#23 - Complexity & Covid-19
Predictions are hard, especially about the future
The origin of the quote “predictions are hard, especially about the future,” is debatable. Its meaning isn’t.
The outbreak of Covid-19 is a reminder of just how difficult forecasting is. Assumptions that seemed ironclad a week ago look less bulletproof right now. One reason why the current situation is so hard to assess is that we’re dealing with two complex systems: the spread of Covid-19 and the economy.
Complex systems involve a lot of math and multi-syllable words. A Simple Guide to Chaos and Complexity is a good primer on the subject if you want to dig in. If not, here are the Cliffs Notes, heavily paraphrased from the link above.
Complex systems have a number of common traits:
They’re composites made up of a large number of subunits. Say, gas molecules or companies.
These subunits interact and feedback on each other.
Feedback can be positive or negative. Positive feedback increases the rate of change in a certain direction while negative does the opposite.
Interaction between individual subunits creates collective behavior that in turn influences the behavior of the individuals.
They’re nonlinear meaning that inputs aren’t proportional to outputs. A small change in some variable won’t necessarily result in a small impact on the system, and vice versa.
They’re sensitive to initial conditions. This means that given the same subunits and rules, a slight difference in starting position can result in a vastly different trajectory.
The consequences of all this is that:
This sensitivity makes it difficult to predict the evolution of a system, as this requires the initial state of the system to be described with perfect accuracy...A small disturbance in the system (even to a single subunit) can produce massive, systemic changes...We should not be surprised if huge catastrophes occur for no discernible reason.
So getting a handle on complex systems is really hard.
Turning back to Covid-19, here’s confirmed caseload outside of mainland China:
This is an example of nonlinear growth. And nonlinear growth makes it difficult to predict what the future is going to look like with a high degree of confidence.
Turning to the economy, supply disruptions are one of the areas that Covid-19 will influence. With factories in China shuttered or operating at partial capacity, many industries are feeling the impact. As investor Howard Marks points out in his recent memo Nobody Knows II:
Supply chain impacts are important. The unavailability of a small Chinese component can cripple the production of a large piece of equipment. And it only takes one, unless there are alternative sources.
A recent analysis by the New York Fed illustrates this point. Because production processes are linked, a stoppage at a large firm can impact the entire economy. For example, when Boeing cuts production it needs fewer parts from its suppliers who in turn need fewer parts from their suppliers. In this way, a shock to one firm can cascade through a supply chain like a snowball rolling downhill. According to the New York Fed, halting 737 MAX production could shave 0.4% off US GDP growth. For context, US GDP is growing about 2%, so that’s a material impact.
At this point, gauging the economic impact of Covid-19 is unknowable. This is where Nietzsche comes in:
To trace something unknown back to something known is alleviating, soothing, gratifying and gives moreover a feeling of power. Danger, disquiet, anxiety attend the unknown - the first instinct is to eliminate these distressing states. First principle: any explanation is better than none.
So, on one hand you’ve got an unknowable situation. On the other, you’ve got businesses that need to make decisions.
What to do?
One suggestion comes from Bill Hanage and Marc Lipsitch, epidemiologists at the Center for Communicable Disease Dynamics at the Harvard School of Public Health:
Seek diverse sources of information. Because no one has digested everything about the state of the epidemic, different experts will know different things and see different holes in our reasoning. This advice applies to scientists, as well as journalists: the best scientists - will consult their colleagues and ask them to find weaknesses in the scientists’ work before sharing the work more broadly - especially in a setting like this one, where the representativeness and accuracy of data are necessarily uncertain.
Extrapolating on this, triangulate your forecast whenever possible. Look at the problem from a few different angles. Get a second or third opinion.
The conclusion of What Coronavirus Could Mean for the Global Economy offers sensible advice:
Don’t become dependent on projections...A wide range of scenarios remain plausible and should be explored by companies.
Treat your forecast with a large dose of humility. Understand that it’s your best guess as of today, but that it’s likely wrong. Question your underlying assumptions. Refine your forecast as new data becomes available. Widen the ranges of your scenarios and decrease your level of confidence in your results.
With risks to growth increasing, it makes sense to scrutinize your expenses. In a letter to portfolio company CEOs, Sequoia Capital recommends making fast, proactive adjustments:
Having weathered every business downturn for nearly fifty years, we’ve learned an important lesson - nobody ever regrets making fast and decisive adjustments to changing circumstances. In downturns, revenue and cash levels always fall faster than expenses. In some ways, business mirrors biology. As Darwin surmised, those who survive ‘are not the strongest or the most intelligent, but the most adaptable to change.’
Lastly, take a deep breath. Returning to Nobody Knows II, Howard Marks reminds us that financial markets are a mixture of emotion and economics:
In the real world, things generally fluctuate between ‘pretty good’ and ‘not so hot.’ But in the world of investing, perception often swings from ‘flawless’ to ‘hopeless.’
Keep that in mind the next time your look at your 401k statement or turn on the TV and see something like this:
The stock market isn’t the economy. Every so often markets trade like the world is coming to an end, but the world has always had the last laugh.
Suggested Covid-19 Resources
If you’re interested in more information on Covid-19, here are a few suggestions:
Below the Line Covid-19 Twitter List. H/T Kai Kupferschmidt for many of these suggestions.
Marc Lipsitch - Director of Center for Communicable Disease Dynamics at Harvard University. @mlipsitch on Twitter. His appearance on the Deep Background podcast is worth a listen (links: Apple, Google, and Spotify)
Kai Kupferschmidt - Journalist at Science Magazine. @kakape on Twitter.
So You Think You’re Going To Be In A Pandemic? - “Planning now and doing something means we can control how well we cope with some of what may be coming.” The most actionable advice is in the section: “But what can we plan for and do?”
How Pandemics Change History - The meta point here is that while Covid-19 is new to us, epidemics and pandemics have been around forever. Humanity has weathered storms like this before.
Remember to wash your hands this weekend. Oh, and don’t touch your face.
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