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Newsletter – 2015 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).
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Predictions for 2015
Please remember that these predictions
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 investment and risk
decisions, consider your unique financial circumstances, and not hold others
(especially me) responsible for your own financial planning or lack thereof.
If you don’t accept these conditions you should stop reading now. For those
still with me, Enjoy!
Over the past year a perceived stability
has given way to a currency war that is interacting with an oil glut to
produce some strange bedfellows. The United States was ahead of the curve
here with its quantitative easing programs so its exports and profits have
grown, allowing the dollar to continue as the world’s reserve currency. Debt
levels are high and growing, yet most of Europe sees negative interest rates
on government debt. Trust in the financial system is still intact, but it
feels like we are sitting at the bottom of an avalanche zone with snow
continuing to fall. It is unclear how it will play out, but somewhat
surprisingly to me the US seems to be in the best position. Unfortunately
this often means that the law of unintended consequences and surprises is
about to dominate. Geopolitical tensions have started to dominate, with
Venezuela, Russia, Iran and China about to lead their regions into a highly
volatile period. Even the United States and India have literally run to each
other as everyone else lines up against them. China has alliances with
countries in South America and Africa, and is doing business with Russia.
More of this trade is being done in currencies/commodities other than the
dollar. The trigger will be something unexpected. We should enjoy the calm
before the storm. Climate change and other sustainability issues will soon
make water and other resources the driving force behind regional conflicts.
In other locations, like Brazil and California, water needs to be priced
appropriately to allow market forces to adjust. Financially the signs
continue to point toward both deflation and inflation. The FOMC is dovish
with Janet Yellen at its head, with Mario Draghi her counterpart in Europe.
We wait until the last minute to deal with problems, and some day our luck
will run out.
At this point President Obama is a lame
duck with two years left to govern. Will Republicans work with him or
maintain a freeze until 2016? That looks likely to me, but I always hope
somewhere moderates will appear to make things right. Recent economic growth
has been driven by fracking, and at this point in time does not look
sustainable. Hillary Clinton is the Democratic frontrunner, and Jeb Bush is
her likely opponent. There is lots of time to screw up in the meantime, and
if the economy is not growing I expect Senator Clinton to bow out. Europe is
a mess and dug itself deeper with the Greek anti-austerity party taking
power there. The new QE Europe is a move toward allowing countries to leave.
The Middle East is very hard to read over the next 10 years. None of the
countries there has successfully diversified away from oil, so some say they
will be living in tents again within a generation. Iran is the wild card and
has grown its influence. China has financial, structural and political
stresses pushing it and will be challenged to generate a soft landing. I
will be surprised if Russia and South America do not have major problems in
2015. Australia will struggle as commodity prices falter.
Some scenarios are completely discounted
by the public but have probabilities over the next decade or so that are
material. Extreme events happen every year. They are rarely identified in
advance. Geopolitical risks blew up in Ukraine in 2014 and Hurricane Haiyan
in 2013 was a massive event, but extreme events overall were limited once
again in the US last year. One exception that should be watched for a
recurrence is the California drought. The economy has so many interconnected
variables, acting like a complex adaptive system, that forecasts are
unlikely to be accurate. In recent years fracking provided excess oil
supplies that improved current account balances in the US, made the Middle
East less important politically, lowered government spending and Chinese
investment in Treasury bonds. Then in late 2014 the Saudis elected not to
support prices and they crashed. There are multiple reasons, with frackers,
Russia and Iran likely in the bulls eye. What will the US role be in each
region? Stocks have risen for six consecutive years. Seven would be a
record. Prices are high, a long lasting correction is overdue, but it needs
an external event to drive it. The dollar remains the reserve currency
despite loose government policies. How much is real and how much due to bond
yields manipulated lower by the Fed? Here are some outlier scenarios I think
are more likely to happen than consensus 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
- 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
- Venezuela erupts in violence, shutting down their
oil industry – contagion in Argentina and Brazil risk 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
- Water resources trigger a regional conflict
(likely Himalayas, or Europe)
I did not change any, and added only the
last item for 2015, but several are much closer (e.g., Ebola, Venezuela,
cyber risk, China).
These predictions were made in January
- Politics: Prediction – President Obama is trying
to play the oil card both ways, and will get caught. He threatens to
block the Keystone pipeline but economic growth during most of his two
terms has been driven by fracking. Now that he is a lame duck President
with a Republican Congress he will use executive orders like he did on
immigration to leave a legacy. It will be interesting to see if health
care reform is far enough along before he leaves to make it sustainable.
Who will the Republicans run for president in 2016? Jeb Bush is now the
frontrunner with Paul Ryan and Scott Walker strong candidates. Someone
may yet come out of the woodwork. Hillary Clinton remains the favorite
on the Democratic side, but I think she will drop out (leaving a free
for all). The taper, along with devaluations in other countries, has
strengthened the dollar. There won’t be any rate increases from the Fed
until at least 2016 as Europe will continue loose policy. Their loose
policy works as if we had raised rates. Venezuela will pull Argentina
down, leaving all of South America in turmoil. While Saudi Arabia seems
to have managed their transition well this time, Sunni and Shia tensions
are building. Europe will set up a structure so they can kick out some
members. Greece is first, but Italy and France will eventually follow.
Deflation and negative interest rates in the region makes the inevitable
day of reckoning sooner than expected. Japan has been the most
aggressive in its currency war, but eventually will implode as
demographics drive rates and economic growth lower. 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 a
regional armed conflict about resources. The next major wars will start
in cyber-space, as all parties are probing for weakness and hiding in
the shadows. The US and India as allies make for interesting bedfellows.
- Stocks: Now that tapering has ended and the market
did not implode, we are entering a trader’s market with limited value
stocks to buy. The US market remains 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 no longer
delevering, but I think this is due to student loans. While single year
predictions are unlikely to be right, plus 5% to minus 20% seems a
reasonable range for 2015. 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. Maybe
both, which is the disaster scenario. Slow and steady up, most modelers
and the Fed’s proverbial soft landing, is unlikely. Higher rates are
equivalent to a currency devaluation unless other countries make the
same move. There is a slight chance of hyperinflation in the United
States, but much higher elsewhere. 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,
although I expect more consolidation as foreign buyers seek
diversification (Protective/Dai-ichi) and US domiciled firms take
advantage of the strong dollar. 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: Gilead GILD 105, Winnebago WGO 20, Whirlpool WHR 200
and Terra Nitrogen TNH 121 (long GILD WGO WHR). The S&P500 closed 2014
- Unemployment: Structural employment provides a
floor of about 6%, but this is confusing as the labor force
participation rate is still reducing so inconsistent with prior data.
Pension plans remain at risk, with funding levels 20% below that needed
even after 6 years of gains. Recent recommendations will do little to
save this market as valuation is the problem and it is not being
addressed. The life cycle of a DB plan lags that of a company so full
funding in the early years is critical. The rules continue to defer
funding, increasing the risk of failure. The latest “fix” is for an
insurance company to buy the liabilities, but for the participant this
is not a good deal as the PBGC has access to the federal printing press
so the guarantee is much stronger with them than with NAIC members.
- Residential home market: US regions continue to
have lower correlation with each other. Fannie and Freddie are another
place we may see President Obama try to set a legacy. I’m still waiting
for the Canadian housing bubble to pop.
- Volatility: The VIX closed 2014 at 19.20, in the
middle 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 loose monetary policy. I
find it impossible to predict VIX but I think a reasonable “normal”
range when debt is high 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 2015.
- Oil: WTI oil on December 31, 2014 was about $59,
below my long-term mean reversion range of $80-120. As more fracking
comes on line and it becomes more efficient I need to adjust this range
down to $80-100. Once the Saudis have taken control of supply I believe
they will manage prices back up into this range. This commodity will
continue to be very volatile. Oil prices below $50 are creating
political instability in Russia and Venezuela and chaos could prevail in
those regions. A geopolitical event or fracking concerns that
drastically reduce supply are risks that could lead to a spike in oil
- Credit risk: much of the junk bond issuance
recently has been to energy companies that are now at risk. Watch out
for defaults here and in emerging markets where the strong dollar is
causing problems for dollar denominated bonds.
- Currency/Inflation: The US started the currency
war with QE (named by Brazilians after the dollar slumped in 2010). Now
Japan and Europe are taking a turn. At YE2014 the Eur/USD exchange rate
had dropped to 1.22 (and by the end of January was down to 1.13. The
dollar should continue to strengthen due to weak growth in Europe and
Japan. At some point there will be no buyers, and then it gets serious
with hyperinflation and defaults (watch VM).
- Fed policy: low rates continue through 2015. A
pseudo tightening has occurred as everyone else has devalued their
currency. This will hurt exports from US firms but lead to a boom in
overseas travel as the dollar buys more than it used to. 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, staph infections or pneumonia),
coronaviruses, Ebola type and new avian flu types that are transmissible
- Global warming – unexpected side effects like new
viral/bacterial attacks, along with coastal flooding, more concentrated
coastal storms, stronger and more frequent convective storms, and
shifting weather patterns that impact farming through changes to the jet
stream. It is going to be increasingly difficult to be a farmer over the
next 50 years as climate warms and modifies. Whether we like them or
not, genetically modified foods may be the only thing that adopts
quickly enough. In 2014 we saw extreme weather events in Boston and
Buffalo (snow), Detroit and Phoenix (rain).
- 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 but leads to stronger convective storms and nor’easters).
- 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
associated with the “giving pledge” by the rich? Is it really so bad to
have aging demographics and a shrinking population? In the long run we
are more susceptible to war, famine and disease.
- Student loans – not only will millennials default
due to student loans, there are many instances where their parents
co-signed for them.
- 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, especially if
leverage is involved. Margin debt is currently high, not a good sign.
Identifying concentrated exposures should be a focus during strategic
planning efforts at companies.
- Terrorism – in the US, political extremists may
become active leading into the election cycle. Anyone named Clinton or
Bush may be targeted.
Top Actuarial Issues
- Defined benefit plan valuation – valuation methods
need to be revamped to front end funding levels for both private and
- ORSA implementation – regulators have moved toward
checklists, but can make it worthwhile if they outsource review of the
reports to experts who understand how risks aggregate and diversify.
- 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.
Pick some of these to do every year,
some qualitatively, some rotate every 3 or 5 years. Total stress scenarios
should be 10 or fewer.
- Negative interest rates
- Spike interest rates over 10%
- High credit risk – double default rate for BIG
- Equities – down 35% and options market dries up
- Mortality – pandemic .6% excess mortality
- For companies writing indexed products –
model/report separately – test product if derivatives market dries up
- 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 1,000 scenarios from the VM
- Low interest rates – Japan scenario
- Flat equity markets combined with higher inflation
- Falling dollar – combine with high interest rate
- Global climate change – how will this impact your
business and suppliers (e.g., 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. What would you do if no one offered a derivative
position for you to hedge against? Are there protections written into
- No diversification is allowed between risks. Do
you have enough capital to survive?
- If you are ambitious run a scenario with equity
markets down 35% and 10 years’ worth of deflation
Predictions from January 2009
Since posting my first annual financial
predictions in 2007, there are 8 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: …with Barack Obama about to be
inaugurated as President of the United States…volatility and tough times
will continue for a while. Obama will need to make some tough decisions,
and the tone he sets regarding personal accountability versus political
expedience will last for years. While the US has had many financial
missteps lately, there do not appear to be other countries doing better.
- Oil will rise above the current range of $40 per
barrel. I believe its long-term mean reversion rate is in the $80-110
range, but recent volatility has made any predictions very risky. The
Arab Spring was an indirect result of oil prices, ethanol subsidies and
crop shortages and could recur in several regions.
- Hospitals are at risk in 2009, along with
municipalities who have offered more than they can pay in benefits
(especially defined benefit pension schemes and post-retirement medical
- Political instability throughout the world will be
a problem, driven by the liquidity crisis, price of oil, and/or
Here are some risks I was worried about
over a longer time horizon.
- 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.
- US political environment – can they say no to
anyone requesting a bailout?
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!