Investing In Bonds Can Help Investors Survive Economic Downturns
America may avoid a calamitous recession or depression in the years ahead. But if one does occur, investing in bonds is the best insurance against it…
Balancing the budget has always helped to bring down interest rates. In fact, in the past, it’s helped quash inflation out of the economy. That’s excellent news for those with ample savings- and no debt. Every year, you’re able to buy more with the money you have instead of losing ground to inflation. But for everyone else, times are more challenging than anyone can remember.
Even the wealthy aren’t too happy; The stock market’s recent volatility has made many investors cautious. The value of tangible assets like real estate and gold has been stagnant. Bonds have had a field day, but only for investors who have managed to avoid the surging tide.
Ironically, the pain is rooted in the cause of deflation; when the stock market crashed in 2001, the federal government decided that controlling inflation and balancing the federal budget were more critical than “bailing out the Wall Street fat cats.”
So, the politicians refused to pump more money back into the economy, as they had done after the short-lived crashes of 1987, 1990, and 1997. Instead, they stuck to a tight monetary and fiscal policy.
This sucked billions of dollars out of the economy precisely when it was needed most to keep growth going. Though considered wasteful spending by some, this cash went to build roads, feed families, provide health care, and finance military research projects.
This fiscal ‘vacuum’ had a ripple effect throughout the rest of the economy. People lost jobs and income, curtailing their spending habits. Anyone doing business with them, from the banks that lent them money… to the communities where they lived, everyone suffered from the trickle-down effect of the sharp drop in spending power.
Deflation also sent ‘real’ or inflation-adjusted interest rates to sky-high levels. That made it difficult for individuals and corporations to borrow money to finance expansion. It also made it difficult for most people to repay their debt, making defaults and bankruptcies evermore standard.
I doubt this sounds shocking. Faster inflation is still the most likely imminent outcome due to rising demand for commodities, a worldwide mandate for more rapid economic growth, and the substantial monetary and debt overhang in our economy.
But folks, it’s a fine line between galloping inflation and catastrophic deflation or depression. The very same forces that will produce rapid inflation in the next decade could, under slightly different circumstances, actually create the opposite condition- a deflationary depression.
The Past Can Predict The Future… Sometimes.
History tends to repeat itself, and this scenario has happened before. The crippling recession of 1973-74, for example, occurred smack dab in the middle of the high-inflation 1970s. The result for the stock market was one of its worst meltdowns in history, with the average share shedding about half its value.
And history always has something to teach us. In the 1960s, Fed chairman Arthur Burns pumped the money supply earnestly. The result was the runaway inflation reminiscent of the 1970s. However, the economy was able to pay off its debt and keep growing.
Conversely, during the 1920s, we weren’t so lucky. The government failed to inflate, and the economy sank into that generational catastrophe known today as the Great Depression.
Only one investment gets a charge from deflation and even depression: bonds, specifically those of the highest credit quality.
Investing in bonds is essentially lending money. Lenders make more money when real interest rates are high, which is most accurate during deflation. Lenders and bondholders lose money hand over fist when real interest rates are negative and inflation rises.
Bonds were big winners during the low-inflation 1980s and early 1990s, beating stocks for much of the period. They were a disaster in the high-inflation 1970s and were losers again as inflation peaked in the latter 1990s.
However, should the economy enter a period of severe deflation and even depression, the bond yield could sink as low as 2% or 3%. That would mean a near-tripling of bond prices before the trend played out.
For good measure, let’s explore what the possibility of a deflationary depression might look like and what could be the catalyst. I will explain why investing in bonds holds their ground during such catastrophes and suggest the best ways to buy them.
Main Causes of Deflation
Deflation is the opposite of inflation. I’ll paint a scenario for you. During a deflationary period, money becomes relatively scarce. Therefore, prices of almost all goods and services would fall. Real asset values would also plummet. Real interest rates would skyrocket, and debt would become difficult to repay. If unchecked by central bank increases in money supply growth- which lower real interest rates and make debt more straightforward to pay off– this trend will lead to loan defaults on a massive scale and bank failures, which in turn shrink economic growth even further.
However, let’s look in the rearview mirror and learn from our economic mistakes…
Under the gold standard, deflations occurred regularly as countries were forced to adjust their domestic economic policies in line with international gold flows. The catastrophic experience of the 1930s Great Depression ended most of the world’s reliance on the gold standard, allowing central banks to prevent future depressions through more flexible monetary policies.
America’s last significant deflation took place in the early 1930s. The catalyst was the famous 1929 Market Crash, which overnight wiped out billions of dollars in equity. At that point, the Federal Reserve was restricted from pumping up the money supply by the shackles of the gold standard. America had to economically ‘fall on its face’ and pick up the pieces while hopefully learning from our mistakes.
At the time, neither the Hoover administration nor the Federal Reserve was willing to stimulate the economy. The money sucked out of the system by the stock market crash was never replaced. Deflationary conditions continued to rage out of control, and the economy sank deeper into a depression.
What are the chances of a repeat performance?
As history clearly shows, the trigger would certainly be some kind of major deflationary event such as another stock market crash and a mistaken response by the government, which would compound the problem by tightening credit, as it did in 1929.
And why would a stock market crash be deflationary?
The answer lies in the history of the crash of 1929. There’s been as much speculation about the causes of the crash as there was investment speculation before it occurred. But most market historians agree on one thing: The 1929 crash and its deflationary aftermath would have been much less severe if fewer Americans hadn’t (literally) leveraged their houses to buy stocks.
It reminds me of the modern crypto craze mania. Some investors took out 2nd and 3rd mortgages on their homes to buy Bitcoin. It seemed like a moonshot investment scenario that would keep going up and up… Until it didn’t. Bitcoin rapidly crashed from its all-time high of $68k+ down to $16k- before recouping value in 2023.
Similar scenario… In the months leading up to the October 1929 Stock Market Crash, everyone from taxi drivers to insurance sales clerks bought stocks in a retail investor mania. People were lured in by an upswing of a ‘get rich quick’ sentiment, combined with low margin requirements.
This allowed people to buy a lot of stock for a small amount of cash.
The risks of using such leverage were ignored mainly since stock prices had been rising for several years, and almost no one expected the good times to end. Truly a recipe for disaster. As a result, the public was excessively leveraged when the crash occurred, resulting in a mind-numbing meltdown with severe repercussions throughout the economy.
Unfortunately, today’s stock market is highly leveraged indirectly, and that’s every bit as threatening. Unless someone buys stocks on margin, which we wouldn’t recommend for anyone who’s not a professional or highly seasoned, the average investor is not borrowing specifically to buy stocks.
However, the typical person still borrows at the fastest pace in history. Over the past decade, consumer debt has been rising at a much quicker clip than consumer income. In recent years, it has grown even faster than the appreciation in financial assets.
What Does Consumer Debt Have To Do With Stock & Bond Markets?
A lot. Although they’re not margining their stock investments per se, Americans are increasingly borrowing money while investing their cash in stocks. In effect, their debt is backed by their equity investments. And in a genuine sense, the big move up in the stock market is being supported by massive increases in debt.
Should we experience a repeat of a stock market crash- the likes of 1929– that debt mountain could come crashing down, setting off a major deflationary depression. To position yourself prudently, it’s always good to hold some high-quality bonds in your investment portfolio to help mitigate a plethora of economic conditions that could arise.
Get In Touch
Our investment professionals understand that building a wealth management strategy can be overwhelming. Take your first steps toward financial freedom by scheduling a no-obligation investment consultation with a registered investment adviser representative.