Is The Global Economy Headed For A 'Worst Case' Scenario?

| About: SPDR Dow (DIA)

Summary

With so much debt in the world, the global economy is much more susceptible to either a crisis of inflation or deflation.

A possible worst case is to have a debt implosion causing deflation followed by massive Central Bank intervention that then causes inflation.

Investors not having a game plan and learning the wrong lessons from an initial bout of deflation could lead to awful investment behavior.

The amount of debt in the world today creates significant risk for substantial inflation and/or deflation. The worst case scenario is not necessarily just what happens to an investor's holdings. It is also a consequence of an investor's behavior in under either scenario. Acknowledging this risk, it is important for investors to develop a plan for what they will do under diverse and adverse scenarios.

For some, the idea of another economic depression on the scale of the 1930s seems impossible. They think we're too smart and the financial markets are too sophisticated. Throughout history, however, the really bad busts were always predicated not on market sophistication but on hubris. And the notion that all our modern computing power will shield us from a massive economic downturn is exactly that: hubris.

Here's a shocking statistic-with debt-to-GDP around 300% and an average global interest rate of say 2%, we need 6% nominal GDP growth indefinitely just to break even. I've written before about why the next market downturn could be one of the worst in history. Just as pilots spend a lot of time training in a simulator preparing for challenging events, it's important for investors to mentally rehearse what they will do when the markets end up in a tailspin.

The first step is to acknowledge the risks. Debt creates fragility that leaves us prone to two major risks: inflation and deflation.

The Deflationary Scenario

In a deflationary scenario, the price of goods comes down usually due to overcapacity built during an overly optimistic period (think real estate in the mid-2000s and oil recently.) With too much competition, businesses struggle to maintain pricing power, and as revenues decrease, there is a smaller profit pool from which to pay wages. This creates a downward feedback loop of less spending and less earning, driving prices lower and lower.

In our current environment, there is another factor: debt. There is already too much of it in the world. With deflation, everyone (governments, corporation and individuals) would have less income to pay off their debts, and some percentage of borrowers wouldn't be able to repay, therefore defaulting. And since one person's debt is another person's asset, the lender must write off the loan and take a hit on their balance sheet, further depressing their income. Theoretically, this downward spiral could go on until the economy fell apart, and in the Great Depression, prices fell about 25% before they started stabilizing.

From an investment standpoint, anything fixed that actually gets paid back does well during a deflationary period. For example, if you hold cash or a high-quality bond, as the price of goods drops, those assets become more valuable in real terms. As a general rule, when facing deflation, good investments are cash and bonds, and poor investments are stocks and commodities.

Inflationary Scenario

Inflation is usually caused by governments printing too much money and/or when some resource (i.e., labor or capital) becomes scarce relative to current economic growth. With more money chasing a limited amount of goods, prices go up. Once this trend starts, fear of ever-increasing prices can accelerate the process.

Inflation can act like a debt jubilee, as the real value of debt falls dramatically. It creates winners and losers indiscriminately. Think of it this way: if someone owes you $1,000 in 10 years, but we have 20% inflation per year, that $1,000 you're due is only worth about $161 when it's paid back. The people who were prudent savers get punished (because their savings are worth less), and the people who were spendthrifts (like many governments around the world) get the reward of unshouldering their debt burden at a fraction of the cost. An extreme version of this, hyperinflation, has happened 55 times in history according to Steve Hanke and Nicholas Krus.

If a country has too much inflation, anything fixed, like bonds, can become worthless. Commodities, like gold, are a hedge on inflation, and any equity investment that can pass through inflation to its clients can be a good hedge, if bought cheap enough. From an investment standpoint, poor investments are cash and bonds, while good investments are commodities and stocks (bought at low prices) of companies with pricing power.

Likely headlines

If we enter a period of deflation or inflation, what are we likely to see? Here are some headlines that you may read if the next downturn is a bad one:

  • Pensions of corporations and municipalities will realize they are even more drastically underfunded than previously thought.
  • Certain large banks (most likely abroad) will fail and pundits will worry about a domino effect in the financial system.
  • European "cohesion" will be put under severe strain.
  • The Chinese debt bubble will likely burst, forcing the government to print trillions of Yuan, depreciating the currency and exporting lower prices to the rest of the world.
  • Equity indices in unison give up a lot (if not all) of the preceding bull market's gains.
  • Fund managers who outperformed during the bull market, having taken a lot of risk, will fall from grace and be seen as brash, young and foolish. Prudent investors who underperformed during the ascent will be seen as wise.
  • Some major fraud(s) somewhere will be revealed by the "tide going out."
  • The wisdom of index funds (after record inflows) will be questioned as they experience 100% of the downside of the market.
  • The sustainability of the capitalist system will come under question.

The Whipsaw Effect

If these things come to fruition, we will be in a serious downturn. But the worst case scenario is not necessarily just what happens to the investor's holdings; it's also a consequence of what the investor does when we hit air turbulence. I call it the "whipsaw effect."

In the beginning of a severe recession or depression, credit markets are strained as we realize a lot of people can't pay back the mountain of debt we've accumulated globally. As the write-offs accumulate, this causes deflation, which in turn causes most risk investments to suffer, inciting people to run towards the safest bonds and cash.

Concurrent with a mass rush into fixed "safe assets," the central banks of the world react, not wanting a repeat of the deflation we experienced during the Great Depression. As their massive reactionary money printing takes effect, we go from a period of deflation to high inflation. This whipsaw could be devastating to the average investor who, now "safely" in fixed assets, sees their purchasing power decimated.

"Manage the downside, the upside will take care of itself" - Charlie Munger.

In my practice, we're always talking about our game plan in a bad case scenario. Thinking through appropriate reactions to such stressful situations is the best way to condition yourself so that when bad events come-and they will-you don't panic and let emotions overwhelm what you know you "should" do.

What will you do if the equity markets lose 50%? What will you do if inflation or deflation rears its ugly head? What will you do if you lose your job amid a recession?

Everyone needs a game plan that accounts for at least an average-to-severe downturn. I personally put the odds of the next downturn being a depression at 1 in 5. That's not high enough to be a probability, but it certainly is enough of a possibility to consider when thinking about the balance between risk and reward.

If you don't know where you stand or how to balance these risks, you need the help of a competent advisor. Check out my article on finding a financial advisor who is right for you. Taking full stock of the amount of debt (and the amount of hubris) in the world, this is a time for preparation. There's no way of knowing with certainty what the future holds, but with support and planning, you can ensure your portfolio weathers the really bad days.

And worst case scenario, you'll be a prepared investor.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.