Covid-19: the ultimate black swan event

We are sailing uncharted waters with the coronavirus global health disaster. Hannah Smith examines what can we learn from past black swans, how soon financial markets could recover, and investor moves and portfolio ballasts.

Rarity, extreme impact, and retrospective predictability. Those are the three characteristics of a black swan event, according to Nassim Nicholas Taleb, the theorist who coined the term. Black swans come out of nowhere to derail financial markets – they are so-called because of an old saying that black swans did not exist, until one appeared to prove otherwise. But what can we learn from these events, and what can history tell us about how markets recover?

Covid-19’s devastating impact on human lives, economies, and stock markets makes it the ultimate black swan. Looking back, we can see parallels between this pandemic and other black swan events through history, from Black Monday (1987) to the Sars outbreak (2003) and the global financial crisis (2008). In the more distant past, and unfortunately the most similar to what is happening now, is the 1918 Spanish flu pandemic, which claimed an estimated 50 million lives worldwide.

“Coronavirus is probably the one that comes closest to being called a black swan event,” says Fidelity’s multi-asset portfolio manager Ayesha Akbar. “I don’t think any of us had any idea that you would be talking about a once-in-a-hundred-years Spanish flu type event that could happen across the globe.” Investors’ shock and fear has rippled through markets, with the FTSE 100 index, for example, recording some of its largest ever daily rises and falls during March.

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Is it different this time?

What sets this sell-off apart is its brutality and speed: similar losses in past crises happened over months and years, not a matter of weeks. From the FTSE’s January peak to a 30% fall happened much more rapidly than we saw during the Asian financial crisis, the collapse of hedge fund LTCM, or the eurozone debt crisis, notes Dean Cheeseman, multi-asset portfolio manager at Janus Henderson. “It has been incredibly fast-paced, faster than ’29, faster than ’87,” he says. “The speed and ferocity has been utterly breathtaking.”

Another key difference is that the market falls caused by the Sars and swine flu outbreaks followed long equity bear markets, while this sell-off comes at the tail end of a decade-long bull market. Adding an extra layer of difficulty for investors is the fact that, this time, traditional safe-haven assets have not behaved as normal - on some days gold and government bonds have sold off alongside equities.

Market recovery – what can we expect?

Looking at past black swans, we can see that market crashes are often followed by strong bull runs. For example, data from Timelineapp Tech shows that after Black Monday in 1987, when UK stock shed 34% in just two months, came another 13-year bull market which would have made investors 571% had they stayed put. And we have just reached the end of a decade-long bull run (+212%), which came hot on the heels of the global financial crisis.

Looking specifically at disease-related black swans, you can also see fairly quick rebounds. The S&P 500 index fell 25% during the Spanish flu pandemic, but was up 9% for the following year. With Sars in 2003, the MSCI Pacific ex Japan fell 13% in two months before recording a 43% gain for the year. All this suggests that, if investors can be patient, the chances are their capital will recover in the long run.

Timelineapp Tech and FinalytiQ founder Abraham Okusanya notes: “There are clearly historical cases of pandemics and other major events causing market shocks – Spanish flu, wars and so on. While these events offer no precise guide to what might happen next, we do know that the stock market tends to recover. Since 1926, the average bear market for UK equities has lasted 20 months and reached the trough at 37%. This latest decline has been sharper than others, but the good news is that evidence of prior research shows that recoveries are likely to also be sharp. No one knows, of course, how things might pan out exactly.” 

But there are no guarantees when it comes to investing and, as we are consistently told, past performance is not a guide to the future. We are sailing uncharted waters: Covid-19 has brought the world to an economic standstill. At the time of writing, the latest country to enter lockdown was India, with a population of 1.3 billion.

“To take economic activity to a grinding halt, I don’t see how we just bounce straight back,” says Cheeseman. “The sheer lack of capacity coming out in quarter one and quarter two is going to cause a recession; it’s the degree, how deep that is and how quickly we can rebound.” His strategy so far has been to take profits on UK gilts and top up on US and Japanese stocks.

‘Not the end of capitalism’

Future Money fund manager Richard Cole says he is not super-bearish on recovery prospects, but the full impact of this global health disaster will be hard to predict. “It’s going to be difficult to call the recovery on this one looking at historic measures, because it is a medical emergency rather than financial mismanagement or geopolitical risk. But we think recovery will come; it is not the end of capitalism and society.”

He says the shape of the recovery will depend on what policymakers do, and at present they are throwing everything they’ve got at the crisis, with the US unveiling a staggering $2 trillion of stimulus and the UK cutting rates to a never-before-seen 0.1%, a whisker away from negative rates.

Premier Miton’s senior investment manager Simon Evan-Cook is among those using cash to raise equity positions, believing there is “every chance this is a V-shaped recovery” given policymakers’ willingness to act swiftly to support companies and consumers.

What should investors do?

Black swans come along every few years and are an inevitable part of life for long-term investors, so they need to be permanently prepared. But how?

Avoid FOMO: Fear of missing out means investors can get swept up in a rising tide and then suffer losses when an unexpected event causes a sudden whipsaw down, warns AJ Bell’s investment director Russ Mould. Instead, you should have a plan and stick to it, and don’t dabble in things you don’t understand.

No market timing: Forget trying to time the market, it’s impossible, and selling at the wrong time can be catastrophic. Data from Fidelity shows that missing the best 30 days in the S&P 500 between 1993 and 2019 would have produced a total return of 159%. If you had stayed fully invested, you’d have banked a whopping 1,170%.

Don’t be a hero: Try to be prudent and don’t bet the house on equities going up, says Akbar. “This is not the time to be a hero. If markets fall, top up slightly, but make sure you have hedges in your portfolio that will protect when markets get panicky,” she says. “That could be gilts and gold, things that take advantage of rising volatility.”

Five portfolio ballasts against a black swan event

Gold: Gold is a store of value that can act as an insurance policy in portfolios because it is easy to sell and should fetch a reasonable price even in falling markets. Cheeseman suggests owning a physical gold ETF from an established provider like iShares, db X-trackers, Invesco or Wisdom Tree. 

Sovereign bonds: UK and US sovereign bonds are traditional safe-haven holdings, and yields have pushed up a bit higher recently making them more attractive, says Cheeseman. Because the margins on returns are small, investors should hold them through a cheap ETF.

Short duration corporate bonds: Cole likes short-dated investment grade bonds for their defensive characteristics. He points to L&G Short Dated Sterling Corporate Bond and Vanguard UK Short Term Investment Grade Bond Index, as “short-dated, investment grade, cheap as chips, and they’re going to do the job you expect of them”.

Cash: You should always have three to six months’ worth of expenses in cash, says Mould. “It’s a really uncomfortable thing to own right now because interest rates are negative in real terms so you're guaranteed a real-term loss because of inflation, but it means your bills can be paid and gives you chance to pick up things at more interesting valuations.”

Japanese equities: There is no single asset that can protect you against every type of black swan, says Evan-Cook, so decide whether you’re more worried about an inflationary or a deflationary shock, and build your portfolio accordingly. He holds Lindsell Train Japan,which he says has done well in this sell-off and also gives exposure to the safe-haven yen.