I created dumbwealth.com to help you take small actions to make big improvements in your life. Dumbwealth is about life balance and truth. It’s not about market timing or the latest FOMC meeting.
With that said, there will be economic or social issues so big they are critical to understand if you are to avoid plunging into a financial hole. Now is one of those times. The issue is Covid-19.
As much as I don’t want to get sick, my biggest fear at the moment is not catching the Covid-19 coronavirus. My biggest fear is the economic and social shocks created by the virus.
I don’t know whether or not Covid-19 becomes a pandemic. Let’s just say it will. To be clear, that doesn’t mean everyone will get sick. And the vast majority of those who do get sick will recover. Indeed, many of the infected will simply experience a moderate inconvenience. I suppose that’s the good news.
While not everyone will get sick, if this virus continues to spread we will all feel the economic and social shocks created by the world’s reaction to the virus.
To understand the economic and social implications of Covid-19, look at China. Since it was the origin of the outbreak and worst hit so far, China serves as a great test model for the rest of the world.
Here’s what the model tells us.
During the early moments of outbreak, with relatively few cases, uncertainty rules. As with any form of uncertainty people spend less. Slowly, businesses begin to feel the rising pressure on cash flows as sales falter. During the early stages – in an attempt to save face and avoid panic – the authorities downplay the risks. This is the smoke before the economic dumpster fire.
Eventually the virus starts spreading rapidly, case numbers rise and deaths occur. This is when panic sets in. Grocery store shelves are quickly emptied as people hoard supplies. Sick patients flock to hospitals, which are quickly overwhelmed. Medical staff start getting sick too. This is when the healthcare system fails and the government cracks down fast and hard.
We saw this in China. Once they saw they were losing control the Chinese authorities quickly changed their plan of attack. To avoid overwhelming the hospital system with sick patients, China shut down businesses and forced people to remain at home. The transition from smoke to blazing dumpster fire took just days.
As the virus spreads outside of China, other governments have used these early lessons to their advantage. Over the past few days, Covid-19 cases in Italy have gone from 0 to 374. Seeing how things played out in China, the Italian government quickly shut a number of cities.
While quarantine sounds unthinkable for democracies around the world, the alternative is potential collapse of the healthcare system. This pattern is repeating as the virus becomes endemic and self-sustaining in many parts of the world – borders are closed, travel is restricted and people are quarantined.
I could see borders and cities shut down on a rolling basis as the virus spreads around the world. The specific experiences within countries will still vary. Some countries will be more restrictive than others, depending on the type of government. However, whether voluntary or compulsory, activity will most certainly decline.
What happens when masses of people are sick or not permitted to leave their homes?
What I described above is the local impact – the impact on the individual’s pattern of daily behaviour. What few are discussing is the potential macro consequences. This is where it gets really dangerous.
During an epidemic or pandemic, people stop going to work and stop going to stores. Factories stop producing and people stop buying things. The result is a shock to both aggregate demand and supply. The larger the shut down of activity, the larger the shock.
Like past shocks, the virus is temporary. Don’t equate ‘temporary’ with ‘insignificant’. Black Death was temporary. WWII was temporary. These are extreme references, but you get my point.
Still, a temporary shock of large magnitude could become a permanent drag on the economy, due to damaged collective psychology. People are irrational and may be very slow to return to normality even after the virus has passed. Nobody is going to spend money while the business environment is uncertain. Business uncertainty will persist as long as nobody spends money. To break this self-reinforcing cycle the collective spirit must shift. As witnessed during the Great Depression and 2010s, it is very difficult to alter mass psychology.
This risks a permanent lower economic equilibrium that requires massive fiscal and monetary stimulus to return to true economic potential.
While this sounds dire, the immediate risks are even more dangerous. Namely, a simultaneous worldwide shock to both supply and demand could create a calamity rivaling that of the great financial crisis of 2008.
Everything is interconnected.
Picture this: you own a small restaurant in Guelph, Ontario when your city gets shut down due to a big spike in Covid-19 cases. Businesses are told to close and employees stay home. With no cash flow coming in you now need to figure out which bills don’t get paid. Your staff (assuming they’re not salaried) now have no income and must figure out how they will afford their next mortgage payment. Few have adequate emergency savings or are prepared.
Multiply this by thousands of businesses and hundreds of thousands of employees across Guelph. Even for this relatively small city, the scale of unpaid bills is massive. Big and small companies across Canada are impacted through the interconnected nature of economies. When bills stop getting paid, loans go bad, collateral is called, businesses go bankrupt. Layoffs occur as executives scramble to save their businesses, creating a vicious cycle.
Now imagine this happened in New York or London – two major, globally-interconnected financial centres. The effects would seem unreal.
In such a scenario, capital markets dry up as investors desperately unwind positions. Banks with the wrong exposures risk a liquidity crunch and possible insolvency. If this process happens quickly and indiscriminately – like it did in 2008 – the financial system could head for collapse.
What does that really mean? Financial collapse hits Main Street as hard as it hits Wall Street. It means businesses can no longer meet payroll. It means pensions implode. It means families lose their savings.
So far I have only discussed half of the issue – demand. At the same time, because workers are no longer producing, supply chains globally also break.
Numerous major companies (e.g. Apple, Microsoft, Hyundai) have already announced parts shortages. There are also countless anecdotes of creeping supply chain issues for businesses of all sorts. And personally I saw my first sign at a local retailer warning about supply problems. Everything from microchips to pharmaceuticals could be affected. This could drag on for months.
- Could Covid-19 Trigger a 2008-Style Financial Crisis?
- Markets Hit Highs: So Why Are You Broke?
- 4 Charts: China Coronavirus Collapse
It is possible that once the virus passes, production will ramp up quickly. However, the lost output is not recoverable. The bigger challenge, however, is for businesses around the world to survive this dual shock to demand and supply. The interconnected nature of global supply chains and financial systems is extremely complex, and the outcome from such a sudden and extraordinary one-two punch is highly unpredictable.
It is quite possible that the negative consequences take on a life of their own even before the virus arrives, as companies and staff anticipate the next shut down. This is how recessions typically start, except this would be much faster. The speed and uncertainty of it all could easily result in mass liquidation of assets as investors shoot first and ask questions later. Consequently, any lingering liquidity concerns of assets on bank balance sheets would quickly surface. Any bank with significant exposure to illiquid assets could risk collapse.
This probably all sounds somewhat familiar to anyone who experienced the great financial crisis of 2008. It wasn’t the slowdown in economic activity that almost destroyed the financial system in 2008. It was the sudden separation of complex networks in the face of generalized uncertainty that brought the system to its knees.
Prepare for the worst, hope for the best.
This is not a prediction. It is a warning. I don’t know what’s going to happen. Hopefully we muddle through this without major problems. But when highly complex systems are tested to this degree, it’s best to have a back-up plan.
Put it this way, I wear my seatbelt not because I expect to crash, but because I want to protect myslf in case I do.
Personally, over the course of the past few weeks I’ve de-risked my portfolio. I’m still appropriately balanced and diversified but I removed any uncomfortable equity positions. Overall, I’m not positioned massively in any direction in particular. Just appropriately diversified with enough dry powder to take advantage of any major corrections.
I’ll leave you with the following important considerations:
- Would you be able to stomach the equity portion of your portfolio dropping by 50%? If not, you might want to re-think your exposures.
- Do you have what you need if you were to get stuck in your house for a month? Food, toilet paper, medicine, etc.
- Do you have what you need if everyone in your household were to get sick at the same time? This could include simple meals that don’t require much effort, tea, etc.
I’m quite sure some people think I’m nuts. Maybe I am. It is in my nature to be conservative. If I’m wrong, then you’ve got a well-stocked house. If I’m right, you can comfortably binge on Netflix while you ride this out.
If any of this resonates with you, my recommendation is to get ahead of this in case people panic, tanking markets and clearing grocery shelves. Because once the panic starts, it’s too late to act.