27 Mar 2020
The devastating coronavirus outbreak has prompted renewed discussion of “black swans”: rare, unexpected events that wreak havoc on markets and economies. But is COVID-19 really a black swan? And to what extent can investors ensure their portfolios are resilient to sudden shocks of this kind?
Bill Gates stepped up to the microphone, adjusted his spectacles, and addressed the room. “There is a significant probability of a large and lethal, modern-day pandemic occurring in our lifetimes,” he said.
Gates added he was particularly worried about the emergence of a new strain of flu, akin to the severe acute respiratory syndrome coronavirus (SARS) that swept East Asia in the early 2000s. The Microsoft co-founder called for the development of a universal vaccine to protect populations from a “highly contagious and lethal airborne pathogen”.1
Gates made these remarks in a speech to the Massachusetts Medical Society in 2018, two years before the flu variant known as COVID-19 spread across the planet, killing thousands, shuttering businesses and wrecking financial markets. The pandemic is far from over and the true impact will not become clear for some time, although a global recession appears almost certain. The human cost is incalculable.
Gates’ remarks were directed at senior policymakers; he had earlier warned that “we aren’t ready” for a global pandemic in a 2015 Ted Talk that highlighted the broader risks of such an event. Governments might have heeded his advice – along with similar warnings from prominent epidemiologists – by channelling resources towards immunisation research and equipping health systems to deal with a viral outbreak before it occurred.
Whether markets should have anticipated the coronavirus fallout is another question. Given the wider competitive dynamics involved in finance, it can be near-impossible for investors to incorporate the risk of specific low-frequency events into their day-to-day management of portfolios. But that doesn’t mean they shouldn’t be prepared for crises of this kind.
“It would be a tall ask to say an asset manager should have had a research team that would have known a virus was going to come and spook the markets to this extent,” says Euan Munro, CEO of Aviva Investors. “Far less forgivable would be not having a portfolio that had some generic resilience to extremely disruptive events; whether that’s a collapse of a banking system, a health crisis or a geopolitical issue.”
Black swans
Faced with market shocks of this nature, commentators often reach for the metaphor of the “black swan”, which was popularised by the academic and former derivatives trader Nassim Nicholas Taleb in his 2007 book of the same name.
Taleb’s black swan has three key characteristics: “First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact (unlike the birds). Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.”2
Although the prescience of Taleb’s book seemed eerie when the global financial crisis hit soon after its publication, the event itself was a poor fit for his criteria. While it certainly carried an “extreme impact”, it is not true to say that nothing pointed to the possibility of a financial meltdown before the fact. Many market participants were aware of lurking vulnerabilities in credit in the run up to the liquidity crunch.
“There are some important distinctions between expected and unexpected sources of volatility,” says Munro. “Some of us saw the price of corporate credit and the explosion of structured credit long before the bubble began to burst in late 2007, and felt there to be just cause for anticipating that credit would be at the heart of the next crisis.”
The coronavirus outbreak is a different kind of event – an external shock, rather than one originating within the financial system. But nor did it lie “outside the realm of regular expectations” any more than the financial crisis. SARS, the H1N1 (swine flu) pandemic of 2009 and the West African Ebola epidemic of 2014 were all harbingers of COVID-19. Last year, Politico magazine predicted a future coronavirus pandemic and analysed its likely effects on public policy and the dynamics of international political cooperation.3
Taleb warned of the risk of a very strange acute virus travelling around the planet
Taleb himself warned of pandemics in The Black Swan, writing of “the risk of a very strange acute virus travelling around the planet” due to the connections fostered by economic globalisation. In 2013, the Singaporean government – whose rapid and effective response to COVID-19 has been praised as a model for other countries to follow4 – invited Taleb to discuss pandemic risk and assist in planning for it.5
Grey rhinos
So if COVID-19 is not a black swan, how should we think about the risk it represents? The writer Michele Wucker argues it is a different animal altogether: a “grey rhino". This category of risk incorporates “highly probable, high-impact yet neglected threats”, such as cybersecurity failures, geopolitical clashes and climate change. In Wucker’s view, policymakers and businesses around the world have been remiss in their lack of planning for such hazards.6
Nevertheless, the suddenness and severity of the coronavirus outbreak would have been difficult for even the best-managed companies to foresee. For example, while a well-resourced investment firm could have theoretically predicted a disastrous pandemic soon after the first cases became known, in reality second-guessing the precise configuration of events that occurred in early 2020 seems far-fetched. Not only did a new flu virus jump the species barrier in a wet market in central China, but Saudi Arabia slashed oil prices after a breakdown in negotiations with other suppliers, exacerbating market uncertainty just as COVID-19 arrived in Italy and Iran. Within weeks, economic activity had effectively ground to a halt across much of the developed world and major stock-market indices had collapsed by a third.
“Few people, at least outside of the epidemiological experts, would have countenanced a world where social distancing and the cessation of freedom of movement would become reality in such a short space of time,” says Mark Robertson, head of multi-strategy funds at Aviva Investors. “In addition, the decision by Saudi oil producers to enter into a price war was the last thing an already fragile market needed. If this had remained an outbreak in China, we would not be seeing anywhere near the damage to global trade, travel and markets that we are currently experiencing.”
Another consideration is that investors need to time their decisions carefully. A portfolio manager who listened to Gates’s speech in 2018 (or worse, 2015) and repositioned their fund defensively in expectation of imminent pandemic-related market disruption would have missed out on years of outsized returns as equities soared. Clients would undoubtedly have questioned such a strategy, particularly given the performance some passive funds were able to deliver over that period thanks to their unmoderated stock-market exposure.
Fat tails and global connectivity
These risk-reward calculations are complicated further thanks to the radical connectivity of the modern world, in which a single event can trigger domino effects across markets.
According to Taleb, financial crises are becoming more damaging because the world is more physically and technologically interconnected than ever before. This increases the occurrence of “fat tails”, named after probability distributions that show an unexpected thickness at the extreme end of the curve (i.e. circumstances in which a single variable can have massive consequences.)7
A good example is the intricacy of the supply chain for a product such as Apple’s iPhone, which links high-end Korean chipmakers, Chinese manufacturing facilities and thousands of small, specialist companies that contribute different components to the finished machine. A single interruption at any point in this highly efficient and finely tuned process can result in delays, supply constraints and price increases further down the line.
The pandemic has illustrated the extent to which modern supply chains are concentrated at certain key points. Central China, where COVID-19 originated, hosts a cluster of manufacturing firms, including Hon Hai, Apple’s main supplier. The Gumi Industrial Complex just outside Daegu, the city at the centre of South Korea’s coronavirus outbreak, produces most of the world’s memory chips and LED displays, including the screens for the latest iPhone models.8 Virus-related cessation in work at these facilities is expected to lead to at least a ten per cent fall in global smartphone shipments this year, with knock-on effects across a range of companies and industries.9
“Supply chains are so integrated and efficient these days, there is less flex when there is an issue in one part of the world,” says Alistair Way, head of emerging market equities at Aviva Investors. “There is no easy way Apple can shift iPhone production away from Hon Hai because it is so efficiently set up with customised facilities.”
Multiple strategies
In their new book Radical Uncertainty: Decision-making for an unknowable future, economist John Kay and former Bank of England governor Mervyn King argue the best way for investors to stay resilient and flexible in such an unpredictable and hyperconnected world is to plan for “alternative futures” through the adoption of “multiple strategies”.10
Their exemplar is Pierre Wack, a former journalist who became an executive at oil company Shell in the 1960s. Wack pioneered the use of multiple scenario planning, ensuring the business was prepared for a range of possible developments; long before the creation of OPEC, he speculated about the risk that major Middle Eastern energy producers would form a cartel to exert monopoly power. His forward-thinking approach ensured Shell was able to weather the oil crises of the 1970s.11
This approach has an analogy in finance, where “broad diversification, involving building a portfolio which will be robust and resilient to unpredictable events, is the best protection against radical uncertainty, because the most radically uncertain events will have a significant long-run effect on only some of the assets you own,” according to Kay and King.
This method of portfolio construction isn’t based on predicting events precisely, but about building in protections against broad categories of foreseeable risk. Take the supply-chain example: investors need not have anticipated the outbreak of a new strain of flu to have discerned the vulnerability of the complex smartphone supply chain to a single catastrophe. A natural disaster, terrorist attack or geopolitical incident – such as a worsening of the US-China trade war – might have triggered a similar level of disruption.
In order to build portfolios that are resilient to such sudden shocks, teamwork across asset classes is key. This is not just because portfolios comprised of uncorrelated assets and multiple strategies tend to perform better when a crisis hits; it is also because investors who work together across asset classes can gain a more complete picture of how companies, markets and sectors influence each other.
For this reason, they are better able to spot underlying vulnerabilities and respond in a timely fashion to relevant signals. Teams working across different disciplines might have noticed the disconnect between Apple’s soaring share price and the mounting problems in its supply chain before the company issued a profit warning in mid-February, for example.12
What is going on here?
Constructing portfolios that can remain resilient under a wide range of scenarios inevitably means allocating time and resources to prepare for the impact of events that never come to pass. On the plus side, however, portfolios constructed in this way should be insulated from the deepest losses during periods of market volatility, protecting investors from the kind of panic that leads to irrational decision-making.
As Kay and King argue in Radical Uncertainty, the organisations that thrive during unpredictable events are not those that leap immediately into action or undertake probabilistic analysis to try to determine exactly what happens next, but those that are able to stand back and ask the deceptively simple question: “What is going on here?”
In the current circumstances, the answer to that question is not yet clear, but there are some early indications as to which sectors may be worst affected, providing guidance for portfolio repositioning decisions. The tourism and leisure sector – including restaurants, resorts, amusement parks, cinemas, theatres and cruise liners – has been severely impacted by government lockdowns. In contrast, the increase in people working from home is benefiting the communications and data-management sectors due to increased reliance on digital networks.
On the policy front, the rapid monetary and fiscal response from governments and central banks to COVID-19 suggests the economic impact may be somewhat different from the last global crisis, when policymakers initially dithered and responses across regions differed. But there remains a risk that a wave of corporate defaults could trigger a debt crisis, or that the sudden halt in economic activity could exacerbate a global dollar shortage, with wider systemic effects. In such an uncertain environment, investors must manage their portfolios to ensure they can withstand a range of scenarios.
Grey rhino, black swan, or otherwise, “How investors exit a crisis is not about luck, it is about judgement,” says Munro. “But whether the source of the volatility is anticipated or not, well-diversified portfolios cope.”
References
- Bill Gates, ‘The next epidemic is coming. Here’s how we can make sure we’re ready’, GatesNotes, 27 April 2018
- Nassim Nicholas Taleb, ‘The Black Swan: The Impact of the Highly Improbable’, Penguin, 2007
- Samuel Brannen and Kathleen Hicks, ‘We predicted a coronavirus pandemic. Here’s what policymakers could have seen coming,’ Politico, 7 March 2020
- Stefania Palma, ‘How Singapore waged war on coronavirus’, Financial Times, 22 March 2020
- Nassim Nicholas Taleb,’Why this is not a black swan’, BBC Radio 4, 18 March 2020
- Michele Wucker, ‘No, the coronavirus pandemic wasn’t an unforeseen problem,’ Washington Post, 17 March 2020. See also Wucker’s book ‘The Grey Rhino: How to Recognise and Act on the Obvious Dangers We Ignore’, St Martin’s Press, 2016.
- Speech at the Fletcher Conference on Managing Political Risk, 2015. Transcript here.
- June Yoon, ‘Lex in depth: why coronavirus spells trouble for smartphones’, Financial Times, 19 March 2020
- ‘The new coronavirus could have a lasting impact on global supply chains’, The Economist, 15 February 2020
- John Kay and Mervyn King, ‘Radical Uncertainty: Decision-making for an Uncertain Future’, The Bridge Street Press, 2020
- Radical Uncertainty
- Apple’s share price was still climbing to record heights in early February, weeks after it became clear Hon Hai’s facilities may be disrupted; it only started falling after the company’s statement on February 17 that iPhone production might be at risk. This example adds to a growing body of evidence that suggests investors tend to be slow to act on signals that pertain to connections between companies. See Mikhail Zverev, ‘In a complex market, investors need to connect information signals more effectively’
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