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Newsletter – 2017 Predictions: Results
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 financial and
historical topics. I try to find examples of history repeating itself. I am
a private investor focused on individual stock selection and value investing
techniques. I believe you can reduce risk and increase return simultaneously
by investing against the herd. Recent interests include complexity theory
and combining it with economics and neuroscience. These are also the topics
I occasionally tweet about @maxrudolph. In addition to client work, I
develop and present continuing education programs and am an adjunct
professor teaching graduate level programs at Creighton University. 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 by
financial institutions. 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 of several months after they are
released to subscribers.
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Predictions for 2017
These are not really predictions in the classic sense.
Treat them more like scenarios that you can build resilience against to
survive over the long term.
Disclosure - 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!
What a year of disruption! The rise of populism, and
with it the electorate voting against the establishment in England, the US
and Italy, was a great surprise to me. Brexit’s win, and the lack of any
major financial repercussions, set the stage for Donald Trump’s victory in
the fall. Last year was one where many economic truisms were shown to not be
absolute. I believe that monetary policy doesn’t work unless fiscal policy
is somewhat in balance, which is not the case anywhere. Debt is too high
everywhere, and resilience is nowhere. Reflation may be hoped for but I
think will be short lived unless all hell breaks loose and we have
hyperinflation. I find myself wondering if Mad Max is fiction or prophetic,
and the same with Wall-E. This shows the level of volatility we are heading
toward – which direction will we head? A post-apocalyptic era where food is
scarce and weapons rule, or one where there is nothing to do and we all live
in chaise lounge chairs because our abdominal muscles have lost their tone
through lack of use?
Results: we are an invasive species on the earth and
causing a rate of change too quick for anyone or anything to keep up through
evolution. Unintended consequences are everywhere and the models seem to
underrepresent the rate of change.
I try to lock this paper down in late January, with
most of it written early in the month and then adjusted as the month plays
out and others release their predictions. Robert Doll, now of Nuveen Asset
Management, annually publishes his Ten Predictions. I like his labeling of
2017 as a year of transition, where we move from
- Economic stimulus driven by monetary policy
- A world progressing toward globalization
- Fears of stagnant growth and deflation
- Investors focusing on safety
- A “rising tide lifting all boats” market
- Stimulus driven by fiscal policy
- Rising nationalism, protectionism and isolationism
- Improving growth and rising inflation
- Higher appetites for risk amid rising volatility
- An environment where selectivity is critical
Results: so far Doll has been very accurate, but the
last two have not yet happened; volatility remains low and all boats
continue to rise.
While I would have included a comparison from climate
awareness to carbon favored, and something about the likelihood of a salute
to our Fuhrer, I think Doll captures the high points.
A side comment about these outside predictions – many
refer to reasons why NATO and the European Union were formed, but none
mention what I thought was the real reason. They discuss a Russian threat,
but I always thought it was a way to keep Germany on the same page as others
in Europe so they would have no incentive for grand ambitions and conquests.
Whether we worry about Russia or Germany, it is important to not ignore free
trade and the importance of people working together to avoid conflict. (same
goes in the US too – diverse people get along much better when they
Results: the German election and confusion in the
aftermath is an opportunity for the far right to show how important they
I continue to believe that the underlying world economy
never recovered from the imbalances built up prior to 2008, and that Chinese
growth and fracking in the United States masked that reality. Low rates
driven by monetary policy have changed incentives. 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 and fascism gained momentum. Going forward it looks
like the Fed will raise rates to offset fiscal policy, at least until the
new administration gets enough of their people involved to dominate the
votes. PE Trump complains that rates are too low, but he needs rates low to
add GDP growth. I am consciously not predicting the Fed’s actions this year.
If both fiscal and monetary policies are loose, within 4 years I think we
will have hyper-inflation.
Results: everything to date in 2017 leads to loose
policy as the tax bill increases the deficit and monetary policy slows the
easing but does not eliminate it completely. When I think of how stressful
the past year has been, what stands out is that this was during a relatively
calm period geopolitically. If Trump gets his way, net immigration will
become negative. This would be a disaster, similar to Japan but with debt
owed to non-citizens.
Debt levels remain way too high, and much of Europe
continues to see negative interest rates on government debt (note that I no
longer refer to it as risk free). A number of European countries are looking
for an exit from the common currency so they can devalue. Velocity of money
continues to hit new lows, reflecting some trust remaining in the financial
system but still a lot of concern. Oil prices are uncertain, but it is
unlikely that OPEC will hold back production for long if US frackers pick up
the slack. Beware of margin. Investors have been forced to be risk-on by the
Fed, and many accepted risks they don’t understand. I expect a lot of
volatility and uncertainty over the next couple of years. The US continues
to be in a good position relative to other countries, which isn’t saying
much, but this will give politicians an excuse to spend and blame the
fallout on others. Active investment strategies will do better over the next
few years than passive ones do, but only when value strategies are followed.
Those running after last year’s best performers will not do well.
Recent investment strategies have focused on passive
strategies, but this likely highlights a shift back to a trader’s market.
Individuals have the ability to reduce expenses much below what a mutual
fund or advisor can offer. Our personal investment expenses were less than
.5 bp in 2016, well below the 8-10 bp offered by index funds.
The US remains the reserve currency, mostly due to the
ineptitude of others. There are rumors of a move to SDRs as the global
currency following the next crisis, and China and Russia have bulked up
their gold reserves so they have a seat at the table. The dollar should
continue to rise, making it very hard for exporters to overcome retaliatory
tariffs. The investments to look for are companies with US monopolies once
imports are turned off. This should result in pure profit for them as prices
can rise with no increase in quality or volume. Warren Buffett’s Berkshire
Hathaway should do well. J
Geopolitical tensions continue to be high throughout
South America and Eurasia. Will a Trump-led America allow Russia to grow by
force? Like many other topics, a Trump presidency increases uncertainty. In
South America assets are leaving, helping to create a real estate bubble in
south Florida. Assets in China are leaving so quickly that the government
has imposed restrictions. Housing bubbles are growing everywhere, especially
along the coasts. Venezuela is done (unfortunately) as a functioning
society. Brazil is having one of its periodic periods of economic and
political malaise. Argentina has turned the corner with the new regime.
India and Venezuela eliminated large bills following Ken Rogoff’s claims
that it will reduce crime by moving to electronic cash (in his book The
Curse of Cash). India included bills that were too small and did not get
everyone an electronic account first, so those who had saved for large
expenses like weddings were left holding lots of worthless cash.
The Zika virus will continue to expand in 2017, and
bird flu, MERS, etc. etc. etc. will continue to cause problems. China is
very fragile right now as politics are driving economics. The US needs a
backup plan if Saudi Arabia falls. Africa is the next migration problem,
leaving many to question the efforts of philanthropists there. Climate
change and other sustainability issues are making water and other resources
the driving force behind regional conflicts. This will only get worse, and
an isolationist US is not going to help. An attempt to shut down the free
and reputable press will end up in the courts if Trump continues to bait
Climate change is real, and it amazes me how many
deniers appear to have read the famous How to Lie with Statistics
text and know how to use it. The data on global temperature clearly shows an
upward pattern, with a very high reading tied to the 1998 el Nino year.
First they used this single point to say there was no issue because later
temperatures were lower. On Inauguration Day 2017, as I am wrapping up this
paper @housescience, the House Committee on Science, Space, and Technology
is making a big deal out of saying that it only beat 1998 by a little bit
that is not statistically significant. Look at the graph, with all the data
points, and use some common sense. There is a clear correlation, and
scientists have shown causation, between global temperatures and CO2
levels in the atmosphere. This does not mean that it will never get cold in
New York City, which apparently is the only place that matters to some
deniers, or that there won’t be places on earth (e.g., Antarctica) that
might get colder or get more snow. The problem is the rate of change. This
impacts biodiversity (plants and animals can’t evolve quickly enough to
survive) and realists should review the Malthus arguments. Note that current
CO2 levels have risen to 406 and that the last time temperatures
were this warm ocean levels were at least 30 feet higher than they are now.
All those living on the coasts today will need to move inland which will
create lots of unintended consequences along the way.
El Nino has ended, so the next several years will trend
to lower temperatures than 2015-6. This does not mean the earth is not
continuing to warm, and individuals should look at the total data set
graphically whenever possible. The climate deniers are expert at cherry
picking data. Recent research is saying that sunspots are not the key driver
of heat trends. Keep posted. Water needs to be priced appropriately to allow
market forces to adjust. Financially the signs continue to point toward both
deflation and inflation. Malthus only needs to be right once. We need a
ratchet for food production. Current methods are unsustainable.
President Obama is the first president in my voting
lifetime to make it through a second term without a major controversy. You
may not agree with his positions, but his family life has been exemplary.
The Republicans now own issues like gun control, women’s rights, climate
change, and health care and should be held accountable. Moderates are
unfortunately nowhere in sight. At each election, ask if your representative
has voted for you or for lobbyists who fill their pockets with cash.
One of the few topics I agree with the populists on is
my fear of “Davos man” and their desire to do what is “best” for everyone
else. Creative destruction can’t work if you don’t let it. This means
individuals and investors should have credit risk. Including banks.
We are now reliant on senators like John McCain and Ben
Sasse to slow dictatorial urges of the executive branch. I hope that insider
trading cases tied to Trump tweets and press conferences are examined
closely. I expect a number of senior officials and family members to end up
in jail. The question is only whether this happens before democrats return
to the White House.
Europe is a mess, led by immigration, Italy, and
France. Brexit will work out fine for the UK, much to my surprise and
keeping them off my prioritized list. I don’t see how the EU stays intact as
a formal union, and the German vote in 2017 may be a bellwether for that.
The Middle East is hard to read, but little is positive. Climate change is
reducing fresh water, oil is volatile, and there is little interest in
democratization or manufacturing. I believe Iran ends up as a regional
power. Trump could take North Korea off his monitor list by warning China
that a strike on Hawaii will result in immediate reprisals. China will worry
about stray warheads and deal with it for him.
China’s need for its fleet to have an exit to the
Pacific will make it tense in Asia for the immediate future. The recent
overtures from the Philippines to China are worrisome, but perhaps higher
risk to the Philippines as it would become a puppet state under China. With
the increase in direct hit cyclones and the election of Duterte this will be
a hotspot for a long time.
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 2016, with a combination of El
Nino and jet stream adjustments leading to heavy flooding in the US and
Europe, drought in California and typhoons in Asia. In a short period of
time Hurricane Matthew barreled up the east coast, dumping heavy rain in the
Carolinas, and was almost immediately followed by forest fires fed by years
of drought conditions.
Much like weather, the economy is a complex adaptive
system so short-term forecasts are unlikely to be accurate. Stocks have now
risen for eight consecutive years, a record. There has been a Trump rally,
but if it does not grow some supporting legs soon longer term downward
trends will return, although this could be delayed into 2018 (when I lowered
the tax rate in my Berkshire Hathaway model the intrinsic value increased by
about 10%, so an increase much beyond this would not be sustainable without
higher earnings). Winners are likely to be companies with domestic
monopolies and small caps. The European model of private ownership of
businesses would work well now in the US, and more firms will go private to
reduce the hassle of dealing with the government. Exporters may struggle
with a strong dollar and poor reputation of US firms. Few firms make it
through my stock filter, and we currently have larger than normal cash
positions. 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 acceptable
substitutes. It should rise, making it hard for exporters. Treasury rates
bottomed in the US but firms should not make the assumption that they will
monotonically increase. I have heard comparisons to 1994, where a blip up
did lots of damage to those who had leveraged bets (e.g., Orange County) but
did not alter the long term trend down for interest rates. Demographics and
slow growth could easily take them lower again. This is a big deal for
savers, especially pension plans and insurers who each are required to
guarantee positive nominal returns. The US$ was volatile in 2016 but ended
up near 120 yen, close to where it started. The renminbi continues to weaken
despite calls for it to be named as a currency manipulator amid China’s
attempts to prop it up. How long will it spend reserve currency (or gold)
before it bails on the effort? We are not far from parity between the dollar
Outlier (Qualitative) Scenarios
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 the power grid
- Space junk knocks out a satellite used for public
- Atmospheric river hits California and dumps rain
on San Francisco for a month (a small version occurred in early 2017 –
tied to el Nino years?)
- A severe earthquake (or volcanic eruption) hits
California, St. Louis or Seattle
- Super-volcano becomes active somewhere in the
world (US option is Yellowstone NP)
- 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 – most likely fresh water or sea-going
- 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 and leaving South America a regional hot spot
- A virus develops drug resistance and becomes
transmissible by air
- Antibiotics fail to work against a common
- Iran encourages regional conflict and becomes the
Middle East’s consolidating superpower (you may have sub-scenarios with
alternative conclusions about how the Russia/US/Iran relationships play
- Water resources trigger a regional conflict
(likely Himalayas, Middle East, or Europe)
- S&P500 down 30% from high point, combined with
double recent bond defaults and real estate collapse in the largest
US/Canadian coastal cities. GDP down for 3 consecutive years.
- Climate change leads south Florida to become
unlivable and becomes a leading indicator for other changes (reduced
biodiversity, sea level rise, increased strength of convective storms)
While I tweaked some of these, the major additions were
antibiotics and climate change, but several are much closer (e.g., virus,
Eurozone, Venezuela, cyber risk, China, Iran).
These predictions were made in January 2017.
- Politics and currency wars: Prediction – Donald
Trump is a geopolitical disrupter. Either he will be popular and the
Europeans will follow the populist path or he will scare voters and they
will not. This is the most interesting issue on the table as we start
2017. I expect the dollar to continue to strengthen, but not from a
position of strength. The velocity of money will continue to drop. There
is a lot of uncertainty about this, but I expect the Fed to increase
rates multiple times to offset loose fiscal policy. Venezuela will be
under new management by the end of the year. Saudi Arabia is at the end
of its run but won’t turn over this year. The UK may end up as the
winner versus Europe as a hard Brexit allows them to avoid the harsh
realities and uncertainty of a Euro breakup. China will drive the next
currency blowup. 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. An
attack on the electrical grid has become increasingly realistic.
Results: The disrupter scared the French initially but momentum is still
moving in the direction of far right while leaving open a rebound to the
far left. The 2018 election in the US will be interesting. It will be
very hard to predict in advance. The dollar has weakened against the
Euro while treading water against the yen and VM dropped for most of the
year before potentially bottoming at third quarter. Three rate hikes and
reversing of QE will have ramifications in 2018 but little impact so far
on the economy. Venezuela and the Middle East are volatile concerns, and
the UK is showing signs that they could survive Brexit. The Chinese
Congress held in late 2017 has consolidated power in Xi Jinping, and I
felt he backed off some initiatives prior so will be interesting to see
what happens now. I still feel they are walking on egg shells as they
accumulate access to resources and gold.
- Political sidebar: a fun game would be to wager on
how long before Trump is impeached, or how long before his advisors are
sent to jail. Both are impossible to predict, and I don’t bet, but my
money would be on Jared Kushner. He’s involved in too many things and
not high enough in the structure to stay clean (unlike Ivanka). Most
likely is he gets caught selling influence. Results: the Mueller
investigation is making jail seem likely for more than Mr. Flynn.
Kushner is still my bet. Impeachment would happen quickly if Democrats
take over Congress, but they would probably try to take out Pence first
much like they did with Nixon/Agnew. Having Gerald Ford become president
allowed the recovery to move forward much more quickly than if Agnew had
become president due to his baggage.
- Stocks and general economic conditions: I keep
waiting for equities to have a correction that sticks. We nearly got one
in early 2016 but markets rebounded. US markets are overdue, and the Fed
increases may be the catalyst for a 20-30% drop. I suggest avoiding
businesses that rely on exports from the US. Mexico will struggle under
Trump. They are easy targets, although trading with Mexico and Canada
will benefit all three countries. Tariffs and border taxes will not help
markets. In fact, pressure on companies to repatriate jobs will lead to
the work returning to the US, but without employees. Robots and other
artificial intelligence methods will be the new workers. Be careful what
you ask for, Donald Trump! When companies cancel projects in Mexico it
sends immigrants a mixed message – we don’t want you here, but we don’t
want you to be able to work at home either. Is bullying the final stage
of a cycle that starts with world dominance and ends with a fall from
power? Emerging markets will suffer through a major bear market similar
to 1997. Contagion may follow. I continue to avoid bonds. My preference
is to use highly rated dividend stocks for this type of exposure. I see
the economy performing okay initially in 2017, with a recession (or
more, depending on how it is handled and how popular the new
administration is) later in the year or early in 2018. Lower tax rates,
if enacted, should add to confidence but may already be embedded in
stock prices. The disaster scenario for interest rates is down and then
spike up. Hyperinflation has arrived in South America. 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 2016 at 2,239, up 12% (total return) for the
year. Results: the market has not yet corrected and continues to
worry me on a daily basis. What will the catalyst for a correction be?
My repatriation comment about AI/robots replacing workers is playing
out, with MAGA Trump leading the charge. Much like the late 1800s,
technology will be disruptive and it will take time for workers to
- Unemployment: Structural unemployment 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 8 years of gains. I expect the unemployment level to
rise from just below 5% in 2017. The uncertainty about the Affordable
Care Act has likely increased structural unemployment even higher as
Trump voters realize that he wants to take away their subsidized health
care. The skill set needed for open positions is not held by the
unemployed. Make sure the next generation becomes lifelong learners.
This will be key to their success. Results: the unemployment rate
stabilized at 4.1%, but with a large population not participating in the
work force. The potential repeal of parts of ObamaCare have made it
harder for gig economy workers since it is hard and expensive to get
insurance that is not tied to employment.
- Residential home market: US regions continue to
have lower correlations with each other. Fannie and Freddie are the only
game in town right now to facilitate mortgages. That is a problem.
Bubbles are forming in some areas as Asian currency seeks an outlet
(e.g., Vancouver, Toronto, Seattle). Miami seems to be a home for South
American money seeking safety. This will interact with climate change in
a bad way for real estate in south Florida. Results: bubbles in
housing markets are building.
- Volatility: The VIX closed 2016 at 14.04. 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 this high would be
at least 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
going forward, especially if we experience both a recession and 20% drop
in the stock market. I am not an options expert but wonder if this
assumption has undervalued the cost of volatility in those markets.
Results: volatility as measured by the VIX has remained low, breaking
into single digits at times during 2017. It will be interesting to study
this period historically to see if there was another metric we should
have been following for risk.
- Oil: WTI oil on December 30, 2016 was about $54
per barrel. I have lost all comfort in predicting the price of oil, but
the combination of OPEC limits and frackers close to or below breakeven
makes it likely that the next spike will be due to a geopolitical event.
I would not be surprised to see $20/barrel oil in the meantime as
frackers become more efficient. Alternative fuel sources are
complicating this complex model. Results: frackers continue to
improve efficiency, but high debt levels make many of them cash flow
negative. An event in the Middle East seems much more likely, and will
make oil stocks act like they are in the defense sector.
- Credit risk: I am still worried that much of the
junk bond issuance recently has been to energy companies that are now
struggling due to the drop in oil prices. 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. European banks have a heavy debt overload, with Italy bailing
out their largest bank and rumors of bank bail-ins swirling. US junk
bond spreads have not widened to reasonable levels yet. Results:
waiting for the junk bond market to take the next step in the cycle.
- Currency/Inflation: With other countries loosening
and the new administration seeking to weaken the dollar for exporters
this will be an interesting chapter in the currency wars that are
ongoing. I expect the dollar to continue to strengthen against China,
Europe and Japan. I am not as sure as to the direction versus the
British pound, although short term strengthening seems likely a hard
Brexit may help the UK currency strengthen. The next couple of years
would be good ones for international travel. Results: it’s a race to
the bottom, but with the US starting to tighten exports should weaken
over time. Boeing has had a good year.
- Fed policy: The US continues to be susceptible to
a large catastrophe, financial disaster, or armed conflict. This will
play out over the next couple of years as Fed governors are replaced and
the Fed attempts to tighten. Results: hurricanes in the Caribbean and
Florida, with wildfires in the west, have impacted insurers a lot but
not the national GDP numbers. Puerto Rico is too small and California
fires too late in the year. The issue is why we haven’t had these types
of events, and whether the earth will have some reaction to climate
change such as super volcano eruption.
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.
Results: some reductions in use of antibiotics in animals is occurring,
but is it too late?
- 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 due at least in part to the shrinking
Arctic ice flow. 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
adapts 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 temporarily as el Nino moves past the peak
of its cycle. The proper comparison will be against the years right
after the last el Nino’s strongest year. It makes sense to look at a
graph of all data points rather than compare single year data points. It
makes it too easy for climate deniers to lie with statistics. The solar
cycle has been argued to be the driver of this warmth, but the current
cycle has been weak and this theory is in doubt. The real estate market
in Miami should blow up in the near future, but to date shows no signs
of doing so. Results: this continues to play out, with the US
government moving in an isolationist direction that will make it harder
to save the earth. Was Malthus just early?
- 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, and other
regions in the US are also at risk due to the pine beetle infestation
combined with drought. 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).
Recent research argues that this environment provides a protective
buffer around the US coasts, keeping small storms offshore. Results:
We saw atmospheric rivers in northern California and Seattle in 2017,
temporarily reducing the drought. By December Santa Ana winds had
created a wildfire crisis in southern California during what should be
the rainy season. The worst hurricane season in recent time devastated
- 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).
Results: cyber risk continues to grow in unexpected ways.
- Malthus – too many people, not enough resources –
will good intentions of the rich to save lives in Africa lead to
increased systemic risk for society (mass starvation, unstable regions,
forced migration) in the longer term? Are there unintended consequences
associated with the “giving pledge” by the rich? How do these complex
systems interact based on changing and fast moving inputs? Is it really
so bad to have aging demographics and shrinking populations? Should we
look at GDP growth by splitting it between population growth and
productivity 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. These retirees are seeing their Social Security
checks garnished. This situation will have much more impact on the
economy in the future than we have seen previously (negative).
Results: certainly not getting any better.
- 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.
Concentration risk also increases contagion risk. Less focus should be
put on fancy econometric models and more on simple exposures and their
downside impacts. Having a president who negotiates using twitter does
not help. Results: it seems there is more interest in listening to
contrarians in 2017.
- Terrorism – in the US, political extremists may
become active leading into the next election cycle. It amazes me that we
have not had more attempts to injure politicians, especially with the
lack of gun controls. Results: too many gun attacks to mention, but
generally against the public rather than targeted.
Top Actuarial Issues
- Defined benefit plan valuation – valuation methods
need to be revamped to front end funding levels for both private and
public plans. Assumed returns remain orders of magnitude too high. I
would suggest using nothing higher than 5%, with a cap using the most
recent 10-year geometric mean, and that might need to be lowered.
Results: continues to get worse. Why actuarial standards of practice
allowed this to happen amazes me.
- ORSA/PBR implementation – regulators have moved
toward checklists with ORSA, but can still make it worthwhile if they
outsource review of the reports to experts who understand how risks
aggregate and diversify. PBR has baked in conservatism (percentile) on
top of conservatism (margins). When a complex system includes margins
the results embed unintended consequences.
- Product design – be sure to look at exposures in
case hedges are not available. The gross exposure is more important
during a crisis, while the net exposure drives results in most
circumstances. A concern I am seeing is that companies are adding the
NAIC 1000 scenarios from the ESG (Economic Scenario Generator) to their
cash flow testing because of the mean reversion feature. Results are
better than from the NY7. As I’ve shown in my research papers, in this
environment the ESG provides best case results.
- Obesity/smoking – how will the various drivers of
mortality and morbidity interact (some good, some bad)?
- Health care – there is so much uncertainty as we
enter 2017 that it is hard to predict. It is unclear that the
Republicans have a handle on how ACA works, let alone how to improve or
replace it. Actuaries can help, if allowed. One hand grenade tossed by
Trump could play out like this: pick a fight with the pharmaceutical
industry; prices on drugs go down as government is the largest buyer;
research on new drugs goes away; Trump declares success; antibiotic
resistant bacteria runs rampant; many die. Results: Republicans
continue to show no understanding of how health care or insurance works.
- Systemic risk – too many insurers rely on FHLB for
capital infusions during a crisis – it has not been tested and may not
play out as expected. Results: every insurer I talk to states that
this is their plan. Has anyone told Treasury?
- Over-reliance on the normal distribution – I would
like to see life actuaries learn from their casualty brethren and learn
more about power laws that appear to represent the tail distributions
better than bell-shaped, normal, distributions.
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. Note that climate change acts as a threat
accelerator as it interacts with other risks. We are at a tipping point as
previously permanent frost melts, releasing long forgotten virus/bacteria.
Carbon, disease, spillover, and freshwater shortages are all terms we will
increasingly see in the press.
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 below
investment grade (BIG) assets
- Equities – down 35% and options market dries up
- Mortality – pandemic .6% excess mortality (compare
- For companies writing indexed products –
model/report separately – test product if derivatives market dries up or
leading counterparty becomes insolvent
- 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 already be testing 1,000 scenarios
from the ESG)
- 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 2011
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
- Politics: The Democrats have lost their
supermajority in the Senate and President Obama is now trying to
reposition himself as a moderate prior to the next election. He will
struggle to implement health care reform and Dodd-Frank this year and
will be seen internationally more to position himself for the reelection
bid as a foreign policy expert. When King Abdullah of Saudi Arabia dies
that will spark a period of uncertainty that could lead to an outbreak
of hostilities in that region.
- Oil: If oil prices fall below $50, political
instability in Russia and South America will quickly follow. Watch
Venezuela for problems.
- Credit risk: the market is once again allowing
liberal covenants, so I am not sure what the market actually learned.
Government entities are at risk and a major state or municipality in the
US is likely to default on their bonds. Junk bond spreads will widen.
- Insurance consolidation will accelerate, with
household names and smaller firms being merged out of existence.
- Currency/Inflation: Food inflation internationally
will be high and lead to riots and potentially regional violence as
countries that import try to reduce their dependency by force.
Top Actuarial Issues
- Defined benefit plan valuation – needs to reflect
marketplace economics, mean reversion and conservatism. Valuation
methods have led defined benefit plans to be little more than a Ponzi
scheme, relying on inflation to reduce the value to the retiree and the
expense to the employer. Everyone needs to save for their own future.
- National health care – we continue to need
actuarial solutions with transparency. Tort reform is not happening but
is necessary for cost reductions. Will health care reform be repealed?
No. The votes aren’t there. The Republicans will attack it through
funding mechanisms and making the legislation difficult to implement.
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!