COVID-19: Beyond Rational
War gaming the economic and financial fallout from coronavirus.
We seem to have lost our minds. The Novel Coronavirus has sent the world into panic and our common sense on a heavily discounted holiday package. There’s a region of 60 million people in quarantine, California in a state of emergency and fights breaking out in Australian supermarkets over a product that is made locally (toilet paper).
The toilet paper memes come dripping in humour reflecting that classical Australian larikkanism; but there are undertones of true panic and fear as supermarkets ration toilet paper, canned foods and sanitiser. This phenomena is no longer limited to the rioting and infected Hong Kong or hysterical Australia but is ocurring in the UK and US as well. We should ask ourselves: is the mass hysteria justified or should we all take a deep breath, practice good hygeine and carry on?
There are so many ways that the ‘pandemic’ could play out, but I think we actually need to ‘war-game’ a few scenarios. To make the best possible decisions and investments we need to understand the potential impacts on the economy, financial markets and the everyday person.
As far as the virus is concerned, I think we can all accept that the genie is out of the bottle, the cats out of the bag and there’s no way we can put it back in.
The State of Things
For us to press play and watch the virus unfold in our scenarios we have to understand where we are today. Currently there is a distinct lack of any public plan to tackle the virus from government or international institutions. There is a lot of talk of plans though, and there is a quarantine program that is distinctly like the game whac-a-mole — where governments spot the virus and hit the area with a quarantine.
So far this approach has slowed the infection rate of the virus and limited the known infections to a tiny percentage of the population. Health and hygeine advertisements have been successful, and surprisingly impressive has been the corporate response, with a swift adoption of working from home initiatives.
As I mentioned the infection rate as a percentage of the population is incredibly low, but the mortality rate is elevated when compared to traditional influenza. However, the mortality rate (deaths) is concentrated to the elderly and those with pre-existing conditions.
In short; you’re probably already aware of the state of things and it’s probably changed again since I wrote this analysis. Therefore the baseline case for our scenario testing, is a China that is slowly easing the population back to work while the rest of the world attempts to deal with contagion. There are two strains of the virus, and in the future it will become a regular seasonal virus such as influenza.
The process of dealing with contagion in the Western world has been in stark contrast to the East. Instead of quarantining entire regions (think Hubei) the West seeks to quarantine sites such as hospitals, to close schools, suspend sporting events, cancel major events or mass gatherings, and force employees to work from home rather than come into the office.
Central banks have announced monetary stimulus to help prevent the health risk (contagion) becoming a financial risk (contagion) and to assist firms with challenges of increased costs and reduced income. Governments have turned the fiscal stimulus taps on to help with healthcare, employment and business solvency.
These measures seem to cumulate into an overarching plan built on hope and buying time. This is an international plan that slows the virus down long enough that summer comes around to kill it or a vaccine is discovered, tested and fast tracked to mass production.
Investing Strategies
Investing in this climate can make for tense, nerve racking moments and white knuckles. There are both lots of opportunities and lots of big scary holes to lose your money in. A lot will depend on the level of risk you are comfortable with and I hope that our scenarios will help you structure your portfolio according to your appetite.
Be fearful when others are greedy, and greedy when others are fearful
— Warren Buffett
A lot of commentators, investors, and punters will say it’s all about value, risk management and opportunities. I believe in times like this it’s about asking; what’s changing?
Are the changes macro or micro?
This is beyond a doubt a macro economic event and there will be structural changes at the macro level. Secondary manufacturing sites will need to be established in geographically diverse locations. For instance, a firm that has two warehouses in China or Asia may now have one in Asia and one in somewhere like South Africa — which has cheap labour and is on a key shipping route. Alternatively we may see a shift in preference for domestic manufacturing, but ultimately at the macro level the only long term impact is a reshuffling of manufacturing and shipping routes. Once the short term shock dissipates the world will largely be the same at the macro level.
At the micro level, I believe the game is going to change. Individual preferences and decision making will be changed for years to come. Fundamental differences in the way firms and households approach work, travel, and consumption. As more and more employers are forcing staff to work from home the consumption and entertainment patterns will shift.
Online shopping should boom, online groceries for instance will become more normalised. If shortages of goods do eventuate then mild hoarding behaviours may appear, just as they did in the boomers parents after the Great Depression. Finally, retailers may diversify their supply lines so they aren’t dependent on goods manufactured in one country.
So rationally or irrationally, the everyday person is going to change their behaviour as a result of coronavirus. Just think, are you washing your hands more? Have you considered buying a mask or santiser? Have you stocked up on toilet paper? Are you working from home?
How do all these changes in preferences and behaviour drive investing?
Well they change the demand for certain businesses. If schools are closed then what are the school kids going to be doing while they are quarantined? I tell you, they will be streaming content, they will be on social media and they will be playing video games. So who wins if schools close? Companies like Activision Blizzard, Microsoft, Sony, Snapchat, and Disney win.
If more and more businesses follow Rio Tinto, Microsoft or Clayton Utz’s examples of forcing their staff to work from home then what happens? Well investment in technology like laptops, webex, online team chat, online project management goes through the roof. Companies like Citrix, Slack, Microsoft and Cisco win.
So if you’re looking to take on risk then think about how your behaviour is changing, think about what your friends or colleagues are doing and identify the companies that benefit from that change.
Of course there may also be a tonne of stocks on ‘discount’ so you can always look there but I’d read through the scenarios first.
Scenario Analysis
Scenario One
Scenario one will be our worst case scenario. Ultimately the worst case scenario would be a Spanish Flu repeat with millions of deaths. That doesn’t seem likely given the advances in medicine, science, healthcare, food and diet. The last 100 years have also involved huge innovations for consumers to access preventive products like sanitisers, masks, vitamins, soaps, and pain/fever relief. Not to mention the infection and mortality rates don’t appear to be high enough to warrant a Spanish Flu repeat.
So our worst case scenario is mostly an economic disaster. The ego’s of decision makers at the WHO and in government continue to create panic by calling the event a pandemic and issuing states of emergency. Quarantines are continued en masse and international school closures occur. Effectively the world shuts down and goes into isolation as people work from home and avoid human contact. The fear intensifies and businesses start to fail.
A month of quarantines, working from home and school closures will result in lost revenue in the trillions of dollars. Starting with small and medium enterprise, businesses will begin to shut down. They simply can’t afford to pay wages, pay their debts or operate when revenue is reduced so severely. In places like Australia that have been ravaged by other events like Bushfires or floods then this turns out to be month three or four of next to no revenue.
Defaults start to pile up. Auto loan defaults come first, then business loans and corporate debt, followed lastly by home mortgage defaults as people find themselves without jobs. The supply chains will be completely gone by this stage so no goods made from virtually anywhere will be available. Unemployment goes to 8% and then up to 15%. Government packages and fiscal stimulus will be way to late to help the businesses that have already knocking on the door of bankruptcy and with that the banks will go down too.
The market drops by 60% and the global economy is shot. It will take years to recover but the rebuild will be on huge stimulus and debt and after 5–10 years investors will all have made their money back. Assuming the companies they invested in didn’t go bust.
Scenario Two
Scenario two will be our best case scenario. What happens here is relatively simple. The world leaders acknowledge that they can’t stop COVID-19 so they engage in fiscal stimulus to help businesses in the short term, as well provide consumer relief to encourage spending. The governments assist with developing a vaccine, supports businesses manage rotational working from home and either provides households with preventive tools like santisers, tissues and hygeine instruction kits or subsidises preventive products for purchase.
They also ramp up on educational marketing on how to stay healthy and avoid the virus while encouraging people to quarantine themselves if they notice any symptoms. The acknowledgement that this is an ongoing and seasonal virus like the flu helps calm the environment and stops the mass hysteria. Confidence starts to be restored and while cases continue to rise, both the market and the public recognise the seasonality and proactive governments so adhere to instructions and carry on as per usual.
There is a U shape rebound in the equity markets and bond yields return to more normal levels. Before the next season starts the government announces a vaccine is available for free and they prevent next years chaos. In the mean time, companies announce earnings and there isn’t a significant impact except companies exposed to pathology, healthcare, business online communication and online/digital entertainment demonstrate a bump in earnings from people spending more time at home.
This may be way to optimistic given the craziness of today but that’s best case.
Scenario Three
This is not the most likely scenario but it’s just another alternative selected out of myriad options.
COVID-19 is labelled a pandemic and the majority of workplaces go into effective shutdown. Employees are asked to work from home where possible and to maintain a vigilant personal hygeine regimen.
Schools are closed for two weeks on a state wide basis. Temperature screening is conducted at all public transport stations and terminals. The number of infected persons continues to rise and probably reaches 500,000 globally. Mortality rate remains relatively low and concentrated to the elderly.
Significant disruptions and loss of income cause mortgage delinquencies and auto loans to rise. Small and medium enterprise closures increase, however some government stimulus enables them to stay operational during the period although they have to lay off non-essential staff. On the news of lay offs, mortgage arrers and low company profits the market slides another 20% to make it 30–35% down from the top.
China becomes a shining light of hope as traffic continues to pick up, steel consumption rises and normalcy starts to return. A second wave of government stimulus and interest rate cuts see the world through June and July. From there the recovery is on the way as the general public have media fatigue on the coronavirus and most people have been infected whilst only displaying mild symptoms similar to that of a cold.
In another 12–18 months investment returns have skyrocketed as business investment in manufacturing, construction and online services go through the roof. The risk has been identified and it all becomes about risk mitigation.
Who Knows
In the end, no-one really knows what’s going to happen or how this virus will be written in the history books. It’s a significant event but it’s no time to panic. Position yourself and your portfolio according to your risk appetite and what you believe will happen. Remember if you exit out of the market completely you may miss a big recovery, but if you stay fully invested you might lose more capital. If you feel the need to go stock up on toilet paper tonight then go do it, but I’d also suggest your risk appetite might mean you should take some capital out of the market too.
You’re risk appetite should determine how big your cash positions but remember your investments should reflect the world around you and only invest in businesses you understand. Think about how your behaviour is changing, think about what your friends and colleagues are doing and identify the companies that benefit from that change. Above all, keep a clear head and stay rational.
If you have any questions then please feel free to comment, and if there is anything you’d like to see analysis on or read about in the future then let me know.
Also, please note that this article does not represent financial advice or the views of any organization; it is only the opinion and analysis of the writer.
Thank you for reading.
Yours,
Chris Leeson
