For some, the idea of another economic depression on the scale of the 1930s seems impossible. But here’s a shocking statistic—with debt-to-GDP around 300% and an average global interest rate of say 2%, we need 6% nominal GDP growth indefinitely just to break even. I’ve written before about why the next market downturn could be one of the worst in history. Just as pilots spend a lot of time training in a simulator preparing for challenging events, it’s important for investors to mentally rehearse what they will do when the markets end up in a tailspin.
The first step is to acknowledge the risks. Debt creates fragility that leaves us prone to two major risks: inflation and deflation.
The Deflationary Scenario
In a deflationary scenario, the price of goods comes down usually due to overcapacity built during an overly optimistic period (think real estate in the mid-2000s and oil recently.) With too much competition, businesses struggle to maintain pricing power, and as revenues decrease, there is a smaller profit pool from which to pay wages. This creates a downward feedback loop of less spending and less earning, driving prices lower and lower.
In our current environment, there is another factor: debt. There is already too much of it in the world. With deflation, everyone (governments, corporation and individuals) would have less income to pay off their debts, and some percentage of borrowers wouldn’t be able to repay, therefore defaulting. And since one person’s debt is another person’s asset, the lender must write off the loan and take a hit on their balance sheet, further depressing their income. Theoretically, this downward spiral could go on until the economy fell apart, and in the Great Depression, prices fell about 25% before they started stabilizing.
From an investment standpoint, anything fixed that actually gets paid back does well during a deflationary period. For example, if you hold cash or a high-quality bond, as the price of goods drops, those assets become more valuable in real terms. As a general rule, when facing deflation, good investments are cash and bonds, and poor investments are stocks and commodities.
The Inflationary Scenario
Inflation is usually caused by governments printing too much money and/or when some resource (i.e., labor or capital) becomes scarce relative to current economic growth. With more money chasing a limited amount of goods, prices go up. Once this trend starts, fear of ever-increasing prices can accelerate the process.
Inflation can act like a debt jubilee, as the real value of debt falls dramatically. It creates winners and losers indiscriminately. Think of it this way: if someone owes you $1,000 in 10 years, but we have 20% inflation per year, that $1,000 you’re due is only worth about $161 when it’s paid back. The people who were prudent savers get punished (because their savings are worth less), and the people who were spendthrifts (like many governments around the world) get the reward of unshouldering their debt burden at a fraction of the cost.
Facing inflation, anything fixed, like bonds, can become worthless. Commodities, like gold, are a hedge on inflation, and any equity investment that can pass through inflation to its clients can be a good hedge, if bought cheap enough. From an investment standpoint, poor investments are cash and bonds, while good investments are commodities and stocks (bought at low prices) of companies with pricing power.
Managing the Downside
The worst case scenario is not necessarily just what happens to the investor’s holdings; it’s also a consequence of what the investor does when we hit air turbulence. In the beginning of a severe recession or depression, credit markets are strained as we realize a lot of people can’t pay back the mountain of debt we’ve accumulated globally. As the write-offs accumulate, it causes deflation, which in turn causes most risk investments to suffer, inciting people to run towards the safest bonds and cash.
Concurrent with a mass rush into fixed “safe assets,” the central banks of the world react, not wanting a repeat of the deflation we experienced during the Great Depression. As their massive reactionary money printing takes effect, we go from a period of deflation to high inflation. This whipsaw could be devastating to the average investor who, now “safely” in fixed assets, sees their purchasing power decimated.
Thinking through appropriate reactions to stressful situations is the best way to condition yourself so that when bad events come—and they will—you don’t panic and let emotions overwhelm what you know you “should” do. Everyone needs a game plan that accounts for at least an average-to-severe downturn.
If you don’t know where you stand or how to balance these risks, you need the help of a competent advisor. Check out my article on finding a financial advisor who is right for you. Taking full stock of the amount of debt in the world, this is a time for preparation. There’s no way of knowing with certainty what the future holds, but with support and planning, you can ensure your portfolio weathers the really bad days.
And worst case scenario, you’ll be a prepared investor.
Loic LeMener is a registered representative of Lincoln Financial Advisors Corp.
Securities and investment advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. Opus Wealth Management is not an affiliate of Lincoln Financial Advisors Corp.
Statements, opinions and forecasts made represent a particular observation and assessment of the market environment at a specific point in time and are not intended to be a forecast of future events or a guarantee of future results. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended. Statements regarding future prospects may not be realized and may differ materially from actual events or results. Past performance is not indicative of future performance. CRN-1628469-102616.
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