Epidemic offers a lesson about risk

In a world now as interconnected as ours, black swan events like the coronavirus should be a wake-up call.

Beijing’s streets are nearly desrted in the wake of the outbreak. Picture: Getty Images

What does this sharemarket rout mean for investors?

The answer involves really understanding risk. Up until this moment the chase for yield, and better returns than cash, has put a rocket under asset prices. Buying at already stretched valuations means that lower returns are virtually assured, as is much higher risk.

By way of example, over recent years, investors have been piling into index funds and exchange-traded funds such as those following the US S&P 500. The S&P 500 index’s earnings yield is about 4 per cent, which is about 2½ times the yield available on an Australian term deposit (I’ve excluded the currency risk), but the S&P 500 could ultimately fall 30 per cent, which is 30 times riskier than a term deposit.

When examined on a risk-adjusted basis, the implied returns available from stretched stockmarket indices don’t look nearly as attractive.

Investors deserve an approach that is aligned with their aspirations and goals. That means reducing the risk of substantial falls, especially when market valuations are hitting historic records.

In a world interconnected by global supply chains, the potential adverse consequences from black swan events such as coronavirus on the economy, on highly indebted companies and on investors’ wealth reminds me there is merit in actively managed funds that navigate the risks. In contrast, index funds remain blindly and dispassionately 100 per cent exposed no matter what.

Notwithstanding the last two days of selling, markets have been relatively sanguine about COVID-19, with the S&P 500 hitting record highs as recently as last week.

The contrast between the market and the real world has, up until this week, been glaring.

The death toll from the coronavirus is now more than 2700 worldwide with more than 80,000 global cases.

In China the authorities’ attempts to corral the virus, in an area home to more than 320 million people and responsible for a quarter of China’s output, is already having a material impact on economic activity there. The speed with which factories are permitted to reopen will determine the length of time China suffers a serious deterioration in economic activity.

Of course, President Xi now finds himself between a rock and a hard place.

Having reprimanded whistleblowers for alerting others to the danger in the initial weeks of the virus outbreak — and having downplayed its severity by telling people it couldn’t be transferred between humans — Xi is being blamed for the slowing economic activity due to his party’s inadequate response. Yet if he pushes people back to work too soon, he will be held responsible for rising infections and a longer slowdown.

China of course plays a critical role in global supply chains. Its manufactured components are found in goods globally and Chinese intermediate goods represent more than 20 per cent of imports for many countries including Japan, Australia, the US, South Korea and Hong Kong.

The lockdown in China also removes an important source of demand. And now, as the virus spreads around the globe, demand will drop further. And this is a key issue. It’s one thing to consider the impact on the economy from individual outbreaks being contained; it’s quite another to contemplate what transpires when citizens start fearing for their health and safety.

The extreme but unknowable probabilities, combined with the most recent and relatively benign SARS experience, has had stockmarket participants preferring to believe a substantial stimulatory response from China would kick start a V-shaped recovery.

But the damage is already being felt beyond those definable industries. Retailers are now reporting difficulty in stocking shelves and manufacturers are beginning to run low on components essential to their production processes.

While the stockmarket has recently been hitting highs, bond yields have been hitting new lows. Optimism in the equities market is not being reflected in the bond market where a flattening yield curve suggests the global economy is going to struggle for a period much longer than investors have been willing to admit.

Up until very recently the stockmarket appears to have ignored the fat-tail risks associated with companies’ cashflows being impacted to such an extent that their debt may become challenging to service. And remember, global corporate debt is at an all-time record. There are a number of reasons for stockmarkets’ optimism but none of them seem logical.

The first, I believe, is that investors are betting on central banks continuing to print money under modern monetary theory. This may indeed be the case.

The second reason is that algorithmic trading and flows into index funds are unable to account for fat-tail risks such as COVID-19, and being unable to anticipate it, they default to doing nothing at all, remaining fully invested. Investors may soon discover ETFs and index funds were significantly riskier than they originally assumed. And how index funds and ETFs respond to a tidal wave of investors wanting to exit remains to be seen.

The final reason for the market shrugging off the increasingly likely consequences of COVID-19 is that it is normal to do so. Equity markets have initially responded equally benignly to past threats going all the way back to the rise of the Third Reich. This is because taking out insurance to cover extreme risks is prohibitively expensive.

The consequence is an asymmetric type response where markets appear to muddle along until they fall off a cliff.

Roger Montgomery is chief investment officer at Montgomery Investment Management.

www.montinvest.com