The COVID-19 shock has challenged the world’s healthcare system, economies, social life and job security in ways that most of us could have scarcely imagined pre-2020. So many questions have been asked: when and how the virus will be tamed; when will social distancing measures be relaxed; what will the effects of the lockdown on consumer confidence and general well-being be; and obviously, how the economy will be impacted by the pandemic, and how it will evolve in response to the shock. There is a great lack of clarity, but one thing that we have learnt over the years is that “there will always be something”.
Economist Frank Knight made a clear distinction between risk and uncertainty shortly after the 1918 flu pandemic. The future is unknowable, but risk is measurable. The latter can be estimated via data, provided similar situations have happened before. On the other hand, uncertainty deals with outcomes we cannot predict or never saw coming. While risk can be managed, uncertainty makes it difficult to weigh costs and benefits.
Managing uncertainty is expensive – it means maintaining cash and shutting down society. Although public health experts had been warning about pandemics for years, COVID-19 was unexpected and shocked everyone. What made things worse was that there were a lot of unknowns about the novel virus – how it affects people from different generations, the quantity of asymptomatic patients, true hospitalisations and death rates and most importantly, how infectious it is.
The future is unknowable, but risk is measurable
What happened in previous pandemics is not particularly instructive as the virus itself, the healthcare system, and the world are very different to how they were in previous pandemics. Over the past months, more information has been discovered about the virus, the way it’s spread and prevented; however there is still a lot which is unknown and this may lead us to continue taking drastic action to limit the spread while managing the risk at a limited cost to both society and the economy.
Policymakers worldwide have tried to react in a swift manner to limit the uncertainty and influence expectations in the future. In such conditions, it is crucial that the authorities demonstrate that macroeconomic policies are under control, to try and provide a stimulus to the economy when everything is in such distress. Stock markets around the world have experienced extreme volatility. Investors had to endure steep price declines, quickly followed by strong rallies.
Despite a degree of optimism over the outlook for corporate profits and an improving economic backdrop, the CBOE Volatility Index, which tracks future expectations of volatility in the S&P 500, shot to levels last seen in late 2008 in the darkest days of the financial crisis. The first quarter of 2020 saw a steep sell-off across markets, however, the S&P 500 has delivered the best third quarter performance since 2010.
In general, stocks are riskier assets to invest in than risk-free assets, and therefore investors command a premium when investing in such assets. The pandemic has further increased the market’s level of risk aversion. However, it should be noted that additional risk is a constant and inevitable in stock markets. Each month, Bank of America gathers data from global managers to obtain opinions on matters concerning the market.
The reality is that history is riddled with several worrisome events, and yet, the stock market has always managed to recover. Whereas investors were concerned about who will win the presidential election in the beginning of 2020, COVID-19 uncertainty was the top tail risk for six straight months beginning in March. Investors should approach the upcoming one to two years as a period of higher risk than normal.
According to DataTrek data going back 30 years, volatility can take months or even years to return to more average levels following a crisis.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.
Noelle Micallef, analyst, Curmi and Partners Ltd