• April
  • 2020

Unprecedented Uncertainty

Unprecedented, unprecedented, unprecedented...If I had a pound for every time I'd seen, heard or written that word over the past few weeks. These are dark days, we are in the grips of a global public health emergency and right now people are rightly focused on making sure we survive it with as few deaths in our families, communities and across the world. Nonetheless, we have been forced to consider the impact that lockdown’s and social distancing measures are having on our economic lives too. This brings us back to our magic word - whilst pandemics are not truly unprecedented for human civilisation, the last one of comparable magnitude was a century ago. The Spanish flu outbreak of 1918 is generally being considered as comparable to COVID-19 from an epidemiological viewpoint. Some fantastic analysis is being done to see what lessons we can learn from that outbreak - and rightly so. We should always look to history to help us unravel the challenges we face today. However, our economies, societies and lifestyles are immeasurably different from 100 years ago, as are the technology, public health and policy responses we will employ to respond to this outbreak. 

So how do we make sense of what is happening right now? The social and day-day implications of living through the Coronavirus outbreak are likely to be in place, to varying degrees, for weeks and months yet to come. For practical guidance, we should certainly comply with what we are being instructed to do by our governments and take heed to updates given by the WHO. Those of us working in financial services are tasked with trying to quantify the impact the pandemic is having on the global economy.  If for the purpose of this analysis alone, we selectively classify the outbreak as a financial crisis, we see a familiar pattern of behaviour: A flight to safety away from risky assets has certainly been evident in the past 6 or so weeks. Bonds, the dollar and (to some degree) gold have all benefited from the market volatility.  The global financial crisis of 2008-9 is a relatively recent reminder of the last time we witnessed similar moves in asset prices. It is absolutely reasonable therefore to look for a correlation between that crisis and where we might head in the coming months and years.  

The 2008 crisis, ubiquitously dubbed the 'credit crunch', was a disorderly collapse of a long-term structural cycle in the global credit market. The catalyst was an irrational bubble that had formed in sub-prime mortgage lending. Coupled with lapses in adequate regulatory control on asset securitisations, the build-up to the collapse saw bank balance sheet leverage expand by orders of magnitude - quite spectacularly exemplified at British regional lender Northern Rock. Liquidity in assets rated AAA under a mark-to-model process suddenly evaporated. Banks refused to lend to one another, even in the overnight market and the unprecedented intervention by governments across the world, culminating in quantitative easing programs, which was required to maintain the integrity of the financial system. Grim stuff indeed.  Analysts are absolutely correct to point out the differences between now and then. The global banking (and for good measure insurance) industry is now governed by a radically overhauled capital and regulatory regime. The culture of 'casino banking' which had dominated the industry in the noughties is now long gone. It is quite inarguable that the industry enters the COVID crisis in a fundamentally stronger position than they were in the self-induced circumstances of a decade ago. 

This has lead, not at all unreasonably, for many forecasters to predict a v-shaped profile for GDP in the developed world in 2020. Locking-down, never mind socially distancing, the global workforce has indeed led to unprecedented disruption to both supply and demand - the core levers which drive our economies. Predictions of a record drop in single QoQ GDP of around 25% are therefore eminently supportable. The second line in our 'v', the recovery is, unfortunately much harder to support prima-facie. As recently as a fortnight ago, when in fairness many of these predictions were made, the notion that COVID would be a short/sharp event which would not cause structural harm seemed sound. The mistake in that premise was to not model the truly paradigm-shifting nature of COVID-19 and how it will affect our behaviour as economic actors, at least in the medium term.

However, our modelling does not need to be extended solely to factor in more downside risk to our economies. As in the credit crunch, developed economies have rushed to announce sweeping support measures. Quantitative easing went much further than 'invisible hand' proponents would have ever previously thought imaginable. Policymakers, perhaps emboldened by the perceived success of QE, have now turned en-masse to bold Keynesian intervention.  In the UK, Rishi Sunak in his now already long-forgotten budget of the 11th of March gave 'austerity' a final written warning. The measures subsequently announced to support SME's, the employed and self-employed represent an unmitigated notice of termination. The previously held orthodoxy of restraint, temperance and 'living within our means' has now been cast aside. In the short term, we all surely hope that these steps can fill the cavernous hole our absence has created to the viability of our economic structures. In the long term, we will need to watch carefully to see what, if any, unintended consequences emerge given the sheer scale of support that has been offered.

This uncertainty surrounding the impact of the stimulus and the shape of the recovery, in turn, causes additional uncertainty in market outlooks such as forecasts of future expected equity returns or interest rate levels. When tasked with creating such outlooks it is essential to quantify the increase in uncertainty associated with a given forecast. Specifically, this means that expected returns for assets and expected future interest rate levels should be estimated with a given level of uncertainty rather than assuming they can be predicted with total precision. Note that there is a distinction to be made between uncertainty and risk, where uncertainty is defined as the range of outcomes for the mean and risk as the range of outcomes around the mean. In other words, instead of stating that an asset has an average return of 6%, we say an average return in the range of 5-7% even if the risk, or volatility, of the asset stays the same. This distinction aside, we still need to specify the range of outcomes for the mean of all relevant assets for which the forecast is carried out. One approach is to define the level of uncertainty relative to the level of uncertainty in a randomised modelling engine, or Economic Scenario Generator (ESG).

One approach for dealing with the uncertainty of this kind is the Black-Litterman model, originally proposed in 1992,  which provides a suitably adjusted framework for portfolio optimisation. In the original Black-Litterman framework,  views are expressed in terms of a portfolio, but it is also possible to express them as expectations of the future mean of one or more variables – such as an investable asset. The original Black Litterman approach recognises the difficulty in expressing views as expectations when performing portfolio construction “…the optimal portfolio asset weights and currency positions of standard asset allocation models are extremely sensitive to the return assumptions used”. For those interested in a real-world application incorporating this approach, tools are available for you to sandbox.

So back to unprecedented; let’s wrap up with a warmer reflection on what has changed in our lives since the start of the outbreak: For many of us, we are probably for the first time really paying attention to our neighbours and communities and looking out for one another.  We are also looking through new eyes at the role played in our societies by carers, delivery workers and those who work in our food supply chains – to name but a few. We thank them and our frontline healthcare workers sincerely and send them our best wishes in this extraordinary, sad and unprecedented period in our lives.

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