Scenario Analysis

Unfortunately, although naturally clever, human beings as not innately wise, especially in crowds.

Immoderate Greatness, William Ophuls, 2012

THIS IS NOT INVESTMENT ADVICE. INVESTING IS RISKY AND OFTEN PAINFUL. DO YOUR OWN RESEARCH. 

Today, I want to focus on the two biggest economies in the world, the US and China, both the most likely path and possible alternative scenarios.  My goal is to find the fastest path to a double digit return with as little risk as possible and I can’t do that without have a read on the US and China. Sometimes knowing what to avoid is as important as what to own.  

My central case:

a) Lower US real yields. 

Before Covid, which seems forever ago, the big problem was the private sector did not want to borrow money. That’s why real yields collapsed, globally. Below is the chart of US real yields. Note that real yields were negative before the pandemic. That means the private sector was paying the government to borrow money. Crazy, but true. It looks similar in the rest of the world. 

This private sector de leveraging followed the 2008 credit bubble. Just like after the 1929 Great Depression, the private sector became debt averse. I think of my father, who grew up during the Depression. It stuck with him; he kept his savings in cash. In 2008, we all learned that home prices could be as volatile as the stock markets. Households have been reducing debt relative to income for more than a decade! Corporations were borrowing, but not excessively, as you can see.

Then came a global pandemic. Faced with collapsing economic activity, uncertainty about vaccines, and negative real yields, governments borrowed heavily and spent. At the time, it made sense. Then came the supply chain problems and inflation exploded. Central banks cranked up interest rates, which is why the real yield in the first chart above is now 1.6%. 

But inflation has receded fast, from 9% to 2% in the US, and is now sliding toward 1% in Europe. It is reported to be around 0% in China but I suspect it is actually negative. This decline in inflation occurred without any meaningful credit or growth shock because most of the US debt was hedged. This also means inflation essentially came down on its own, an important clue and, possibly, interest rate hikes had little to do with inflation coming down at all. Perhaps the economic structure itself is disinflationary. It also may mean that the expected slowdown in growth isn’t happening, which is perhaps why unemployment remains so low, as we found out with today’s employment report.

Part of this disinflation is because the internet allows us to price shop more easily than ever. Part is remote work allowing us to have a workforce split between Ukraine, Kenya and the US, driving down salaries. Part of it is that the private sector does not want to borrow heavily. AI is accelerating this process. To me, it suggests the pop in real interest rates is a temporary aberration and a friend to the saver.  

It’s also forced me to rethink US government deficits. I had initially thought these massive (6%) deficits would drive up interest rates. But increasingly I think that the government borrowing is stopping rates from falling faster than they already are. Maybe in a world where private sector borrowing is weak, 6% budget deficits are easier to finance than you might first think. The debt clears at less than 4%.

b) Higher US tech stocks. 

Essentially, valuation is not extreme and the potential for a boom is high across an entire range of industries (from outsourced services to drug discovery to warfare). The PEG Ratio (the PE relative to the earnings growth rate) is below the recent average. The PE is a little high, but not extraordinary. While there is a lot of talk about a transformative change, there isn’t that strong an expectation of it occurring as reflected in discounted prices. These stocks all roared higher earlier in the year but have been sideways since even as earnings grew. Fast earnings plus steady prices = lower PEG ratio.

c) Avoiding Chinese assets.

At this point, I am neither long nor short on China. I am out. What stands out to me is that China’s policy interventions are attacking the symptoms of the problem, but not the problem (a deflationary deleveraging) itself. De-leveragings are hard to combat and in all cases (US, Europe and Japan) monetary policy alone does not work. In China’s case it would take a large fiscal borrowing, like $1 trillion, and then buying up the bad assets, which are enormous, and forcing money into the system. Getting the private sector to respond is that much harder given the political overlay. People are rattled. Chinese households have savings but a combination of politics and the decline in assets during Covid (where they did not get fiscal support) is making them very risk-averse for a good reason. To be sure, it’s possible Chinese stocks leap higher Monday morning again. But this is either a speculative frenzy or a bet that China will fiscally stimulate even if they have not so far. There is nothing meaningful in the stimulus to date to boost corporate earnings, so I am watching.

Other scenarios

The above is the central case, but there are a lot of scenarios we need to consider. 

1.        The US election. There are four outcomes, an R sweep or a D sweep, R win and split Congress or D win and split Congress.

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