Enclosed are some thoughts on decision-making inputs that might influence portfolio construction as we move through the novel coronavirus (COVID-19) epidemic towards a potential pandemic. I will frame these as questions with analysis for further consideration.
Our thinking on this has been aided by due diligence via global experts and debate with Jerome Lander, Managing Director of ProCapital, who has written a good piece on the subject calling for dynamic asset-allocation.
Approaching the February correction, we had been very conservatively positioned across our portfolios, with average credit ratings in the AA band and high cash weights relative to recent history. We had generally been derisking aggressively in 2020 in anticipation of future dislocations and/or primary issuance that would liberate attractive buying opportunities. It is not yet clear whether that time has arrived…
How Does COVID-19 Compare to Other Viruses?
The latest data out of China indicates that the ex-Hubei case fatality rate (CFR) is ~0.4%, which researchers speculate could be inflated by the inability (or unwillingness) to diagnose the virus properly (and under-reporting generally).
Across more than 72,000 infections, the total Chinese CFR is ~2.6%, although this possibly struggles from large underestimates of infections in Hubei where early data dissemination was heavily censored.
Outside of China, the global CFR is around ~1%, which makes COVID-19 more lethal than influenza with research finding a 0.1% to 0.45% CFR for the flu.
The volatility in these estimates and the presence of flu vaccines beg the question as to whether the CFRs could ultimately be quite similar. These are also crude CFRs, and there are lead-lag relationships that can be controlled for to generate more precise estimates.
COVID-19 is likely more infectious than the average seasonal flu with an estimated “R0”, which is its reproduction number or transmission rate, of around 2.3 (estimates of the R0 for influenza are 1.2 to 2.4 in a community setting according to WHO).
The reported CFR globally for COVID-19 of around 1% is significantly lower than the SARS CFR of 9.6% and the MERS CFR of 34.4%, but COVID-19 is much more contagious. (There are also debates as to COVID-19’s true R0.)
Will COVID-19 Morph into a Global Pandemic?
Nobody knows, although it is interesting that many medical professionals think this is a serious risk, if not their central case (for example, the US CDC official who is suggesting this is probable). To our mind, the key is to watch how successful containment strategies play-out in different jurisdictions.
We have some decent data on the Chinese experience, which has been studied in depth in this new research paper. And we have had mini-outbreaks in Hong Kong, Singapore, Japan, Iran, South Korea and Italy.
What is interesting is the diversity of experiences. In Japan there have been 170 cases, but only one fatality, with no signs yet of an acceleration. Singapore has had 91 cases and no deaths, with recent stability in infections. Hong Kong has had 85 cases and two deaths with no likewise evidence of contagion. Fascinatingly, Taiwan, notwithstanding its close proximity and ties to China, has also avoided any real problems with total infections of 31 persons and one death.
In contrast, we have seen explosive growth in infections in South Korea (1,146), Italy (322) and, presumably, Iran (95?), which might be driven by idiosyncratic factors that are basically bad luck. (The Iranian data is clearly bogus.)
South Korea and Italy are crucial because unlike the Chinese experience, we can in theory trust their data evolution alongside that which is published by other relatively open states like Singapore, Japan and Hong Kong.
About half the 1,146 cases in South Korea have been attributed to a secretive religious cult, which conducts huddled private prayers that increase the probability of transmission—much like the prayer practices in Iran where individuals also greet each other with kisses (they are now switching to tapping feet)—and resists public identification of its members.
In Italy it is notably also common for folks to greet one another with kisses on the cheeks that could boost infection rates.
South Korea resembles a Hollywood-style worst-case scenario where a cult propagates a contagious disease throughout society partly because of the inability to determine who belongs to it. Juxtaposed against this risk is the fact the South Koreans have a very advanced health system and technology infrastructure, which combined with the real-time learnings from China’s trajectory (especially since January when data has become more freely dispersed), give it a decent chance of containment.
Similar thinking can be applied to Italy, which is the third important case study—above and beyond China and South Korea—to help us ascertain whether serious outbreaks can be thwarted through rigorous containment strategies after an initial spike in infections.
Naturally, there must be the risk of other concentrated outbreaks around the world that may or may not be contained.
Does Weather Play a Role?
Some of the differences between the COVID-19 paths of, say, Hong Kong and Singapore, on the one hand, and South Korea, China and Italy, on the other, could be weather related.
COVID-19 is reportedly vulnerable to warmer climates, and it is interesting that there is only one case in South America, few in Africa, and, despite Australia’s close socio-economic ties to China, no evidence of an outbreak here.
There was an early burst of infections in Thailand in January, but these appear not to have spread. You might think Iran is warm, but it is winter there right now and very cold, as it is in Northern Italy. (It is also very chilly this time of the year in Wuhan.)
President Trump and others have speculated that if containment is possible, COVID-19 could be cauterised as the northern hemisphere moves into its warmer summer months.
Will Central Banks Come to the Rescue?
One of the problems with containment strategies is that you are effectively shuttering your economy, or at least severely limiting activity. This will likely drive extremely negative economic growth data for Q1 2020, which will only be fully realised when that data is published over the course of Q2 2020.
Within economies, it is also possible that individual sectors could be damaged permanently, particularly if that sector is characterised by high levels of leverage. Highly levered airlines and tourism-dependent firms are prospective vulnerabilities as are Chinese banks, South Korean banks and Italian banks, to name a few.
Any levered company that relies on supply-chains where economic activity is sharply curtailed, such as it has been in China, and finds that it cannot repay its debts, could face a serious solvency crisis. This is one reason why we have repeatedly warned about the rapid rise of “Zombie firms” that are paying 100% or more of their earnings to service the interest on their debts.
Any shock to those earnings presents a real threat to their viability. It is also why we have highlighted risks in global “high yield” or junk bonds where you have effectively subprime companies that cannot borrow from banks or cheaper investment-grade bond markets that must now contend with a potentially sudden and very large reduction in their revenues. It is no surprise that junk bond spreads have exploded this week. The Financial Times reports:
The premium that investors demand for owning risky high-yield debt has surged by more than at any time since the Brexit vote in 2016, as the coronavirus outbreak has menaced corporate credit markets this week. The extra yield on US junk bonds versus Treasuries, known as the spread, jumped 52 basis points from 366bp on Friday to 418bp on Tuesday, the biggest two-day rise since the UK voted to leave the EU nearly four years ago, according to a closely followed index from Ice Data Services. A junk bond sell-off has unfolded alongside a sharp drop in global equity markets, reacting to the spread of the coronavirus beyond its epicentre in Wuhan, China. “The market has been slapped hard,” said Ken Monaghan, co-director of high yield at Amundi Pioneer in Durham, North Carolina.
In theory, the negative Q1 activity could be washed against an equally strong rebound over Q2 and Q3 of 2020 if a global pandemic is avoided. But an alternative hypothesis here is that containment strategies that mitigate a pandemic could unwittingly throw the economic baby out with the bathwater in their blind desire to avoid infections. That is, containment paralyses the economy and tips it into recession.
A further risk is that hyperbolic markets descend into a negative feedback loop or death spiral. Markets have never really had to price in global pandemic contingencies. They are trying to price probabilities around something that is relatively unknown, which could lead to exaggerated reactions. Markets generally hate uncertainty, and this is a rather extreme form of it.
The worry would be that markets spiral downwards on tape bombs and feverish, unsubstantiated speculation (excuse the pun!), and by doing so they become a self-fulfilling prophecy: ie, they crush household wealth, animal spirits, sentiment, and business and consumer activity.
So while the first order analysis might be to look-through the temporary shock posed by COVID-19, a more prudent approach could be to assume negative feedback loops.
But then there is a third-order effect called the policymaker’s reaction function. Central banks have become highly sensitive to financial accelerators and the associated price action.
If they conclude that the markets themselves could become a contagion delivery device for financial stability, they are likely to move quite quickly to insure against these hazards. This is something central banks have become increasingly adept at doing, and it would presumably involve more asset purchases (or QE), cash rate cuts, and potentially innovations like helicopter money.
The interest rate markets are already pricing in additional cash rate cuts from the Fed and the RBA on this basis by mid 2020. And today we heard that Hong Kong has launched helicopter money, or HK$10,000 cash handouts, for all individuals. They government will also be guaranteeing all companies’ wage and tax repayments, eliminating some solvency risks.
Another set of important non-linear risks to the distribution of potential outcomes are vaccines and other medical remedies. Human trials on various vaccines have already started. Likewise, WHO has pointed to human trials in China of a drug produced by Gilead Sciences, which may be effective in speeding up recovery times and preventing infections altogether (the US has commenced its own human trials of the same remedy). The rapid development of a vaccine and/or an effective drug could result in markets rebounding more quickly that might otherwise be anticipated.
If portfolios are not already defensively positioned, one can take out insurance and hedge against these outcomes through equity derivatives, credit default swaps, and/or by going long interest rate duration, which has performed well this month.
If certain recovery paths become more probable, and containment a proven response strategy, one can also fade the correction and seek to acquire assets trading at newly cheap discounts to fair value.
All of these choices require active real-time decisioning.
Great commentary, I think the "unknown" factor is the biggest problem. Pricing in a pandemic is not the easiest thing to do. Doesn't help to not be able to trust the Chinese data or the WHO. Interesting - not sure if you know about the 2017 Catastrophe Bond issued by the World Bank. $425 million for its Pandemic Emergency Fighting Facility. Wonder how that will influence the WHO...
Great article Chris and insightful commentary from Matt also. Thank you for the acknowledgement Chris, and I hope people read my article from earlier this week that you kindly reference. You have definitely demonstrated a sense of curiosity and a willingness to investigate and get up to speed on this important issue fast, which sets you apart from the average fund manager (going beyond the headlines). The coronavirus issue is the driving narrative of the market right now, and I expect will continue to be for a while yet.
The heavy market falls this week reflect the slow but growing realisation of a growing global pandemic and admission of such by some US and Japanese health officials last night. The market being "imminently coronered" was predictable (as I published on this early this week). It is not over yet. Further clustered outbreaks in other countries are likely to strike soon. Many governments are now likely to find containment of the coronavirus impossible. Some will likely move to a strategy of attempted mitigation, as will affected and frightened communities themselves. The economic impacts from the reactions to coronavirus - as the world's people and government move from denial there is a problem, to attempted containment to mitigation measures - are being underappreciated.
Thanks Chris - your comments on the markets reaction and the subsequent central bank reactions are the important factor that most are missing. I think on the mortality rate is also key. Its probably below 1% when controlled. Its probably 5%+ if it gets out of control. Now, governments have a decision. Lock down your economy and have 1% mortality rate. Ignore it and get a 5% rate. Choose.
The death number should be compared with the recovered number, not the infected number, to give a meaningful outcome.
A meaningful mortality rate must use death rates and recovered, not infections. Infection might last days or weeks anda then what, recovery or death, the outcome is the answer not the infection. Not sure I can work this thing to get a comment in. Russell King
Hi Russell, I see how what you're saying might be informative, but I think the assumption is if you don't die, you've recovered. In terms of risk management, you'd want the infected v death I guess. In terms of trading - those questions don't matter to a large degree. The price and human/algo emotion is what matters. It is still not panic in my opinion - whether that is right or wrong is another question.
Some new research from Los Alamos labs suggests a much higher R0 value than originally thought - rather than the "accepted" 2.2-2.7, the research suggests 4.7-6.6. This is important not only for considering how quickly the virus will spread, but how strongly the quarantine measures have to be for the virus to become "extinct".