Essay

HOW TO PLAY A PANDEMIC

A new kind of threat could shock the global economy and the markets

DONALD COXE October 24 2005
Essay

HOW TO PLAY A PANDEMIC

A new kind of threat could shock the global economy and the markets

DONALD COXE October 24 2005

HOW TO PLAY A PANDEMIC

A new kind of threat could shock the global economy and the markets

DONALD COXE

Essay

UNTIL RECENTLY, portfolio strategists paid to look for potential problems in global financial markets confined themselves to discussing familiar investment fears: inflation driven by soaring oil and gas prices, deflation driven by low wages in China and India, rising short-term interest rates, government deficits, and the timing of the bursting of the housing bubble.

Rather suddenly, a new kind of threat has emerged: the possibility of a global pandemic that could shock the global economy and devastate financial markets.

Now, it seems, nearly everyone knows about H5N1—avian flu, which has reached Turkey and, possibly, Romania. Leading institutions such as Deutsche Bank are holding seminars in which epidemiologists tell institutional investors about this new killer flu that could overwhelm hospital systems, kill tens of millions of people, shut down airlines, and even (horrors!) force stock market closures.

Stories on the flu threat are no longer confined to the inside pages of newspapers— they’re on the front pages of nearly all major papers, including the Wall Street Journal and the Financial Times—the two must-reads for serious investors. As stock markets display queasiness, despite record corporate earnings, they could already be showing symptoms of flu fear.

Two months ago, our firm published a report for investors on avian influenza. The reaction from doctors, scientists and institutional investors was strongly positive, but much of the reaction from retail brokers and clients was even more strongly negative. Why, they complained to us, waste their time with a horror story from the backwoods of Asia? That furious feedback illustrates why governments and organizations have such difficulty in preparing their people for a pandemic: it’s too horrible to contemplate and nobody can guarantee it will strike within the next few months or years. Despite powerful testimony before congressional committees and urgent pleas from President George W. Bush, Congress has authorized only a few billion dollars to fund a preparedness and surveillance program that includes aid to the Asian nations most at risk.

Katrina should have made it relatively easy for Bush to get pandemic funds. Just

MORE and more of what the world produces comes from International supply chain systems that would shut down

as the experts told Louisianans for decades that a category four hurricane would send Lake Pontchartrain into New Orleans, so the experts are now virtually unanimous that a global pandemic is inevitable . . . sometime. But some attitudes don’t change. According to the New Orleans TimesPicayune, nearly three decades ago the U.S. Army Corps of Engineers got funding to strengthen the levees on Lake Pontchartrain and send any flooding to the Mississippi. An environmentalist lawsuit blocked that program, because it could mean damage to fragile wetlands. When Bush hinted he would consider using the army for enforcing quarantines, leading Democrats protested that it would be an unacceptable use of military force.

So, despite all the current publicity about the flu threat, investors would be wise to assume that most democracies will not respond with enough resources, organization and compulsion to prevent a catastrophe if the current bird flu mutates into full-scale human-to-human transmission. It will achieve that breakthrough, experts believe, the way the Spanish flu of 1918 became the most serious pandemic since the Black Death. Scientists believe it started when one soldier on a base in Kansas, who had a more benign flu in his system, contracted the killer virus. That virus recombined with the garden-variety flu, thereby acquiring that flu’s most notable characteristic: its skill at spreading rapidly from human to human. The confined conditions of trench warfare made that easy—the rest is history. Depending on which historian you believe, the death toll was 25 million, 50 million or 100 million. For a similarly lethal virus today, multiply that toll by three or four.

From an investment standpoint, here’s the bottom line on an outbreak. If it reaches even small-scale epidemic stage anywhere in the world, most governments will immediately impose embargoes, permitting no planes or ships or tourists from infected nations into their own countries. The likeliest region for an outbreak will be East Asia, where poultry, animals and humans—each in their billions—live in close proximity. The flu can progress from poultry to pigs to people without having to spread geographically. It would reach North America within months.

If the new pandemic mimicked 1918, the kill rate would be highest among the healthiest population cohort-ages 20 to 45. That would mean that many businesses and most hospitals would experience serious problems, both because of employees who were actually infected or already dead, and because others, understanding the risk and knowing there’s no vaccine, would, like the New Orleans cops, not report for work.

The growth in globalism means that more and more of what the world produces and sells comes from international supply chain systems, which are typically managed on just-in-time inventory principles. For example, Canadians know that a prolonged closure of Windsor’s Ambassador Bridge would mean shutting down auto assembly lines from Ohio to Quebec. But the process is more widespread: when a U.S. shopper buys any one of thousands of items in Wal-Mart, an order goes to China that day to replace it; pharmaceutical manufacturers rely on perishable ingredients from around the world. The list is almost endless.

INVESTORS WITH contingency plans would soon find their best buying opportunities in decades

What would a confirmation that H5N1 had broken out mean for investors? Answer: a temporary financial epidemic of panics, shortages, closures and bankruptcies affecting most segments of the economy across most parts of the world.

What does “temporary” mean? With luck, the pandemic would be over in 18 months to two years.

What would such prolonged disruption mean for financial markets?

Chicago-based Donald Coxe is Global Portfolio Strategist, BMO Financial Group. dcoxe@macleans.ca

Since supply chains developed, we have never experienced a lethal pandemic. So no one knows how severe the impact on stock prices would be. But stocks globally are priced at generous multiples of expected earnings that would assuredly plummet. Investors who had made contingency plans for a possible pandemic would soon find their best buying opportunities in decades. Which means their opportunities would arise from the distress of investors who had not made contingency plans for a possible pandemic.

What should investors do?

Even though the risk of an immediate pandemic is remote, you should not ignore it completely. Talk to your adviser. Identify the stocks you own that are most vulnerable in a temporary panic. If, after you’ve read about what this flu could do, you decide to take some defensive measures, use the opportunity to upgrade your portfolio by lowering its internal risk. Consider such diverse strategies as options, high-dividend blue chips, and a somewhat higher than usual holding of cash.

Most likely, those strategies will prove unnecessary and you would later regret them— the way a buyer of term life insurance may regret, a year later, paying those premiums.