Wednesday, January 29, 2020

Coronavirus and the "Unsinkable" Titanic Analogy

Unthinkable doesn't mean unsinkable.
As we all know, the "unsinkable" Titanic suffered a glancing collision with an iceberg on the night of April 14, 1912. A half-hour after the iceberg had opened six of the ship's 16 watertight compartments, it was not at all apparent that the mighty vessel had been fatally wounded, as there was no evidence of damage topside. Indeed, some eyewitnesses reported that passengers playfully scattered the ice left on the foredeck by the encounter.
But some rudimentary calculations soon revealed the truth to the officers: the ship would sink and there was no way to stop it. The ship was designed to survive four watertight compartments being compromised, and could likely stay afloat if five were opened to the sea, but not if six compartments were flooded. Water would inevitably spill over into adjacent compartments in a domino-like fashion until the ship sank.
We can sympathize with the disbelief of the officers, and with their contradictory duty to simultaneously reassure passengers and attempt to goad them into the lifeboats. Passengers were reluctant to heed the warning because it was at odds with their own perceptions. With the interior still warm and bright with lights, it seemed far more dangerous to clamber into an open lifeboat and drift off into the icy Atlantic than it did to stay onboard.
The evidence was undeniable, but humanity's first response is denial, regardless of the evidence. The evidence that the coronavirus is contagious is undeniable, as is the evidence that carriers who have no symptoms can transmit the virus to others.
Just as the eventual sinking of Titanic could be extrapolated from the basic facts (six watertight compartments were flooding), so the eventual spread of the coronavirus can be extrapolated from these basic facts.
But the official global response is "these facts don't matter," and so hundreds of airline flights continue to leave cities swept by the disease. That once the virus spreads globally it will impact the global economy is easily extrapolated, but few want to consider the sinking of the unsinkable, so they don't.
As a result, the first lifeboats left the doomed ship only partially full. Only when it became undeniable that the ship was doomed did people attempt to get on a lifeboat, but by then it was too late: the lifeboats had all been launched.
This may be an appropriate analogy to the U.S. stock market, which is widely considered "unsinkable" due to the Federal Reserve's unlimited ability to create "liquidity" (cash) out of thin air.
The stock market just had a minor collision with the coronavirus, and few are heeding the warnings, preferring to heed the reassurances that thanks to the omnipotent Federal Reserve, the market is unsinkable, and the party in the First Class deck will continue indefinitely.
The lifeboats are already leaving, but few have escaped the doomed ship, i.e. sold all their equities.
When the crowd partying in First Class awakens to the inevitability of the stock market sinking, it will be too late to get on the lifeboat, i.e. sell out at the top.
A half-hour after the fatal collision, the reassurances are so comforting and credible: how could this great ship sink? Indeed, how could a stock market racing so confidently to Dow 30,000 sink to Dow 20,000 or even 10,000? It's unthinkable.
Unthinkable doesn't mean unsinkable.
Here are some informative science-based links on the coronavirus, courtesy of longtime correspondent Cheryl A.:
Money and Work Unchained $6.95 (Kindle), $15 (print) Read the first section for free (PDF).


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Tuesday, January 28, 2020

Could the Coronavirus Epidemic Be the Tipping Point in the Supply Chain Leaving China?

Everyone expecting a quick resolution to the epidemic and a rapid return to pre-epidemic conditions would be well-served by looking beyond first-order effects.
While the media naturally focuses on the immediate effects of the coronavirus epidemic, the possible second-order effects receive little attention: first order, every action has a consequence. Second order, every consequence has its own consequence.
So the media's focus is the first-order consequences: the number of infected people and fatalities, government responses such as quarantines, and so on. The general expectation is these first-order consequences will dissipate shortly and life will return to its pre-epidemic status with virtually no significant changes.
Second-order effects caution: not so fast. Second-order consequences may play out for months or even years even if the epidemic ends as quickly as the consensus expects.
The under-appreciated dynamic here is the tipping point, the imprecise point at which a decision to make fundamental changes tips from "maybe" to "yes."
These tipping points are often influenced by exhaustion or frustration. Take a small business that's been hit with tax increases, additional fees, more regulatory compliance requirements, etc. When the next fee increase arrives, the onlooker might declare that the sum is relatively modest and the business owner can afford to pay it, but the onlooker is only considering first-order effects: the size of the fee and and the owner's ability to pay it.
To the surprise of the onlooker focusing only on first-order effects, the second-order effect is the owner closes the business and moves away. Invisible to everyone focusing solely on first-order effects, the owner's sense of powerlessness and weakening resolve to continue despite soaring costs and declining profits has slowly been moving up to a tipping point.
Beneath the surface, every new fee, every tax increase and every new regulation has pushed the owner closer to "I've had it, I'm out."
When the owner shuts the business, onlookers can't understand how one little extra fee could trigger such a fundamental change. The observer is only looking at the new fee as a single cause with a single consequence. In the real world, each new fee, tax increase and regulation was another link in a causal chain of consequences generating consequences.
Turning to the possible second-order effects of the epidemic in China, let's start with the decision to keep supply chains in China. The reasons to keep supply chains in China have been dwindling for years: wages and other costs have been rising, the central government has increased demands for technology sharing, the general sense that foreigners and foreign companies are no longer needed or wanted, and the trade war, which is more or less in a truce phase rather than over.
One common belief is that it's "impossible" to move supply chains out of China. This is a classic first-order effect analysis. When the supply chain gets disrupted for one reason or another and alternatives must be found, alternatives are found. What becomes "impossible" isn't moving the supply chain from China but keeping it in China.
The mistake made by those only considering first-order effects is that a modest effect "should" only generate modest consequences. For the observer focused solely on first-order effects, if the coronavirus epidemic blows over as expected, then supply chains "should" be unaffected because the effect is quantitatively modest.
But once we start considering cumulative second-order effects and potential tipping points, then the disruption of supply chains caused by the epidemic, no matter how modest, could be "the last straw" to those who had beneath the surface already shifted from "never leave China" to "maybe leave China." The epidemic could tip the decision process into "must leave China."
Consider two executives, one who looked at the longer term consequences of being dependent on production in China and began establishing alternative suppliers at the start of the trade war 18 months ago, and another exec who looked at the first-order hassles and expenses of moving out of China and stayed put to minimize short-term expenses.
Individual decisions add up to trend changes, and these charts reflect a trend change in globalization and China's share of global exports. Globalization and China's share of global exports have both plateaued and are now entering the stagnation / decline phase of the S-Curve.
Everyone expecting a quick resolution to the epidemic and a rapid return to pre-epidemic conditions would be well-served by looking beyond first-order effects and easy assumptions that the consequences of the epidemic will be near-zero.
Here are some informative science-based links on the coronavirus, courtesy of longtime correspondent Cheryl A.:
Money and Work Unchained $6.95 (Kindle), $15 (print) Read the first section for free (PDF).


If you found value in this content, please join me in seeking solutions by becoming a $1/month patron of my work via patreon.com.

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Thank you, John D. ($50), for your magnificently generous contribution to this site -- I am greatly honored by your steadfast support and readership.
 
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Monday, January 27, 2020

Is the Market Grossly Underestimating the Potential Impact of the Coronavirus Epidemic?

The potential for a consequential disruption in China's supply chains appears to be vastly under-appreciated.
Despite the current drop in stocks (less than 1.5% as this is written), there's a tremendous reservoir of complacency about the economic and financial impact of the coronavirus epidemic. The zeitgeist reflects an implicit confidence that the coronavirus will blow over like the SARS scare a few years ago and the impact on the global economy will be essentially zero.
Have all the risks already been fully discounted? Here are some of the reasons why the assumption that this will have little effect on the U.S. economy and stock market may be misguided:
1. Patient One (the first reported case of 2019-ncov) on 31 December was unlikely to be the person in which the mutation enabling person-to-person contagion occurred. The latest genetic analysis suggests the virus first mutated into its present form sometime between late October and late November.
It's thus highly likely the virus had already been spreading for at least a month before 31 December. The symptoms of this new virus are not that different from typical flu strains, so why would authorities spend the time and money searching for a novel flu in a patient? The only reason authorities become involved would be a cluster of flu/ pneumonia patients dying.
Hundreds of thousands of people die of the flu every year, between 12,000 and 50,000 in the U.S. alone, so the death of a patient with flu-like symptoms is not uncommon enough to trigger an official investigation.
This line of reasoning suggests there was already an expanding pool of virus carriers long before officials discovered the new virus and began acting to limit its spread.
If this is the case, then the virus may have spread outside Wuhan before officials reacted.
2. This virus is a new type, and this makes it especially dangerous as humanity may have limited immunity to viruses that are sufficiently different from existing variations.
There are several bits of evidence that this novel flu is both contagious and dangerous. One is that health workers have caught the flu from patients despite all precautions and anecdotal evidence that the disease has spread from one family member to everyone else in the household.
The other is the relatively high death rate. Based on data from Chinese authorities (likely incomplete) , about 3% of the patients have died. The great flu pandemic of 1918-19 killed about 2.5% of its victims, and since it was highly contagious, it's estimated 50 to 60 million people died in that pandemic--often young healthy people.
3. The incubation period for this flu may be up to 14 days, and someone who has it may be asymptomatic (display no symptoms) for 5 or 6 days. This means screening passengers for fever is essentially useless.
Even more alarming, the new virus doesn't always cause a fever, making screening for fever even less effective.
Despite these data points, the American populace is being assured that screening is effective and so it's perfectly safe to travel as usual. This complacent confidence appears to be unfounded.
4. The Chinese populace is highly mobile within China and the world. Hundreds of thousands of Chinese work in other nations, and a significant percentage of these offshore workers returned home for Lunar New Year and will be returning to their jobs in the U.S., Europe, Africa, Southeast Asia, the Mideast, etc. next week.
To assume that none of these returning workers are asymptomatic carriers of the flu is a stretch.
5. Researchers are busy developing a flu shot to offer some immunity, but if this virus is virulently contagious, the question becomes: can authorities outrace the spread of the virus? Realistic estimates of how long it will take to develop and test a vaccine are 6 to 7 months, and that's if everything works perfectly, i.e. the virus doesn't mutate, etc. Producing hundreds of millions of doses and administering the vaccine to hundreds of millions of people will take additional time.
6. The implicit model for this coronavirus in the mainstream is SARS, which was isolated and contained. But this new virus may be much more contagious and so the relatively rapid and successful isolation of SARS may be a misleading model.
7. Authorities seem to prioritize "don't panic" messages, as if fear of this flu is irrational. But fear of a risk that cannot be assessed with any confidence is entirely rational. The smart strategy is to lay low and wait for more evidence on the nature of the risk.
8. The potential economic impact of this virus is grossly underestimated. The Chinese economy is particularly vulnerable now for a number of reasons. In essence, all the low-hanging fruit of rapid development have been picked, and adding more debt to boost building and consumption is no longer as effective now that debt has soared.
The world has depended on China's skyrocketing consumption for growth for the past 30 years. Should China's economy actually contract due to the knock-on effects of the virus, the global economy will soon follow.
How fear triggers a domino-like effect in an economy is poorly understood. In an economy that's already teetering on recession, quarantines, disruption of travel and commerce and a generalized "circle the wagons" response to uncertainty will push the precarious economy over the cliff.
Once tourists cancel trips, incomes plummet and businesses are forced to close. There's no guarantee that they will re-open after months of recession.
If you fear catching a potentially life-threatening flu, you're unlikely to go shopping for a new car or furniture; you'll put that off if at all possible.
Then if you read about layoffs and recession, you decide the car and furniture can wait indefinitely.
This is how the transition from complacency and confidence to fear and caution ripples through the economy, as the initial impact unleashes knock-on effects that increase caution which then reinforces reduced spending and investment.
9. Confidence in the truthfulness and effectiveness of authorities is already low in China, and this loss of confidence will likely spread to other nations as people awaken to the authorities' obsession with "keeping the economy going" by discounting the risks with false assurances that "everything is under control."
When people realize everything is not under control and they've been misled to grease the wheels of commerce, the legitimacy of the state may come into question: if they downplayed the flu, putting me and my family at risk, why should I trust them about anything else? The epidemic has the potential to trigger a political crisis as well as a severe economic slump.
10. The potential for a downward spiral of confidence is high as authorities will be pressured to increase their reassurances that all is well at every new wave of evidence that the virus is spreading despite their efforts. Doubling down on "don't panic" as the virus spreads will eventually backfire and unleash the very panic they feared.
11. Global stock markets are at all-time highs or near-term highs, on the euphoric belief that central bank stimulus will push stocks higher essentially forever. The virus has to potential to refocus attention on sales, profits and future risks, and that could change the general mood from complacent confidence to uncertainty, which is Kryptonite to market confidence.
The virus might be the needle that will pop all the speculative bubbles, regardless of central banks' stimulus.
12. History suggests that this virus may rise in two waves. The initial wave may die down and everyone sighs with relief, assuming it's like SARS: everything's fixed, risk is back to zero. Restrictions are eased, travel bans lifted, etc. Then the second and much more virulent wave rises, catching everyone by surprise.
13. The potential for future mutations which increase the lethality of the virus are not being factored into current risk assessments. Assuming the virus will retain its current configuration is a leap of faith.
The potential for a consequential disruption in China's supply chains appears to be vastly under-appreciated. Again, the working assumption is that any disruption will be temporary and everyone in China will be back to work as usual in a few weeks. The market has yet to discount the possibility that China's supply chains will be disrupted for months, with all the ripple effects that would generate throughout the global economy.
The market also has yet to discount the possibility that China's consumption could crater (buying an iPhone 11 is no longer a priority, etc.) and knock-on effects in its currency and debt markets could disrupt global financial markets, potentially triggering insolvencies in overleveraged companies not just in China, but in the developing and developed economies as well.
While it's too early to predict global depression, it's also too early to predict a rapid return to pre-epidemic normalcy.
Here are some informative science-based links on the coronavirus, courtesy of longtime correspondent Cheryl A.:
Money and Work Unchained $6.95 (Kindle), $15 (print) Read the first section for free (PDF).


If you found value in this content, please join me in seeking solutions by becoming a $1/month patron of my work via patreon.com.

NOTE: Contributions/subscriptions are acknowledged in the order received. Your name and email remain confidential and will not be given to any other individual, company or agency.
Thank you, Bengen Financial Services ($50), for your superbly generous contribution to this site -- I am greatly honored by your support and readership.
 
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