Two Scenarios (out of 5 probable ones)

 

 

It’s a given that no one knows what the future holds.

But that does not mean we merely shrug our shoulders and stumble blindly into whatever comes next. We can consider the probabilities, map out higher (and lower) possible outcomes, and wargame various scenarios. We can ponder how recent history led us to the present circumstances.

Let’s consider two possibilities: One where many things go right, and another one where most do not (avoiding unlikely extremes). Our expectations are that reality ends up somewhere in between the two. That’s the higher probability but any point along the spectrum between the extremes is a viable potential outcome.

There are endless challenges facing America and the world, but let’s consider the 5 biggest ones: Inflation, War, Recession, Covid, and Market Volatility. There are dozens more, any one of which – Monkeypox! – could spiral into something awful. But for our purposes, let’s stay with those 5.

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

Scenario 1: Everything goes right: The pandemic that shut down the global economy in 2020 finally runs out of steam. In the US, we achieve herd immunity when more than 70% of the population is vaccinated and boosted. Kids under 5 vaccine is approved, and most parents get their kids immunized at the urging of pediatricians and schools (it turns out children were a huge vector for transmission). With so few potential new hosts, the pandemic burns itself out.

Life begins to normalize: Economically, the country returns to a more services-oriented and less goods-based economy. The side effect is an untangling of many supply chain snafus. Semiconductors see a ramp-up in production, which increases the supply of new automobiles. Price increases have already peaked, and across a range of goods, they head lower. Home prices stabilize and begin to drift modestly lower, as more single-family homes are built and multifamily apartment buildings are completed.

The Fed recognizes that the worst of price spikes is already behind us, and so they change their tone from fighting inflation to getting off of zero and normalizing monetary policy. After a 50 bps increase in June, they go 25bps for the rest of the year. Fed Funds finish 2022 at 2% and stay there for years to come.

Russia begins to recognize the futility of their war – either Putin declares victory and withdraws, or is forcibly removed by insiders. Within three months, Oil prices fall 30-40%. Hungary is kicked out of NATO, paving the way for Sweden and Finland to join.

The market finishes the year nearly flat (e.g., up 5% to down 9%), a huge victory considering how much fear there was. The VIX volatility index drops to the low to mid-20s. The NASDAQ fares less well, but still makes up more than half of its peak to trough losses. With many of the excess squeezed out, the tech index ain’t cheap, but it’s much less pricey than it was pre-correction.

Scenario 2: Everything goes wrong: Delta to Omincron to BA2: Covid keeps mutating, including more dangerous and deadly variants. Rolling lockdowns fail to contain the outbreaks. Florida refuses to cooperate with the CDC/NIH and remains the nation’s superspreader feeder region. Hospitals fill up, the U.S. suffers another million deaths.

The pandemic runs amuck and prevents the supply chain from untangling. Making matters worse is China’s Zero Covid policy. The manufacturing capital of the world suffers a recession, contracting for the rest of the year. Unable to supply key goods, shortages of nearly everything become acute.

Including food and energy: The Russian invasion of Ukraine has become a slog, an endless war of attrition: Ukrainians fight against the invaders, funded and supplied by western proxies. Ukrainian food production plummets, as do Russian energy exports. China buys all of the Russian output, keeping prices high and Russia solvent enough to continue prosecuting the war. Oil goes to $200 a barrel, and gasoline rises to $9/gallon in the US.

The Fed continues to raise rates, despite the lack of impact the prior increases have had. At 5% Fed fund rates, the US is already deep in a recession, but prices remain elevated. Stagflation dominates the headlines.

The combination of lockdowns, inflation, and recession sends the markets into a nosedive. The S&P500 falls another 35% bottoming around 2500, and the Nasdaq gets cut in half from here to under 6000. The VIX spikes to 50 then 60, eventually kissing 70

Probabilities: Given all of these potential variables, it’s impossible to confidently predict what happens by year-end.1 My wishful thinking is that we finish 2022 closer to Scenario 1, which requires a few things to go right while avoiding a few potential disasters. A lot has to go wrong for Scenario 2 to occur – it’s improbable, but not impossible.

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

Great! 20%  Threading the needle as inflation fades, war and pandemic end, market volatility ends, indices recover. A perfect Fed dismount and they stick the landing.

Good! 30%  A soft landing and no recession. A few sectors are in retreat, but overall, the economy remains robust. Inflation turns out to be transitory after all.

Meh! 20%  A hard landing: The pilot taxis what’s left of the plane to the terminal, and we are thankful things are not worse. Maybe a mild recession or flat GDP makes people nervous, as unemployment moves higher from 3.6% to 5%. Inflation eases, but not as much as hoped for.

Bad! 20% Only a handful of issues work out, but most do not. A recession drives unemployment over 6%, but inflation remains mostly stubborn.

Terrible! 10%  Everything goes to Hell all at once…

About half of my scenarios (percentage-wise) are pretty good, and half are not so good.

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When thinking about the future, we should know what the possible outcomes are, what the outliers might be, and consider which are the more likely result.

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

 

 

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

Capitulation Playbook (May 19, 2022)

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

Transitory Is Taking Longer than Expected (February 10, 2022)

 

 

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1. If enough forecasters make guesses, one will be right by chance, giving them an opportunity to cash in on random luck.

 

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