About RFC
Meet Max
Follow Max on Twitter
Articles and Presentations
Links
Newsletter
Brochures
CERA-kickoff |
|
Newsletter – 2014 Predictions
Newsletter – 2014 Predictions
My name is Max
Rudolph. I consult with companies on enterprise risk management, investment
and strategic planning topics. I believe you can reduce risk and increase
return simultaneously. I live in Omaha, Nebraska, USA, am credentialed as an
actuary and hold a CFA charter. I write a monthly newsletter and each
January post my predictions for the year. Late in the year I review and
analyze what actually happened, including any tweets I got right during the
year. Coverage is mostly related to risk management and investments. Some
are written at a high level, dealing with the general economy, and some
cover specific topics. Most discuss issues that I am stewing over and need
to do a brain dump. I read a lot, and that impacts what I am thinking about.
The newsletters are educational in nature and do not constitute investment
advice. They are released publicly at
www.rudolph-financial.com within 6 months after they are released to
subscribers (predictions are made public immediately).
For those interested in a 12-month
subscription, and having input on topics, corporations should send $1,000
and individuals $100 in US currency payable to
Rudolph Financial Consulting, LLC
5002 S. 237th Circle
Elkhorn, NE 68022 USA
The newsletters are distributed via
email, so please include an active email address.
You can also follow me on twitter @maxrudolph.
Predictions for 2014
Please remember that these predictions,
and my newsletters, are for fun and to encourage deeper thinking across
topics and a longer time horizon. If I really knew what was going to happen,
I would not share that information with you! You must make your own personal
decisions, considering your unique financial circumstances, and not hold
others (especially me) responsible for your own financial planning. If you
don’t accept these conditions you should stop reading now. For those still
with me, Enjoy!
General happenings
Perceived stability is hiding a growing
risk as debt levels remain high, which will lead to currency wars and
inflation. Sometime soon the calm will break. It feels like geopolitical
stability is building pressure in an earthquake zone. Whether due to natural
disasters or man-made wars/terrorism, we are likely enjoying the calm before
yet another storm. We are not ready for it. It could be that the
population/sustainability tipping point is getting nearer, and more frequent
extreme events make it harder to react until some event takes us over the
edge into a new regime. Financially there are pressures leading toward
inflation (debt, monetary policy) and deflation (oil supply, demographics,
costs of climate change). Janet Yellen becomes Fed Chair in early 2014,
replacing Ben Bernanke, and several other members of the FOMC will also
retire. Our strategy continues to be just-in-time science, and concentration
risk in everything we do makes our way of life susceptible to one swinging
strike.
The geopolitics of the world continue to
evolve. Democrats are becoming the party of oil, and maybe business, as they
recognize where lobbyist money comes from. Hillary Clinton has aligned
herself with fracking interests, and has become the sane candidate for
President in 2016. Republicans retreat to the right, a guarantee they won’t
win national elections. Europe continues to be a mess, and the US withdrawal
from the Middle East combined with the impact of fracking will reverse many
positive events for that region, and especially for women. Over the next
decade we may see Iran rebuild its long-lost empire and become a regional
economic power. China will need resources, and it will be interesting to see
if they use negotiation or force to get it. Fresh water access is becoming
more important. Glaciers are melting and runoff from snowfall is starting to
come at the wrong time for crops. While I don’t expect the world to collapse
in 2014, event interactions and unintended consequences are becoming more
important. It’s time for the adults to enter politics. People committed to a
single direction and unwilling to negotiate will only make the eventual
results worse. Our critical path is becoming shorter.
Some scenarios are completely discounted
by the public but have probabilities over the next decade or more that are
material. Extreme events happen every year. They are very rarely
specifically identified in advance. Hurricanes Sandy in 2012 and Haiyan in
2013 were massive events in their regions, but extreme events overall were
limited in the US last year. The economy has so many variables that
short-term forecasts are unlikely to look like what actually happens. In
2013 fracking provided oil supply that improved current account balances in
the US, made the Middle East less important politically, lowered government
spending and Chinese investment in Treasury bonds. Tensions are building,
and the US will need to decide how its role will evolve in each region.
While a stock market correction is overdue, the market will not have a major
correction without some external event to drive it. Bubbles are not yet
obvious, although some asset classes seem overvalued. How much is real and
how much due to bond yields manipulated lower by the Fed? Here are some
outlier scenarios that I think are more likely to happen in the next several
years (some may not happen for a decade or more). Due to the long-term
nature of these scenarios, in some years they might not change or only
slightly be tweaked.
- Cyber-terrorism impacts the banking system or
shuts down power stations
- Space junk knocks out a satellite used for public
communications
- Atmospheric river hits California and dumps rain
on San Francisco for a month
- A severe earthquake (or volcanic eruption) hits
California, St. Louis or Seattle
- Super-volcano becomes active
- Fracking is declared illegal in the US or Canada
due to environmental impact
- China erupts in civil war or regional conflict
with a neighbor over resources
- Eurozone breaks apart – could be north/south, poor
countries/rich countries
- Venezuela erupts in violence, shutting down their
oil industry – Argentina is at risk of making this a regional hot spot
- A virus develops drug resistance and becomes
transmissible by air
- Iran encourages regional conflict and becomes the
Middle East’s superpower
These predictions were made in January
2014.
- Politics: Prediction – President Obama is now the
oil president. Democrats must abandon their environmental roots to get
funding nationally. Something will appear to happen this year on
immigration reform but, much like gun reform, the status quo will
remain. Economic woes have done more to slow immigration than any other
measure. Who will the Republicans run for president in 2016? It’s a wide
open race and the winner may not yet be a household name. Paul Ryan
seems the best early bet. Chris Christie and “trafficgate” may have
sealed his fate. If the Republicans go further to the right and there is
not a financial crisis they will lose. If the economy tanks Hillary
Clinton will drop out due to health issues, but otherwise she will give
it a go and be the favorite. It’s hard to say how she will balance the
ticket. The economy is evolving to a new state with a new (higher)
steady state unemployment rate. It will move forward more quickly if the
politicians can resolve budget issues. The taper will speed up but rates
won’t rise until at least 2015 under Yellen’s watch. Watch for major
problems in Venezuela in the short term with contagion throughout South
America. Syria and Iran continue as hotspots in the Middle East, but
problems may actually show up sooner in Turkey. Hosting the Winter
Olympics in Russia is a risk for them as it will highlight issues and
expose the region to terrorism. The Middle East is building a tension
that may erupt soon between Sunni and Shia regimes in a regional
conflict. Europe continues to kick the can down the road, but some
deflation in the region makes the inevitable day of reckoning sooner
than expected. So far Japan is winning its currency war, but it’s only a
matter of time before others join in. The risk of China experiencing an
economic hard landing and consolidating around nationalism is
increasing. This could have major consequences, everything from an
internal revolt to a selloff in US Treasuries to an armed conflict. The
next major wars will start in cyber-space, as all parties are probing
for weakness and hiding in the shadows. A lessened reliance on imported
oil by the US due to fracking increases the likelihood that China makes
a resource driven power grab.
- Immigration reform: both political parties will
reach out to Hispanics through legislation to set up the 2016 election.
With jobs scarce in the US this becomes a less pressing issue and may be
punted to 2020.
- Stocks: As the taper begins the US will enter a
trader market, with more volatility in both directions. The market in
the US is certainly due for a correction but it is unlikely to be a
crash unless sparked by an event. I continue to avoid bonds, using
highly rated dividend stocks (not the highest rate but the most
consistent) for this type of exposure. The US consumer is delivering,
meaning there is less consuming. Single year results are very hard to
predict. I am more comfortable looking at specific companies. With that
said, plus or minus 10% seems a reasonable result for 2014. I still
believe that over the next 10 years stocks will outperform both cash and
especially bonds. Interest rates will either spike or remain low with
possible deflation over time. Slow and steady up, the Fed’s proverbial
soft landing, is unlikely. Higher rates will be equivalent to a currency
devaluation unless other countries make the same move. I understand why
variable annuities force investors into bond funds when their options
are in the money, but this reduced hedging cost seems to lock in the
likelihood that the goal will not be met. It seems like a mispricing is
in there somewhere. There is a slight chance of hyperinflation in the
United States, and it might only temporarily relieve us from a
demographics driven low interest rate scenario. It will take a few years
for inflation to develop before suddenly appearing. Good companies to
buy now are staples that can pass on inflationary cost increases to
their customers while remaining low cost producers. Avoid life insurers
until the regulators get serious about interest rate guarantee relief.
Based on my filters here are a few companies that appear to be
undervalued based on publicly available information (not
recommendations, just ideas for further analysis) and year-end prices:
Tidewater TDW 59.27, Hornbeck HOS 49.23, Seakor CKH 91.20 and Transocean
RIG 49.42 (long TDW HOS). The S&P500 closed 2013 at 1,448. For those
interested you can follow my portfolio at
www.tickerspy.com under maxrudolph.
- Unemployment: Structural employment provides a
floor of about 6%, but this is confusing as the labor force
participation rate is not steady or consistent with prior data.
Additional municipal defaults may impact the job market. The temporary
drop of extended benefits immediately caused some workers to stop
looking.
- Residential home market: US regions will continue
to become less correlated with each other as regional economies improve
and inventory works its way lower. Fannie and Freddie continue as a
discontinuity waiting to happen. The trend of young and old moving in
with empty nesters will continue, much to the dismay of everyone
involved. Even if rates fall again, little refinancing will occur. That
ship has sailed. Watch for the Canadian housing bubble to pop over the
next couple of years.
- Volatility: The VIX closed 2013 at 13.72, at the
lower end of its annual range. I have thought for several years that if
VIX was a predictor of the future it would be higher. Known risks
include heavy personal and government debt levels, and extremely loose
monetary policy that is about to tighten. I find it impossible to
predict VIX but I think a reasonable range would be 20-25. A single
digit VIX is definitely too low and above 35 is too high, but as usual I
see more possibilities for a higher result in 2014.
- Oil: WTI oil on December 31, 2013 was about $99,
toward the middle of my long-term mean reversion range of $80-120.
Volatility continues to make short term predictions very risky as
fracking supplies come on line and Iranian supplies open back up. US
withdrawal of forces from Iraq/Afghanistan will also reduce demand. If
oil prices fall below $50, political instability in Russia and Venezuela
will quickly follow. Venezuela may not need that big a drop. As the
world economy improves the price of oil should increase with demand, but
so much supply is coming on line that increases have not occurred.
Either a geopolitical event or fracking concerns that drastically
reduce supply would be needed to have a spike in oil prices in 2014.
- Credit risk: credit spreads continue to be tight
as assumptions abound in the market about too big to fail companies and
whether the government will ever allow large scale credit defaults. Junk
bonds are not a good deal, but some municipals may outperform if you do
the research.
- Financial Services Consolidation: Bank
consolidation will accelerate as the taper is discontinued. Hopefully a
consolidator of these banks will grow to a large size over the next few
years. Leverage ratios among large banks, especially Deutsche Bank, are
reaching stratospheric levels. Insurance company consolidation has
started, with private equity entering with unintended consequences for
the life insurance industry. Federal regulation is moving closer but
will take only baby steps in 2014.
- Currency/Inflation: Japan has started a currency
war. Who will be the next entrant? At YE2013 the Eur/USD exchange rate
was 1.38. The dollar should strengthen due to fracking in 2014,
especially against the yen.
- Fed policy: low rates continue through 2014 as the
mid-term election looms. Hopefully right after that they will be able to
tighten, or else it will wait another 2 years. The US continues to be
susceptible to a large catastrophe, financial disaster, or armed
conflict.
Emerging Risks - Concerns
- Levees in California, earthquakes/volcanos, water
poisoning in big cities, cyber hackers, transportation of oil and oil
based products (e.g., downtown Chicago).
- Infectious disease - increased resistance to
antibiotics (e.g., tuberculosis, staff infections or pneumonia),
coronaviruses and new avian flu types that are transmissible by air.
- Global warming – unexpected side effects like new
viral/bacterial attacks, along with coastal flooding, increased
hurricane activity, stronger and more frequent tornados and convective
storms, and shifting weather patterns that impact farming through
changes to the jet stream.
- Earthquakes and hurricanes – the US is overdue for
a major quake on the west coast and areas not normally thought of for
seismic activity due to long dormant periods (e.g., Seattle,
Yellowstone, St. Louis, New York City) are well into their cycle. I’m
starting to worry more about at atmospheric river event in California.
The drought is strong enough that there is no longer a season when
wildfires are not common. Due to warmer air, more moisture is held in
the atmosphere, with unknown results (so far it looks like this breaks
up hurricanes and leads to stronger convective storms).
- Malthus – too many people, not enough resources –
will good intentions of the rich to save lives in the 3rd
world lead to increased systemic risk for society (mass starvation and
unstable regions) in the longer term? Are there unintended consequences
and systemic risk associated with the “giving pledge” by the rich? The
IPCC base year of 1998 turned out to be misleading as it was an
especially warm year for its era. Look at all the data graphically.
Population growth continues to exacerbate the problem. Some estimate the
earth already holds three times as many people as is sustainable in the
long run. I believe this makes us more susceptible to war, famine and
disease.
- 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, short term liquidity, 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. This should be
a focus during strategic planning efforts. I have found that those who
have strong investing abilities choose to avoid leverage. Unfortunately,
margin debt is revisiting levels not seen since 2008. Not a good sign,
especially when combined with other types of concentration risk.
- Terrorism – the Sochi Olympics will be very
stressful even if no events occur. In the US, political extremists may
become active leading into the election cycle.
Top Actuarial Issues
- Defined benefit plan valuation – valuation methods
need to be revamped to front end funding levels for both private and
public plans.
- ORSA implementation – regulators will likely try
to shoehorn this into existing processes and not use holistic thinkers
who can think across risks and product lines. This is an even more
important characteristic for reviewers. Capital requirements continue to
move forward but no one really knows what they are doing. Groups that
have worked on this issue for years are not part of the decision making
process. When the C-3 Phase I interest generator model, which has not
been updated in 20 years, replaces the mean reversion parameter all hell
will break loose at companies primarily selling deferred annuities.
Required capital will increase as models reflect today’s recent rates.
This will be a preview of the ramifications of a long lasting low
interest rate scenario.
- Product design – be sure to look at exposures in
case hedges are not available.
- Obesity/smoking – how will the various drivers of
mortality and morbidity interact (some good, some bad)?
Strategic Scenario Planning
Look at stress scenarios qualitatively
and graphically in addition to quantitative focus. Consider a combination of
several deterministic scenarios, including one where the Wall Street tool
kit is not available.
- Higher interest rates and inflation: grade 3% per
year until you get to 12%
- Qualitatively consider 20% inflation environment
(if you have annuities you should be testing the VM scenario generator –
the mean reversion rate will update going forward so you have 20 years
of historical data that was not included in the C-3 Phase I generator
- Low interest rates – Japan scenario
- Flat equity markets combined with higher inflation
- Falling dollar – combine with high interest rate
scenario
- Global climate change – how will this impact your
business and suppliers (look out 20 years to consider new agents or a
mortgage in southern Florida, where over $100 billion of property value
is at risk from a 3 foot rise in sea levels)
- Liquidity risk – consider your largest markets and
what would happen if they dried up or were regulated out of business.
Have you accepted risks that you thought were mitigated? A core line of
business should not be at risk here. If it is then it should be a
satellite line
- No diversification is allowed between risks
- If you are ambitious run a scenario with equity
markets down 35% and 10 years’ worth of deflation
Predictions from January 2008
Since posting my first annual financial
predictions in 2007, there are 7 years of history to look at. Each year I
will look back 5 years and share interesting comments I made that seem
accurate in hindsight.
- “Economy: there is not much positive to look
forward to in the United States.”
- “Credit risk will increase with unintended
consequences as the sub-prime crisis plays itself out”
- “Counterparty risk – it is currently so
concentrated that one misstep could have major repercussions. Watch the
credit default swap market. Much of the economy is now concentrated in a
few parties. This leads to more contagion in the system and more
correlation in the tails.”
From the 2008 results document
- “Defined benefit plan valuation…Making assumptions
above about 5% for future asset growth is irresponsible.”
Hopefully these annual letters look at
things from a slightly different perspective than you see from others and
make you think. That is my goal.
Happy New Year!
|