Thursday, June 22, 2006

Personal Finance in an Influenza Pandemic

Everyone's first and most fervent wish is that they and their family survive. Only the survivors give a hoot about the economics. Still, all but an unlucky few will survive, and they will find a changed world.

Many small businesses that cannot sustain months of closure will go broke, but large businesses and institutions will not be too traumatically affected. Schools and universities will experience long closures, but eventually things will return to normal. The infrastructure elements (public utilities, highways, media) will be modestly degraded, but most will remain functional almost all of the time.

Hospitals are an exception. In the course of a 1918-level pandemic, hospitals without a well-designed pandemic plan will quickly become worse than useless. They will lose many employees, and they will lose a very great deal of money as resources are diverted from their normal activities. In the post-pandemic period there will be calls for government bail-outs, and some government assistance will eventually come through --- though predictably it will be too little and too late for many institutions.

The CBO estimates a worst-case hit to US GDP of 5%, which is just a little bit more than a typical recession. If this guess holds up, the large scale economic consequences of a pandemic are certainly not so terrible. Still, the CBO has been caught before walking around wearing rose-colored glasses. The World Bank statement on the economic impact of a pandemic does not pick a number.

Interest rates and inflation rates are almost certain to decline during the pandemic, though there will be some price gouging at the retail level. US Treasuries should do very well, but quality spreads are likely to widen and corporate bonds will do less well. Muni's are certainly a mixed bag, and some may submarine since cities will face many unplanned expenses and many already live close to the edge of solvency. On the equity side, my guess is that one can expect at least a 10% sell-off as soon as Wall Street tells itself "this is the real deal" --- an event that will probably lead the real deal by several months. My further guess is that the initial sell-off will be followed by a malaise that will take the market down another 15 to 25% before a bottom is reached. Thus, my worst case scenario is for about a 35% decline; so I am actually a bit more optimistic than some Wall Street analysts.

The CBO takes an optimistic view and says "It seems quite likely that the stock market would fall initially and then rebound later, as it did in Hong Kong during the SARS episode." Here it seems that CBO may not have taken fully into account the fortunate fact that SARS did not develop into a pandemic. I would also expect a full recovery, but not until the end of the pandemic is firmly part of the collective consciousness.

Even if death rates are comparable to those of 1918-1919, there is likely to be an almost full market recovery within two years of the initial sell-off. Curiously enough, the US market did not do badly in 1918; it went up 23% from August 1918 to August 1919. To be sure, there were confounding effects due to the end of WWI, and in 1918 there was nothing like the information flow that we have today.

The lesser pandemics of 1957 and 1968 failed to show any clear-cut market impact and the relevance of the SARS scare is ambiguous. Still, clumps of sell-side research that now circulate the planet convince me that the case has been made for a pretty big sell-off the minute that efficient H2H transmission is strongly suspected. Wall Street will probably ring its bell a day or two before WHO makes it official that we are at pandemic level four.

What Should You Do Economically --- While Staying Alive?

If you are a genuine long-term investor, it may be rational for you decide right now to do nothing. I am sure this will be the choice of many of my wisest friends. Under the CBO model, this would not be much different than staying full invested during a recession. Prediction of a pandemic does seem a little easier to me than prediction of a recession, but this may just be hubris.

Still, once a pandemic begins, it will unfold in a sequence of almost reasonably well-defined steps, so our investment task is reduced to guessing right about how the market will react to those steps. Personally, don't plan to spend too much time hunting for single issue home runs on either the long or the short side.

Nevertheless, the scenarios that I have suggested do make the case for acting early with a staged reduction of equity exposure. There is also a case for holding US Treasuries over corporate bonds, municipal bonds, or TIPS. Also, let's not forget that --- even more than a recession --- a pandemic is of finite duration. Once the market is off 15%-20% there is no reason not to start moving back to your previously preferred bond/equity mix.

Resources and References

World Bank Statement: Economic Impact of Avian Flu
Congressional Budget Office Report (May 22, 2006)
Congressional Budget Office Report (December 8, 2005)
"Bird Flu Fears Ripple through Market" Business Week (5/23/06)
Laurie Garrett at the Council on Foreign Relations
Nesbitt-Burns (Canadian Brokerage) Research Report
Becker-Posner Blog (Tsunami Related, but relevant)
142 Million Lives (CNN Report)


Blogger gs said...

again, most economical analysis assumes that a mild pandemic is most likely. You hardly find any model with a CFR of 10% or higher.
But, when the pandemic is really severe, which I think is possible, then it could be different.You might see inflation with collapsing economies
and distrust in country-depts and
a run on gold as compensation currency.

6:24 AM  

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