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My name is Max Rudolph. I
am a credentialed actuary and CFA charter holder working as a sole
Omaha, Nebraska, USA. I write a monthly
newsletter, covering a variety of topics. It has varied from 1 to 4 pages,
but most are less than 2 pages. Coverage is mostly related to risk
management and investments. Some are written at a high level, dealing with
the general economy, and some cover very specific topics. I try to write
something about the current financial environment, and there have been
plenty of topics to choose from. The newsletters are educational in nature
and do not constitute investment advice. The newsletters are released
www.rudolph-financial.com after 3-6 months.
For those interested in a 12-month
subscription, please send $100 in US currency payable to
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Elkhorn, NE 68022 USA
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Financial Predictions for 2010
Please remember that these
predictions are for fun. If I knew what was going to happen, I certainly
would not share that information with others! You must make your own
decisions regarding your financial future and not hold others, including me,
responsible for your own results. Enjoy!
These (mainly) economic predictions
were made in January 2010.
- Politics: every year I
write about the political cycle, and this year is no exception. Barack
Obama was a disappointment in his first year, working a strictly
democratic agenda rather than being a consensus President. His
initiatives have focused on political expediency rather than bringing
Americans together. In the 2010 elections he will surely lose his 60
seat filibuster proof Senate and will lose some seats in the House while
maintaining a majority in both houses (this actually happened already as
the democrats lost Teddy Kennedy’s seat in Massachusetts, mainly because
they took it for granted). Once he loses the 60 seats he will become a
lame duck President unless there is a new armed conflict for US citizens
to rally around. Personal accountability has been ignored, with only the
“rich” expected to pay taxes. A better plan would be to have an income
based tax like FICA taxes but that is unlikely to happen anytime soon
from either political party. The lack of 60 Senate votes has cost the
democrats their big issue, health care reform, so now they will take on
reregulation of the financial sector. God help us all! Political
instability throughout the world will be a problem, driven by the
liquidity crisis, price of oil, and/or terrorism. Countries most at risk
are Iran, Venezuela, Pakistan, Mexico, and the Philippines. China could
see a negative surprise here.
- Stocks: The stock
market is currently overvalued, having anticipated a quick recovery. The
stock market will be volatile in 2010 but end up within 10% of its
starting point. My gut feel is up slightly, but it is hard to get it
right over such a short period of time. Over the next 3 years I expect
the market to operate within trading ranges as increased productivity is
offset by higher valuation discount rates. Good companies to buy now are
ones that can pass on their inflationary cost increases to their
customers like those in the transportation and utilities sectors.
- Unemployment: Fiscal
stimulus has helped to bottom out unemployment, and I don’t expect it to
get worse than the current 10%. What worries me is the higher percentage
of government workers as a percentage of all workers. We can’t all work
for the government. That would wipe out the creative destruction process
that is capitalism and leave us with socialism. We have entered an era
where saving is more popular, but this will only be complete when some
who choose not to save are allowed to fail. There is enough money on the
sidelines that this should not cause a slowdown in growth. 2010 will be
a year when firms cut expenses so far (training, travel, new hires) that
it begins to impact their ability to profitably grow. The “survivors” at
big firms will no longer be the best and brightest, and these firms will
need to hire creative minds from outside to succeed. Budget imbalances
will eventually create inflation, but long term treasuries will increase
first. Taxes will not be impacted until unemployment returns to a more
normal level but will eventually need to rise.
Securitization/Mortgages: The securitization market will thaw a bit but
capital requirements will continue to be high for banks, discouraging
loans. I don’t think we are done with the bad news from home mortgages
either. Some are saying that the Fed will have major balance sheet
issues if interest rates rise. Are these unintended consequences or just
a plan that was not thought through? Probably some of both. I don’t
understand why there are so many governmental organizations designed to
oversee residential mortgages. One positive development would be for
GSEs to eliminate their lobbying arms. Higher interest rates will drive
another round of foreclosures on home mortgages as ARM contracts reset
- Volatility has fallen
all the way back below 20, indicating to me that investors think the
government will bail them out no matter what and no matter when. This is
clearly wrong in the long term. A reasonable VIX seems to be about 25
for 2010 unless there is political instability.
- Oil: Oil is currently
about $80, at the bottom end of my long-term mean reversion rate of
$80-110 range, but volatility continues to make short term predictions
very risky. If oil prices fall back below $50, political instability in
Russia and South America will quickly follow in the next couple of
years. With the recent devaluation of the Venezuelan currency this may
occur no matter what the price of oil is. As the world economy improves
the price of oil should increase. The interesting dynamic will be
whether natural gas takes market share as a green substitute as well or
if the world continues on as if nothing has happened. This will have
currency implications as well, with higher oil leading to a falling
- Credit risk:
commercial mortgages and junk bonds will especially impact smaller
firms, while CDOs and credit default swaps continue their negative
cycle. Government entities are at risk and a major state or municipality
in the US is likely to default on their bonds. These governments have
always pointed to their balanced budgets, but accruals have not been
honestly assessed. Unions in general will have to deal with these
unfunded benefits, whether for legacy manufacturing firms, school
districts, or governments. Investigative reporters will find easy
pickings and will drive the market to make these balance sheets more
transparent. Junk bond spreads need to widen before investing in that
- Financial Services
Consolidation: Bank consolidation will continue, with mid-sized and
smaller banks merging to gain economies of scale and consumer trust.
Bank capitalization will get a lot of tough talk, and may drive a “tax”
on investment banks. Expenses at insurance companies are too high and
industry overhead will need to be reduced. Insurance consolidation will
accelerate, with household names as well as smaller firms being merged
into other firms. Larger, supposedly sophisticated, firms accepted the
investment and product risks knowingly, and many smaller firms were led
along with the crowd to the cliff by statements like “all the
sophisticated insurers are doing this”. AIG and its subsidiaries will
become known for setting market prices low and keeping industry
profitability down. Long term, AIG will be dismantled and the government
will take a loss. GM, GMAC, and Chrysler will never pay back the
government either and GM/Chrysler will eventually be merged into one
company. Despite a lot of bluster, GLB will stay on the books but with
some modifications that will be material only if unemployment stays
high. Capital requirements will drive risk out of banks. Insurers will
join this crusade once the federal charter is put in place and
principles based approaches are put in place, but this will not happen
in 2010. Goldman Sachs will return to the partnership model and
privatize. This will reduce transparency into their books as well as
monetize restricted options.
- Currency: Eventually
the dollar will revert to its trend and fall based on imbalances in our
trade and borrowing policies. Other scenarios focus on countries heavily
invested in dollars, such as China, Japan, and the oil exporters,
choosing to dump them. US Treasuries would then spike and the US economy
could find itself in a vicious cycle resulting in stagflation. This
would take several years to play out. Various energy subsidies will play
out here, from ethanol subsidization to wind farms, with unintended
consequences following the well intentioned efforts of politicians
(latest example is forcing auto makers to make “green” autos). Watch for
others to make vehicles that people will buy, making it even tougher for
the auto industry to survive. Unless another economy steps up to provide
a flight to safety currency the dollar will only be down moderately in
- Energy subsidies:
Ethanol subsidies caused regional food shortages. Now subsidies for
things like wind farms and green cars are creating unintended
consequences. Who knows what technology is not being worked on
because of the focus on wind power? Congress likes to tout that they
are making Detroit make green cars, but they are ignoring the
supply/demand balance that is so necessary for a profitable company.
If they make green companies but the price of oil stays low, people
will go back to buying SUVs and pick-ups. The market will determine
who wins, not the politicians. Sometime in the next 5 years Hugo
Chavez will either implode or try to cut OPEC production of oil. He
continues to nationalize firms which will lead to poor performers.
My prediction is that poorly designed energy subsidies will
- Global warming:
while Al Gore has been winning the Nobel Prize and appearing on
Saturday Night Live, engineers have designed cheap potential
solutions that don’t see the light. Governments naturally design
complex systems, while often a simple solution will work. Is carbon
dioxide the right focus? I am reading material now that says no.
- Airline cost
saving on maintenance will result in increased numbers of crashes
- Education – many
companies are reacting in 2010 with restrictions on travel and
continuing education. This may look good in the short run on the
income statement but will lead to long term negative balance sheet
consequences. Watch for investment banks to offer to provide this
education for “free” and describe products they are selling. I see
this all the time at my local CFA chapter.
- Continued low
interest rates by the Federal Reserve – the US needs to reload the
bullets in its gun over the next couple of years to be ready when
the next disaster or catastrophe occurs. It would be hard today to
react to a major terrorist attack and its economic impact.
Emerging Risks - Concerns
- There are many
physical disasters that could happen, and a really bad one could
stimulate the country to work together and build cohesion. I continue to
be worried about unintended consequences of actions today, with the FHA
and FHLB on the radar. I expect the economy to double dip into a second
recession by the end of 2010. It will be mild if the Obama
administration pulls back on stimulus early and deeper but occurring
after the election if they do not. The stock market will anticipate this
and end up close to where it starts with volatile swings in both
directions this year. Inflation will remain low while longer term
Treasuries creep up, although the seeds of inflation are already
planted. This will cause a problem for ARMs at reset as the higher rates
will lead to higher defaults.
- Levees in California,
earthquake in NYC/St. Louis/San Francisco, water poisoning of NYC,
hackers of Windows – all potential issues to develop contingent plans
- Can an internal CRO be
strong enough to stand up and be counted, or will fears for their job
keep them “in line”. Every firm needs a Chief Skeptical Officer. There
is career risk to doing your job as a Chief Risk Officer. Speaking out,
even (or especially) if you are accurate, does not lead to a long
career. Perhaps skeptics should be for hire and independent. Regulators
and rating agencies are not strong enough in this regard. NAIC risk
focused exams could be so much more than they are so far, and rating
agencies have perceived/real conflicts of interest since the company
being rated pays for the rating.
- Tort reform needed –
the world continues to become more litigious at its peril
- Infectious disease -
increased resistance to antibiotics (e.g., tuberculosis, staff
infections or pneumonia). Watch for Nassim Taleb’s new book which is
expected to address issues such as these. It is getting more dangerous
to visit a hospital.
- Global warming –
unexpected side effects like new viral/bacterial attacks, along with
coastal flooding and increased hurricane activity.
- Earthquakes and
hurricanes – the US is overdue for a major quake on the west coast and
other areas not normally expected for seismic activity are well into
their cycle (the Haiti earthquake occurred as this was being written).
The US is also due for a strong hurricane season.
capital in the financial services industry will be abused by some and
not always caught initially by peer review. Currently it is doubtful
that the US will have a major influence on PBA worldwide due to the
NAIC’s political games.
- Lots of games but
nothing has passed yet. The SOA research project will help companies
better understand the implications of implementation. The NAIC is
moving away from including multiple product types in the analysis.
This eliminates much of the real diversification that occurs.
- The games being
played by the NAIC regarding stochastic analysis and the interest
rate generator in particular are embarrassing to the institution. I
believe these types of politically based discussions with other
entities pulling strings in the background will lead in the next 5
years to a federal charter and the dissolution of the current form
of the NAIC. Just like all good ERM practices, the NAIC needs more
transparency and peer review.
- Home building sector
will finish bottoming and level or slightly improve over the next couple
of years depending on interest rates (up would be worse). It will take
longer for the upscale market to recover. It is probably time to buy
stocks in materials firms that serve this market and have low debt.
Discussion will start in the next couple of years about a tax overhaul
that could include a reduction of the mortgage deduction. Perhaps the
AMT will form the model tax law and many deductions will be eliminated.
While this might be good incentive, it would hit the home market hard.
- US political
environment – can they say no to anyone requesting a bailout? Who is
- Malthus – too many
people, not enough food – will good intentions of the rich to save lives
in the 3rd world lead to mass starvation and unstable
regions? Genetically modified seeds will delay this into the future.
Perhaps it will never happen, but unstable regions will come from low
economic activity and lots of people, along with the Chinese high male
population ratio. This will drive internal unrest in China over the next
- Economy – risk of
stagflation and the lack of an internal hedge for investors holding both
equities and bonds. There is currently a large interest rate risk in
long bonds. Make sure you are laddered so you grade to the current rates
as they rise.
- Pandemic influenza –
2009 provided a test that countries and businesses should learn from.
Recent signs show the opposite as Europeans claim it all was a hoax.
What is scary is the ability to create these superbugs in the lab. At
some point terrorists (or someone entrusted to guard the bugs) will
create a pandemic of some kind as Tom Clancy wrote about years ago (his
example was Ebola).
- Counterparty risk –
will losses be allowed? AIG provided a great example of concentration
risk. A central clearing house is needed that keeps track of net
exposures. How Bernie Madoff survived all these years is a mystery to
me. Where was the due diligence? Much of the US economy continues to be
concentrated in a few parties, and now the American taxpayer is one of
them. This is not a positive consequence and will lead to more contagion
in the system and more correlation in the tails. Plus you will have
stupid comments like Nancy Pelosi saying that GM will eventually pay
back the government loans. It’s not going to happen. More qualitative
analysis needs to be done by financial experts rather than relying on
models that aren’t accurate in the tail or focus on top line rather than
bottom line growth. Relying on Black-Scholes models to both determine
value and confirm prices has been a disaster. If you can’t understand a
risk without complicated mathematics it should be avoided.
- Concentration risk –
this will be a hot topic over the next few years much as emerging risks
have become. Whether it is power at the top of an organization,
geographic focus or silo risk focus, too much concentration in too few
entities or people is a great risk. Eventually it will take you down.
- Risk combinations –
some of my research is showing that, even as risk managers, we tend to
anchor based on current events and have trouble getting our hands around
how multiple risks interact.
Top Actuarial Issues
- Defined benefit plan
valuation – needs to reflect marketplace economics, mean reversion and
conservatism. Actuaries from other disciplines should be welcomed, along
with those from outside the profession. Focus should be on cash flows
rather than regulatory requirements. An estimate of fair value of these
liabilities should be calculated and shared with stakeholders. Firms had
the opportunity to get out of DB schemes when the stock market was up
for 5 consecutive years after the bursting of the tech bubble. Why more
did not do so shows how little scenario planning was being done.
Municipal plans and teacher plans especially are going to default. This
may be the issue that causes unions to lose power, although that will
not happen until democrats are out of the White House. Whatever DB plans
are still active will shut down as soon as they become completely
funded. Another trend I expect is for companies to pre-fund this risk
and get it off their books, passing it to insurers or to the unions to
- Demographics –
designing products that are economically sound to both policy owner and
company. Variable annuity writers seem to have learned and adjusted with
their new products, but will anyone sell or buy them? Have UL with
secondary guarantee writers learned anything? What role will AIG subs
play in supply/demand? Will they price at a lower rate given the
government guarantees? Will the government walk away at some point and
let them default (my prediction)?
- Obesity – how will the
various drivers of mortality and morbidity interact (some good, some
- Lack of rudimentary
knowledge of assets and how to value them – need teaching sessions that
are short of stochastically based financial economics. Focus on
transparency and peer review.
- Peer review – how to
make it extend beyond a regulatory requirement to help manage the
business by identifying and exploiting advantages as part of a strategic
- National health care –
we continue to need actuarial solutions with transparency. Tort reform
is not happening but is necessary for cost reductions.
- Systemic risk – this
is another topic where actuaries can help but are not being engaged. I
personally don’t think it can be done due to the political pressure
surrounding the topic.
In one of my 2009 newsletters I
promised a base set of scenarios that companies/individuals could use to
plan for the next few years. Some analysis will reflect quantitative tools
but all should look at the risks on a qualitative basis first.
- Higher interest rates
and inflation: either deterministic scenarios grading 3% per year until
you get to 12% or a mean reversion process that does the same would
provide some eye-opening results.
- Flat equity markets
combined with higher inflation: defined benefit plans are especially
vulnerable to this risk.
- Health care – assume a
national plan takes over. How would that impact your business? What
should you do at that time?
- Falling dollar
- Global climate change
– how will this impact your business