Why didn’t we see the Covid-19 crisis coming, given such poor global health systems?
You can’t hedge against all eventualities or you’d have virtually no portfolio left to manage
As 2020 proved beyond doubt, new tear predictions can be of limited value. But left field shocks such as this year’s devastating pandemic were less “unpredictable” than many now make out. Sometimes they’re just hiding in plain sight.
In January — before the Covid-19 crisis unfolded — the World Economic Forum’s (WEF) annual global risks survey put the threat of infectious diseases as “high impact” but relatively low “likelihood”.
Of two dozen or so mega-risks to the world economy, only “weapons of mass destruction” and — perhaps ominously for 2021 — “unmanageable inflation” were considered less likely.
But the WEF report devoted a whole chapter to the threat of unprepared and poorly funded health-care systems. And arguably it was this, as much as the deadliness of Covid-19 per se, that forced the serial lockdowns of the world’s major economies and one of the deepest recessions in modern history.
“Health systems worldwide are still underprepared for significant outbreaks of other emerging infectious diseases, such as SARS, Zika and MERS,” according to January’s WEF study, released just before its annual gathering in Davos.
“A recent, first-of-its-kind comprehensive assessment of health security and related capabilities across 195 countries found fundamental weaknesses around the world: no country is fully prepared to handle an epidemic or pandemic,” the report outlined somewhat presciently. “Our collective vulnerability to the societal and economic impacts of infectious disease crises appears to be increasing.”
Separately, the WEF cited estimates that flu pandemics could cause annual average losses of 0.7% of world GDP, or about $570bn, over the coming decades — in the same ballpark as unchecked global warming. That number now looks almost quaint against the 4.4% shrinkage in world activity in 2020 alone.
It wasn’t a prediction of Covid-19, obviously — but a stark warning about how serious a pandemic could be. What made the current health and economic crisis a shock when it unfolded was that most governments, businesses and investors considered it to be such a relatively unlikely event.
Looking at prior global shocks and dialling back 12 years, Britain’s Queen Elizabeth was reported to have responded to an analysis of what caused the banking collapse and Great Recession of 2008 with the question: “Why did no-one see it coming?”
The most straightforward answer again was that all the individual ingredients of the crisis were, indeed, seen back then — just not their confluence into one overarching and almost existential financial collapse.
Looking ahead, then, should markets consider all unlikely events, from meteor strikes to nuclear armageddon?
Investors see it slightly differently. You can’t hedge against all eventualities or you’d have virtually no portfolio left to manage. But even though no-one can see the future, you can avoid being wiped out by such “tail risks” — the sort of things deemed impossible to point-forecast over a 12-month horizon at least.
TS Lombard strategist Oliver Brennan said most lists of “risks” discussed at this time of the year really fall into the “known unknowns” category, the terminology former US defence secretary Donald Rumsfeld famously used around the 2003 invasion of Iraq.
These are often things related to ebbs and flows of economic cycles and earnings, policy moves or diaried political events.
“The most important takeaway from 2020 is that ‘known unknowns’ are not true tail risks,” he said. “It is what we have no idea about which is the problem.” But even if, almost by definition, you can’t predict a true shock you can still position in markets against some of the wilder price moves they trigger, Brennan said.
Despite — or maybe because of — record-high equity prices and the convulsive year gone by, implied equity volatility and hedging costs remain pricier than normal. But assumptions of bond-yield suppression by central banks and benign inflation for years mean interest-rate volatility stands out at 1.5 standard deviations below its 10-year averages, he added.
Advising positioning in “swaptions” — or options in the interest rate swaps area — to take advantage of that, he believes that would cover an unlikely inflation scare that raises fears of more hawkish monetary policy — while also acting as a wider portfolio hedge for resulting risk-off flows elsewhere.
Deutsche Bank’s international private bank also said this week that higher inflation remains on the radar despite being an unlikely story for 2021. The centrality of ever easy monetary policy to the whole public finance and markets edifice now makes it a hugely heightened concern.
“We would not be completely relaxed about [the risk of rising] inflation. This is a potential threat to monetary policy,” it said. “Concerns remain about high monetary aggregates, for example, and an upward spike in yields cannot be ruled out.”
Asset manager Ninety One also cited an unexpected inflation uptick or sudden central bank angst about financial stability as a potential “punch you don’t see coming that knocks you out”.
After 2020’s pandemic, it may well be worth considering the WEF’s other unlikely, high-impact mega-risks from January — and not the one about weapons of mass destruction.
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