Markets are collapsing because investors hate uncertainty. Will COVID-19 be as bad as last year’s flu? Will it be 10 times as bad? No one knows. But markets are acting as if we are going to encounter the worst-case scenario, notes Eric K. Clemons in this opinion piece. Clemons is a professor of operations, information and decisions at Wharton. Analyzing four possible scenarios that the pandemic’s evolution could take in the future, Clemons argues that the market reaction is more extreme than any of the likely possible futures would justify. The markets are reacting to uncertainty rather than to expectations, he writes.
Why are the markets collapsing? Why is it impossible to find hand sanitizer in the U.S.? Why are my Chinese friends sympathetically offering to ship me anti-viral face masks, since they have learned that panic buying has eliminated supplies in the West? Are the markets over-reacting? Is the panic justified?
Let’s review what we know and what we don’t know about COVID-19, and let’s approach the risks rationally.
Public-health officials, global risk management experts, and others have been warning about a new Plague, a global pandemic, for decades. Higher population densities, the ease of global travel and super-bug strains of centuries-old killers that are resistant to all known antibiotics are all factors. We have been warned of a global plague of biblical proportions, something with Pestilence, Famine and Death, with at least three of the Four Horsemen of the Apocalypse.
Relax. This is not that Plague.
Markets are collapsing because investors hate uncertainty. Will COVID-19 be as bad as last year’s flu? Will it be five times as bad as last year’s flu? Will it be 10 times as bad? No one knows. But there is no reason for markets to react as if it will be 100 times or 1,000 times worse. The markets are over-reacting. They are acting as if we are going to encounter the worst-case scenario. Market reaction is much more extreme than any of the likely scenarios would justify. The markets are not reacting to expectations. They are reacting to uncertainty.
What We Know – and Don’t Know
Let’s reduce that uncertainty. Let’s review what we all know, and what none of us knows.
COVID-19 is a new coronavirus, like the common cold and the flu. Since it’s a new coronavirus it was initially named simply Novel Coronavirus. Although COVID-19 sounds scarier than Novel, like something out of a horror novel, this is not Michael Crichton’s Andromeda Strain or Kurt Vonnegut’s Ice Nine. Even in a worst-case scenario, in which we all get sick, we are not all going to die.
We know a lot about coronaviruses because they are not new. They’ve been with us for centuries. Many of them are zoonotic, which means they mutated and jumped to humans from animals. That’s why we deal with Swine Flu and Avian Flu; their initial hosts were domestic livestock.
We know COVID-19 has achieved permanence. The virus is established globally. Enough people have the virus in enough locations to ensure that it is not going to vanish on its own. It can no longer be contained.
Mutation is a critical aspect of most coronaviruses. That’s why we have no vaccine against the common cold, and why we never develop immunity to the common cold no matter how many times we catch colds. Every season’s cold virus is just different enough to ensure that neither last year’s immunity nor last year’s vaccine would offer any protection. The mutation rate in the flu is lower. That’s why we can develop vaccines and why we have some immunity to future strains of the flu after we have contracted the flu in previous seasons. We don’t know how extreme COVID-19 mutation will be.
The markets are over-reacting. They are acting as if we are going to encounter the worst-case scenario.
Because of mutation, lethality also varies. Let’s assume that this year’s COVID-19 is about average for future strains. This year’s strain is about four times as lethal as an average flu season, but at present we have no residual immunity from infection in previous years. That probably will change, and we probably will develop some residual immunity that will be helpful in future years. I’m going to assume that once COVID-19 is fully established on average it will be about as lethal as the flu, but I’m guessing. We don’t know how lethal COVID-19 will be.
Possible Futures
Scenario analysis allows us to combine what we know and what we don’t know to generate a set of all possible futures. We may have high or low lethality and high or low mutation rates. This yields four scenarios. Three of these combinations are delightfully, reassuringly, boringly familiar.
- Still Normal: What Was All the Fuss About? — Low mutation rates mean that we can develop a vaccine. Low lethality means that while the vaccine would be helpful, the risk to unvaccinated individuals is low. This would be the case if in the future COVID-19 is on average less lethal than this year and is also more stable than the common cold. There is nothing to worry about. This is shown in a dark and reassuring green.
- Take Two Aspirin and Call Me in the Morning — High mutation rates means that we cannot really develop a vaccine, but low lethality means that we don’t really need to worry very much. In steady state COVID-19 will turn out to be a minor annoyance, like the common cold. High-risk individuals like asthmatics would need to take precautions, but for most people there is almost nothing to worry about. This is shown in a lighter but still reassuring green.
- Lessons from Edward Jenner: We Eliminated Smallpox — Low mutation rates indicate that we can develop a vaccine. High lethality means that we really need the vaccine. It is inevitable that we will develop this vaccine. Smallpox was a lethal scourge for centuries. Childhood polio was a source of terror until the 1950s. Jenner discovered vaccination in 1796. Jonas Salk’s vaccination against polio was approved in 1955. Both smallpox and polio have virtually been eliminated in the developed world. This scenario is no different. We will develop a vaccine. The world will return to normal. Again, this is shown in a lighter but still reassuring green.
So, really, the only combination we would need to worry about is high mutation and high lethality. Fortunately, this is the least likely of the four combinations. The “objective” of a virus, if a strand of DNA or RNA could be said to have an objective, is to produce as many copies of itself as possible. If a virus is too lethal, it kills its hosts too quickly and it doesn’t infect enough people for optimal virus reproduction. Over time, natural selection usually reduces the lethality of a virus or any other parasite. Quite simply, there is an optimal level of lethality that allows maximum reproduction and transmission of the virus.
Crudely speaking, that’s why long-term parasites like the common cold, another coronavirus, is so much more prevalent than Ebola, and while remaining deadly even Ebola’s kill rate and kill speed have declined. Still, waiting for natural selection to tame a virus is not an optimal strategy for the hosts. If we find ourselves dealing with high lethality and high mutation rates for an extended period, society would need to develop an effective response. It is not certain that we can do so.
If we are spectacularly unlucky, COVID-19 will turn out to be lethal with a high mutation rate. While this scenario is not the most likely, it is the most critical. For that reason, I divide it into two sub-scenarios, based on the effectiveness of societies’ responses.
1. Brave New World: Remember, this scenario assumes lethality high enough to require a vaccine and mutation rates high enough to make a vaccine unlikely. It likewise assumes that this condition continues for an extended period. In this scenario we assume that technical and social engineering changes provide an effective response. White-collar professions attain a high degree of virtualization. Executives and their staffs telecommute. Faculty and their students engage in distance learning. Farm work continues largely unchanged. Blue-collar workers mostly are replaced by increasingly intense levels of automation, and social programs are developed to avoid total devastation of low-income populations. Medical treatment for all COVID-19 patients becomes the law of the land throughout the developed world, if for no other reason than the wealthier segments of the population do not want to risk contamination from untreated members of the lower-income segments of the population. The scenario is shown in a cautionary amber.
Successful transition into the Brave New World scenario is by no means certain. Could countries with highly skewed income distribution like Brazil and India afford to support their desperately poor urban slums? Would they choose to do so? Would the most disadvantaged populations in the world, Bangladeshis and the residents of Sub-Saharan Africa, perish in vast numbers while other parts of the world escape relatively unscathed? Mass migrations and floods of refugees would be unprecedented; think in terms of half the world’s population undertaking migrations on a level comparable to the Irish migrations during the Potato Famine of the late 1840s, while the other half of the world experiences the worst economic crisis in a century. Responses would be brutal, and pogroms would be universal. Anyone who was foreign, or who even was other, would be seen as both as a potential source of disease and as a potential economic burden.
This scenario might be unstable, and might inevitably transition into another, even worse scenario.
2. Pale Horseman: I am Death: Once again, this scenario assumes lethality high enough to require a vaccine and mutation rates high enough to make a vaccine unlikely. However, it also assumes that it is impossible to develop an effective response. Class warfare erupts between wealthy and impoverished populations throughout the developing world. Mass migration and ethnic warfare erupts between the Third World and the more fortunate segments of the population. Lack of effective leadership does not save the wealthy nations of the West. This is brutal, and is shown as a dangerous red.
What is our final assessment? The markets are reacting as if the most likely scenario — indeed the inevitable scenario — is Pale Horseman: I am Death. This actually is the least likely scenario. It assumes rapidly mutating virus with continued high lethality for an extended period, which really is something out of a science fiction novel. The markets are over-reacting.
Most Likely Scenario
Unfortunately, the most likely scenario is a more extreme version of Take Two Aspirin and Call Me in the Morning. COVID-19 will be like the common cold, only worse. We are all going to have to adapt to increased socially responsible behavior by individuals who believe themselves to be sick. We are going to require increased socially responsible behavior from employers, granting greater numbers of sick days and provide incentives for sick employees to stay home until they are no longer contagious, instead of returning as soon as they are able to perform adequately at work. This will require a more generous governmental response, with assurances that employees will not suffer financial losses taking sick leave because they are ill, or because family members are ill, or because they have been exposed to the virus.
This would be expensive for business and would require governmental support for businesses that are increasingly paying absent workers. And we are going to require increased public health spending, so that everyone, insured or not, legal resident or not, can have safe and anonymous testing for COVID-19. Any attempt to limit testing so that only insured legal residents could be tested would make the virus impossible to control. Likewise, any attempt to limit confidential and anonymous testing, for any reason, will make the virus impossible to control. We learned this from previous public health emergencies, like the initial spread of HIV/AIDS.
Returning to the markets, I believe that the markets have over-reacted and that they will recover. If you are light in equities now or have available cash, it might be a reasonable time to invest. But you need to be patient, since recovery will not be immediate. Do not invest money you will need soon.
And what about life in general, beyond your investment strategy? Be prepared for inconvenience, for disruptions in travel plans, and changes at work. Don’t panic. And remember to wash your hands.
Join The Discussion
11 Comments So Far
Christopher Hawley
Hi. The article is excellent. But please be careful in future not to make offensive, ill-informed comments about certain countries. As a Brit living in Brazil, I can assure you that despite income disparity, Brazil always makes sure that ALL vaccinations are FREE for EVERYONE in the country and the campaigns roll on and on with adverts on TV etc, plus all vaccines are offered at clinics, hospitals, metro stations, public squares, companies etc etc. Nobody misses out unless they want to. Ever.
I’m sure the offensewasn’t intentional, but it is better to say ‘country A3’ or ‘country B2’ so as not to recreate old prejudices.
Brian Galinat, M.D., MBA
Your optimistic viewpoint does not account for long term impaired productivity associated with “recovering” from the virus. Many people will have a chronic decrement of their respiratory function.
Peter Roney
Thank you for this perspective. It is very interesting. I know nothing about medical matters but a little about the stock markets. I would suggest that the underlying, and more serious, global contagion is debt.
The majority of trading these days is undertaken by players for whom tomorrow afternoon is the long-term. This combined with the increase in debt – visible, margins and invisible, credit agreements – is a toxic cocktail. When markets are thin, much trading is formulaic and supported by debt, the downward spiral feeds on itself. Why am I not liquidating my 401k? Because I don’t have to, but if my debt, which is already excessive, is growing with every down tick of the market, I have to sell – anything I can.
Corporate debt is also a major problem. In times of historic low interest rates it surely makes sense to borrow up to the hilt? Not if, as often been the case, the borrowings are not used to grow the business sustainably but rather, just as an example, to inflate the share price with buy-backs. In a recession, towards which we are surely moving, indebtedness becomes a much more difficult issue to manage and sustain.
Are companies and traders in the wrong? Not necessarily. What gets measured and rewarded gets done. If we not only condone, but reward such behavior – which we have done – we should not be surprised at the outcome. Governments, markets, companies and individuals have embraced extraordinary growth in all types of debt the implications of which we are just starting to witness and understand. It will not be good.
David Gleason
This reads a bit like Pushkin’s Feast at the Time of the Plague:
“A man whose jokes and funny stories,
Witty retorts and observations,
So biting in their mock pomposity,
Have enlivened our table talk
And driven away the gloom that now
The plague, our guest, is shedding Over the most brilliant minds.”
I don’t think we can just smile and assume it won’t be all that bad.
Anumakonda Jagadeesh
Economic turmoil associated with the 2019–20 coronavirus pandemic has wide-ranging and severe impacts upon financial markets, including stock, bond, and commodity (including crude oil and gold) markets. Major events included the Russia–Saudi Arabia oil price war that resulted in a collapse of crude oil prices and a stock market crash in March 2020. The effects upon markets are among the many socio-economic impacts of the pandemic.
Movement of the Dow Jones Industrial Average between December 2019 and March 2020, showing the all-time high in February, and the crash in February and March during the COVID-19 pandemic
On Monday, 24 February 2020, the Dow Jones Industrial Average and FTSE 100 dropped more than 3% as the coronavirus outbreak spread worsened substantially outside China over the weekend. This follows benchmark indices falling sharply in continental Europe after steep declines across Asia. The DAX, CAC 40 and IBEX 35 each fell by about 4% and the FTSE MIB fell over 5%. There was a large fall in the price of oil and a large increase in the price of gold, to a 7-year high. On 27 February, due to mounting worries about the coronavirus outbreak, various U.S. stock market indices including the NASDAQ-100, the S&P 500 Index, and the Dow Jones Industrial Average posted their sharpest falls since 2008, with the Dow falling 1,191 points, its largest one-day drop since the 2008 financial crisis. On 28 February 2020, stock markets worldwide reported their largest single-week declines since the 2008 financial crisis.
Following a second week of turbulence, on 6 March, stock markets worldwide closed down (although the Dow Jones Industrial Average, NASDAQ Composite, and S&P 500 closed up on the week), while the yields on 10-year and 30-year U.S. Treasury securities fell to new record lows under 0.7% and 1.26% respectively. U.S. President Donald Trump signed into law an emergency appropriations and pandemic countermeasures bill including $8.3 billion in government spending. After OPEC and Russia failed to agree on oil production cuts on 5 March and Saudi Arabia and Russia both announced increases in oil production on 7 March, oil prices fell by 25 percent.
Week of 9 March 2020[edit]
On the morning of 9 March, the S&P 500 fell 7% in four minutes after the exchange opened, triggering a circuit breaker for the first time since the financial crisis of 2007–08 and halting trading for 15 minutes.[15] At the end of trading, stock markets worldwide saw massive declines (with the STOXX Europe 600 falling to more than 20% below its peak earlier in the year), with the Dow Jones Industrial Average eclipsing the previous one-day decline record on 27 February by falling 2,014 points (or 7.8%).The yield on 10-year and 30-year U.S. Treasury securities hit new record lows, with the 30-year securities falling below 1% for the first time in history.
On 12 March, Asia-Pacific stock markets closed down (with the Nikkei 225 of the Tokyo Stock Exchange also falling to more than 20% below its 52-week high), European stock markets closed down 11% (their worst one-day decline in history), while the Dow Jones Industrial Average closed down an additional 10% (eclipsing the one-day record set on 9 March), the NASDAQ Composite was down 9.4%, and the S&P 500 was down 9.5% (with the NASDAQ and S&P 500 also falling to more than 20% below their peaks), and the declines activated the trading curb at the New York Stock Exchange for the second time that week. Oil prices dropped by 8%, while the yields on 10-year and 30-year U.S. Treasury securities increased to 0.86% and 1.45% (and their yield curve finished normal). On 15 March, the Fed cut its benchmark interest rate by a full percentage point, to a target range of 0 to 0.25%. However, in response, futures on the S&P 500 and crude oil dropped on continued market worries.
The reduction in the demand for travel and the lack of factory activity due to the outbreak significantly impacted demand for oil, causing its price to fall. In mid-February, the International Energy Agency forecasted that oil demand growth in 2020 would be the smallest since 2011. Chinese demand slump resulted in a meeting of the Organization of Petroleum Exporting Countries (OPEC) to discuss a potential cut in production to balance the loss in demand. The cartel initially made a tentative agreement to cut oil production by 1.5 million barrels per day following a meeting in Vienna on 5 March 2020, which would bring the production levels to the lowest it has been since the Iraq War. Meanwhile, analytics firm IHS Markit predicted a fall global demand for crude to fall by 3.8 million bpd in the first quarter of 2020, largely due to the halt to Chinese economic activity due to the virus; it also predicted the first annual reduction in demand for crude since the financial crisis of 2007–08.
However, Russia refused to cooperate with the OPEC cuts, effectively ending the agreement it has maintained with OPEC since 2016. Russia balked as it believed that the growth of shale oil extraction in the U.S., which was not party to any agreement with OPEC, would require continued cuts for the foreseeable future. Reduced prices would also damage the U.S. shale industry by forcing prices below operating costs for many shale producers, and thus retaliate for the damage inflicted on Russian and OPEC finances. The breakdown in talks also resulted in a failure to extend the cut in output of 2.1 million bpd that was scheduled to expire at the end of March.
On 8 March 2020, Saudi Arabia unexpectedly announced that it would instead increase production of crude oil and sell it at a discount (of $6–8 a barrel) to customers in Asia, the US and Europe, following the breakdown of negotiations. Prior to the announcement, the price of oil had fallen by more than 30% since the start of the year, and upon Saudi Arabia’s announcement it dropped a further 30 percent, though later recovered somewhat. Brent Crude, used to price two-thirds of the world’s crude oil supplies, experienced the largest drop since the 1991 Gulf War on the night of 8 March. Also, the price of West Texas Intermediate fell to its lowest level since February 2016. Fears of the Russian–Saudi Arabian oil price war caused a plunge in U.S. stocks, and have a particular impact on American producers of shale oil. On 13 March, oil prices posted their largest single-week decline since 2008.
On 13 March 2020, U.S. President Donald Trump announced that he was directing the U.S. Department of Energy to purchase oil for the U.S. Strategic Petroleum Reserve. This will allow the purchase of up to 92 million barrels. At the time, the Reserve held 635 million barrels with a capacity of 727 million. The Washington Post characterized this as “bail[ing] out domestic oil companies,” though the effect on prices is expected to be minor in a 100 million barrel per day market. Goldman Sachs predicted on 14 March that one-third of oil and oil service companies in the U.S. would be bought by competitors or driven out of business by the low crude prices.
Prior to the coronavirus pandemic, a massive amount of borrowing by firms with ratings just above “junk,” coupled with the growth of leveraged loans, which are made to companies with significant amount of debt, created a vulnerability in the financial system. The collapse of this corporate debt bubble would potentially endanger the solvency of firms, potentially worsening the next recession. In January, new U.S. corporate debt fell 10% from the previous year, potentially indicating more caution from investors. As the economic impact of the coronavirus began to be felt, numerous financial news sources warned of the potential cascade of impacts upon the outstanding $10 trillion in corporate debt. Between mid-February and early March, investors increased the premium, or additional yield, to hold junk bonds by four times the premium demanded of higher credit lenders, indicating increased wariness.
During the 2020 stock market crash that began the week of 9 March, bond prices unexpectedly moved in the same direction as stock prices. Bonds are generally considered safer than stocks, so confident investors will sell bonds to buy stocks and cautious investors will sell stocks to buy bonds. Along with the unexpected movement of bonds in concert with stocks, bond desks reported that it had become difficult to trade many different types of bonds, including municipal bonds, corporate bonds, and even U.S. Treasury bonds. The New York Times opined that this, coupled with the fall in gold futures, indicated that major investors were experiencing a cash crunch and were attempting to sell any asset they could. As big investors sought to sell, the spread between the prices sellers and buyers wanted widened. As banks were unable to sell the bonds they were holding, they also stopped buying bonds. As the number of traders fell, the few trades remaining wildly swung the bond prices. Market depth in Treasuries, a measure of liquidity, fell to its lowest level since the 2008 crisis.
On 12 March, the U.S. Fed took almost unprecedented action to, in its words, “address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak”.The Federal Reserve Bank of New York announced that it would offer $1.5 trillion in repurchase agreements in U.S. Treasury securities to smooth the functioning of the short-term market that banks use to lend to each other. The New York Fed further announced that it would buy $60 billion of Treasury bonds over the next month to keep the bond market functioning. The seizing up of markets was a critical step in the subprime mortgage crisis that led to the financial crisis of 2007–08 and the Fed appeared to want to act quickly. On 15 March, as well as dropping interest rates, announced it would buy at least $500 billion in Treasures and at least $200 billion in government-backed mortgage securities over the next few months. On 16 March, as the stock market plunged, bond prices jumped according to their historical inverse relationship.
On 17 March, the Fed announced that they would utilize the Commercial Paper Funding Facility (CPFF). The CPFF was first used in the 2007-08 financial crisis to buy about $350 billion of commercial paper (CP), thereby increasing the amount of cash in the CP market, used by business to pay bills and other short-term demands. CP most directly affects the mortgage and auto loan markets, as well as credit to small and medium-sized businesses. The U.S. Treasury Department authorized $10 billion to backstop any losses incurred by the Fed using the Treasury’s Exchange Stabilization Fund. U.S. stock markets rallied on the news.
(Wikipedia)
Dr.A.Jagadeesh Nellore(AP),India
Jerry Szatan
Interesting piece systematically laying out possibilities. Yes the markets probably are reacting to uncertainty, but uncertainty is high in many ways including obviously how long it will take to better understand the lethality and mutability of Covid-19, and the possible knock-on effects in thee economy as others have pointed out. When uncertainty is high that’s reflected in risk-premiums in financial prices and volatility. I hope that your more optimistic scenarios play out. But consider the amount of social and economic adjustment necessary to get to “Take Two Aspirins” or let alone to “Brave New World.” Perhaps this would be especially difficult in the U.S., as illustrated by ongoing reluctance to accept the ACA in many quarters.
Eric K Clemons
Comment to Jerry Szatan: You are absolutely right. I have started a companion piece on just how difficult it is to predict whether responses will be adequate. I should have the piece finished by the end of the weekend.
Eric K Clemons
Comment to David Gleason: I have a scenario entitled PALE HORSEMAN: I am Death, and you think I am optimistic? I would hate to see what you consider pessimistic!
Eric K Clemons
Comment to Christopher Hawley: I would never intend to be ill-informed, prejudiced, or offensive, and I would never intend to be all three at the same time. Sometimes scenario analysis takes us to places where we would rather not go, and shows us thoughts that we would rather not have. But it is dangerous to ignore these places. A couple of years ago one of my co-authors, at least as experienced as I am in scenario analysis as I am, ripped into a piece I was writing that examined the implications for Russia and Canada if oil dropped below $50 a barrel. He told me neither he nor I would ever see oil below $100 a barrel in our lifetimes. West Texas Intermediate was below $30 when I checked early this morning, recovered briefly, and was heading below $20 as I finished this piece. It is dangerous to assume well-behaved data when we explore the extremes that can be encountered in an unfamiliar scenario.
It is also dangerous to assume well-behaved people and adequate resources. I was not questioning the behavior of Brazilian society, though we have both experienced the enormous wealth disparities in Rio. I was questioning the ability of nations like Brazil, India, Pakistan, and Bangladesh to provide the necessary financial support to segments of their populations that will not have income or accumulated savings as the pandemic unfolds. In a piece I wrote today I am wondering whether the US will unite to provide an effective social safety net or fragment into separate communities. As a scenario analyst I question everything; that doesn’t make me ill-informed. In my defense, I will argue that if I am offensive, I am offensive to everyone in at least some of my scenarios.
I was thrown off a faculty scenario team in 2001 for insisting that we at least consider a never-ending sectarian struggle in the Middle East if we attempted regime change in a nation such as Iraq. I was accused of some pretty awful prejudices, which I would prefer not to list here. I was not prejudiced, but I was worried. I am a professional paranoid, and that takes me into dark and scary places.
Scott S
Could the markets be reacting to the political future of the USA? If the economy does not do well going into the November election, most likely Trump will not be reelected and it is possible the democrats may control both houses. At this time, our deficit is $23.6 trillion. The stimulus plan will add another $2 trillion and if Joe Biden gets elected, he will overturn many of Trump’s capitalistic methods and raise taxes especially the capital gains tax. Could this be the fear? As mentioned in Bill Clinton’s campaign for president, “Its the economy, stupid!”
Michael McEvoy
The article is an interesting read, but I feel it misses the point: the worry over Covid-19 isn’t about the proportion of the population who may die from it. I don’t think anyone was predicting a high mortality rate – and, in fact, that’s been the basis for much of the commentary that has resulted in some people in authority not taking it seriously and basically mocking the concern that experts have. This article seems to feed into that narrative and now seems quite dated, a month after publication.
Instead, the article misses the point: healthcare systems risk being overwhelmed, as has happened in parts of Europe already, as too many people are in need of respirators, intensive care, etc. relative to what’s available. New York is experiencing this right now. While fewer than one per cent of the population may need this type of medical intervention, clever sounding metaphors offer little consolation or comfort to those of us concerned about our fellow human beings.