Why Is Inflation Scarier Than a Market Crash?

Inflation is now the #1 fear with “6 in 10 Canadians concerned they might not have enough money to feed their family”, according to an Ipsos poll. Most Canadians have never experienced high inflation. It has been flat at 2% for 3 decades, but jumped to 8% in 2022 and is down to 5% now in 2023.

Inflation has a major effect on your life and your finances. Many people are asking me what is going on and can I give them some context. Looking at inflation in the past is very helpful to understand what is happening today.

• Why is inflation scarier than a market crash?
• How do inflation & market crashes affect your retirement plan?
• Why are our expectations for inflation so critical?
• Should we be worried?
• How long will it last?
• What is happening with each of the causes of inflation?
• How does today’s inflation compare to past periods of high inflation?
• How can we fix inflation?

Why is Inflation Scarier than a Market Crash?

This important concept can have a major effect on your life and your finances:

Market crashes are temporary, but inflation is a permanent increase in our cost of living.

The stock markets have recovered from 100% of declines, but inflation compounds on our cost of living. The 8% inflation in 2022 is added to the 5% inflation today to mean 13% higher cost of living for you. We do not ever expect negative inflation (deflation), so that 13% is there for the rest of our lives and is added to inflation of every future year. Over a few decades, this is huge!

Bear Markets

There have been 26 “bear markets” (a decline of 20% or more) since 1900 and the market has recovered 100% of the time. 88% of recoveries were in 1-2 years or less. The risk of a market crash is you – if you panic and sell after the decline.

We were officially in a “bear market” in 2022, since markets were down more than 20%. They appear to have bottomed October 2022 and have bounced back partly now. They may or may not fall further, but if they do, they will recover all of it. There is a good chance we will have a recession, but stocks usually rise during a recession. They are always anticipating, so they usually fall before a recession and then rise during a recession anticipating the economy recovering.

For long term investors, your main fear related to market declines should be missing the inevitable recovery. Major stock markets have recovered from 100% of declines.

Today is clearly a buying opportunity for investments. Our growth fund manager considers this the best buying opportunity of the last 30 years. Stocks are on sale – and the sale is temporary.

When the market crashes, but you stay invested and it recovers, you have not lost anything. This does not happen with inflation.

Inflation

Inflation is a permanent increase in our cost of living. It piles on top of all past years. A year of high inflation is not followed by a year of negative inflation (“deflation”) to offset it.

One or 2 years of inflation is not a major problem, but if it lasts for quite a few years, it’s a huge problem. It’s your #1 problem. Your cost of living takes a big jump every year and they pile on top of each other.

A long period of high inflation is what I worry about most for our clients. I have studied the effect and experienced it. The 1970s and 1980s were 2 decades of high inflation, which were really the worst time for investors in the last 150 years. Worse than the Great Depression.

I learned this by looking at reasons the “4% Rule” failed. I tested this general rule of thumb that says you can retire and withdraw 4% of your investments each year, increase it by inflation and it should last for a 30-year retirement. With a portfolio of 100% stocks, the “4% Rule” succeeded 97% of the time in the last 150 years.

It failed only 5 times:

• 1 time because of a market crash – Retiring in 1929, just before the Great Depression.
• 4 times because of high inflation – Retiring in the last 1960s, just before 2 decades of high inflation.

In this chart, every line is a 30-year retirement for someone doing the 4% Rule. Notice the times the portfolio fell below zero.

4% Rule – Inflation Caused 4 of 5 Failures

In short, high inflation for 2 decades is almost the only reason the 4% Rule has ever failed in history. This is why high inflation that lasts could be the single biggest risk to your long-term finances.

Inflation expectations are the fear.

With my first jobs in the 1980s, inflation was 10%, so we all expected a 10% COLA (“cost of living”) raise every year. A buddy quit a job after an 8% raise. He considered it a pay cut. It was insulting to get a raise lower than inflation.

Inflation had been high for a while and was the expectation. It was ingrained. We all assumed everything at the store would go up 10% every year and our incomes would go up by 10%/year.

If inflation lasts long enough that the public expects it, then it’s really hard to bring it back down. It took interest rates at 20% and 2 recessions to bring inflation under control. This was a valuable lesson we all learned.

I worked for a savings & mortgage company in 1982 at the peak of interest rates. We offered GICs paying 19.9%/year and 5-year fixed mortgages at 22.75%/year. The 1-year mortgage was only about 15%, but people were taking the 5-year fixed because rates were shooting up. They expected interest rates to go to 30% or 40%. Many people lost their homes when their mortgage came due and their payment doubled.

These unaffordable interest rates were the only way to stop inflation once it became an expectation. It caused recessions in 1982 and 1992, which finally brought inflation down to the 2% low inflation we have enjoyed the last 3 decades.

Here is our inflation history. Note how long it stayed high and what a great period of low inflation we enjoyed the last 30 years.

Similarities between now and 1970s to 1980s:

Are we at risk of a long period of high inflation like those 2 decades with high inflation? Will inflation become an expectation? Most of the causes of inflation are similar today, but not all.

Interestingly, the causes of inflation include some eerie similarities:

a. Oil supply shock: Inflation took off with the Arab oil embargo of 1973. The cost of gas leaped, and with it the cost of gasoline and everything that is shipped. Today we have an oil supply disruption from the Ukraine war and a supply shortage from the restart of demand after the Covid shutdowns.

b. High government deficits: Governments printing money is a major cause of inflation. Too many dollars chasing too few products and services.

Almost all our government debt in Canada was accumulated in the 1970s and 1980s. We had a Trudeau government with Pierre Trudeau in power from 1968-84. Now we have a Trudeau government since 2015 and our government debt has almost doubled (mostly from Covid spending).

We learned our lesson after the 2 decades of high inflation. Governments balanced their budgets and debt did not rise from 1996-2015 (other than a few years right after the 2008 “Great Recession”). Here are the last 60 years of federal government deficits (current year over-spending). Note the large deficits in the 1970s and 1980s, and the surpluses since 1996.

Federal Government Deficits – 20 Bad Years and 20 Good Years

Here are the last 60 years of federal government debt (total we owe). Note how little we owed before 1970, shot up during 2 decades of high inflation, slowly came down after 1996, jumped up during the 2008 Financial Crisis, stayed flat for a few years, and has been rising since 2015.

Government Debt – 20 Bad Years & 20 Good Years

Is inflation temporary?

If I have scared you up until now, don’t worry. 😊

It is important to understand why inflation can be a big fear. However, I believe it will not last long, and should not really be a major problem for us.

The general expectation of economists and my personal expectation is that inflation is “temporary”. It should be back down to the 2-3% range in a year or 2. This is the most likely scenario, which is why I am not really concerned today. However, this is far from definite.

Economists are often wrong. It was only a few months ago that they considered inflation “transitory”, meaning it should only last a few months, but that was clearly wrong. The current expectation of a year or 2 is likely right, though.

To understand why, let’s look at the main causes of inflation to see whether or not they will continue:

Gas

Prices at the pumps have been painful. They jumped about 50% from February to June 2022 and almost doubled from before Covid, but have come down to early 2022 levels now. This affects the cost of everything delivered. Many experts think gas prices have stopped rising. Inflation is a 1-year comparison, June 2023 will show gas prices lower than the peak in June 2022. Why?

Gasoline Prices

Supplies are catching up after the global supply shock from the Ukraine War and the end of Covid. The gear-up of supply, especially at oil refineries, was slower than the gear-up in demand. We are getting back to normal now. The Ukraine War only affected oil price briefly. Importing countries changed sources, but the total supply is not affected.

Remember, inflation is the rate of price increase. If gasoline stays at this level and stops rising, then it is not causing inflation. Oil prices are political all over the world. It’s not just a local supply/demand issue, so they are hard to predict. It is most likely, though, that gasoline does not rise a lot from here.

However, big jumps in carbon tax will likely mean somewhat higher prices.

Food

Sharply rising food prices at the grocery store affect us all directly. Food is one of the highest areas of inflation and it has stayed high. Prices are still rising a lot.

It’s not price gouging. Loblaws kicking all Frito Lay products out of all their stores for 2-3 months in 2022 showed the battle to keep prices low.

They should stop rising and even come down as supply chain bottlenecks ease, which may take a year or 2. Whatever happens with the price of oil has a major effect here. Oil is the main cost of both transportation and fertilizer, so it is a major cost of all food.

Housing

A major part of inflation is the cost of housing, both real estate prices and mortgage payments.

Real estate prices are pulling back as the froth and overbidding is gone. Super-low interest rates fuelled real estate prices, but are probably gone for years. However, prices are not likely to fall much because we have a systematic housing shortage.

We have the “Battle of 2 governments” going on between the federal government and municipalities that is likely to keep real estate prices rising over time. The federal government wants increasing immigration, which helps grow our economy. A larger population means larger economy. Immigrants are also on average more highly educated and more entrepreneurial than people born here.

But we don’t build enough homes for them. Municipalities want to keep their character and limit growth. Toronto has a history of keeping multi-unit homes out of many neighbourhoods. The 1912 By-law #6061 banned apartments in much of the city. This NIMBY culture is still strong. Vancouver has limited space inside the bridges that surround most of the city.

The housing supply shortage is likely to continue. Immigration is still a lot higher than new home construction. However, the rate of increase in prices should go back to pre-Covid levels.

There is a risk that at some point, they could drop. Canada did not have the real estate price decline after 2008 that the US had. We are long overdue for prices to fall.

Mortgage payments have jumped with interest rates finally coming off their near-zero rates. Mortgages rates have essentially quadrupled from about 1.5% to almost 6%. Interest rates have probably peaked – as long as inflation gets under control. This means mortgage payments have jumped a lot.

After this year or 2, assuming inflation comes under control, interest rates may come down a bit and should go back to a “normal” pre-Covid level. This rise in interest rates is just going back to normal. We should expect mortgage interest rates to stay in the 3-5% range.

Worker shortage

Unemployment is at 4.9% (February 2023) – the lowest since the 1970s. Many businesses are complaining they cannot find enough workers. We see it most with restaurants, nurses, construction and manufacturing. Most industries have a worker shortage today.

This started with the reopening after Covid, with people not wanting to go back to work until their CERB & EI benefits stopped and because of Covid-hesitancy. The initial shock from Covid-related issues should work itself out and normalize.

However, we also have structural labour shortage that is going to get worse over time. My view is that low unemployment is not from a strong economy (since your economic growth is anemic). Low unemployment is mainly from people dropping out of the work force.

Many people enjoyed working from home (WFH) during Covid and now want to continue to work at least part-time from home. We see lots of self-employed people that have started new online businesses working from home. Many people used to have more than one job, but now have a part-time job and a side hustle from home. They used to be considered unemployed, but not anymore – even though they don’t have a conventional job.

The Baby Boomers are our largest generation. About 20% of our workforce are Baby Boomers, born from 1947 to 1964, according to Stats Canada. The peak was 1961, with more Canadians born in 1961 than any other year. The peak age that Canadians retire at is age 62. The Baby Boomer peak is people aged 62 today. 2023 is expected to see more retirees than any year in Canadian history. Millions of experienced and hard workers will retire the next few years. Nearly all of this 20% of our workforce is expected to retire this decade.

Our worker shortage is likely to continue as trend to work from home (WFH) continues and the Baby Boomers retire.

“Stagflation” has been a news story recently, will the 1980s stagflation return?

Stagflation means high inflation combined with high unemployment and low GDP growth.

Note this is a major difference between now and the 1970s and 1980s. We had high unemployment of 8-12% for most of those 2 decades, but low unemployment now about 5% and expected to stay low for years.

Here is unemployment for the last 50 years. Note how low it was in the 1960s, how high it was from 1975-1995, and how low it is now.

Unemployment – High in the 1980s. Low now.

Stagflation includes low GDP growth of the economy. Canada actually had decent growth in the 1970s and 1980s, averaging about 4%. At the time, we though growth was slow, because it was less than the 1950s and 1960s when we had growth over 5%.

I find it quite funny when we talk about the “low GDP growth” of stagflation in the 1970s and 1980s. It was about 4%! 😊 That was a lot higher than growth of our economy since then. Today, 4% growth of our economy is a distant memory. We think of 2% growth as good!

Since then, our growth has continued to slow. From 2000-2015, our growth averaged about 3%. From 2015-19 before Covid, it slowed further averaging below 2%. Our projected growth for the rest of this decade is down to about 1%.

This chart is “real GDP”, meaning growth of our economy after inflation. Note the steady decline over all of the last 60 years – over 5% in the 1960s, 4% from mid-1970s to 2000, 3% from 2000-2015, and 2% from 2015-2019. And now projected to be down to 1%.

Real GDP: Growth of our Economy after Inflation

Our growth is expected to slow even more to less than 1% for the rest of this decade. The OECD predicts Canada will have the slowest growing advanced economy of 38 OECD countries for the rest of this decade – and the next 3 decades.

This is not because of inflation. It is political. Growing our economy and our standard of living, and being competitive internationally are simply not priority in Canada today.

Economic growth is almost gone in Canada now. We will likely fall from the 9^th largest economy to 11^th soon as the economies in tiny South Korea & Brazil pass us.

This is one of the main reasons we invest almost entirely outside of Canada. There is lots of growth for global investors.

In short, we do not expect “stagflation”, because inflation is likely temporary and unemployment should stay low.

If inflation does last for years, we would get stagflation, but different. Growth will be low, but unemployment will likely also stay low. In the 1970s and 1980s, we had stagflation with very high inflation, high unemployment and low growth by 1970s standards (although high by today’s standards). Today, we have high inflation (hopefully temporary), low unemployment and very low growth.

Government deficits

“Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” In other words, too much money chasing too few goods and services. We are testing this now.

The Covid stimulus was truly unprecedented “money printing”. It was by far the largest in history. Essentially, we borrowed $400 billion from investors by issuing government bonds. This money ended up in the hands of Canadians either directly or indirectly (see chart).

Most Canadians actually had higher income during Covid (other than small businesses) and were spending quite a bit less. We had record disposable income and record new investment account openings in Canada.

Canadians now have record cash holdings and pent-up spending demand. This has been one of the main causes of recent inflation. After being locked up for 2 years, we are out driving, going to restaurants and entertainment, and lots of shopping. Supply issues, such as supply chain & transportation issues, oil refineries slow to open, and workers slow to return could not keep up with the surging demand.

Bank of Canada should make sure inflation comes down.

The main reason I believe inflation will come down is because that is the main job of the Bank of Canada (and the Federal Reserve in the US).

Our central bank is mandated to keep inflation between 1-3%, with a target about 2%. They were very successful at is from 1992-2019. Inflation stayed close to 2% for 30 years.

If the Bank of Canada does its job, inflation should come down to 2-3%, hopefully within 1-2 years. The only question is how high do interest rates have to go to bring down inflation? They will keep raising interest rates until inflation comes down to their target range.

I fully applaud this. Inflation is the #1 risk to our financial futures – and our clients’ retirements. The question is not really whether inflation will come down, but how high interest rates will have to be to keep inflation low. This means interest rates will likely go back to normal or a bit higher.

There are 2 risks to this:

a. The Bank of Canada’s mandate was changed in 2021.

They now have 2 jobs – keep inflation about 2% and create “maximum sustainable employment”. For the last 30 years, they had one job – 2% inflation – and they succeeded at keeping it about 2%. Now they have 2 jobs.

It took 20% interest rates and 2 recessions to bring down high inflation in the 1980s. Will the Bank of Canada focus on avoiding a recession because it would increase unemployment? If so, will that make them less effective at reducing inflation?

In my view, adding employment as a second job for the Bank of Canada was a political decision, but is a risk financially. Unemployment is a lagging indicator, which means it usually takes a year or more for employment to respond.

The Bank of Canada and the Fed in the US are already almost always very slow to respond. The investment industry widely wanted interest rates to start rising in October 2021 and believes the Bank of Canada was about 7 months too slow in starting.

This mandate change may make them even slower & less effective. Scenarios where they lose control of inflation to avoid creating a recession are unlikely, but more likely with this mandate change.

The 2 mandates should not be a problem this time, since unemployment is very low and likely to stay low, even if we have a recession.

b. “Battle between the federal government vs. the Bank of Canada”.

Governments have 2 main tools to control the economy: “fiscal stimulus” (governments spending money and running deficits to create growth) and “monetary policy” (the Bank of Canada raising interest rates to slow the economy). Today, these 2 are pushing against each other.

The Bank of Canada intends to raise interest rates until inflation is under control. The government plans to continue to have large deficits and print money, which stimulates inflation.

This year’s federal budget projected a deficit of $40 billion, but this federal government has not come close to their projections in most years. There are some projections of reducing to $30-50 billion in a couple years. Many permanent new programs have been added, so deficits may well stay at $50-80 billion/year. Until the last few years, a $20 billion deficit was thought to be huge and governments targeted living within their means by balancing their budget (no deficit).

The risk here is that government debt increases are permanent. Our federal government debt is $500 billion higher than pre-Covid and this debt will all be owed 100 years from now. This year’s $50-80 billion additional debt will also be permanent. All of us and our kids will pay interest every year of our lives on this debt – plus the new debt every year.

Government Debt – Huge Increases are Permanent

We learned our lesson after previous inflation and balanced budgets for 20 years. However, we seem to have forgotten that lesson since 2015. Will Canada become financially responsible again or continue to pile up more and more debt?

In the end, the Bank of Canada should win. The worst-case is that the money printing may just mean interest rates will have to stay higher to keep inflation down to the target range of 1-3%.

How to solve inflation.

Here are 7 ways to solve inflation. How likely do you think these are to happen?

a. Supply chain issues work themselves out. We are getting there.
b. Ukraine War ends. Likely a few years, but it will end eventually. It has not hurt the Russian economy (despite what they say on the news). Russia’s economy grew more than Canada’s in 2022. Putin is popular in Russia, since he controls the media and what Russian people hear about the war.
c. Supply of oil increases enough to keep up with growing global demand. 3 billion people still live in extreme poverty and developing countries are slowly moving to middle class, which should keep global demand rising. This should keep the price of oil and gasoline at current prices.
d. Keep immigration high to replace retiring Baby Boomers.
e. Build enough housing for immigration. Or reduce immigration to the net new homes we build so we can provide homes for them. If municipalities won’t allow more building, then it needs to be higher concentration in the cities. Supply & demand for homes determines home prices, which a large part of the cost of living.
f. Governments go back to fiscal responsibility and balancing budgets. We all have to live within our means. Governments should be a good example. This one is highly unlikely to happen!
g. Bank of Canada stays focused on inflation and keeps interest rates high until inflation comes down to their 1-3% target. High interest rates are less of a problem than letting inflation last longer and become an expectation. This may cause a recession, but probably not high unemployment.

Summary

1. Why is inflation scarier than a market crash?

Stock markets have recovered from 100% of crashes, but inflation is a permanent increase in our cost of living. It piles on top of the inflation from all previous years.

2. Should we be worried?

I agree with most economists that inflation should come down to the Bank of Canada’s 2-3% target. However, I am very aware that higher inflation lasting quite a few years is probably the single biggest risk to our financial futures. Years of high inflation are the #1 risk to Canadians having a sustainable retirement. The Bank of Canada needs to keep interest rates stay high until inflation comes back down. We cannot let inflation become an expectation!

3. How long will it last?

Many factors affect this, so any forecast is far from certain. I agree with most economists that inflation should come down to 2-3% within 1-2 years.

Worst case: Inflation stays high and becomes an expectation. Interest rates stay high. They won’t be anywhere close to 20%, but staying above 5% is possible.

Best case: Interest rates stay at this level this year and bring down inflation by next year, so interest rates can start to decline.

Ed