Shock or crisis?

Recently, both Howard Marks in his latest memo and Cullen Roche on his Pragmatic Capitalist blog have touched on the question of how fast we are going to leave this crisis behind? Cullen makes the crucial distinction between a shock and a crisis. In a shock, some external event derails the market for a while, but it doesn’t cause a sustained decline in economic activity or a long-lasting recession. Instead, markets and the economy get back on their feet quickly, once the shock has been digested. Meanwhile, the typical cyclical downturn is slower to unfold and often the result of a previous boom like the tech boom in the 1990s or the housing boom in the 2000s.

If you look at stock markets, 2020 sure looks more like a shock than a crisis. The chart shows the MSCI AC World Index in 2020 in comparison to a typical shock episode (I used the 1998 Russia crisis and LTCM default) and a typical crisis (I used the 2008 financial crisis). Shocks create a more V-shaped pattern with a fast decline and a fast recovery, and this is the pattern we observed in 2020.

Stock markets during a typical shock and crisis and today

Chart, line chart

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Source: Bloomberg

And if you think about it, Covid-19 certainly wasn’t the result of the previous boom. It was the quintessential exogenous shock that nobody anticipated. Stock markets today are already in the process of betting on a vaccine in 2021 and thus price in a return to normal in the next 12 months. And that makes a lot of sense to me, which is why I remain in the bullish camp for now and expect 2021 and 2022 to be exceptionally good years for stock markets.

But I also acknowledge that it might take longer to roll out a vaccine than currently anticipated and – more importantly – this shock has been so big that it might trigger a long-lasting crisis. The economic decline due to the pandemic was so strong and in some industries like airlines, cruises, hotels, conferences, etc. it will be so long-lasting that it creates more than just a temporary shock. It creates a full-blown existential crisis that will change these industries forever. I am not going to shock anyone when I say that there will be many prominent business failures in the industries hardest hit by the pandemic – and probably some prominent failures in other industries as well. 

In the long run, this is good because it triggers the creative destruction that Hayek described as the regenerative process of capitalism. But obviously, this creative destruction also creates a lot of suffering in the short-term. And if the destruction and disruption are strong enough, it can spill over to the rest of the economy and create a full-blown crisis. Retailers, car manufacturers, and other businesses have already been struggling in the years before the pandemic hit. With consumption declining as unemployment rises, it could be that they are pushed over the edge.

I am hopeful that this won’t happen because governments have been willing to help with emergency loans in 2020 and seem to be willing to do so again in 2021 if needed. This hope means that my base case scenario is one in which this episode will go down as a classic shock, not a crisis. But I have to avoid being overconfident in that outcome. And that means being vigilant and continue to look for signs why things might turn out differently and we indeed slip into a crisis.