It’s no good just writing scenarios.
You have to supply the flags that would suggest you are moving from one scenario to another.
Moreover, as the flags go up or down, you must adjust the probabilities that are assigned to each scenario.
This means continually assessing the changes in the environment around you 24/7.
For example, in late 2006 the world was still firmly in the Long Boom scenario on the right of the global gameboard illustrated below:
But we identified one flag that – if it rose – would signify the end of the boom. The flag was a decline in asset values in the US, particularly property and equities.
Our reasoning was that American consumers were borrowing more to spend more, and the only reason they could borrow more was because they were worth more. If their assets started diminishing in value, that game would come to an end.
Furthermore, since American consumers are two-thirds of the US economy, and the latter is 30% of the world economy, a halt in consumer spending in America would precipitate a global Hard Times scenario (pictured on the left of the above gameboard).
In January 2007, the official US property index started falling, and by mid-year, with that flag half up, we were giving a 50% probability on a shift from Long Boom to Hard Times.
When the stock market turned later in the year, we upped the percentage to 80%. By December 2007, we were saying to clients that, according to our analysis, 2008 would most likely be a horrid year.
Indeed it was, and the globe moved firmly into a Hard Times – classic recession – scenario the like of which has not been seen since the early 1980s. We missed the flag of toxic debt, but our motto is: “it is much better being vaguely right than precisely wrong”.
So what are the scenarios and flags now? There are two exits from the Hard Times scenario (see diagram below). The first is a recovery along the lines suggested by Ben Bernanke and Barack Obama, where green shoots will proliferate in the remainder of 2009 and lead to a mild recovery in 2010.
By 2011 we’ll be back in the game, but it will be a new game that we call New Balls Please. Credit will not be as easy to obtain as it was in the Long Boom; banks will be more heavily regulated; the East will be the economic equivalent of the West (a historic moment, bearing in mind that the West has dominated the global economy since 1400); and a new technology will propel the new game, probably around new energy sources and energy savings, given the importance of addressing the issue of global warming.
The flag for this scenario is a continuous improvement in US property prices over a period of at least three months. Another clear flag would be a drop in the US unemployment rate. Neither flag has risen as yet, but commentators are already talking about a bottoming-out of the property market, while the monthly figure of jobs lost is now declining.
We therefore accord this scenario a 60% probability despite no clearly visible positive signs. Some of you reading this article may vote for a lower figure, but this is the whole point of our methodology – to get people debating not only the selection of the flags but also their estimate of each scenario’s probability.
The second exit from Hard Times is a much more sinister scenario called Perfect Storm, which is also depicted on the above gameboard. It is a protracted recession or depression resembling a ‘U’ rather than a ‘V’.
The 1930s were an obvious example, but in a way Japan has been in a similar scenario since 1990. It is sobering that the Dow Jones Industrial Average only recovered the peak it had reached before the 1929 crash in 1954. Likewise the Nikkei is still around 25% of its December 1989 peak.
We have four flags to indicate the approach of a Perfect Storm. The first is the intensification of protectionism in the form of trade barriers that would fragment the global market a great deal more than we see today. The second is a major war to stop nuclear weapons ending up in the hands of terrorists – or, if they do, a nuclear strike on a Western city as envisaged in our letter to Mr Bush in June 2001.
Obvious candidates for a war are Iran, which has nuclear ambitions, and Pakistan, which already possesses nuclear warheads. Whichever, it would be much larger than Iraq and sorely test America’s already overstretched budget. Bad economic times make for a divisive world: Hitler would never have ascended without the Depression. Moreover, North Korea is once again a problem.
The third flag is a national bankruptcy of note. We have already had Iceland, but if a European Union member went down (e.g. Hungary, Poland or Ireland), the event would severely disrupt the international monetary system. The fourth is a meltdown in China where the halving of the economic growth rate triggers widespread social unrest, possibly causing a switch from outward-looking to inward-looking government policies. China becomes a brake instead of an accelerator on the world economy.
Hybrid scenario
None of these flags is flying at the moment, but the probabilities of one rising in the near future are growing. At present, we accord a 40% chance to the Perfect Storm, which is significantly up on the odds we were giving at the beginning of the year.
There is also a hybrid scenario, where we have a V-shaped recovery but it proves to be a False Dawn. The flag is an increase in the American inflation rate without any reduction in debt during the recovery process. As interest rates rise to compensate for the higher inflation, so do the loan defaults (yet again) and we have a repeat of the present recession.
Only it is a much deeper one. Consequently, the flags that differentiate New Balls Please from False Dawn are a significant decline in America’s total debt-to-GDP ratio and a decline in its household debt-to-income ratio. If pressed, we would split the 60% probability of a ‘V’ outcome equally between these two scenarios.
To summarise then, we give a 30% chance to a long-term sustainable recovery, a 30% chance to a short-term (say 5-year) recovery followed by another crash, and a 40% chance to no recovery at all. We hope this informs people sufficiently to calibrate the size of the bet they are prepared to take as a proportion of their own individual wealth or the wealth of their companies.
It’s all about weighing up the impact of each scenario in terms of the potential for profit or loss and then, on the balance of probabilities, deciding on a strategy that matches your risk profile.
Good luck, watch the flags and be prepared to adapt your strategy if the probabilities change (or a new scenario emerges). No other approach can handle the sheer unpredictability of the future and the volatility of the markets today.
South Africa: A good place to be
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A nice piece of news in May 2010 is that South Africa is now ranked 44th out of 58 in the Premier League. It is a shame that Zimbabwe has not made progress, as a change for the better there would be a very positive flag for South Africa. Nevertheless we have stuck with the probability ratio of 70:30 for the Premier League and Second Division.
Some members of our audiences criticise us for being too optimistic and put forward the flags of violent crime, corruption and a possible split in the ANC as reasons to invert the ratio to 30:70. Our response is that it is quite in order for them to disagree with our odds, but then their future behaviour must be consistent with the odds they apply.
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