Author: linksweb

Nassim Taleb, and Benoit Mandelbrot before him, referred to “black swans” as extremely rare, significant events with non-calculable probabilities. Covid-19 is not such an event and its consequences are quite predictable. Among other things, Covid-19 may have accelerated the dominant trends in the economy, with significant impact on long-term expected returns of equities and bonds.

There is a school of thought that our experience of Covid-19 is largely due to the echo chamber created by social media. If this were the case, it is hard to imagine that the global pandemic could have any meaningful long-term impact on the economy. To a very limited extent this line of reasoning is justified; there are many things about the novel corona virus that are very unremarkable: we have experienced viruses both deadlier and more contagious, even viruses that are deadly and contagious at the same time.

• Detailed assessment of pandemics in the last 1000 years and why this history is NOT applicable
• Detailed industry-by-industry assessment and impacts
• Relevant impacts for interest rates, equities, GDP and profitability by region
• Calculations based on the comprehensive data-driven forward looking Mira ABM analysis

Precisely because of this, Covid-19 is not a “black swan” event in the sense that almost all its features are very ordinary. In fact, the novel corona virus is remarkably like another very average virus – the one that caused the 1918 flu pandemic killing by some estimates nearly 100 million people and causing multiple decades of economic impact.

Webinar / Covid-19: The Long-term Impact

Full webinar is now available. Click below to access the recording.

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.

Despite the immense importance of the foreign exchange exposure for global investors, the generally accepted approach to currency hedging at euro-based pension funds is too generic, sometimes – counterproductive and often driven by inaccurate assumptions.

Pension funds in the Netherlands and elsewhere in Europe implement a foreign currency (FX) hedging policy with an aim of limiting the risk (measured in terms of volatility) of the investment returns and consequently, the funding ratio. A typical hedging policy consists of multiple ad-hoc rules by asset class and may include for instance a hedging ratio of say X (usually below 100)% for JPY, USD, HKD and GBP equity (and similar) exposures and 100% of developed market and USD- denominated emerging market bonds. In this issue of Risk Wire we assess whether such ad-hoc rules can be improved by examining a large number of wholistic hedging policies for all asset categories in combination, and for the balance sheet of the fund (including liabilities). The question to be answered is whether the current typical policy can be improved by either limiting the costs of hedging at the same risk level or by achieving a lower volatility at the same cost.

The goal of the currency hedging policy is to strike a balance between:

• limiting the volatility of the assets and the funding ratio
• limiting the drawdowns in extreme circumstances and
• limiting the cost of currency hedging.

LINKS have carried out an empirical study based on actual monthly returns of the underlying asset classes, using a realistic portfolio rebalancing policy and multiple hedging policies. Our analysis
shows that:

1. hedging the total US dollar exposure at a significantly lower level than the typical current policies would deliver better results given the period of analysis. The optimal hedging ratio of US dollar for the full period examined (2005-2018) is close to 20%.
2. currencies other than US dollar may be hedged up to 100%, however, the only currency that has a meaningful impact on a typical pension fund portfolio if hedged at 100% is the British pound.
3. at the balance-sheet (funding ratio) level, the hedging requirement of US dollar exposure is even lower, as liabilities become a partial natural hedge against the US dollar If the analysis period is expanded or assumptions changed, the optimal hedging ratio for US dollar may increase to as high as 40-50% driven by costs and number of extreme events in the period. We have not found circumstances in which higher hedging ratios for US dollar are beneficial for a fund’s return or volatility.

The complexity of hedging the US dollar is entirely due to its safe haven status. The conclusions in this report are valid only if the safe haven status of USD is retained. Any major macroeconomic or geo-political shift precipitating change in the safety perceptions of US dollar will require revisiting the conclusions of this study.