I wonder what King Solomon would choose if he was faced with the prospects of recession and inflation. The wise old King of ancient Israel famously managed to resolve the dilemma of two women who lay claim to being the mother of the same child.
How the Federal Reserve would wish that it had the wisdom of Solomon to choose between recession and inflation. Should it continue to play hardball on inflation and run the risk of awakening the spectre of recession? Or should it spur economic growth and allow inflation to run rife?
Neither is a good option.
With inflation, the price that we pay for goods and services could rise. Consequently, workers could demand higher wages to cope with those rising prices that could feed into even higher prices. Prices could continue to climb until they become totally unaffordable. Then, demand drops, some businesses might retrench, whilst some companies could fail, and unemployment could rise.
With recession, economic activity drops as a result of lower demand for goods and services. That is normally a consequence of reduced disposable income for one reason or another. It’s generally because interest rates are rising. The upshot is that businesses could retrench, staff could be laid off until such time that supply matches demand. Companies that can’t cope with the downturn could fail.
So, what is worse – recession or inflation? In some ways, recession might be preferable unless we are someone who has lost our job as a result of it. Inflation, on the other hand, could be the better option until it gets out of control. Then we enter the realms of hyperinflation that could lead to not just recession but perhaps outright depression.
So, what would King Solomon prefer – inflation or recession? The answer is probably neither. But if he had to choose, it could be recession. It might not be pleasant. It might even be uncomfortable for a while. But it is the free-market’s way of separating the wheat from the chaff. And our job as investors is to make sure that we have invested in the former and not the latter.
So, it might be best to avoid companies that are over-indebted and under-capitalised. Steer clear of business with little or no pricing power. Stay away from outfits with flaky business models, eschew corporations that can’t generate free cash, and keep well away from zombies.
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Disclosure: David Kuo does not own any of the shares mentioned.
