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. 

1. https://www.planet-wissen.de/geschichte/deutsche_geschichte/weimarer_republik/pwiediehyperinflationvon100.html

Economic Scenario 2: Recession

Economic Scenario 2: Recession

The second scenario that could possibly happen is an economic recession. A recession is characterized by a sustained economic decline, which manifests in two consecutive quarters of negative GDP (Gross Domestic Product) growth. Furthermore, the time line for a recession is usually between one and three years. An example of this is the last recession in 2007/ 2008. The high of the market was formed  in October 2007 and the lowest point of the decline was reached in March 2009. So the entire down move lasted for one and a half years. This falls exactly within the timeline we established earlier and if the corona virus was to start a recession we would expect a similar timeline.

There are a couple of aspects, that could prevent a quick recovery and aid the economy going into a recession. First of all, interest rates are already at, or very close to zero percent in the US and Europe. Because of this Central Banks have less options within the realm of monetary policy. They can’t lower interest rates as they did in 2007/ 2008. Before the start of the recent decline in the markets the FED, contrary to the ECB, had some room left to lower interest rates, but they immediately used this option at the beginning of the downturn. The only option left to central banks is the use of direct monetary stimulus. Among these options are the use of helicopter money as well as lending directly to companies in need. However, even the effect of these direct stimuli is highly controversial among economists, especially for high public debt ratios. Nickel and Tudyka find: “From a policy perspective, these results lend additional support to increased prudence at high public debt ratios because the effectiveness of fiscal stimuli to boost economic activity or resolve external imbalances may not be guaranteed.”* Ironically this paper was published by the ECB, the same institution that has been relying on the use of stimuli for years. 

Interest rates already being at zero and the possible ineffectiveness of stimuli in the context of high public debt ratios massively limit the effectiveness of the central banks. These are also factors favoring the scenario of a recession.

Another aspect to consider is the virus itself. If the corona virus was to appear in waves over a couple of years, as the spanish flu in 1918 did, it might be necessary to disrupt supply chains for much longer than we assume at the moment, thereby also sending the economy into recession. 

*https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1513.pdf

Economic Scenario 1: Quick Recovery

Economic Scenario 1: Quick Recovery

Quick Recovery

This scenario most people tend to forget. You only hear the media talking about the crash and companies that might experience difficulties because of the Corona Virus shock. However, a quick recovery, with a timeline of a couple of months, is definitely on the table. Most of the losses in the S&P 500 could be recouped, even though we probably won’t be at new all time highs soon. In this scenario the government provides aid to especially affected companies. Also, this scenario can be fueled by a decline in the number of infected people due to quarantine in many parts of the world. China is already reopening Hubei province and picks up production in their factories. 

Moreover the quick passing of a $2 Trillion stimulus bill by the US government could stabilize markets and initiate a recovery. The bill consists of a loan program for small businesses, an aid fund for cities and states and the use of helicopter money. Many Americans will receive checks directly from the government, thereby creating demand and stimulating the economy. However, only time will tell if this stimulus really has the effect politicians hope it will.

Finally we can conclude that an economic recovery over the course of the next months is a possibility. Also we should not get too pessimistic about the future. Even though the virus outbreak is a huge catastrophe this, too, shall pass.

Corona Crisis: Economic Scenarios

Corona Crisis: Economic Scenarios

Stock markets have dramatically gone down over the course of the past few weeks and investors are highly uncertain about the future. Long term investment strategies, like Compound Investing, can profit a great deal in volatile times. Using low prices to buy has a huge positive impact on the strategy’s return over the next years. However, times like these can also lead to bad decisions, because experiencing losses evokes a strong emotional response. In order to avoid such a response I will publish a series of posts on possible economic scenarios. Finally the goal is to provide the reader with a broad range of future scenarios. That will enable him to maintain an open mind and not freeze in light of his fear of an economic depression.