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Uncorrelated
reflections - Zuhair Mohammed

Our viewpoint

I’ve been helping institutional investors since the late eighties and I’m not convinced we need a new paradigm every time we face a new economic adversary. A simple diversified strategy would have served you as well in 2020, as it has in previous years, and will most likely continue to do so.

“Following the science” is harder than you think  

We’re not capable of managing extreme economic shocks

When people talk of managing risk to 1 in 200 years or worse still 1 in 10,000 years, I can’t help but think we are deluding ourselves.

Broadly, we’ve all experienced the same 10-40 years during our working lives and we’ve read the same books about historic economic events. It feels hugely optimistic to think we now understand all the ways in which we can go into an economic downturn and manage our way out of it.

Even those that considered pandemic risk got it wrong. Surprised? I’m not. Let’s just consider how it would feel if you were making the case for this extreme outcome?

You ask for a meeting with your company’s audit and risk committee. In preparation, they ask you to attach a probability of a pandemic occurring, assess the impact (gross), think of potential mitigations and therefore opine on the net impact to the company.

Using your cunning intellect, you rightly predict the timing and consequences of a pandemic like Covid-19. You tell them it could bring the company to its knees, extreme cost-cutting will be needed across the entire operation, essential workers will be redefined within your organisation, the contingency plans for offsite offices will be redundant and staff will have to work from home between caring for kids and possibly the vulnerable. You even identify how different economic sectors will fare.

It wasn’t so much that you were accompanied from the room, as the roar of laughter which still haunts you to this day.

We need to be honest with ourselves about our ability to imagine the unimaginable, if anyone would believe you even if you could, and therefore how much control we can really exercise. That awareness means we can own up to holding a subjective contingency margin for all those unknown unknowns. Not everything in finance can be quantified.  

Lies, damned lies and statistics

The crisis took hold in Q4 2019 in China and the human traffic over the Chinese New Year celebrations meant that there was little chance of it being contained in one area. Let’s look at the “facts”. The official Chinese numbers looked small and local doctors were being silenced when they tried to alert the world. Then the percentage of infected Chinese visitors arriving abroad didn’t tally with the official numbers, so the story changed.

But it’s not just the Chinese numbers that look dubious. Try getting any consistency in the number of deaths from one country to the next and you’ll soon realise no-one wanted to be tarnished as the worst hit. That label had real economic consequences; travel bans, trade flow was disrupted and there was political risk.

So maybe “the only thing certain in life is taxes”?

“In the short-run, the market is a voting machine but in the long-run, the market is a weighing machine”

Worse still, in the short-term, is the market voting on the correct matter? When coronavirus was first taking hold, what was the market focused on? Trump’s paper-thin trade deal with China, which is one of the shortest reads you’ll find on international trade; even the “thin” Brexit deal is over five times longer.

The markets only took the virus seriously when it came to Europe and the US. Selling was indiscriminate, panic took hold and the usual sources of liquidity became costly to trade. Having a clear liquidity ladder and holding your nerve proved to be the best course of action. Not least because for the second time in as many crises, the central banks came to the rescue but this time they were joined by fiscal stimulus on an unimaginable scale.

How might indebted countries deal with the debt load?

Remember the stories about the US trillion dollar debt? Strange how the market seems to have forgotten that but it’s not about to disappear fast, so watch this space. We may not see hyperinflation, but the net result will be the same.

Couple normal inflation with negative rates and hey presto, the debt slowly becomes more manageable. You might be concerned about wage inflation but our labour market was nowhere near true capacity (just think of the part-timed, self-employed that might yearn for full-time employment contracts) even before the pandemic and with a more isolated workforce, they will have less bargaining power on wage growth. With online deliveries and self-serving machines, full employment may be a thing of the past in certain labour-intensive sectors.

A further attraction to negative rates is that it slowly but surely ebbs wealth away from the baby-boomer generation to the younger generations. Politicians can pass the blame onto the economy, so they don’t face the wrath of the grey-haired voters.

Over-arching all of this is one basic fact: the finance rule book can always be rewritten by those in power. The Dollar has just become the longest-serving reserve currency in history and who knows whether a new digital coin reserve could be used to redefine debt burdens?

So where does this leave us?

You don’t have to restructure your asset strategy every time we’re faced with a challenging event. You spent good time and money building a well-diversified beta strategy and a sound liquidity ladder – keep the faith. Trying to jump on to the financial-engineering bandwagon, just at the right time is a fool’s errand. They’ll have fleeting moments of glory and bragging rights but in the long run, it’s your beneficiaries that will be grateful for your pragmatic risk management.

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