The AIQ Podcast: The source of the next crisis

[Open: Audio - Italians singing from their balconies during the coronavirus pandemic]

Ben Moss

The soundtrack for 2020 - where Italians took to their balconies to sing, to raise spirits in the middle of the COVID-19 lockdown. It was a lifting antidote to reports of fatalities from around the world.

Ian Goldin

“The single biggest threat to the world is pandemic. Pandemics have always been the biggest killers of humanity, but the risk is much greater now, because we are more connected than ever. The super-spreaders of the ‘goods’ of globalisation – for example, airport hubs, are also super-spreaders of the ‘bads’ – like a pandemic.”

Ben Moss

That was Professor Ian Goldin from the University of Oxford, former Vice President of the World Bank, speaking before the COVID-crisis. The pandemic was no surprise to him. His view, which he set out in his book The Butterfly Defect, is that how we live has created enormous benefits and lifted millions out of poverty. But globalisation and hyper-connectivity have costs; they create conditions which make cross-border infections inevitable.

Ian Goldin

“More and more concentration of people, the connection between animals and people, the proximity of slums and bad hygiene in areas near the airports of rapidly growing emerging market cities. All of these increase the risks of new natural pandemics evolving, and then spreading around the world more rapidly.”

Ben Moss

The crisis triggered by COVID-19 has had painful repercussions around the world. Hundreds of thousands of lives have been lost and millions of livelihoods have come to an abrupt halt. From this point, recovery may take years.

In this AIQ podcast, we look at the lessons learnt. Are we any closer to understanding complex risks, and can we possibly anticipate where the next life-changing shock might appear?

With around 1 point 7 million viruses known to infect humans, the human population growing into new habitats, and scope for bad actors to get involved – it’s just a matter of time before another life-threatening infection appears. Add in weak oversight from a poorly-funded World Health Organisation, and prospects don’t look so good.

[Audio: Italian singing]

Ben Moss

This raises some important questions: What do we really understand about our world? Can we ever anticipate where the next crisis might emerge? 

For advocates of complexity theory, the answers are not clear. The theory suggests that even if we think we understand the main variables and core parts of a system, it’s not enough to predict with accuracy. Here’s Professor Danny Quah from the London School of Economics, to explain:

Danny Quah

“Complexity theory tells us that no matter how well you understand the ingredients or components of the system, there will still be something at the aggregate macro level that will surprise you. Technically, the mathematicians that we know think about this as the theory of emergence – there are things that emerge that you will never be able to predict from studying the representative agent.”  

Ben Moss

Dynamic systems involving lots of agents, and thousands of variables connected by feedback loops, have pockets of predictable behaviour - but they also have a nasty habit of surprising us.

This is the world former options trader Nassim Nicholas Taleb describes as populated by ‘Black Swans’. Like the swans that startled visitors to the New World, events that challenge conventional views happen. And the surprises don’t stop. All sorts of changes can follow, with knock-ons that can amplify or even change the nature of the initial event.

Here’s Quah again. 

Danny Quah

“What really matters are not these variances that we have underestimated or tail probabilities that we don’t really understand, but the systemic spillover and contagion that lead from one part of the world to the next. They lead from a crisis that blows up in people’s faces. And that is the real danger.”

Ben Moss

COVID-19 is an obvious example. A contagious new virus which emerged from a Chinese wet market led politicians around the world to close national borders, shut workplaces and order whole communities to stay at home. As a result, around 147 million people - more than 4 per cent of the global workforce – have lost their jobs. The outcome: a humanitarian and economic catastrophe.  

Margaret Heffernan

“Pandemic is intrinsically uncertain, and as such is quite an excellent way of thinking about life in general. They are generally certain. There have always been epidemics, and epidemiologists think there always will be. So they are generally certain, but specifically ambiguous. We don’t know when they are going to break out or where they are going to break out, or what the disease will be.”

Ben Moss

That’s why Professor Margaret Heffernan from the University of Bath believes pandemics say something very profound:

Margaret Heffernan

“What they teach is that however smart we are, however much data we have, however cool the technology is, there is always going to be uncertainty in life.”

[Audio break – storm]

Ben Moss

One of the greatest uncertainties at the moment is what is happening in the biosphere. Climate is just one part of it. Millions of hours of super-computer processing time are being spent trying to mesh together what we know. Have humans changed the composition of the atmosphere enough to trigger catastrophic changes? Could our actions contribute to flooding, or extreme drought?  

There are so many unknowns, including where the tipping points are, which could tilt the system into a new phase.

But there are also details most scientists agree on. Average global temperatures are increasing about ten times faster than ever before. And the number and intensity of natural hazards is increasing in a non-linear way, fast enough for risk experts to talk about an “era of disasters”. 

Back to the million-dollar question - could one of these be the source of a future crisis? We put that to Dr Robert Glasser, former head of the UN Office for Disaster Risk Reduction, now a visiting fellow at the Australian Strategic Policy Institute. He believes rising global temperatures bring risks which could cascade into a major, extended shock. Please excuse the quality of the recording, but his answer is worth hearing.

Robert Glasser

“Climate science suggests that, at 1.5 degrees of warming, almost all of the reefs all over the world will have died because of coral bleaching. So not only is that food supply in danger, but as the reefs die, the main natural barrier to storms and to wave action in a lot of tropical countries will die as well, and that will expose millions of people to more extreme weather and hazards.

“If you put all those things together, it is extremely likely we will see these cascading impacts happening relatively quickly. They will happen in a given year, but also in consecutive years, and the individual events will, in effect, become one big event as the interval of time between them shortens.”

Ben Moss

Where will it stop? Glasser points out that climate change has already contributed to massive political upheaval in North Africa and the Middle East, in an intense period from 2011. Droughts and fires in Russia, Ukraine and parts of China coincided with floods in Canada and Australia, creating a food shortage. That led to riots, fuelling the Arab Spring.

[Audio: shooting]

Ben Moss

Glasser’s disaster cascade includes extreme weather. In the past, the largest cyclones have brought storm surges over 14 metres high, a huge threat to low-lying, crowded parts of Asia and the Americas. Higher sea levels, plus a cyclone, could bring greater losses than we have experienced recently with hurricanes like Katrina or Sandy. Both cost over 70 billion dollars.

Might flooded homeowners see the value of their properties collapse? Could some default, and what could that mean for the banking system? Could it bring a regional bank down? These questions are being asked right now by climate advisors modelling synthetic mortgage portfolios in the US. 

For the moment, those watching the broader financial system feel comfortable about the size of the capital buffers that have been built-in, to make the whole system more robust. Here is Lord Adair Turner, former chairman of the UK’s Financial Services Authority, setting out what was agreed by the International Financial Stability Board after the last crisis.

He explains why he is not alarmed – for now.

Lord Adair Turner

“We tightened up the definition of what counts as capital, the numerator of the capital ratio; changed the definition of risk-weighted assets; increased the required ratio; introduced a counter-cyclical capital buffer and a capital conservation buffer on top of the basic ratio; and implemented a globally-systemic surcharge. The big global banks at the core of the global banking system now have effective capital ratios that are approximately four or five times higher than they were in 2008.

This has put us in a good position and is why I don’t see another financial crisis as a huge threat.”

Ben Moss

Will the buffers be enough for banks to absorb losses from the COVID-crisis, and beyond? Professor Goldin, formerly employed at the World Bank, is less certain than Lord Turner that the system is bullet proof:  

Ian Goldin

“Finance and the banking system has spent a huge amount of effort and time trying to stop another financial crisis with all sorts of regulation, including Solvency II and Basle III. My view is that the system is no more robust than in 2008. Certainly, we are not going to have the same crisis we had in 2008. It never is like that. The potential for the financial system to fall apart after a Hurricane Sandy or event in Canary Wharf is greater than ever.” 

Ben Moss

Who should we believe? Leading risk specialist Professor Didier Sornette from the Swiss Federal Institute of Technology Zurich sits closer to Goldin than Turner.

As someone with experience monitoring disturbances in complex systems, his concern is that markets have become swamped by central bank intervention and are now dysfunctional.

Who knows? Perhaps the Italian central banker Mario Draghi whose soothing words helped calm investors’ nerves in 2012 will rue the day he light-heartedly pointed out an enigma:

Mario Draghi

“The euro is like a bumble bee – it’s a mystery of nature. It shouldn’t fly, but it does…”

Ben Moss

Meanwhile, on the world stage, the mood is delicate. The US has demanded reparations from China for economic damages caused by the coronavirus. It’s an exceptionally sensitive time for the relationship, according to Alistair Way, head of global emerging market equities at Aviva Investors.

Alistair Way

“It feels like the tone of the relationship between the US and China has fundamentally changed. There is far more to it than Trump himself. Notably on the coronavirus, you would have thought the countries could have done a much better job of working together, given it is a global economic healthcare crisis, but from the start it has felt as if it has been marked with mistrust and blame. Even beneath Trump, it feels to me as if the channels of diplomacy are worse than they have ever been, which does make things harder…The entire relationship is more sensitive to volatility.”

Ben Moss

Let’s take a step back again and look at the cascade. A viral mutation and one cross-species leap has superpowers in a stand-off. There are implications at many levels, including vulnerabilities for companies depending on China for raw materials and products.

At the level of individual businesses, it’s all about change. Mikhail Zverev, head of global equities at Aviva Investors, sees it like this: 

Mikhail Zverev

“Change works both ways; it can be an opportunity and a threat. Primarily, for us, change is a source of inefficiency; when something is changing in a business, when the future isn’t equal to the past in a meaningful way, the market is more likely to misunderstand and misprice it. When you can’t extrapolate from the past any more you have to do more work, do more digging, connect the dots a bit better. That brings opportunities for us.”

Ben Moss

One example where the future looks very different is the pharmaceutical industry. Out of favour in the pre-COVID world, it was accused of aggressive pricing and potentially vulnerable to unwanted political attention. 

During the pandemic, all that has changed. Collaboration became the name of the game, as public and private resources were pooled to treat patients with coronavirus quickly.

Matt Kirby

“COVID-19 has highlighted how important pharmaceutical companies are to society. They have provided a continuous supply of essential medicines for patients, carried out extensive research and development, and worked on solutions that will ultimately support the re-opening of the global economy.”

Ben Moss

Matt Kirby, equities fund manager with responsibility for healthcare at Aviva Investors highlights that it is not only big-pharma working to overcome such dramatic change. Pharmaceuticals packaging providers are managing their responsibilities in the therapeutics supply chain, while also seeking to support the scaling up of vaccine immunisation programmes.

Matt Kirby

“The number  of vials needed for an ambitious global immunisation scheme would run into billions – not millions. One and a half to two and a half billion vials is the current estimate. There is currently not enough capacity for the industry to simply squeeze these out these out alongside everything else.”

New investment, new agreements to onshore the production of active pharmaceutical ingredients in Europe, new design solutions including syringes that can be dropped by drone and new agreements to ensure vaccine distribution to lower income countries. All of these have been agreed in less than 12 months. 

[Audio: vial production line]

Ben Moss

Appreciating that we can’t know the future, and that uncertainty is part of life, means taking a different view. Our systems need to be engineered so stress in one part of the system won’t collapse the lot, and we need high tolerances – just in case we underestimate what ‘worst’ might be.

What happens now depends on the trajectory of the pandemic, and how that might impact our appetite to engage with our neighbours and others around the world. How geopolitics reshapes supply chains, and whether we choose to build back in a greener way will be key.

The uncertainty may feel uncomfortable, but it is not all bad news. More than a century ago, the economist Frank Knight wrote about the positives. Perhaps we can end with a reminder from one of his modern contemporaries, Professor John Kay, to remind us of what they are:

John Kay

“What Knight said when he wrote about uncertainty 100 years ago was that uncertainty created innovation, entrepreneurship and profit – and unfortunately that is an insight we seem to have lost.”

Ben Moss

Thank you for listening.  If you would like to find out more about risk and uncertainty, and Frank Knight’s ideas, try our AIQ podcast – Risk and resilience in an age of uncertainty. Read the latest issue of AIQ magazine, a risk special, at our website at www.avivainvestors.com. Please look out for future episodes and feel free to subscribe through any of the major podcast channels.