Corona Crisis: Conclusion

Corona Crisis: Conclusion

With this short series on possible economic scenarios I wanted to illustrate to you how I think about recent events. First of all it is important to think in terms of scenarios. This helps keeping an open mind and not focus on only one economic outcome. Further, one can assign probabilities to each scenario. Even though there is no way to calculate objective probabilities, assigning probabilities helps to put things into perspective even more. In my personal opinion I would give the scenarios of quick recovery and recession a probability of 45% each leaving a 10% chance to the scenario of a depression. Please note that a depression has by far the lowest probability, but still this scenario is being talked most about in the media.Talking about a depression raises the most attention and gets the most clicks, despite the fact that it is the least likely scenario. 

Implications on Investing

Furthermore I would like to briefly talk about the implications of these scenarios for investing. In my opinion it is prudent to build an investment strategy that takes into account each scenario. For example that means to hold at least 10% to 15% of the portfolio in gold. Gold acts as an insurance and can protect your wealth in a depression. To account for a recession it would normally be prudent to hold a portion of the portfolio in AAA rated government bonds that give you liquidity and have somewhat of a negative correlation to the stock market. However, 0% interest rates and high government debt make government bonds a less attractive investment. An alternative could be to hold some cash instead and/ or go into investment grade rated corporate bonds. At last, to thrive during a quick recovery, it is best to hold stocks. As most investors had stocks before the crash that means not to sell all stocks and also use low prices to buy and thereby lower the average entry price. The different probabilities of the scenarios show themselves in the weighting of each asset class. Because a depression has, in my opinion, the lowest probability I would only invest 10% to 15% into gold (someone who thinks a depression is more likely would invest more into gold). The rest of the portfolio would be distributed into stocks and bonds/ cash, where I would slightly overweight bonds/ cash, because of the higher volatility of stocks.

Finally it is paramount to maintain a positive outlook. Even the worst case of a depression would be mastered within a couple of years. In any case we will master this health crisis and likely enter a new era of prosperity and economic growth.

Economic Scenario 3: Depression

Economic Scenario 3: Depression

This third and last economic scenario is the one of an economic depression. Contrary to a recession, the timeline for a depression is at least several years. It takes this much time of continuous economic contraction until the lowest point is reached and the situation starts to get better. Furthermore a depression is characterized by high unemployment that can be as high as 25% and the passing of many new political programs. For example during the last depression in the US, Franklin D. Roosevelt passed a series of programs, summed up under the term New Deal.

How could a depression play out?

1. Deflation

During a Deflation prices are falling. In a deflationary environment consumers and businesses alike, anticipating prices falling further, bring their spending to a minimum. They prefer holding on to cash, because the same amount can buy more later on. The reason why Deflation is so dangerous is that it can quickly lead to a vicious cycle. Whereas the first decline in prices can be caused by an exogenous shock, consumers and businesses holding on to their cash cause further declining prices even though the shock is already absorbed. Now that prices declined further consumers and businesses will hold on to cash even more and so the vicious cycle ensues. Ultimately this behavior can bring the entire economy to a halt and it will be very difficult to get going again. The Great Depression of the 1930s is an example of an economic depression that was caused by deflation. During this crisis deflation was caused by a collapsing financial sector and bank failures, which ultimately resulted in a depression. 

2. Inflation

There are many examples in history, where economic depression goes hand in hand with (hyper-)inflation. Countries experiencing hyperinflation in present times that come to mind are Zimbabwe and Venezuela. The example I want to discuss further is Germany (Weimarer Republik) in 1923. After the end of World War 1 Germany had to pay massive reparations. Because the entire economy was destroyed and the state was completely broke, the central bank (Reichsbank) had to print large amounts of money. This increase in the supply of money, while at the same time the amount of goods produced was very low, caused one of the biggest hyperinflations ever recorded in a western nation. On June 9th 1923 1$ was equal to 100.000 Reichsmark. Six months later on December 2nd 1$ equaled 4.21 Trillion Reichsmark.¹ Finally there was a monetary reform and a new stabilized currency. The consequence was, that anything people owned in cash or cash equivalents became worthless. 

3. Deflation then Inflation

A further possibility is a depression, that is caused by a combination of deflation and inflation. In such a scenario an exogenous shock would lead to deflation and a collapsing economy. States intervening by printing money in order to stop deflation could then lead to massive inflation in the end.