Strategy Note /

Coronavirus: Should it be ignored because it is such an unquantifiable risk?

    Hasnain Malik
    Hasnain Malik

    Strategy & Head of Equity Research

    Tellimer Research
    25 February 2020
    Published byTellimer Research

    The coronavirus (COVID-19) is an unquantifiable risk for investors. We know it is material and global (both in terms of countries and sectors) but we simply cannot adequately estimate how lasting will be the damage. 

    Even if the pace of infections slows and quarantines, travel restrictions and industrial supply chain disruptions prove temporary, the damage to highly levered corporate balance sheets and banking systems, vulnerable currencies, geographically concentrated supply chains, and even political legitimacy may be more permanent. 

    We have highlighted before the risks to, for example, the tourism and commodity sectors. We could add the industrial manufacturing (technology hardware, autos) to this. There is almost nothing left which is entirely immune in the small emerging and frontier markets.

    Below we explore what are the possible responses open to emerging and frontier equity portfolio managers and argue that ignoring such an unquantifiable risk may be the most rational approach.

    As with any outcome that is difficult to quantify, there is very high sensitivity to any change in the trajectory of data on infections and associated deaths; e.g. the leap in reported cases in China on 13 Feb following a change in definition, or the spike in cases internationally such as in Iran, Italy and South Korea on 21-22nd Feb. The Iran example is particularly noteworthy because it is the first major spike in a country with weak public healthcare infrastructure relative to developed markets; surely, there are bigger population countries with even weaker healthcare provision which have not registered many cases yet (e.g. Ethiopia, India, Indonesia, Pakistan)

    Judging what are consensus expectations of the coronavirus are complicated by the policy response of economic stimulus and the precedent (however highly imperfect) of sharp asset price recovery after the 2002-03 SARS pandemic (both factors lead to a default strategy to "buy the dips").

    So, what is the best course of action for active portfolio managers in pre-defined asset classes (e.g. emerging and frontier equity portfolios) who cannot simply "take risk off" in the manner of global multi-asset macro funds?

    (1) Ignore the coronavirus because it is almost impossible to establish an analytical edge on a risk with such global repercussions and using such immature, unreliable and incomplete data (i.e. treat the risk as a falling and rising tide that floats or sinks boats indiscriminately). We do not run portfolios but we are inclined to recommend ignoring the coronavirus (and this may be a circular conclusion from our premise that this is an unquantifiable risk).

    (2) Reduce exposure to companies with vulnerable balance sheets (which can less easily withstand the hit to near-term cash flow) and to countries with weak banking systems or vulnerable exchange rates (the intra-asset class equivalent of taking risk-off). The problem with this option is that if the coronavirus proves more temporary relative to expectations (whatever those are) then these higher risk positions are likely to rally the hardest.

    (3) Keep re-calibrating the portfolio to the coronavirus risk as new data on the geographic spread of infection comes through. The problem with this option is that it assumes an ability to predict where the virus spikes next (and in the less liquid emerging and frontier equity markets it usually not possible to be this nimble anyway).

    (4) Take on the most risk (the highest leveraged companies and the countries with the most vulnerable banking systems and external accounts) on the assumption that governments will ultimately counter the negative economic effects of the coronavirus with economic stimulus (e.g. easier central bank liquidity) and that relatively more vulnerable exposure benefits the most. The problem with this option is that the global coordination necessary on timely policy to combat the spread of infection and to stimulate the economy is probably less likely after years of erosion in global institutions; in other words, things may get a good deal worse before they get better.