Monday morning, February 24, was the moment when a thoroughly somnolent market, after a decade of steadily rising prices and accommodative central bank policy, awoke to the fact that coronavirus would have serious implications for the world economy — and that, at the same time, almost every asset was priced for perfection.
How did the market become so sanguine? Why were the red flags missed? These are questions not just for traders and investors, but also risk managers in businesses of every kind, who must fight the human tendency to believe that if yesterday was a good day, tomorrow is sure to be a good one, too.
The penny seems to have dropped on February 24 because it became undeniable that the virus would not be confined to Asia. The previous Friday, US bond yields had risen as investors read of four deaths from the virus in Iran and a small but rising number of cases in northern Italy. By Monday, Italy was locking down towns and the sell-off was on.
Since then global stock markets are off by one-fifth. The Vix, which looks at derivative markets to determine how much volatility investors expect, has spiked to highs last seen in the financial crisis of 2008. The “spread” between government bond yields and those of risky corporates has blown out, too.
But well before February 24, some were raising the alarm. In a prescient blog 10 days previously, Scott Minerd, chief investment officer at Guggenheim Investments, wrote: “The cognitive dissonance in the credit market is stunning . . . yields are low, spreads are tight, and risk assets are priced to perfection, but everywhere you look there are red flags.”
The coronavirus, he notes, had been in the news since early January and looked more dangerous than Sars, its predecessor. “This will eventually end badly. I have never in my career seen anything as crazy as what’s going on right now.”
The question is how organisations can maintain Mr Minerd’s level of vigilance.
Brian Moynihan, chief executive of Bank of America, raised a further concern in a recent interview with the FT. He said that companies “now have a substantial amount of our employee base that weren’t [adults in the 2008 financial crisis]. You have to think about how do you get those teammates to understand all of what happened without appearing to be, you know, lecturing them.”
Risk and portfolio managers agree that — other than a healthy paranoia — strong processes and habits are the key. Make a risk-control plan and stick to it. Have a sensible risk strategy and repeat it constantly. Ensure that channels of communication are open, so if anyone picks up risk signals, they are heard.
Max Gokhman, head of Asset Allocation at Pacific Life Fund Advisors, offers a simple definition of complacency. It is “when markets shun all the bad news and only focus on the good news”. He became aware that markets were complacent when there was little response to the US killing of Iranian General Qassem Soleimani.
Cultivating a contrarian element to your thinking is also important, he adds: “When sentiment becomes extreme, consider taking the opposite position.” Quantitative models that track a wide variety of sentiment indicators help him follow changes in investor attitudes.
His next rule of thumb: “Have a plan in place before an event occurs.” Having decided in advance how to respond to a range of scenarios helps avoid getting caught up in emotion as an event unfolds, allowing traders to “focus on the facts” rather than market sentiment.
The head of risk management at a large US bank — who did not want to be named — echoes Mr Gokhman’s prescriptions and adds some of his own.
He says the job of a risk manager is to ensure everyone in an organisation can “take that hard look in the mirror and be honest”. For him, that starts with reminding everyone that the bankers who made terrible mistakes leading up the financial crisis were just like them.
“Those people made decisions that they truly believed were going to create shareholder value . . . people will [always] start to think they have it all figured out.” Again, he thinks the coronavirus is the perfect example: “All the information was always out there, and until February 21, risk managers all over the world were just ignoring it.”
To stop people thinking they have it all figured out, he follows a few simple guidelines.
First, give people enough autonomy that they think like the owners of their part of the business. “You say to everyone: ‘If you were the owner of this little part of the business, would you run it this way? Are you waking up . . . thinking about what you might be missing?’ ”
Second, when people answer those questions, listen and act on it. This reinforces the ownership mentality.
Third, before big decisions are taken, go through a thorough risk identification process. Write down everything that could go wrong, “all the ways you can win or lose”. When a decision does go wrong, go back to the list. If the risk was not identified, determine why not.
Last, repeat your risk principles to everyone in the organisation. “You know it’s working,” he says, “when people repeat the same stuff back to you.”
