A Black Swan Pandemic: Analyzing the Impact
Published 02-28-2020, by Jeff Garden, CFA®
People often ask us, “What’s the next black swan event?” The question, though seemingly straightforward, is a loaded one: if we knew what the next black swan event will be, it wouldn’t be a black swan.
According to former options trader turned philosopher Nasim Taleb, a black swan event explains one of the three following conditions:
- The disproportionate role of high profile, hard to predict, and rare events that are beyond the realm of normal expectations in history, science, finance, and technology.
- The non-computability of the probability of the consequential rare events using scientific methods.
- The psychological biases that blind people, both individually and collectively, to uncertainty and to a rare event’s massive role in historical affairs.
The most recent reaction in the financial markets to the ongoing spread of the coronavirus certainly fits the descriptions of a black swan event. February 27, 2020 marked the S&P 500’s worst day in 8 1/2 years as the market tumbled and posted a -4.4% return closing at the low for the day. Since its peak on February 19th, the S&P 500 has declined in value by just over 12%.
Across the pond, the Eurostoxx 600 index dropped -3.8% and the British FTSE 100 fell -3.5%. All the while interest rates have collapsed all along the curve, most notably, the United States 10-year treasury yield that reached an all-time low of 1.2%. Given the current state of affairs, two key questions come to mind: first, how bad will this get? Second, how long will it last?
How Bad Will This Get?
As with all black swan events, it is extremely difficult to quantify the expected impact of the coronavirus on the global economy. In fact, the most recent reference point available to us is the 2003 SARS outbreak. During the SARS outbreak, the S&P 500 declined by about 9% between January 1, 2003 and March 11, 2003. While the U.S. participated in declines, it was other countries that bore the brunt of the SARS virus’ impact. According to some estimates, the SARS virus temporarily destroyed about $40 billion in global market cap. At first glance, the comparison is obvious – both outbreaks began in China, the viruses themselves belong to the same category, and both have wreaked havoc on the markets. But there are some very significant differences that need to be considered.
First and foremost, during the SARS outbreak, China was still only the sixth largest economy in the world. Today, it is second only to the United States. This places China in a completely different position relative to the previous outbreak. This time around, China is clearly one of the primary drivers of growth around the globe. According to the World Bank, in 2003 China accounted for just over 4% of global GDP. By 2018, China’s contribution to global GDP was up to 16.3%.
The ramifications are clear – China’s status as a major global economic power means that any effect the virus has on China’s economy will impact the global economy much more than it did during the SARS outbreak. As such, the extent of the damage that the virus will do to the global economy and the equity markets will depend on the severity and duration of the outbreak. Given the impact that the Chinese economy now has on the rest of the world, it is fair to deduce that all other factors being equal, the impact of the Coronavirus will be more severe than that of the SARS outbreak. How much more severe is a far more difficult question to answer given that many other factors need to be accounted for, including the fact that the global economy itself is far larger than it was in 2003, how quickly the outbreak is contained, and the effects that the virus has on exports and economic production from other countries should it spread more aggressively than it has thus far.
How Long Will This Last?
How long the market stays in correction territory will also depend on additional factors, some of which have nothing to do with the virus itself. During the SARS outbreak in 2003, the market declined steadily over the first 2 1/2 months of the year only to completely recover by the end of Q1 and finish the year about +26% up. This would imply that the effects of the virus in 2003 were entirely transitory. Those with the fortitude to stay in the market or continue to invest throughout the decline were well rewarded for their efforts. There are, however, even more factors to consider: first, in 2003, the global economy was in the early stages of a recovery, whereas the current economic expansion is long in the tooth by all measures. Second, 2003 was not an election year, whereas 2020 is. Finally, global underlying economic conditions are simply not the same. In 2003, the idea of negative rates was largely abstract and theoretical at best, but in 2020 it is a $17 trillion global reality. In 2003, the flow of information, (while rapidly increasing in speed and efficiency), was nowhere near what it is in 2020, and processes like algorithmic trading were still in early stages. Today, information is processed, filtered, and acted on in a matter of seconds, computers do the bulk of the trading both on and off exchanges, and are programmed to take advantage of irrational market behavior when they find it. When taking all of this into consideration, one cannot help but wonder how much of the current declines are in fact related to the coronavirus and how much of the current declines are in fact related to other factors like an overvalued market, an extended bull market, potential election of a socialist to the White House, or a global economic slowdown.
Sun Tzu famously wrote that every battle is won before it is fought. Volatility has always been a factor and an element of risk that is inherent and part of investing. Some fear and shy away from the thought of volatility, but Lido embraces it. As your advisors, we look at the short-term behaviors and actions of investors with the potential of creating long-term opportunity. Of course, we factor how the impact of this virus can affect earnings, sales, and the macroeconomy. But, more importantly, we want to understand the value that is presented when behavior and psychology goes too far and creates an opportunity that we can pounce on. Many of Lido’s strategies have cash ready as we continue to, in every market environment, seek value and opportunity.
Further, Lido is active in hedging strategies to mitigate and manage volatility. We do this several ways including using options to cap the upside while cushioning the downside (Cap and Cushion). We also seek strategies that offer current income through private debt and credit – without the daily volatility of the market. Additionally, we seek to invest in equity strategies not tied to daily market action. Equity investments in various real estate strategies present a prime example.
To summarize, the pain is real. The factors and data points laid out here are common knowledge, and frankly, very easy to find. As such, it is highly likely that other market practitioners across the globe are making the very same comparisons we are and coming to a similar conclusion. The coronavirus has now infected and killed more people than the SARS virus, the Chinese economy means more to the global economy then it did in 2003, and the global macro-economic environment as well as global equity market environments are not as favorable as they were during the SARS outbreak. That said, we should not entirely discount the possibility of a quick recovery. The current outbreak really should not impact the economy as long as production and distribution are not materially impaired. Once the situation is contained and companies can begin to produce at full capacity again, a recovery should not be far behind… unless of course, this sell-off is not entirely about the coronavirus.