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Risk Wire: Long-Term Investment Implications of Covid-19

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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.

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

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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

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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 Wire: Reassessing the Approach to The Currency Hedging Policy

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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.

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Investment Risk: Higher Rate Drivers

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Institutional investors often assume a degree of “return-to-normality” for long-term rates in their investment plans. But what are, if any, the preconditions for return to higher interest rates? And if those preconditions are not met, what could be the expectation range that takes into account the structural drivers of interest rates?

The fortunes of pension funds at least on paper depend on the level of long-term (real) interest rates. Despite new all-time highs in equity prices, pension funds are not keen to celebrate so long as the rates remain subdued and the net present value of liabilities remains high.
Our conventional “classical” understanding of business cycles suggests that there should be a positive correlation between long-term interest rates (bond yields) and equity markets: as the aggregate demand picks up, so does the long-term GDP growth rate and finally – interest rates. This understanding however falls short of explaining the secular decline in long-term interest rates observed in most of the developed markets.

 

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Dissecting the Risk of EM Sovereign Bonds

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In a negative yield environment of present days the high single-digit dollar yield of emerging market sovereign bonds is indicative in itself: few believe that the principal will be repaid as debt levels are anything but sustainable. Even before the maturity, any global liquidity event could render these bonds worthless. However for a selective investor the asset class may offer a very interesting yield opportunity with limited debt sustainability and contagion risks.
There have always been plenty of wrong reasons to invest in the financial instruments issued in a collection of countries inappropriately termed emerging markets. To be clear from the onset, these countries have very little in common that would warrant bundling them together, and what is more important, as a group they are not emerging anywhere. Yet, there is at least one good reason to invest in sovereign bonds issued by some of these countries at present – reasonable yields at limited incremental risk. 
What we call reasonable yield is close to 7% for dollar-denominated sovereign paper rated BB and below. Few would argue against the reasonableness of that level given the present environment of negative yields in Europe. A somewhat more difficult argument needs to be constructed to support the assertion of limited added risk. This issue of risk wire expands on the real and perceived risks of investing in dollar-denominated EM sovereign bonds and proposes a controlled implementation process with a custom benchmark. The custom benchmark achieves a level of risk-return combination that is appealing, something that the standard benchmark fails at, particularly once we take into account all aspects of risk.
Key to our argument for limited incremental risk is that past EM crises have one way or another been induced by rising USD interest rates and unsustainable debt levels. In our earlier issues of Risk Wire this year it was demonstrated that yields were very unlikely to rise any time in the foreseeable future.
We get the first hint of the attractiveness of the asset class while comparing valuation/pricing risk across asset classes – the Graham Risk levels (Figure 1). The GR level of -2.7% for EM USD bonds means that there is at least that much yield cushion: given the current macroeconomic risk in these markets the fair compensation for risks is ~4.3% yield instead of the 7%. In other words, an investor in these bonds is overcompensated for the risks.

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Deflation Across Industries

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Falling prices of commodities have been passed through the supply chains to most industries with varying effects. Industries that are more consolidated and manage to keep the output prices stable enjoy higher margins, whereas more fragmented industries see output prices falling quicker than raw material prices. The overall picture is unfortunately negative for equities and equity-linked asset classes.

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