Financial markets did not see coronavirus coming. But some people did, including the American epidemiologist Larry Brilliant.
“The whole epidemiological community has been warning everybody for the past 10 or 15 years that it wasn't a question of whether we were going to have a pandemic like this. It was simply when,” said Mr Brilliant in an interview with Wired magazine this month. “It's really hard to get people to listen.”
Everyone – financial markets included – is listening now. And if there’s one small potential silver lining to the current health crisis, it’s that science will be granted a much greater role in influencing public policy. However, it feels like wishful thinking to expect the investment industry to emerge from this crisis with its risk management credentials intact.
This isn’t to argue that sophisticated investors should have predicted Covid-19, or its rampant global spread. But a look back at the last few months of commentary tells us a lot about the inability of even the best-resourced financial market actors to account for, let alone manage, the next major risk to investor portfolios.
That, in part, is the nature of low-probability events, or 'tail-risks' as they are known in investment jargon. It is easier to focus on existing threats, precisely because they are measurable. But focusing on what is known also encourages group-think, and a complacency towards what are only retroactively called ‘black swans’.
For much of the last four years, the favourite buzz-phrase of banks, asset managers and other large institutional investors has been ‘geopolitical risk’. On one level, the tendency to describe both the world and the global investment landscape in terms of elevated geopolitical tension was (and is) understandable. Chief among these concerns is the world’s pre-eminent superpower, which in recent years has responded to the rise of China by turning inward and combative, sparking a rethink of globalisation and the rules of trade.
But is it possible that this narrative became too dominant in the wide universe of potential risks to asset prices?
Take passive fund giant BlackRock (US:BLK), one of the many exponents of this approach. Each month, using data from its ‘geopolitical risk dashboard’, the group plots the relative likelihood of its ‘top 10’ international flashpoints against their potential impact on global equities (see picture below).
Each of these risks reflect known tensions with real implications for financial markets. But what use is a list of potential ‘non-market’ shocks that fails to capture far greater ‘non-market’ threats to global equities? As we wrote in December, BlackRock’s “assumptions look sensible. Risks notable by their absence: climate change, pandemics and rising inequality between and within nations.”
The investment firm is not alone. With the benefit of hindsight, HSBC’s (HSBA) assessment of the biggest risks facing investors in 2020 also looks myopic, herd-like and somewhat vague. “In the context of muted economic growth, shocks can come from various sources, including geopolitical risks,” the bank’s asset management arm told clients in December. “Considering the environment, and high valuations across some fixed income segments after this year’s rally, we think investors should be selective moving forward. An emphasis on fundamentals will be important.”
Even when the coronavirus had already begun to spread outside of China, the risk management industry was failing to connect the dots to the wider looming impact on the global economy. On 13 February, a team of equity and risk researchers at US-headquartered index provider MSCI (US:MSCI) published a report that focused solely on the stress on China’s economy and its knock-on effects for various equity markets.
“A hypothetical 60-40 portfolio could lose around 3 per cent, whereas global equities could lose slightly more than 5 per cent under a stress test we conducted,” the report’s authors concluded. A month later, MSCI’s own World Index was down 30 per cent.
