Colorized transmission electron micrograph of Avian influenza A H5N1 viruses (seen in gold). Image provided by CDC/C. Goldsmith, J. Katz, and S. Zaki.
Pandemic Economics
By Grattan Woodson, MD, FACP
Economic and Financial Implications of an Influenza Pandemic
A truly severe pandemic similar to the 1918 Spanish Influenza occurring at any time but especially under today’s circumstances where the human population is both highly concentrated in urban areas and enriched with many elderly and infirm persons is likely to result in a human catastrophe. A medical disaster, disrupting commerce and civil order thorough out the world can only result in grave economic consequences. The advent of globalization and interdependence of the world’s economies means that adverse affects occurring anywhere in the world has significant affects everywhere. Economic contraction due to a loss of production and consumption during and after an event like this is a predictable consequence. Future productive capacity will be impaired due to the death or incapacitation of a portion of the work force at all skill and professional levels. These events are likely to cause a fall in the value of many asset classes leading to further reduction in personal consumption due to a negative wealth effect. Several years will probably be required for the overhang of these fundamental factors to be worked off by the economies and GDP growth and capital markets recover.
The Congressional Budget Office Flu Study
The Congressional Budget Office (CBO Flu Study) studied the macroeconomic effect of a mild pandemic and concluded that this would not affect the US economy very significantly although a more severe event would likely lead to a recession of similar magnitude as that seen in over the past 50 years1. They concluded that a mild pandemic would result in a 1.5% decrease in GDP with a “severe” pandemic resulting in a 5% drop in US GDP. In essence they conclude that a mild pandemic will be absorbed by the economy while a severe one would result in an effect equivalent to an average post-WWII economic recession. Most world economies, societies, and their intuitions are more than resilient enough to withstand these mild to moderate pandemic events.
The CBO Flu Study is interesting from the point of view that it is the first published model of its kind and for its use of statistical data on the worker productivity and consumer demand. Like the Department of Health and Human Services Pandemic Influenza Plan (DHHS PIP) the CBO Flu Study uses optimistic assumptions for the pandemic’s effect on the workforce and also ignores several important economic factors sure to be adversely affected by a pandemic that have a strong influence on US GDP2. The model used assumed that 10% to 30% of workers in 6 economic sectors (non-farm, business, households, farm, non-profit, and government) would be affected by the flu. During a “severe” pandemic the model predicts 30% of these folks would be away from work for 3 weeks with 2.5% dying. The assumptions used for the mild pandemic is for there 25% of the workforce becoming ill with a loss of 3.5 work days and 0.114% dying. In the CBO severe scenario they expect 10% of farm sector workers will become ill missing 1 week of work. During a mild pandemic, just 5% of farm sector workers become ill with this lasting 1.25 days.
Weaknesses in the CBO Flu Study assumptions
The mild pandemic scenario
The CBO Flu Study predicts that a mild pandemic would have a case fatality rate of 0.114% or only half the rate of the DHHS PIP. It also uses a clinical attack rate of just 25% compared with 30% used in the DHHS PIP. Another major issue is their assumption that the pandemic will last no longer than 12 months rather than the more conservative 18-month estimate. The assumption that farm sector workers will experience a lower rate of illness and death than other sectors is without foundation.
The “severe” pandemic scenario
The CBO study does not take into account a reduction in export orders for US goods and services from other nations during the pandemic. There is no adjustment made for a negative wealth effect on demand for goods and services due to a fall in US asset valuations. The model does not calculate in the impact of increased US Government and State government borrowing for spending on their pandemic response. There is no adjustment for changes in interest rates or the value of the US dollar. The impact of falling tax receipts and increased rates of bankruptcies are not contemplated.
An independent estimate of economic effect of a truly severe pandemic
The model I used for The Bird Flu Manual predicts the clinical attack rate in the US will be 40% with a case fatality rate of 8% during an 18-month severe influenza pandemic3. Using these estimates and the other items mentioned above rather than those assumed in the CBO Flu Study would result in a much larger loss in US GDP. Under these truly severe conditions, a 20% contraction in US economic activity spread over a 36-month period beginning with the onset of the pandemic is not unrealistic. This estimate fails to take into considerate the cost or consequences of civil disorder during a pandemic. There is no question that a 20% drop in US GDP would equate to an economic depression in the US and globally. Unintentional unemployment, corporate and personal bankruptcies, reduced overseas demand for US exports and reduced US imports would all have a profound influence on national incomes in the US and all other nations
The US stock market: reality sinks in
Once stock and bond traders begin to understand that a severe flu pandemic comes with a predictable economic impact, they will begin the process of calculating this risk and adding it to their economic modeling programs. As this process and its probability become clearer, they will see that certain pandemic scenarios carry risk of resulting in a general economic contraction rather than one having affects within one or two industries. They will response to this finding by beginning he process of discounting the possibly. The investment community worldwide is similar in that they tend to be a skeptical bunch on the whole. Most but not all remain focused on short-term returns.
Greed, fear, and herd mentality
In normal times, opinions on the direction of markets is usually fairly diverse such that their and almost equal numbers of buyers of a specific financial instrument as sellers. This essential balance in market opinion leads to markets that move in slow up or down waves that reflect the aggregate effect of either the accumulating or distribution of securities. In the simplest terms, if on the whole, more stocks are being accumulated that sold or distributed, then the market averages rise and it is said that we are in a “bull market”.
Greed and fear are two emotions that can disrupt this balance if it infects too many money managers at the same time. This is because it can lead to the phenomenon of herd behavior in this usually calm and collected cadre of financial professionals. If powerful and widespread, these emotions can cause them to act irrationally. Rarely these emotions lead a significant number to move to the buy or sell side in the marketplace at the same time causing the equivalent of a financial stamped. When too many money managers try to take the same side of a position at the same time this disrupts the balance between buyer and sellers and forces large and unexpected moves in the markets. The resulting action is reminiscent of a herd of wild beasts and has a very unsettling affect on the markets leading to a big move in the financial markets.
The economic turmoil will simply mirror the human impact of the pandemic. As with our other social institutions, these markets will recover with time but if we experience a truly severe pandemic, this could take several years as it did after the 1929 stock market collapse and subsequent economic depression.
Elements of Defensive Investment Strategy
- Cash invested in short-term US Government only money market funds
- Gold exchange traded funds
- Have some enough currency on hand for 3 months expenses and consider purchasing some gold coins (1/10th oz US American Eagles) for personal use in an emergency. These need to be stored in a safe place where you can gain access to them quickly.
While some securities may rise most will fall under these economic conditions. The US Treasury bond market may or may not be a refuge as the value of the US dollar, inflation, sale of overseas holding of US Treasury bonds are powerful influences that are difficult to predict in prospect. For this reason, holding long-term instruments entails risk. On the other hand, short-term US Treasury debt is likely to a relatively safe investment for those seeking capital preservation. Most brokerage houses offer a short term Money Market Fund that invests in US Treasury debt exclusively. As of May 2006, these funds have a 7-day yield of about 4.5% compared with 4.75% for the typical short-term money market account invested in corporate debt4. The greatest risk for those investing in these instruments is inflation, which could substantial devalue the buying power of the dollar under certain scenarios. Having a portion of a portfolio investing in gold is one way to hedge this risk.
Avoid hybrid US Government Money Market Funds that in addition to hold US Treasury Debt, buy notes from Agencies who are not part of the US Government but whose debt is guaranteed by the US (like Fannie Mae or Freddy Mac). Avoid placing your money in the standard brokerage house Money Market Fund, short-term corporate bond funds, or Municipal bonds, even those rated AAA+ that are insured. While the rate of return on these instruments will be a little higher, repayment of even this high quality debt could be impaired if the country enters a severe economic reversal5. It would not be prudent to invest money in a high risk short-term “junk bonds” or in the bonds of any foreign companies or governments. Avoid investing with banks or insurance companies or in their debt as they could experience economic reversals during the pandemic. The main reason to avoid these asset classes is because none of the companies or municipal governments who borrow in the Money Market or Bond Market will be able to operate during the emergency and as a result, some of them will go bankrupt afterwards6. The US Government can print money if it needs to and has the power to tax US citizens in order to pay its debts. This is why US Treasury debt is superior to all other debt instruments and way it commands a lower interest rate.
A gold backed security can be purchased in your IRA or other qualified retirement accounts as well as in an individual account. One way to do this is by purchasing an electronically traded fund or ETF that trades on the New York Stock Exchange under the symbol GLD. Your brokerage houses can advise you on this fund as well as provide you with a prospectus for the GLD ETF. Each GLD share is backed by 1/10th oz of pure gold bullion that is physically held by the underwriter of the security in bank vaults. The value of these shares rise and fall based upon the price of gold.
The US American Eagle 1/10th ounce gold coin can be purchased from coin and gold dealers like Monex®.
If you have real estate, you will be stuck with it until either the bank repossesses it from you or enough years pass to allow you to sell it again. It could take many years for prices to return to the levels seen when real estate prices reached bubble proportions during 2005.
In summary, plan how to position your portfolio in the event of a pandemic. As the risk of this event rises, begin executing your plan. Your goal is to have completed your plan implementation before the pandemic and the stamped begins or as soon thereafter as possible.
1 A Potential Influenza Pandemic: Possible Macroeconomic Effects and Policy Issues, The Congress of the US, The Congressional Budget Office, December 8, 2005, US Government Printing Office.Return to article.
2 The US Department of Health and Human Services Pandemic Influenza Plan. November 2, 2005.Return to article.
3 Woodson G., The Bird Flu Manual, 2006 in press.Return to article.
4 The difference in rates is because money loaned to the US Government is considered to be the safer than any other US borrower and is virtually guaranteed to be repaid come what may.Return to article.
5 Contrary to general opinion, money invested in these investment instruments are at risk. Under usual circumstances this risk is negligible but under conditions of a major pandemic these risks become palpable.Return to article.
6 For example, after Hurricane Katrina hit the US Gulf coast, The Entergy Corporation announced that it might place its New Orleans operating unit in chapter 11 bankruptcy due to its lack of revenues in the aftermath of the disaster. The city of New Orleans is also without income and is likely to remain so for many months. It is unlikely that their debt or even interest on it will be repaid any time soon. It is likely that it will need to declare bankruptcy once these debts become due unless it receives a bailout from the State or Federal governments which is unlikely..Return to article.