Stalking the Specter

by futurist Richard Worzel, C.F.A.

In my last blog, “A Specter Is Haunting Europe”, I described the running crisis that threatens Europe’s financial markets and economy with potentially severe knock-on effects for the global markets and global economy. I got a very swift reaction from a number of readers: You say this global crisis is a matter of when not if; so what should we do to protect ourselves?

This is such a fluid and complex situation that I’d be foolish to respond – so, of course, I will. And let me start by quoting a conversation between Peter G. Peterson and Margaret Thatcher. Peterson was Secretary of Commerce under Richard Nixon, was a member of the Federal Reserve Bank of New York, and was co-founder and Chair of the Blackstone Financial Group until he retired in 2008. This comes from an interview he gave in 2004 to CFA Magazine in an attempt to get Americans to pay attention to the disaster hurtling towards us:

I got to know [former British Prime Minister] Lady Thatcher. I once asked her, “What do leaders talk about at the Group 7 meetings? Don’t they know that the age wave is about to hit?” She said, “Yes, Mr. Peterson, they all know that it’s coming. But their theory is, ‘It’s going to happen on somebody else’s watch, so why should I take the pain for somebody else’s gain’” That’s a sobering thought, that kind of generalized irresponsibility.”

In other words, the leaders of all major nations knew that the problems now besetting Greece and the other EU countries were coming, just as we know, today, that Canada and the United States will experience the same kinds of problems in the future. Yet, European leaders did nothing about the looming problems until the crisis hit. Even now, the leaders of the various governments cannot agree on what to do about them, even though they know what must, eventually, be done.

Why won’t elected officials act?

So, why won’t elected officials take action they know is necessary, especially when early action could have prevented the problems? Well, as one senior British civil servant is reputed to have said to his political master, “Yes, I can tell you how to solve the pension crisis, but I can’t tell you how to get re-elected afterwards.” Simply put, we, the voters, won’t stand for short-term pain for long-term gain, and this is reflected over and over in all developed country democracies.

Right now, Angela Merkel, Chancellor of Germany, should be moving towards some kind of commonly issued EU debt, and should pledge Germany’s support for the EU financial system. If Germany doesn’t act, and soon, to do this and more, then when the whirlwind hits the EU, German banks will fail, and probably take the German government with it, much as has happened with Ireland and Spain. But this would mean that a great deal of German money would flow out of the country to support lazy, shiftless Club Med members of the EU, and the German voters won’t stand for that. What’s more, if Merkel tried to get out in front of this issue and provide the leadership she desperately must, she would probably be tossed out of office, and someone who would say calmer, sweeter words to the electorate would be installed. This, indeed, is what happened in France, with that soothing M. Hollande replacing that awful M. Sarkozy (although Sarkozy had other flaws as well). M. Hollande’s hopeful, upbeat, palatable prescriptions, including lowering the retirement age that Sarkozy spent so much political capital raising, will now accelerate France towards the disaster looming ahead of it.

So things could be done, but won’t, just as things should have been done, but weren’t in Europe. In America, Congressional leaders and presidents have known for decades that Social Security and Medicare were financial disasters waiting to happen, but except for Senator Daniel Patrick Moynihan of New York (who died in 2003), none have had the courage to do anything about it as it might anger voters. The truth is that if the corrections had been made early enough, voters would barely have noticed, as few think about retirement until it’s close at hand. Indeed, the government of Canada, in conjunction with the provincial governments, dramatically revamped the Canada Pension Plan, counterpart to U.S. Social Security in 1996, and made it virtually self-sustaining, and there was little or no voter outcry.

So, with all the wasted chances behind us, and with the disaster certainly before us, what do we do to protect ourselves, our families, and, to some extent, our communities?

How do you prepare for the future?

The first, and by far the most important step is to accept that disaster could happen, and that you should have contingency plans prepared so you have thought through how to respond. If you insist that the world will continue with business as usual, then you will be surprised when the worst does happen, and will be unprepared for it. Indeed, many people will deny that it’s happening, even as it unfolds. An unfortunate part of the human psyche is to be unable to see things that are radically different, or that conflict with strongly held hopes or ideas. So, first, accept that disaster may be coming.

Next, think about what the early indicators of disaster would look like (“signs of the apocalypse”), so that if they appear, you know it’s time to fall back on your prepared contingency plans. In Europe, if one of Portugal, Ireland, Italy, Greece, or Spain is headlined as being in another crisis (although this is all really one, big crisis), and a last minute, desperation fix fails to materialize, that’s a bad sign, and you should put your finger on the trigger of your contingency plans. The same is true if a new country, such as Belgium, emerges as needing a major bailout. Ditto if bond yields for Spain, Italy, or Portugal consistently are near or above 7%. But if there’s a major rift between socialist-minded France and austerity-minded Germany, that’s a very bad sign, and you should definitely head for your prepared fallout shelter.

In America, if there’s a renewed confrontation between the Congressional Republicans and President Obama that can shut down the government, that’s a bad sign. By the way, there are two such confrontations looming: the lapsing of the Bush tax cuts plus the sequestering of government expenditures under the debt ceiling agreement reached last July, both scheduled for January 1st of next year; and the government reaching the new debt ceiling, which is scheduled to happen some time in the 1st quarter of 2013.

The first pair of problems, if unresolved, would cut spending and increase taxes at a time when the economy looks increasingly fragile. Some have estimated that both things happening at once could chop 5 percentage points off GDP growth for the United States, forcing it back into a renewed Great Recession.

A renewed fight over the debt ceiling might force the U.S. government into a historic default, which would panic the markets. And part of the reason it would panic the markets is that everyone thinks it can’t happen, that there will be an eleventh hour resolution, “just like last time.” But if Obama wins re-election, Republicans extremists just might decide to make it a poisoned chalice, and to hell with what it does to the country.

Risk Management

And this brings me to the next part of my prescription: risk management. First, let me provide my own definition of risk. In my view, risk is the cost of being wrong. To see this, imagine being required to walk across a 12 foot-long plank placed on solid ground. Now imagine walking across the same plank firmly lodged over a chasm with a 1,000 foot drop. The task involved is fundamentally the same, but the risks are not. In this case, the risk is the cost of making a mistake.

So, given the potential problems ahead (which I’ll return to in a moment), what are the risks, and what the rewards? Well, if a financial crisis or crises do occur, then it would almost certainly precipitate a global recession, and possibly one that would be much worse than last time. And if it’s bad enough, it could bring the entire banking system down, effectively freezing all funds you have in bank deposits or bank securities. The stock markets in such a case would crash in much the way they did after the 1929 crash. Everyone remembers the crash of 1929, when the Dow Jones Industrials dropped 48%, from 381.7 to 198.7, and then bounced upwards by 50% (which only returned them halfway to their previous highs – work it out for yourself). But the real investment disaster is the one that happened after the 1929 crash, when, over the two and a half years to the summer of 1932, the market fell to a low of 41.22 – down 79% from the 1929 low, and a whopping 89% from the 1929 high.

And what are the rewards if the problems are resolved, and life goes serenely on? Well, the stock markets could resume their upward rise. Let’s assume that they could even recover their all-time highs. The S&P 500 Index reached a high of about 1,575 in October of 2007, which would be a gain of better than 21% from where it is at time of writing (~1,300). On the other hand, what’s the potential downside? Well, if the market retraces to the March 2009 low of about 700, that would be a loss of more than 50%. And if the 1932 precedent were to prove more appropriate, you could be looking at much more than that. So the balance of risks seems clear: gambling a potential gain of 20% against a potential loss of between 50% and 90%. Worse, if the worst happens, it will also carry an economic sting with it: you or others you care about might well be out of a job.

Risk Scenarios

We truly don’t know what will happen with these crises. Fortunately, there is a toolset that is designed for precisely this kind of situation called scenario planning. Instead of predicting one future, and betting everything that your prediction is right, you anticipate a number of possible futures, and have a series of contingency plans prepared to deal with them. Indeed, scenario planning is the step before contingency planning, in which you decide which contingencies to plan for.

Before I propose a range of possible scenarios, though, it’s important that I add that none of these scenarios will turn out to be the exact future that happens. Whatever scenarios you create, you will always miss some important aspects of the future. That’s perfectly OK; the purpose of scenario planning is to prepare your mind for a range of eventualities. When something does happen, you are then much better prepared to accept it, and respond constructively to it than you would be otherwise.

Scenario 1: Fairy Godmother Saves the Day!

I would rate this scenario as possible, but unlikely. Too many things have to go right, and too many people have to take decisive, and painful, actions for this scenario to happen. But it should be considered because (a) it is possible, and (b) it’s the scenario that most of the world wants, and therefore believes. It would go something like this:

The EU nations come to an overarching agreement on a bailout mechanism for all of the PIIGS, plus others besides. Such an agreement would include at least a limited economic union, plus some form of banking union so that all EU, or at least all euro-area banks would be supervised and supported centrally. Eurobonds would be issued under the joint-and-several liability of all euro members, and proceeds used to bail out economies in trouble on a carefully defined and limited basis, and with thick strings attached. Germany would get what it wants in terms of austerity measures in the medium-term (three years and beyond), while France would get what it wants in terms of short-term stimulus to encourage growth. Economic growth would pick up in response to the more favorable financial situation, and the repairing of the creditworthiness of the euro-area nations.

Meanwhile, America’s economy begins to pick up again. The November, 2012 elections are resolved in such a way that confrontation is avoided between Congress and the presidency. The tax cuts are extended, spending cuts are spread out over three years instead of happening all at once on January 1st, and a credible, long-term financial plans is created that includes postponing or trimming many entitlements, increasing some taxes, and placing limits on spending growth on defined government programs, including social welfare and defense.

Developing nations see their growth pick up in response to the positive developments in the OECD nations, and this further adds to the growth rates in developed countries. A synergistic virtuous cycle emerges, and inflation begins to become a concern.

Recommended actions: once critical agreements are in place, invest in American stocks, the bonds of the weaker euro-area economies, and natural resources, which will rise as demand from developing countries rises. Sell gold & precious metals.

Scenario 2: The Medium-Bad View

In late summer or early autumn, two or more countries crash out of the euro (perhaps Greece and Portugal), and at least one of them defaults on its debts. There is a market panic from investors who thought it wouldn’t happen, that somehow, someone would fix things but didn’t. Coordinated action by virtually all of the world’s central bankers stem the panic and secure the European banks that are too big to fail, although some of them have to be bailed out.

Then, following the U.S. elections, there’s a confrontation between Congress and the President, leading to another round of brinksmanship. This time, all major rating agencies drop their AAA rating for U.S. debts, reasoning that the political risk of default is unacceptably high, no matter how economically strong America may be. This, once again, triggers a market panic, which forces the two branches of the American government to come to a last-minute resolution that none of them likes, but which they can sell to the markets. This time, several major American banks go bust, and this time the shareholders, boards of directors, and senior executives have to give up everything, including jobs, stock options, bonuses, and the banks go through bankruptcy – to secure the bailout funds and protect the small depositors.

The markets plummet, but recover from the euro debacle, then, just as they’re starting to recover, plummet again when the U.S. crisis hits. They finally reach equilibrium at about half the highs they reached in the summer of 2012, then bump along the bottom, going nowhere, for months, mostly because the global economy has gone into a serious slump, with prolonged recessions in North America and Europe. The Canadian housing market finally cracks, and suddenly it’s Canada’s turn for a housing and banking crisis, and a more severe recession that it dodged in 2008-09.

Recommended actions: Sell all stocks, buy precious metals early, and hold cash in small enough deposits that they are covered by deposit insurance. When things stabilize, buy the stocks of solid companies, probably in America, that sell necessities, and pay reasonable (but not outsized) dividends.

Scenario 3: Armageddon

By late autumn, the euro-zone and the EU as a whole collapse in acrimony and recriminations as several members, including Spain and Italy, go into default on their debts, and there’s a run on French bonds that continues, forcing M. Hollande to recant his socialist principles and plump for devastating austerity in an effort to cajole the markets into preserving the Republic. The Canadian housing market collapses, and the Canadian banking system is narrowly saved by prompt action by the Canadian federal government and the Bank of Canada, with assistance from the U.S. Federal Reserve and other major central banks.

Obama is re-elected, but much weakened, with an even more extreme Republican party now in firm control of the House, and tenuous control of the Senate. By January, Republican leadership decides to caponize the president, and in exchange for an increase in the debt ceiling, demands that the Bush tax cuts be made permanent, and that all entitlements and social programs be cut by enough to allow it to rescind the cuts to the Pentagon’s budget. President Obama attempts to find a negotiated middle ground, but fails, and finally refuses the deal. American defaults on its debt payments, compounding the market problems arising from the European mess and throwing all global markets into a flat panic.

This time, all the world’s central bankers cannot stop the persistent runs on commercial banks and questionable sovereign credits. Most banks go bankrupt, markets crash to 30% of their previous highs, and massive numbers of people in the developed world lose all of their savings and investments.

The global economy goes into a persistent depression of indefinite length. Unemployment reaches levels not seen since the 1930s, and even the developing countries see the gains of the last decade virtually wiped out.

Recommended actions: Cash your investments (bonds as well as stocks) out early, put your money in cash deposits covered by deposit insurance. Buy precious metals early, both on paper, and in coins and bars. When it looks like the crisis is about to peak, withdraw your money from the banks to protect from bank closures, find a defensible farm somewhere, buy books on medicine, growing food, and read up on your survivalist literature. Pray there isn’t a World War at the end of this depression.

Conclusions

I find the first scenario least likely (perhaps 20% probability), the second most likely (I’m guessing a 55% probability), and the third in between, possibly at a 25% probability. And of course, there are other, more nuanced possibilities as well that I’ve glossed over in the interests of time (I’m about to go on an extended trip overseas, but wanted to finish this first).

I’ve proposed the recommended actions for the third scenario with more than a dash of whimsy, but that’s mostly because I truly don’t know how anyone can protect themselves from a world-wide melt-down! I do know that in such a world, cash is king, and you will be able to buy things at enormous discounts – but only if you have cash.

Many will say I’m being alarmist. Perhaps so, but do your own risk management. What is the upside here, and what the downside? If my analysis is too negative, how do you think it could happen, and what do you think the alternative scenarios are? Who has to do what for your scenarios to come to pass, and how will markets react to them? What’s most important is not that you agree or disagree with my views, but that you think through the varieties of things that can happen, and are at least prepared to act if they come to pass.

And good luck. It promises to be a wild ride.

© Copyright, IF Research, June 2012.