With 20-20 hindsight, it’s easy to say that banks, regulators, and investors should have seen the housing bust coming and acted appropriately. (Of course, many did see the bust coming – whether they acted appropriately depends on your point of view).
What about volcanoes? Should airlines and safety regulators have seen the April eruption of Eyjafjallajokull coming? Actually, they did. According to The Economist, “In February 2008 officials from air-traffic-control services across Europe, as well as representatives of weather services and airlines, ran an exercise that simulated a strikingly similar eruption.”
It now seems unlikely that grounding all northern European air traffic for nearly a week was the right reaction, but jet engine failures related to volcanic ash in 1982 and 1989 provided legitimate grounds for concern.
The economic consequences of this eruption may be short-lived, yet instructive as we contemplate the possibility of larger scale surprise disruptions. Many of the losses can be recouped – additional flights will get passengers where they need to go, jet fuel not purchased last month will be purchased this month, etc. Indeed, the no-fly period created a boon for trains, ferries, and rental car companies.
Those who rely on airfreight to transport perishable items, on the other hand, were out of luck. Consumers may not notice a restaurant or florist with fewer flowers than usual, but the flower farmers just lost sales they cannot recoup. Companies with tight supply chains also faced great risk. Although planes carry only 2% of overall freight volume, that 2% accounts for 35% of the value, because items like expensive electronic components travel by air to accommodate just-in-time inventory systems. Recession-weary manufacturers have reduced inventories to preserve cash. What will happen to just-in-time inventory during a month-long eruption?
A previous Eyjafjallajokull eruption, well before the jet age, lasted for two years. According to the Wall Street Journal, April’s grounded flights “reduced jet-fuel consumption by about 1 million barrels a day, or slightly more than 1% of global oil demand.” This reduction in demand briefly lowered the price of oil, but investors should imagine how an extended disruption of service might affect demand.
Investors need to expect the unexpected, which is less of a paradox than it seems. We know that volcanoes erupt, and that ash can damage jet engines (the fine particles melt under the turbines’ heat and then solidify on cooler parts of the engine, gumming up the works). We know how the jet stream works, largely because of the Krakatoa eruption of 1883, which was heard literally around the world, and sent particles of ash just as far.
We cannot predict when volcanoes will erupt or when earthquakes will strike, yet we can model the results and build contingency plans for these events. Investors must also exercise our imaginations to prepare for surprises – from a volcanic eruption that depresses the price of oil to an FDA ruling that takes a drug off the market to a fraud charge that undermines investor confidence. How might these events affect YOUR portfolio?
Businesses in general – and investment managers in particular – design disaster recovery plans so they can continue to conduct business under extraordinary circumstances. Here in California, residents are encouraged to maintain survival supply kits and family plans for responding to an earthquake.
What is the investor’s equivalent to a disaster recovery plan or earthquake kit? Hedges? Liquidity? Insurance? Gold? That is the topic of part 2 in this series.