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Black swan

Has the Black Swan landed?

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In a research note earlier this week, Nitesh Shah, Director, Research, WisdomTree commented on the coronavirus, quoting both Nassim Taleb, author of the influential book Black Swans, and the United Nations.

Shah writes that Taleb defined Black Swans as extremely unpredictable events that have massive impacts on human society. 

“One of the defining elements of Black Swans is that models can explain their existence after the fact,” Shah says. He then goes on to quote a September 2019 report, compiled at the request of the United Nations secretary-general, that said: “If it is true to say ‘what’s past is prologue’, then there is a very real threat of a rapidly moving, highly lethal pandemic of a respiratory pathogen killing 50 to 80 million people and wiping out nearly 5 per cent of the world’s economy.” 

Shah comments that the report went largely unnoticed at the time of publication, but that it now reads eerily like some of the central bank stability reports written in 2007. “Many risks were correctly identified, but urgency of remedial action wasn’t there. That is the nature of risks in the tail,” Shah says.

“Come February 2020, the report to some is starting to read like a prophecy. Thankfully things aren’t that bad yet. But with close to half the population of China facing various forms of lock-down due to the coronavirus and many other parts of the world becoming affected (notably, Korea and Italy, where cases are growing at a rate that has taken many by surprise), the market is understandably experiencing extreme jitters.”

Shah reports haven assets are up (data at 24 February): gold (+7.9 per cent YTD), US Treasuries (yield down from to 1.91 per cent to 1.38 YTD per cent), US Dollar Basket (+3.0 per cent YTD). While cyclical assets are down: oil (-13.9 per cent YTD), BCOM Industrial metals (-8.9 per cent YTD). Equity markets, which had largely ignored the threat (S&P 500, +5.1 per cent in year to 19th February 2020), have given up all the gains so far this year in the past three trading days. The Chicago Board Options Exchange Volatility Index (VIX) has jumped to 25 (24 February 2020) from 14 a week ago (18 February 2020).

“Getting clear data on how much demand has already declined at the epicentre (China) is difficult as data is already clouded by the lunar New Year (seasonally adjusting this data is fraught with difficulty). But we know that a sharp decline in flights, road journeys, factory activity (which can all be anecdotally monitored with satellites and thermal imagery) are likely to dent the demand for productive goods. In the 3rd February release of the Caixin China Manufacturing Purchasing Managers’ Index (PMI) press release, there wasn’t even a mention of the word ‘virus’. The PMI level was above the 50 demarcation between expansion and contraction. We expect the March 3rd release for February to be very different. We would be surprised if manufacturing is able to expand in current circumstances.

“For now, we expect defensive assets to continue to perform well. A tailwind of momentum could introduce gold into portfolios that have largely ignored the asset class in the past. Meanwhile cyclical assets could struggle to perform under the cloud of doubt placed on demand. However, should this just be another false dawn, for example if the contagion is contained and vaccines are developed quickly, we could see bargain hunting opportunities open up. There are some commodities like, oil which under the auspiciousness of a cartel that controls 60 per cent of global production, could get a boost in the near term from a production cut.”

In terms of which ETF strategies will provide the best hedge for nervous investors, Shah says: “We believe gold could be the best port of call in times of investor nervousness. Its defensive features are time-tested. For example, when looking at the S&P 500s worst 24 monthly performances over the past 10 years, where the S&P has fallen by 4.2 per cent on average, gold had risen 1.8 per cent on average . Gold is quite unique in having such a negative correlation with cyclical assets. Physically-backed gold ETFs are generally favoured as they carry minimal credit risk, have strong transparency, are very liquid and trade with tight spreads even in times of investor anxiety.”

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