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Newsletter – 2016 Predictions
My name is Max
Rudolph. I consult with institutional investors, companies, and individuals
about enterprise risk management, asset-liability management and strategic
planning topics. I also do research projects and read quite a bit about
current and historical financial topics. I am a private investor focusing on
individual stock selection and value investing techniques. I believe you can
reduce risk and increase return simultaneously. In addition to client work,
I develop and present continuing education programs and am an adjunct
professor at Creighton University working with students completing a Masters
in Investment Management and Financial Analysis. 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. Some topics are written at
a high level, dealing with the general economy. Some are more detailed,
covering specific topics like incentives or modeling financial assets. Most
cover issues that I am stewing over and need to do a brain dump. In March I
update my intrinsic value calculation for Berkshire Hathaway and in the fall
I update the scenarios I think should be tested. I am a lifelong learner,
and that impacts how my current thinking evolves. My newsletters are
educational in nature and do not constitute investment advice. They are
released publicly at
www.rudolph-financial.com with a delay after they are released to
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Predictions for 2016
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!
2015 was a transition year, with
currency wars driving trends that played out in oil prices, geopolitical
risk and economic growth. I would argue that the underlying world economy
never recovered from the imbalances that built up prior to 2008 and that
Chinese growth and fracking in the United States masked that reality.
Central banks, by keeping rates low and following quantitative easing
programs, encouraged projects that were short term in nature as well as
various financial engineering attempts to grow profit metrics. With the
Federal Reserve starting to tighten there are many similarities to 1937,
when the Great Depression was reenergized by the Fed. I’ll be very surprised
if the Fed raises rates beyond 50 bp before it has to take action to ease
(they have several options, several of which are very odd – e.g., getting
rid of paper money).
Debt levels remain high but growing more
slowly in the US, and much of Europe continues to see negative interest
rates on government debt (note that I no longer refer to it as risk free).
Velocity of money continues to hit new lows, reflecting some trust remaining
in the financial system but still a lot of concern. So far the oil and junk
bond bubbles have burst. In 2016 additional bubbles will blow up, but the
response will inflate new ones. Interestingly, many are only available to
sophisticated investors, and most are illiquid. When they burst the fall
will be substantial. It is not a time to be buying on margin. Investors have
been forced to take additional risk by the Fed, and many accepted risks they
don’t understand. I expect them to be better understood by this time next
year, and it will be interesting to see who gets hit hardest. I will be
surprised if hedge funds and private equity have a good year. The US
continues to be in a good position relative to other countries, which isn’t
saying much, but will this be helpful or give politicians an excuse to
maintain gridlock and ignore needed reforms.
The Presidential election will be
impacted by the economy, and I don’t see it helping the Democrats as the
incumbent party (Congress somehow avoids their portion of the blame).
Geopolitical tensions are now high throughout South America and Eurasia. In
South America assets are leaving, helping to create a real estate bubble in
south Florida. Assets in China and Russia will increase market prices in
large cities like Seattle, New York and Washington much as Japanese
investors did in the late 1980s. Venezuela is in worsening shape, Brazil is
having one of its periodic periods of economic malaise, but Argentina might
have turned the corner with the new regime.
The Zika virus may build unintended
consequences and interact with economic forces (and the Olympics) if not
contained. Russia has little room for error, Iran is desperate to free up
trade, China is slowing at the same time as there are political stresses,
and Saudi Arabia wasted the last century and has limited industry beyond oil
and few citizens who know what hard work is. Africa is leaving what may be
known in the future as its democracy phase. Climate change and other
sustainability issues are making water and other resources the driving force
behind regional conflicts.
The cyclical El Nino has made this the
warmest period in history, but the next several years will trend to lower
temperatures than 2015-6. We should not be comparing against a single year
but a solar cycle. Especially in places 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 now tightening while everyone else is loosening monetary policy.
We wait until the last minute to deal with problems, and some day our luck
will run out.
At this point President Obama is in his
last year, using executive orders to move the agenda. I hope he is
successful with gun control, women’s rights and Obamacare. Republicans have
become part of the problem, and the front runners in the Presidential race
are embarrassing the country with their backward views regarding topics like
climate change and gun control. As I write this in mid-January, an issue
with Iran was recently defused because there is already a relationship
between administrations. This is a good thing. Moderates are nowhere in
sight, and I don’t see an obvious candidate for me to support. Clinton knows
the issues but scares me because of her poor relationships with “little
people”. She comes across as knowing what is best for all of us, and may be
right, but has no empathy. Maybe that is what Bill will bring to the White
Companies dependent on fracking that are
leveraged are on their last legs. I wonder if it was they who championed
selling US oil overseas. Otherwise it makes little sense. Hillary Clinton is
still the Democratic frontrunner, but needs to get past mistrust of her and
several scandals. The Republican side is more jumbled. Jeb Bush and Marco
Rubio remain the favorites in my mind, but Trump and Cruz are the current
leaders. There are still rumblings of a late Joe Biden run if Clinton
Europe remains a mess, with immigration
now a major issue. They may not be able to maintain the European Union, with
the UK’s limited role on the ballot this year. If they exit it will
encourage others to try. The Middle East is very hard to read over the next
10 years. The uncertainty that groups like ISIS bring and lack of moderates
don’t lead to happy outcomes. Iran may emerge as the consolidator. China has
its work cut out for it. Slowing growth, historical tensions between haves
and have-nots, climate change and political stresses will be interesting to
watch. North Korea will provide a surprise or two, or China may decide to
try out some of its new toys and merge it into the Middle Kingdom. Australia
will struggle as commodity prices falter and the climate evolves.
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. Weather and seismic events continued to be present in 2015, with a
combination of El Nino and jet stream adjustments leading to heavy flooding
in the UK, drought in California and typhoons in Asia. Extreme events,
especially those covered by insurance, overall were limited in the US last
year. The economy is a complex adaptive system, so short-term forecasts are
unlikely to be accurate. Stocks have now risen for seven consecutive years,
a record. January 2016 results are confirming that it is unlikely we will
make it to eight. It would not surprise me to see stock prices down 20% or
more this year, with a small chance for 50% drops over the next couple of
years. The dollar remains the reserve currency, mainly due to a lack of
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
countries/rich countries or just kicking out individual members
- Venezuela erupts in violence, shutting down their
oil industry – contagion in neighbors risk making this a regional hot
- A virus develops drug resistance and becomes
transmissible by air – mosquito borne Zika virus is one to watch out for
- Iran encourages regional conflict and becomes the
Middle East’s consolidating superpower
- Water resources trigger a regional conflict
(likely Himalayas or Europe, with water issues expanding in the
- S&P500 down 30% from high point, combined with
double recent bond defaults and real estate collapse in the largest US
cities. GDP down for 3 consecutive years.
While I tweaked some of these, the major
change is to call out the Zika virus, but several are much closer (e.g.,
virus, Eurozone, Venezuela, cyber risk, China, Iran).
These predictions were made in January
- Politics and currency wars: Prediction – President
Obama’s legacy will be as the fracking President who used drones to
assassinate opponents. If he stays within ISIS that will probably be
supported by the world establishment. Amazingly he has not had the
scandals found in recent two-term Presidencies. Obama won the Presidency
during a disastrous scenario, and could go out with the country in the
same shape. He will use executive orders and Congress will be useless
this year, failing even to pass common sense gun control laws. Who will
the Republicans run for president in 2016? Jeb Bush or Marco Rubio are
still my expectation, but one of them needs to step up and act as if
they want the job. No concerns there with Hillary Clinton. If she runs
in November the Republicans will choose a female vice president. If she
doesn’t I think it will be John Kasich. Clinton has more health risk and
scandal risk than the other democrats. I am not excited about a Joe
Biden run but it is possible if she falls out. If Trump runs as an
independent it likely means the democrats will win. The taper and minor
increases in rates by the Fed, along with devaluations in other
countries, will continue to strengthen the dollar and lower the price of
oil. There won’t be more than one rate increase in 2016 from the Fed due
to the economic turmoil and as Europe/Japan/China all continue loose
policy. Venezuela will continue to lead South America into turmoil.
Saudi Arabia has no Plan B, and with Sunni and Shia tensions building,
could erupt in the next few years. Low oil prices may be a short-term
phenomenon as frackers go bankrupt and geopolitical issues bring
volatility to the market. Europe needs to develop an exit strategy, but
those in the east will push to maintain a military alliance. Japan has
been the most aggressive in its currency war, but eventually will
implode as demographics drive rates and economic growth lower.
Eventually a Bretton Woods type meeting of the world’s powers will be
needed to resume stability. Some are even calling for a gold standard,
but more likely is a global currency using many countries rather than
the US$ as the reserve currency. This will be a good thing in the long
run but will impose controls on US politicians that reduces flexibility
but increases controls. The risk of China experiencing an economic hard
landing and consolidating around nationalism is quickly 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.
- Stocks: The US raised rates once in 2015 and its
trend is diametrically opposed to everyone else. Japan, Europe and China
are all loosening, leaving oil and emerging markets in a bad spot. I
expect the US market to lose about 20% in 2016 and come out of its funk
once the US Presidential election loses its uncertainty. This could
occur before November if the race is not close. There is still a small
probability of a larger crash due to contagion due to the previous
stimulus that took it out of sync and created a bubble. Emerging markets
will suffer through a major bear market similar to 1997. I continue to
avoid bonds, although lower rates (even negative) are possible, using
highly rated dividend stocks for this type of exposure. Single year
predictions are unlikely to ever be right, but I look at -20% returns in
the first three quarters and some rebound in the fourth quarter. I see
the economy performing similarly, with a recession early in 2016 lasting
through the summer. The disaster scenario for interest rates is down and
then spike up. Hyperinflation will appear somewhere in the world over
the next couple of years, with South America a leading candidate
(Argentina is already there). I expect consolidation in the insurance
industry as foreign buyers seek diversification and US domiciled firms
take advantage of the strong dollar. The S&P500 closed 2015 at 2,044,
nearly unchanged for the year. Dividends made the total return slightly
- Unemployment: Structural employment has risen in
the last decade as it becomes harder to go between jobs (locked into
mortgage or health insurance, last in first out mentality for layoffs).
Pension plans are doomed for failure, with funding levels 20% below that
needed even after 7 years of gains. I expect the unemployment level to
rise from 5% to at least 7% in 2016.
- Residential home market: US regions continue to
have lower correlation with each other. Fannie and Freddie are the only
game in town right now to facilitate mortgages. That is a problem.
- Volatility: The VIX closed 2015 at 18.21. 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 2016,
especially if we experience both a recession and 20% drop in the stock
- Oil: WTI oil on December 31, 2015 was about $37. I
have lost all comfort in predicting the price of oil, but with Iran
coming back online and others (frackers, Russia, Venezuela) desperate
for revenue, it won’t see $100 for a while. Saudi Arabia will eventually
drive high cost producers from the market, but the unintended
consequences may not suit their own long-term needs. A desperate Russia
or Iran will not roll over. We could see $20/barrel oil.
- Credit risk: much of the junk bond issuance
recently has been to energy companies that are now in free fall. Watch
out for defaults here and in emerging markets where the strong dollar is
causing problems for dollar denominated bonds. These issues will cause
spillover in other markets and industries as hedge funds sell “safe”
assets to cover losses.
- Currency/Inflation: The US will not raise rates
more than once in 2016. With other countries loosening and the US
entering a recession (watch manufacturing in the future for leading
indicator) they will be forced to back off and may even enter into a new
round of QE. I expect the dollar to continue to strengthen again China,
Europe and Japan.
- Fed policy: The US continues to be susceptible to
a large catastrophe, financial disaster, or armed conflict. This will
be an issue leading into the Presidential election and throw into
question the independence of the Fed especially if a right wing
Republican is the nominee.
Emerging Risks - Concerns
- Infectious disease - increased resistance to
antibiotics (e.g., tuberculosis, staph infections or pneumonia),
coronaviruses, Ebola (and similar), avian flu types that are
transmissible by air. Mosquito borne diseases are making a comeback led
by Zika and Dengue, quickly becoming endemic in Brazil and moving north.
- Global warming – unexpected side effects like new
viral/bacterial attacks, along with coastal flooding, more concentrated
coastal storms at unusual times of year, 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. We’ll continue to see
extinctions as conditions change too quickly for most species to adapt.
Record high temperatures for the planet will subside as el Nino moves
through its cycle. The proper comparison will be against the years right
after the last el Nino strongest year. It makes sense to look at a graph
rather than compare single year data points. It makes it too easy for
politicians to lie with statistics.
- 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
super volcano, St. Louis, New York City) are well into their cycle. I’m
starting to worry more about an atmospheric river event on the west
coast. The drought is strong enough that there is no longer a season
when wildfires are not common in California and Australia. Due to warmer
air, more moisture is held by the atmosphere, with unknown results (so
far it looks like this breaks up hurricanes but leads to stronger
convective storms and nor’easters).
- Levees in California, earthquakes/volcanos, water
poisoning in big cities, cyber hackers, transportation of oil and oil
based products via rail through urban centers (e.g., downtown Chicago).
- 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? Should we look at
GDP growth by splitting it between population growth and economic
growth? In the long run we are more susceptible to war, famine and
disease through population growth, and this interacts with climate
change issues. Hopefully more billionaires will follow the Zuckerberg
model to rebuild infrastructure.
- Student loans – not only will millennials default
due to student loans, there are many instances where their parents
co-signed for them. This situation will have much more impact on the
economy in the future than we have seen previously (negative).
- Concentration risk – this will be a hot topic over
the next few years. 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 at record levels, 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. It amazes me that we have
not had more attempts to injure politicians, especially with the lack of
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 still 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 (e.g., derivatives) is not available.
Pick some of these to do every year,
some can be done qualitatively, some rotate every 3 or 5 years. Total stress
scenarios completed 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 2010
I posted my first annual financial
predictions in 2007. Each year I will look back and share interesting
comments I made that seem accurate in hindsight. I have deleted sections but
not changed the wording in what remains.
These (mainly) economic predictions were
made in January 2010.
- 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.
- Unemployment: Fiscal stimulus has helped to bottom
out unemployment, and I don’t expect it to get worse than the current
10%. 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. 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. 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
- 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
- If oil prices fall back below $50, political
instability in Russia and South America will quickly follow in the next
couple of years.
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!