Two scenarios – the big picture

Admittedly, no one knows what the future holds.

But that doesn’t mean we just shrug our shoulders and stumble blindly on whatever comes next. We can consider the possibilities, mapping higher (and lower) possible outcomes, and different maneuver scenarios. We can reflect on how recent history has led us to present conditions.

Let’s think of two possibilities: something in which many things go right, and one in which most of them don’t (avoid the unlikely extremes). Our expectation is that it will actually end up somewhere in between the two. This is the highest possibility but any point along the spectrum between the two extremes is a viable possible outcome.

There are endless challenges facing America and the world, but let’s look at the 5 biggest: inflation, war, recession, Covid, and market volatility. There are dozens, any one of them – Monkey pox! – It could turn into something terrible. But for our purposes, let’s stay with those five.

Consider what a plausible best or worst-case scenario might look like:

Scenario 1: Everything is going well: The pandemic that shut down the global economy in 2020 has finally run out. In the United States, we achieve herd immunity when more than 70% of the population is vaccinated and boosted. The vaccine is approved for children under the age of five, and most parents get their children at the behest of pediatricians and schools (it turns out that children have been a significant vector of transmission). With so few potential new hosts, the epidemic is burning itself out.

Life begins to normalizeIn economic terms, the country is returning to an economy that is more service-oriented and less dependent on goods. The side effect is the untangling of many supply chains. Semiconductors are seeing an increase in production, which increases the supply of new cars. Price increases have already peaked, and across a range of commodities, they are trending lower. Home prices are stabilizing and beginning to decline modestly, as more single-family homes are built and multi-family apartment buildings are completed.

The Fed knows that the worst of the price hikes are already behind us, and so they are changing their tone from fighting inflation to zeroing in and normalizing monetary policy. After an increase of 50 basis points in June, it rose by 25 basis points for the rest of the year. Federal funds expire in 2022 at 2% and stay there for years to come.

Russia begins to realize the futility of their war – either Putin declares victory and withdraws, or he is forcibly removed by insiders. Within three months, oil prices drop by 30-40%. Hungary was expelled from NATO, paving the way for the accession of Sweden and Finland.

The market ended the year almost flat (say, up 5% down 9%), which is a huge victory considering how much fear there is. The VIX volatility index drops lower to the mid-20s. The Nasdaq has underperformed, but still accounts for more than half of its peak-to-trough losses. With much of the surplus trimmed, the technology indicator isn’t cheap, but it’s much less expensive than it was before the patch.

Scenario 2: Everything is going well: From Delta to Omincron to BA2: Covid continues to mutate, including the most serious and deadly variants. Rolling shutdowns fail to contain outbreaks. Florida refuses to cooperate with the CDC/NIH and remains the nation’s super-feeding region. Hospitals are filling up, and the US suffers another 1 million deaths.

The pandemic is going poorly and preventing the supply chain from untangling. To make matters worse is China’s zero-Covid policy. The industrial capital of the world is stagnating, and shrinking for the rest of the year. Due to the inability to provide basic commodities, the shortage of almost everything becomes acute.

Including food and energy: the Russian invasion of Ukraine has become a torch, an endless war of attrition: Ukrainians are fighting the invaders, funded and supplied by Western proxies. Ukrainian food production declined, as did Russian energy exports. China buys all of Russia’s production, which keeps prices high and makes Russia payable enough to continue the war. Oil goes up to $200 a barrel, and gasoline goes up to $9 a gallon in the US.

The Fed continues to raise interest rates, although the impact of previous increases has been reduced. At 5% fed funds rates, the US has already entered a deep recession, but rates are still high. Stagflation dominates the headlines.

The combination of lockdowns, inflation and stagnation causes markets to deteriorate. The S&P500 is down another 35% around 2500, and the Nasdaq is cut in half from here to below 6000. The VIX rises to 50 and then 60, eventually accepting 70

Possibilities: Given all these potential variables, it is impossible to predict with confidence what will happen by the end of the year.1 My wishful thinking is that we finish 2022 closer to Scenario 1, which requires a few things to go right while avoiding some potential disaster. A lot has to go wrong for Scenario 2 to happen – it’s highly unlikely, but not impossible.

I would put the odds from best to worst in something like this:

Great! 20% Thread the needle as inflation fades, war and pandemic end, market volatility ends, and indicators recover. The Fed breakup is perfect and they stick to the downside.

good! 30% Soft landing and no stagnation. There are a few sectors in decline, but overall, the economy remains strong. Turns out, inflation is temporary after all.

Meh! 20% Hard landing: The pilot left the plane to the terminal, and we’re thankful things weren’t worse. Perhaps a mild recession or flat GDP is causing concern, with unemployment rising from 3.6% to 5%. Inflation is receding, but not as much as hoped.

bad! 20% Only a few issues are resolved, but most of them don’t. Recession drives unemployment to more than 6%, but inflation remains mostly intractable.

distasteful! 10% Everything goes to hell at once…

About half of my scenarios (in percentage terms) are very good, and the other half are not so good.

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When thinking about the future, we must know what the possible outcomes are, what outliers are, and consider the most likely outcome.

Approaching the world in this way is not only realistic, but a healthy way to think about risk and reward.

Previously:
Nobody Knows Anything, Kentucky Derby Edition (May 9, 2022)

Surrender Guide (May 19, 2022)

Secular vs. Cyclical Markets (2022) (May 16, 2022)

The transition period is taking longer than expected (February 10, 2022)

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1. If enough predictors make the guesses, one will be right by chance, which gives him a chance to take advantage of random luck.

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