Counting the cost of catastrophe says Old Mutual Wealth
The continued rapid spread of the Wuhan coronavirus – which goes by the technical name of 2019-nCov – is still dominating the headlines and markets have predictably been under pressure over the past few weeks. This raises a number of important questions, including how we should think about potentially disastrous events in an investment context.
Highlights of this week’s investment note include:
• What do we know so far? More people have now been infected than in the 2003 SARS outbreak, but fewer have died, about 2% of those infected. The Chinese government has acted with speed to contain the spread of the virus and treat patients. This is clearly hugely disruptive and will knock first quarter economic growth in China. Its own economy has also shifted away from a focus on manufacturing to consumption and services. The 2019-nCov economic impact might therefore be worse than SARS in 2003, even if the virus is less deadly. The negative economic impact from 2019-nCov is therefore not the scale of death or hospitalisation, but rather the disruption to economic activity as a result of the precautions taken to halt its spread. The outbreak of the virus was an unexpected shock to the Chinese economy, but if the contagion is contained, the fear will go away and economic activity will resume.
• Apart from the coronavirus, the increased attention on global warming and rising Middle Eastern tensions have brought the idea of catastrophe to the fore again. There is always uncertainty when investing for the simple reason that we cannot predict the future. We can make educated guesses (otherwise known as forecasting), but will never have absolute certainty. It is when unknown risks materialise that market mayhem ensues. As former US Defence Secretary infamously said in the context of the Iraqi weapons of mass destruction they never found: “There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns - the ones we don't know we don't know… it is the latter category that tend to be the difficult ones”. These unknown unknowns are known as “tail risks” or “black swans” in investing jargon: low probability events with potentially disastrous consequences.
• Apart from the relatively small asset class of catastrophe bonds (which pay out when something really bad but specific happens, like a hurricane), the best defence we have is diversification. While equity markets have sold off everywhere in response to the coronavirus fears, global equities were still positive in rand terms in January due to the weaker currency. South African investors have a lot of exposure to Chinese consumer spending through shares like Naspers and Richemont, and to Chinese industrial activity through the big commodity exporters. Local equities have therefore been hit by the coronavirus.
• Climate change, which is really a euphemism for global warming, presents a new problem for investors that is rightly getting a lot of attention. Broadly speaking, there are three risks to portfolios: an unstable climate can lead to more disasters (such as hurricanes, floods and bushfires), disrupting economic activity and leading to huge insurance losses. Secondly, some areas might become undeliverable due to rising sea levels or persistent droughts, leading to real estate assets losing value. Thirdly, as consumption patterns and regulations change in response to climate change, it could lead to ‘stranded assets’. These technologies present a huge investment opportunity. Despite our ability to hurt each other and damage our planet, it has never paid to bet against human ingenuity in the long run.
• Back to the present, financial markets are always volatile in the short term. However, over the longer term, equity prices move to reflect company earnings, property prices reflect rental growth and bonds respond to the inflation outlook. History also shows that most of these events have a short-lived impact on markets and the best approach is to be patient and sit tight.
