RE:drunken equities markets Markets Go Viral 
The deadly new coronavirus is spreading around the globe.
January is not yet over, and already 2020 has confronted investors with two black swans. First there was the brief intensification of the conflict between the U.S. and Iran, which quickly ramped back down — although it would be unwise to bet too much that it will stay that way indefinitely. And now there is the coronavirus epidemic in China, which in the space of a week has spread from Wuhan and imprinted itself on the world’s consciousness, while bringing much of China to a standstill when it would usually be celebrating the Lunar New Year.
Black Swans Like most readers, I care about this most as a human being, rather than as an investment commentator. The prospect of a deadly epidemic is horrific. But viewed dispassionately, the incidents have the following things in common:
- The actual damage (in financial or human terms) is still minimal in the greater scale of things, though the death toll from the virus continues to rise, as do the number of confirmed cases.
- The risks involved are truly terrifying — World War III, or a global pandemic.
- The chance that those risks will actually happen is close to impossible to identify.
- The damage that would be involved in a realistic worst-case scenario, or even a nightmare scenario, is truly impossible to quantify.
For all these reasons, the intensified hostilities between the U.S. and Iran, and now the coronavirus, are risks that make life very difficult for asset allocators. There is a risk involved, and the probability of that risk is higher now than it was. But we don't know exactly how much higher it is, and how to adjust assets accordingly.
Thus for the time being it would make sense for investors to behave in the way that the “random walk” theory would suggest they should, and adjust prices to each new piece of information — which at this point probably means dialing down risk somewhat. In practice that is unlikely to happen. More likely, unless we are blessed with emphatically good news over the next few days, we will suffer a classic investment panic. The level of anxiety, rather than actual information, will dictate the market response, and that means that the market will be driven by crowd psychology. When a narrative takes hold, the Nobel laureate professor Robert Shiller now recommends that the best way to understand its effect on markets is through epidemiology. As the coronavirus becomes an epidemic in the physical world, we should expect fear of coronavirus to become an epidemic in the financial world.
Previous epidemics: SARS and Ebola How can we measure that crowd psychology? One good old-fashioned measure that works well is the magazine cover. Peter Atwater of Financial Insyghts kindly provided these illustrations of how The Economist called the peak of the panic over the last two most similar alarms over epidemics.
The SARS epidemic of 2003 is the most similar to what we now confront with the coronavirus. The current situation is not as grave as SARS became, but SARS might easily have spread further, and this epidemic could yet be even worse. Atwater shows that the moment of peak press interest, and the low for Hong Kong’s Hang Seng index, came as SARS made the cover of The Economist.
The other obvious parallel is the 2014 American scare over the Ebola outbreak in western Africa. As I showed last week, two dips in the S&P 500 in the latter half of that year overlapped exactly with peaks of concern over Ebola, as revealed by Google Trends searches. And again, The Economist was there with Ebola on the cover at the point when the panic reached its apex:
The news this weekend has been very concerning, and coronavirus is already beginning to dominate the headlines. It has become an epidemic more quickly than SARS did, and has already found its way to countries as dispersed as Australia, Canada, the U.S. and France. Thus, I suspect it will pass the magazine-cover test very soon. And we should all hope that magazine covers mark the bottom once more. Ebola prompted a sell-off of almost 10%. Providing this epidemic can also be brought under control before it breaks out in the western world, the chances are that it will create a buying opportunity before long.
The most recent epidemic: MERS What are the likely longer-lasting effects? For a tighter parallel to use as a base case, the foreign exchange team at NatWest Markets suggests the South Korean outbreak of MERS (Middle East Respiratory Syndrome) coronavirus in 2015 as the most similar. This is how that disease spread, and the effect it had on the Korean won:
The outbreak began to come under control after three weeks, with the last death occurring a little more than a month later. It did lead to a rate cut by the Bank of Korea that might not otherwise have happened and, as we can see, a strengthening in the dollar against the Korean won — although much of this was due to general strength for the dollar at the time. Now look at the spread of the latest coronavirus so far, this time substituting the offshore Chinese currency:
So far, the spread of the disease looks similar, as does the reaction of markets. But there are some important caveats. First, the Chinese yuan had been in the process of appreciating against the dollar, as part of the trade detente with the U.S. That reversed last week, thanks in large part to the virus. Should it weaken much further from here, as the won did during MERS, it will need to go back through the level of 7 per dollar. So this has the potential to destabilize the most important and difficult trading relationship in the world at a difficult time.
Second, this is happening at the Lunar New Year. The travel associated with the holiday makes it harder to contain the virus, and also has great effects on economic activity. Further, with Chinese authorities now having opted to extend the holiday as part of the battle to contain the virus, it will have an effect on the rest of the global economy. China’s economy simply matters far more to the world than it did during SARS in 2003, or than South Korea’s did during MERS. So if there is a base case, it is that Chinese economic numbers take a noticeable hit, and that its currency depreciates noticeably again.
What is the worst-case scenario? I have no idea how to quantify the risk that this epidemic surpasses the SARS death toll of about 800. The influenza pandemic of 1918 killed 50 million people, and affected a fifth of the world’s population. There is no point in working on the assumption that a disaster on that scale lies ahead of us. But this is the problem of a black swan; it isn't even clear exactly what a “realistic worst case” might be.
In the meantime, unless you are an epidemiologist with good reason to believe that you can predict the course of this epidemic better than the rest of us, you should probably make no adjustments, beyond tweaking models to assume a weaker Chinese currency and slower Chinese growth. It is uncomfortable not to do more, but there simply isn't good enough information to help manage risks or allocate assets.