Risk Wire: Covid-19 – What Is the End Game?

We consider two likely exit scenarios of Covid-19 pandemic and the world economy, but without a need to select one. A blueprint with early data signals will guide institutional investors and help them decide when (and IF) to switch from the “bad” scenario to preparing the portfolio for the “really bad” scenario.

The spread of Covid-19 disease globally tests the limits of the usefulness of conventional statistical models for building expectations with regards to the financial markets. Indeed, if the nearest equivalent to this virus is the 1912 Spanish flu epidemic, there is very limited or no relevant data to guide us. Given the lack of historical precedent, we build scenarios using Mira’s Agent-Based Modelling, which is more suitable for cases, when available history is not relevant.

In this issue of Risk Wire we develop two broad directions (scenarios) in which the sequence of events can take us, building up from the industry-level information and covering both supply- and demand-side impacts. Beyond the two scenarios, we also examine the likelihood of outcomes that are currently in the spotlight of our institutional clients and the general investment community, such as for instance stagflation. We then conclude with some remarks about certain investment cases we believe are either “hyped” (gold) or overlooked (the likely impact of the specific geographical spread of the virus). The latter could turn out to be a decisive factor in switching between scenarios and building a contingency plan specific to the fund.

The two scenarios are introduced for Mira ABM users and available on the platform:

  • LINKS Covid-19 Scenario A (the “mild” outcome), and
  • LINKS Covid-19 Scenario B (the severe outcome)

The scenarios differ in the extent of “lock-down” that it takes to fight the corona virus, or rather the number of the required “lock-down” cycles that may be required. Industry-level supply- and demand-side effects of the range of scenario outcomes will help to adjust institutional portfolios in order to limit the risks and position for any recovery.

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Risk Scenario Global Covid-Triggered Crisis

Earlier China nCoV Scenario

On February 6, 2020, urged by our clients, we introduced a stress scenario in Mira ABM called China-2019 nCoV to reflect the quickly spreading epidemic of a yet unnamed disease in China. At the time our concerns were:

  • China will in lock-down for up to three months, with the economy working only at the quarter of capacity
  • Intra-Asian traffic will slow down for one quarter
  • Although in retrospect, these assumptions appear to be mild now, at the time this was perceived to be the severe and plausible case. Mira ABM assessment showed a significant risk to equities and much lower yields.

This scenario was broadly in line with what happened at first. Asian air traffic did collapse and China appears to have been shut for business for 3 months now. The resulting performance was broadly in-line with the forecasts, although it appears that Mira ABM underestimates the performance of US equities and overestimates moves in EU Bonds/interest rates – an area we will focus our research on.

China-nCov Scenario impact on yields, Source: Mira ABM
China-nCov Scenario impact on equities, Source: Mira ABM

The New Scenario

The subsequent events, however, require a reassessment and introduction of a new scenario that is only nominally triggered by the Covid-19 disease. The scenario reflects:

  • Sharply lower oil price environment,
  • Lower global demand for travel,
  • Sudden freezing of commercial aircraft orders from Boeing and Airbus

Lower oil prices, triggered by slowing demand due to Covid-19 triggering a slow-down in transport traffic, has resulted in a global price war. Our assumptions are that countries with lower cost of production will continue to sell at current prices, so will see higher volumes, while countries with higher cost of production (e.g. US shale oil), will face declining volumes as well as prices.
Rapidly falling airline traffic has placed most airlines dangerously close to insolvency. IATA have recently published their limited spread and extensive spread scenarios, that estimate global airline industry loss of revenue at 11% and 19% respectively.

Revenue Volume
Limited
spread
11% 10%
Extensive
spread
19% 15%

What IATA does not take into account (in fact notes to the contrary) is that far from being positive for airlines, lower oil prices actually create a huge immediate pressure due to oil price hedges. Any benefit from low oil price would be accrued during the year, as and when the airlines operate and sell tickets, while the losses from hedging position are immediate. If the travel volumes drop drastically, so does any benefit from low oil prices, while the losses on hedging position remains.
Finally, aircraft manufactures (Boeing and Airbus) see abrupt market halt of historical proportions. In February, both companies experienced ZERO new orders, which has not been the case in decades.

Industry Price Volume
Airlines globally -15% -25%
Aircraft manufacturers -10% -10%
Russian oil -30% -5%
US oil -30% -20%
Rest of world oil -30% 10%

At the time of publication of this article, Mira ABM users are able to assess the impact of this new scenario on their portfolios. Impact on equities, given LINKS Default World View, are in the range of 10-26%, while impact on yields are 150 basis points.

New scenario impact on equities, Source: Mira ABM

Risk Scenario: BREXIT

LINKS have introduced two new BREXIT scenarios in Mira ABM.

There are many geo-political consequences of BREXIT, including the eventual Irish border and the status of the UK post-exit, but the impact of BREXIT on institutional portfolios depends on more mundane trade arrangements.

To begin with, any UK exit that is accompanied by an amicable trade agreement will have virtually no impact on asset returns as any change in trade patterns will be marginal. We therefore have introduced two BREXIT scenarios that are both no-deal exits: 1) Hard BREXIT: revert to WTO rules and 2) Hard Brexit followed by the Euro break-up. The latter, strictly speaking, is not only BREXIT scenario, but one that may be triggered by BREXIT.

Hard BREXIT: Revert to WTO Rules

We apply price increases for cross-border trade in relevant industries (industries with meaningful trade volumes between UK and EU) commensurate with the WTO tariffs. Exiting EU means that EU will apply its WTO tariffs to the UK agricultural and non-agricultural exports: on the average 14.4% and 6.9% respectively.

WTO EU tariff schedule, Source: WTO

 

We also apply volume declines, driven by the application of 14.4% and 6.9% tariffs to mutual imports of agricultural and non-agricultural goods respectively (based on elasticities of demand). For details of inputs, see Mira ABM. Mira ABM estimates the impact on profitability and prices globally and works out asset returns based on the estimates.

By far the greatest burden falls on UK-based importers of the EU-based components: 10.2% of their total cost is impacted. Chemical, petroleum and automotive industries will have the biggest issues, with between 24% and 30% of costs sourced from EU. UK-based exporters to the EU will suffer too, as 5.7% of their revenues originate from the EU.

Trade relative to total revenues and costs, Source: LINKS Analytics calculations

Finally, EU-based companies that export to the UK will suffer, however the total impact there is very muted – at only 0.5% of revenues. Some industries and geographies are disproportionately exposed, of course: systemic exposure to the UK market exists in Ireland and Malta (on the average between 20% and 30% of all revenues). The widely quoted and politically charged automotive industry of Germany, for instance, is exposed at only 5.7% of revenues (assuming a 10-20% decline in UK sales this translates into only up to 1% impact on global revenues).

For impact analysis on your portfolio and asset class returns please check your MiraABM account or request a trial.

 

Hard BREXIT: Euro Break-Up

Scenario inputs are based on raising prices for all intra-EU trade between the large economies (Germany, UK, France, Italy, Netherlands) and volumes falling in-line with elasticities (see Mira ABM for detailed inputs). This scenario assumes that there is an orderly conversion of government debt into new local currencies and there is no loss of principal value (except any loss due to new appreciation/depreciation of local currencies).

Risk Wire: Corporate Debt to GDP – Should We Worry?

In recent years there have been increasing concerns over corporate debt build-up in the US and Europe. Debt levels are considered high IF they cannot be sustained – in our assessment, a difficult claim to make for US and European companies.

 

The marked increase in the stock (volume) of corporate debt both in developed and emerging markets, particularly in comparison to the GDP levels, has triggered a concern over the balance sheets of the corporate sector and the build-up of financial risks.
Indeed, the total debt dynamic for instance in the US appears unsustainable, reaching ~73% of GDP in 2019 (Figure 1). Debt to GDP in European countries has reached 130-140% of GDP, up 10-25 percentage points compared to the 2008 levels.

However, there is a common misconception that higher debt levels automatically translate into riskier business or worse balance sheet. If this were the case, there would be a direct relationship between the level of debt adjusted for the economy (GDP) and the interest rate, which reflects the riskiness of debt…

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Risk Wire: Climate Change – The Cost of Transition

We have integrated the available industry-level climate change transition research from multiple sources and included climate change transition as the fourth long-lasting trend in Mira ABM*, along with automation, ageing population and globalisation/trade conflicts.

 

The transition of our economy in response to the climate change has begun in the earnest and is likely to continue in the years to come. The ultimate physical impact of climate change is arguably still uncertain, not least because it depends on the speed and extent of the policy reaction of major countries. Yet, there are energy transition facts that are already having significant impact on global supply chains, economic development and consequently, on asset pricing. Most importantly, these transition facts will continue to have impact on asset pricing in the foreseeable future, which qualifies climate change as the fourth long-lasting trend included in Mira ABM – our strategic asset management platform, along with ageing population, automation, and globalisation/trade conflicts.

 
Attempts to account for climate change in asset pricing so far have been focused on top-down macroeconomic analysis. Such analysis often misses the complexity of the underlying supply chain shifts. At the same time, there are detailed industry-specific studies covering climate change; however, they are fragmented and focused on individual industries. In this report, LINKS have tried to combine the body of knowledge on climate change from multiple industries into a single supply chain picture and draw conclusions with respect to asset prices.

 

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Mira ABM Risk Severity (April 2020)

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Scenario: Germany Industrial Crisis

The recent fall in the industrial production in Germany appears to be larger than typical quarterly volatility. Year-on-year change was -4.8% in November 2018 – the greatest decline since 2009 (source: Bloomberg).

Source: Bloomberg

A more detailed analysis of the business sentiment – IFO index (source: IFO Institute, Center for Economic Studies) suggests that while the declines are broad, the leader in decline is the chemicals industry. Order backlogs have shrunk most considerably in the chemicals industry, though the declines are evident elsewhere.

Indeed, German chemical companies have reported poor results and reportedly expect poor 2019.

As a quick first step to defining a stress scenario, we have applied a 20% volume decline for the four main industries in Germany: automotive, mechanical engineering, electrical equipment and chemicals.

The scenario results are available for Mira ABM users through the Excel App or linksmira.com.  

 

Risk Wire: China – The Threat of Unchecked Leverage

In the six years since LINKS first covered risks of excessive leverage in the Chinese economy, both understanding of and dealing with leverage has been a key focus for the government of China. Despite this focus and even though the debt is domestically funded, the results of deleveraging are less than encouraging. Sustainability of this debt is further away, which has major consequences for global investment portfolios.
In 2012 LINKS Analytics wrote about the looming debt crisis in China (Global Systemic Risks, 2012). At that time, we estimated the size of the local government finance vehicle (LGFV) debt at $4.2 trillion, or nearly double the size of Moody’s estimate. The conclusion was that the size of this debt was too large to grow out of (as China had previously done).
Through the following six years China’s policy makers continued to balance the demands of managing the mounting debt on one hand and delivering the economic growth on the other. China’s economy did not implode under the debt burden but judging by the now widespread recognition of the problem, the debt issue did not go away.
We believe It is now time to revisit the issue of systemic risks posed by China’s economy, focusing specifically on the following questions:

  1. Is China still inefficient and is debt still accumulating?
  2. If so, is it more or less sustainable in 2019 compared to 2012?
  3. What are, if any, signs of imminent distress?
  4. What would be the impact on balanced portfolios in case of an economic collapse?

To answer the last question, we use scenarios in LINKS Mira Agent-Based Model (ABM), which enables assessment of system-wide impact of scenarios on investment portfolios.

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Risk Wire: The Fragile Exposure to Technology

Much has been discussed about the technology sector concentration of S&P 500. Although we find that the degree of concentration is not unusual, once certain myths about the largest companies are dispelled, the nature of exposure and corresponding end-market risks indicate a degree of fragility.
The concentration of the US stock market performance in the technology sector has been source for concern in the last few years. The variedly used FAAMG or FAANG acronym (alternating inclusion of either Microsoft or Netflix along with Facebook, Amazon, Apple and Google/Alphabet) has successfully taken its place next to the old favourites, such as BRICS or PIGS.
Much like the latter two sets of countries, the companies in question have more differences than commonalities and it is the underlying markets that drive the risk profile rather than the companies themselves: fortunes of Google and Microsoft are as aligned as the future performance of Brazil and India. Although there are common drivers, the specific risks are driven by underlying end-market exposures. In this issue of Risk Wire we attempt to zero in on the ultimate sources of risk with respect to the leading technology platforms, dispelling some myths on the way.
To be clear, this is not analysis of the technology sector investments in general. Rather, we attempt to evaluate the exposure of the market to the five leading companies and the underlying risks that exposure implies.

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