton, Fla. “That’s the biggest no-brainer in the world right now.”
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