Tag Archives: Brexit

Risk-O-Meter

As is now customary ahead of Davos week, the latest World Economic Forum report on global risks was released and the usual graphic of the top 5 global risks in terms of likelihood and impact are reproduced below. Environmental risks and technology risks again dominate the likelihood list which is indicative of the current consensus. As this post highlights, the likelihood of irreversible climate change within the next 10 to 20 years is the short, medium and long-term issue of our times.

Although the report does state that “geopolitical and geo-economic tensions are rising among the world’s major powers” and that these “tensions represent the most urgent global risks at present”, I was somewhat surprised to see that geopolitical risk did not make the top 5 likelihood list this year. Despite the current market (wishful in my view) thinking of a kick the can down the road fudge outcome, Brexit in 2019 may result in a constitutional crisis in the UK or the possibility of a large portion of the population being alienated by a possible rushed outcome this Spring (e.g. hard Brexit or permanent custom union). His Orangeness and his ability to flame division, whether internally in the US after a bad Mueller report or against China to deflect from his pitiful negotiating style, are ever present possibilities for 2019 (if not hopefully remote ones). Although maybe somewhat alarmist, I can’t but help worry that his reign may end with some form of violent turmoil, he will not go quietly!

As an aside, the wonderful TV show “Brexit: The Uncivil War” from the UK’s Channel 4, which I think is on Netflix now, does raise the issue of how democracies will operate in a world where all sides can use technology to manipulate a (potentially decisive) disengaged minority to the political extremes. If the long-term success of democracy is dependent upon compromise, then we may be in trouble. Pundits say the implications of Brexit politics is a break from the traditional left/right or conservative/liberal divide, into a much more complex mixture of differing tribes. In fact, I would highly recommend this video from Dominic Cummings, the main subject of the show, who ably explains the parameters of the new political landscape (if you don’t have the time to watch it all, watch a few minutes after the 15-minute mark on how they did it).

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One other item that caught my attention in the WEF report, in section 6 called Open Secrets, was the assertion that when “the huge resources being devoted to quantum research lead to large-scale quantum computing, many of the tools that form the basis of current digital cryptography will be rendered obsolete”. The article further asserts that “public key algorithms, in particular, will be effortlessly crackable” and, under certain scenarios, “a collapse of cryptography would take with it much of the scaffolding of digital life”. Do I hear a new arms race approaching? The report predicts “as the prospect of quantum code-breaking looms closer, a transition to new alternatives—such as lattice-based and hashbased cryptography—will gather pace” although “some may even revert to low-tech solutions, taking sensitive information offline and relying on in-person exchanges”. Imagine having to rely on people meeting other people to get things done……..unthinkable!

Keep on moving, 2018

As I re-read my eve of 2017 post, its clear that the trepidation coming into 2017, primarily caused by Brexit and Trump’s election, proved unfounded in the short term. In economic terms, stability proved to be the byword in 2017 in terms of inflation, monetary policy and economic growth, resulting in what the Financial Times are calling a “goldilocks year” for markets in 2017 with the S&P500 gaining an impressive 18%.

Politically, the madness that is British politics resulted in the June election result and the year ended in a classic European fudge of an agreement on the terms of the Brexit divorce, where everybody seemingly got what they wanted. My anxiety over the possibility of a European populist curveball in 2017 proved unfounded with Emmanuel Macron’s election. Indeed, Germany’s election result has proven a brake on any dramatic federalist push by Macron (again the goldilocks metaphor springs to mind).

My prediction that “volatility is likely to be ever present” in US markets as the “realities of governing and the limitations of Trump’s brusque approach becomes apparent” also proved to be misguided – the volatility part not the part about Trump’s brusque approach! According to the fact checkers, Trump made nearly 2,000 false or misleading claims in his first year, that’s an average of over 5 a day! Trump has claimed credit for the amazing performance of the 2017 equity market no less than 85 times (something that may well come back to bite him in the years ahead). The graph below does show the amazing smooth performance of the S&P500 in 2017 compared to historical analysts’ predictions at the beginning of the year (see this recent post on my views relating to the current valuation of the S&P500).

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As for the equity market in 2018, I can’t but help think that volatility will make a come-back in a big way. Looking at the near unanimous positive commentators’ predictions for the US equity market, I am struck by a passage from Andrew Lo’s excellent book “Adaptive Markets” (which I am currently reading) which states that “it seems risk-averse investors process the risk of monetary loss with the same circuit they contemplate viscerally disgusting things, while risk-seeking investors process their potential winnings with the same reward circuits used by drugs like cocaine”. Lo further opines that “if financial gain is associated with risky activities, a potentially devastating loop of positive feedback can emerge in the brain from a period of lucky investments”.

In a recent example of feeding the loop of positive feedback, Credit Suisse stated that “historically, strong returns tend to be followed by strong returns in the subsequent year”. Let’s party on! With a recent survey of retail investors in the US showing that over 50% are bullish and believe now is a good time to get into equities, it looks like now is a time where positive feedback should be restrained rather than being espoused, as Trump’s mistimed plutocratic policies are currently doing. Add in a new FED chair, Jay Powell, and the rotation of many in the FOMC in 2018 which could result in any restriction on the punch bowl getting a pass in the short term. Continuing the goldilocks theme feeding the loop, many commentators are currently predicting that the 10-year treasury yield wouldn’t even breach 3% in 2018! But hey, what do I know? This party will likely just keep on moving through 2018 before it comes to a messy end in 2019 or even 2020.

As my post proved last year, trying to predict the next 12 months is a mugs game. So eh, proving my mug credentials, here goes…

  • I am not even going to try to make any predictions about Trump (I’m not that big of a mug). If the Democrats can get their act together in 2018 and capitalize on Trump’s disapproval ratings with sensible policies and candidates, I think they should win back the House in the November mid-terms. But also gaining control of the Senate may be too big an ask, given the number of Trump strong-holds they’ll have to defend.
  • Will a Brexit deal, both the final divorce terms and an outline on trade terms, get the same fudge treatment by October in 2018? Or could it all fall apart with a Conservative implosion and another possible election in the UK? My guess is on the fudge, kicking the can down the transition road seems the best way out for all. I also don’t see a Prime Minster Corbyn, or a Prime Minister Johnson for that matter. In fact, I suspect this time next year Theresa May will still be the UK leader!
  • China will keep on growing (according to official figures anyway), both in economics terms and in global influence, and despite the IMF’s recent warning about a high probability of financial distress, will continue to massage their economy through choppy waters.
  • Despite a likely messy result in the Italian elections in March with the usual subsequent drawn out coalition drama, a return of Silvio Berlusconi on a bandwagon of populist right-wing policies to power is even too pythonesque for today’s reality (image both Trump and Berlusconi on the world stage!).
  • North Korea is the one that scares me the most, so I hope that the consensus that neither side will go there holds. The increasingly hawkish noises from the US security advisors is a worry.
  • Finally, as always, the winner of the World Cup in June will be ……. the bookies! Boom boom.

A happy and health New Year to all.

Farewell, dissonant 2016.

Many things will be written about the events of 2016.

The populist victories in the US election and the UK Brexit vote will no doubt have some of the biggest impacts amongst the developed world. Dissatisfaction amongst the middle class across the developed world at their declining fortunes and prospects, aligned with the usual disparate minorities of malcontent, has forced a radical shift in support away from the perceived wisdom of the elite on issues such as globalisation. The strength of the political and institutional systems in the US and the UK will surely adapt to the 2016 rebuff over time.

The more fundamental worry for 2017 is that the European institutions are not strong enough to withstand any populist curveball, particularly the Euro. With 2017 European elections due in France, Germany, Netherlands and maybe in Italy, the possibility of further populist upset remains, albeit unlikely (isn’t that what we said about Trump or Brexit 12 months ago!).

The 5% rise in the S&P 500 since Trump’s election, accounting for approx half of the overall increase in 2016, has made the market even more expensive with the S&P 500 currently over 60% of its historical average based upon the 12 month trailing PE and the Shiller CAPE (cyclically adjusted price to earnings ratio, also referred to as the PE10). A recent paper by Valentin Dimitrov and Prem C. Jain argues that stocks outperform 10-year U.S. Treasuries regardless of CAPE except when CAPE is very high (the current CAPE is just above the “very high” reference point of 27.6 in the paper) and that a high CAPE is an indicator of future stock market volatility. Bears argue that the President elect’s tax and expansionary fiscal policies will likely lead to higher interest rates and inflation in 2017 which will further strengthen the dollar, both of which will pressure corporate earnings.

Critics of historical PE measures like CAPE, such as Jeremy Siegel in this paper (previous posts on this topic are here and here), highlight the failings of using GAAP earnings and point to alternative metrics such as NIPA (national income and product account) after-tax corporate profits which indicate current valuations are more reasonable, albeit still elevated above the long term average by 20%-30%. The graph below from a Yardeni report illustrates the difference in the earnings metrics.

click to enlargenipa-vrs-sp500-earnings

Bulls further point to strong earnings growth in 2017 complemented by economic stimulus and corporate tax giveaways under President Trump. Goldman Sachs expects corporations to repatriate approx $200 billion of overseas cash and to spend a lot of it buying back stock rather than making capital expenditures (see graph below) although the political pressure to invest in the US may impact the balance.

click to enlargesp500-use-of-cash-2000-to-2017

The consensus amongst analysts predict EPS growth in 2017 in the high single digits, with many highlighting further upside depending upon the extent of the corporate tax cuts that Trump can get past the Republican congress. Bulls argue that the resulting forward PE ratio for the S&P 500 of approx 17 only represents a 20% premium to the longer term average. Predictions for the S&P 500 for 2017 by a selection of analysts can be seen below (the prize for best 2016 prediction goes to Deutsche Bank and UBS). It is interesting that the average prediction is for a 4% rise in the S&P500 by YE 2017, hardly a stellar year given their EPS growth projections!

click to enlargesp500-predictions-2017

My best guess is that the market optimism resulting from Trump’s victory continues into 2017 until such time as the realities of governing and the limitations of Trump’s brusque approach becomes apparent. Volatility is likely to be ever present and actual earnings growth will be key to the market story in 2017 and maintaining high valuation multiples. After all, a low or high PE ratio doesn’t mean much if the earnings outlook weakens; they simply indicate how far the market could fall!

Absent any significant event in the early days of Trump’s presidency (eh, hello, Mr Trump’s skeleton cupboard), the investing adage about going away in May sounds like a potentially pertinent one today. Initial indications of Trump’s reign, based upon his cabinet selections, indicate sensible enough domestic economy policies (relatively) compared with an erratic foreign policy agenda. I suspect Trump first big foreign climb down will come at the hands of the Chinese, although his bromance with Putin also looks doomed to failure.

How Brexit develops in 2017 looks to be much more worrying prospect. After watching her actions carefully, I am fast coming to the conclusion that Theresa May is clueless about how to minimise the financial damage from Brexit. Article 50 will be triggered in early 2017 and a hard Brexit now seems inevitable, absent a political shock in Europe which results in an existential threat to the EU and/or the Euro.

The economic realities of Brexit will only become apparent to the UK and its people, in my view, after Article 50 is triggered and chunks of industry begin the slow process of moving substantial parts of their operation to the continent. This post illustrates the point in relation to London’s insurance market. The sugar high provided by the sterling devaluation after Brexit is fading and the real challenge of extracting the UK from the institutions of the EU are becoming ever apparent.

Prime Minister May should be leading her people by arguing for the need for a sensible transition period to ensure a Brexit logistical tangle resulting in unnecessary economic damage is avoided. Instead, she acts like a rabbit stuck in the headlights. Political turmoil seems inevitable as the year develops given the current state of the UK’s fractured political system and lack of sensible leadership. The failure of a coherent pro-Europe political alternative to emerge in the UK following the Brexit vote, as speculated upon in this post, is increasingly looking like a tragedy for the UK.

Of course, Trump and Brexit are not the only issues facing the world in 2017. China, the Middle East, Russia, climate change, terrorism and cyber risks are just but a few of the issues that seem ever present in any end of year review and all will likely be listed as such in 12 months time. For me, further instability in Europe in 2017 is the most frightening potential addition to the list.

As one ages, it becoming increasingly understandable why people think their generation has the best icons. That said, the loss of genuine icons like Muhammad Ali and David Bowie (eh, sorry George Michael fans) does put the reality of the ageing (as highlighted in posts here and here) of the baby boomer generation in focus. On a personal note, 2016 will always be remembered by me for the loss of an icon in my life and emphasizes the need to appreciate the present including all of those we love.

So on that note, I’d like to wish all of my readers a prosperous, happy and healthy 2017. It looks like there will be plenty to write about in 2017…..

London Isn’t Calling

In a previous post, I reproduced an exhibit from a report from Aon Benfield on the potential areas of disruption to extract expenses across the value chain in the non-life insurance sector, specifically the US P&C sector. The exhibit is again reproduced below.

 click to enlargeexpenses-across-the-value-chain

The diminishing returns in the reinsurance and specialty insurance sector are well known due to too much capital chasing low risk premia. Another recent report from Aon Benfield shows the sector trend in net income ROE from their market representative portfolio of reinsurance and specialty insurers, as below.

click to enlargenet-income-roe

It’s odd then in this competitive environment that the expense ratios in the sector are actually increasing. Expense ratios (weighted average) from the Willis Re sector representative portfolio, as below and in this report, illustrate the point.

click to enlargewillis-re-expense-ratios

The 2016 edition of the every interesting S&P Reinsurance Highlights, as per this link, also shows a similar trend in expense ratios as well as showing the variance in ratios across different firms, as below.

click to enlargesp-expense-ratios

Care does need to be taken in comparing expense ratios as different expense items can be included in the ratios, some limit overhead expenses to underwriting whilst others include a variety of corporate expense items. One thing is clear however and that’s that firms based in the London market, particularly Lloyds’, are amongst the most top heavy in the industry. Albeit a limited sample, the graph below shows the extent of the difference of Lloyds’ and some of its peers in Bermuda and Europe.

click to enlargeselect-expense-ratios

Digging further into expense ratios leads naturally to acquisitions costs such as commission and brokerage. Acquisition costs vary across business lines and between reinsurance and insurance so business mix is important. The graph below on acquisition costs again shows Lloyds’ higher than some of its peers.

click to enlargeselect-acquisition-cost-ratios

Although Brexit may only result in the loss of fewer than 10% of London’s business, any loss of diversification in this competitive market can impact the relevance of London as an important marketplace. Taken together with the gratuitous expense of doing business in London, its relevance may come under real pressure in the years to come. London is, most definitely, not calling.

Restrict the Renters?

It is no surprise that the populist revolt against globalisation in many developed countries is causing concern amongst the so called elite. The philosophy of the Economist magazine is based upon its founder’s opposition to the protectionist Corn Laws in 1843. It is therefore predictable that they would mount a strong argument for the benefits of free trade in their latest addition, citing multiple research sources. The Economist concludes that “a three pronged agenda of demand management, active labour-market policies and boosting competition would go a long way to tackling the problems that are unfairly laid at the door of globalisation”.

One of the studies referenced in the Economist articles which catch my eye is that by Jason Furman of the Council of Economic Advisors in the US. The graph below from Furman’s report shows the growth in return on invested capital (excluding goodwill)  of US publically quoted firms and the stunning divergence of those in the top 75th and 90th percentiles.

click to enlargereturn-on-invested-capital-us-nonfinancial-public-firms

These top firms, primarily in the technology sector, have increased their return on invested capital (ROIC) from 3 times the median in the 1990s to 8 times today, dramatically demonstrating their ability to generate economic rent in the digitized world we now live in.

Furman’s report includes the following paragraph:

“Traditionally, price fixing and collusion could be detected in the communications between businesses. The task of detecting undesirable price behaviour becomes more difficult with the use of increasingly complex algorithms for setting prices. This type of algorithmic price setting can lead to undesirable price behaviour, sometimes even unintentionally. The use of advanced machine learning algorithms to set prices and adapt product functionality would further increase opacity. Competition policy in the digital age brings with it new challenges for policymakers.”

IT firms have the highest operating margins of any sector in the S&P500, as can be seen below.

click to enlargesp-500-operating-profit-margins-by-sector

And the increasing size of these technology firms have contributed materially to the increase in the overall operating margin of the S&P500, as can also be seen below. These expanding margins are a big factor in the rise of the equity market since 2009.

click to enlargesp-500-historical-operating-profit-margins

It is somewhat ironic that one of the actions which may be needed to show the benefits of free trade and globalisation to citizens in the developed world is coherent policies to restrict the power of economic rent generating technology giants so prevalent in our world today…