This is the third article in this series. First one was written in the end of March 2009. Market switched to a bull mode then and future seemed to be rosy. Next one was written in November of the last year. Future still seemed rosy, although a little bit darker. May of 2010 changed everything.
What happened in May? Europe woke up to the depression. They call it liquidity crisis, bank crisis, sovereign debt crisis. Wrong! This is full blown financial crisis, part of Great Worldwide Depression of 2008-?
Inflation and stagnation = stagflation
After last May, there is no possibility for this scenario. Inflation does not happen when banks don't lend. You can get inflation during crisis, but you still need banks to lend money for that to happen. Now banks in US and EU and many other countries just do not lend money. Worse, there are multiple reports from both US and EU that in many areas demand for loans is low, which means that banks can't lend more money even if they wanted.
Probability of stagflation any time soon: 0.
I wanted to believe it. Almost everybody wanted to believe it. US economy grew nicely in the second half of 2009 and in the first quarter of 2010. And in this scenario, we should be out of the woods already. But, again, May changed everything. Economy might still grow couple more quarters. But deep recession in Europe, which will definitely follow current financial turmoil, cancels the possibility. EU economy is as big as US one, when it goes down, it pulls down everybody, just like US. There might be tiny possibility that quick response from European governments and central banks can trigger quick recovery there, but I just don't see it. Instead of emergency spending, governments cut budgets. It's OK for Greece, with its bloated government sector, or maybe for Spain, but Germany, with relatively small sovereign debt, should not cut. They need emergency spending. There is always a way to spend money for a good reason. There are always roads to build and repair, bridges to rebuild, schools to improve.
Probability: around 5%, if we are lucky.
Great Depression 2.0
Here we are. This is just too much like version 1.0. Started in US, becomes full blown when Europe goes to pieces. Current scenario is different on one account only: neither US nor Europe is in the mood for trade wars. Which is great, because any kind of trade war between EU and US will make situation very bad very fast. Main problem: both regions are in deflation. And deflation was the main problem during Great Depression in 1930s. Latest information about M3 money aggregate in Euro Zone and US is awful. ECB and Fed failed, the last thing they should allow is falling money supply. Remember, what Bernanke said? That Fed can always increase money supply, having fiat money and printing press. So, where is the printing press when we need it? Or, as it happened during GD v1.0, every dollar coming from printing press goes directly to mattresses?
Probability: about 60%
Japanese disease (Zero growth with zero inflation or low deflation)
I still think this scenario has lower probability than GD 2.0. Maybe it's just my wishful thinking. Arguments against this scenario: US and even Europe are more dynamic societies than Japan, there is no habit of sweeping problems under the carpet and keeping them there for many years, voters kick out governments much faster etc. But there are arguments for this scenario as well. Demography: Population is not growing in Europe, it's falling in many countries, just like in Japan. Government sector is way too big in Europe, and government employees are not enterprising enough to pull countries from depression. US is different, our population is still growing, but mostly because of immigration.
Probability: about 35%
Most probably, we are in GS 2.0. It will last several more years. I hope that it will not end in a big war, like Great Depression did. In this case, and in case of ended Great Recession, the right investment behavior would be to buy stocks. Question is: which stocks? In case of Great Depression, best stocks are high yielders with relatively safe market. Tobacco, entertainment, food, cheap retail. In case of ended recession, it's fast growing companies, high tech first of all. The worst case scenario would be Japanese. In this case, the best investment is in cash.
I am going to change my portfolio this summer. Reduce or eliminate bond funds, leaving only bank bonds, because governments will not let majority of the banks fail. Add more high yield companies. Reduce weight of tech. And keep large cash reserves to play with opportunities.