BLOG: Stress Testing in the Pandemic

Written by Daniel Finn, Head of Risk Solutions, North America, Conning and Matt Lightwood, Director, Risk Solutions, Conning

14/05/2020

The spread of COVID-19 into a global pandemic has resulted in one of the most significant economic events of our lifetimes. It has been more than 100 years since the world has seen an epidemic of this scale, and even longer since such an epidemic has caused this degree of economic distress; even the Spanish Flu outbreak of 1918–1919 did not have a comparable impact, as its economic effects were muted by those of World War I. News reports frighten us daily with words like “unprecedented” and “unimaginable.” Is it impossible to plan for the future at such a moment in history?

We at Conning believe that the “unprecedented” may have some precedent after all. If we focus on current primary economic indicators, we see the following broad conditions.

• Large drops in government bond yields
• Significant widening in corporate bond spreads
• Dramatic drops in equity prices
• Expected large drops in GDP

If these conditions sound familiar, it is because we saw them not long ago: all of these events were also hallmarks of the 2008 Financial Crisis. While the magnitude of the losses caused by the COVID-19 crisis have been smaller than the 2008 crisis so far, it is important to note that the time window is much shorter; it is likely that we will be counting the costs of the current crisis for some time to come, and the final effects on the global economy may yet equal or outstrip those of the 2008 crisis.

There are also other potential correspondences with the past that we might hypothesize. What if the massive worldwide stimulus packages currently being put into place are not able to stabilise the economy? In that case, equity returns and real GDP would likely continue to fall, but the massive borrowing by governments in Europe and around the world used to fund this spending could easily lead to a spike in both yields and inflation. In that case, it would make our near future look similar to the Stagflation event of 1973–74. While these are not necessarily the only outcomes, or even the most likely, we can use these historical events to understand the potential risks of the current crisis.

It is comforting to know that the rough waters we are navigating now may not be as uncharted as some would suggest, but the similarities between today’s economic climate and the events of the past are of more than mere academic interest; this information can also be applied to practical purposes. Historical data is a real-world case study in how the markets have behaved under similar conditions, and the use of historical scenarios for stress testing can give us a window into how a portfolio might perform during a time of crisis and recovery. Such information is critical to a robust and effective risk management program.

Conning’s own GEMS® Stress Test Scenarios package simulates ten significant economic events from the past 100 years, including Black Monday, The European Debt Crisis, and The Great Depression, and it has helped its clients incorporate historical data into their risk analysis to give them a glimpse into how such crises may impact their solvency and financial stability. Conning has supplied its clients free of charge with a selection from this scenario package based on current market data. In the spirit of togetherness at this testing time, we would now like to extend this offer more widely in the market. You will be able to run you existing models through these scenarios and gain new insights into how your company might perform in the months and years ahead. If you would like to take advantage of this offer, please visit http://go.conning.com/COVID-19-Stress-Test-Social_COVID-19-Stress-Test-Request-2.html, or go to https://www.conning.com/ for more information about our company.

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