As the world turns…

The phrase “the Pacific Century” is now something of a trope, while the probability of a recurrence of the so-called Thucydides Trap in the context of rivalry between the US and the PRC causes furrowed brows and debate amongst geo-political scholars and military analysts.

This is not surprising given the re-emergence of economic power across Asia. The two-century dominance of the European and North American economic and political systems tends to cause many to overlook (assuming they are aware), that such domination is something of an aberration in the period since the fall of the Roman Empire (which, even then, was part of a multi-polar world.) At the end of the Seventeenth Century, Europeans were the ones admiring the influence and cultures of Asian powers (Asia constituting some two thirds of GDP and three-quarters of its population) such as the Middle Kingdom Chinese Empire and the Mughal one of India; and as late as 1820, Asian economies constituted an estimated 60% of global GDP at Purchasing Power Parity (PPP). Jared Diamond’s now iconic book “Guns, Germs and Steel” chronicles what changed the “natural order”.

The United States and the EU may still constitute the world’s largest economic blocs, but their dominance is beginning to fade. They may still be rich and militarily powerful (in the case of the US), yet Asia now has more than half of the world’s population and the majority of its largest conurbations.

Of course, statistics and trends can be manipulated by selective use and interpretation of data, but the rate of economic growth within Asia is such that, in relative terms and at UNCTAD-defined PPP levels, The Financial Times (FT) estimates that the size of Asia’s collective economies will surpass those of the Rest of the World within the next year or so. Even at market value (as the FT also points out) Asian economies account for 38% of global output (up from 26% in the early 2000s). The PRC alone, at PPP, now probably has a larger economy than that of the US.

Such projections can be disrupted or even reversed. However, given the trends, one should not ignore the contingency that eventually Asian economies will again become dominant economically. That does not mean that all of them will, or even wish to project power beyond their borders, with the obvious exception of the PRC. India probably wishes too, but is a good example of scale in terms of economic potential and population failing to equate to global influence.

Naturally, in a world of Make America Great Again and the desire of some within the EU for “Ever Greater Union”, there are those who would deny current reality and future possibility. While such intellectual avoidance may be comforting for those who hold such views, ultimately it is likely to prove counter-productive, because it prevents consideration of how to adapt to, or even challenge, reverse or guide outcomes.

At Awbury, we are both realists and pragmatists. We thrive by thinking strategically, while being tactically flexible, recognizing that denial and wishful thinking are simply foolish. Our world is constantly changing, and is a mixture of volatility, probabilities and certainties.

And we are very certain that the trends and potential changes described above will continue to present opportunities, as those affected try to manage changes in risk.

The Awbury Team

Jaded, Distracted, or just Overwhelmed…?

In our world of potential “information overload”, in which attention spans are supposedly becoming ever shorter, and the tendency in some quarters to misrepresent, distort or simply repeatedly lie seems ever more prevalent, there is a danger that one’s mind (the System 2 part in Kahneman terms) can suffer what amounts to processing paralysis.

Not only is there too much data masquerading as information, but one has to exercise great vigilance and maintain abundant skepticism in order to be able even to function. One has to practice a form of informational triage, deciding what matters and what does not in terms of the particular decision at hand- and one has to know when to stop. It is always possible to ask another question or examine another factor, but is it relevant or material? Does it supply new information or a different perspective?

Of course, much of the skill behind effective decision-making is a product of both experience and constant practice. Theory is all very well, but it is essential to have seen the outcome of one’s own decisions, as well as observing and learning from those of others.

In the (re)insurance underwriting context (as in others), there is the danger that familiarity can breed contempt, as well as complacency- both of which run the risk of causing decision errors- because, while some factors are largely unchanging (e.g., lack of cash kills companies), others may be new and unexpected. For example, the “Softbank effect”, in which an early stage, or even relatively mature business is essentially “forced” to accept far more money than its principals know what to do with or can deploy effectively may lead to them changing the very behaviours and processes which made the venture promising in the first place. Paradoxically, there can sometimes be something such as having too much cash.

Therefore, any underwriter has to be able to adapt his or her mental models when circumstances and new information dictate, including the heuristics which we all use, often subconsciously (System 1 behaviours in Kahneman terms.)

At the same time, as stated above, one has to be able to ensure that your System 2 thought processes are able to filter sources in terms of their accuracy, relevance and “weight”. Going back to primary sources is usually essential (i.e., reading the actual accounts; interview transcripts; and regulatory filings) is essential. Just reading pre-digested pablum such as presentations means that one is already dealing with someone else’s filter and motivations. Often those may be harmless, but equally they may deliberately distort or deflect. US GAAP or IFRS may be far from perfect, but “adjusted” numbers almost invariably only go one way in terms of their purpose, which is to make things look favourable- unless a new CEO is using the “kitchen sink” approach to clear the decks for his or her new regime.

The Awbury Team has by now getting on for a couple of centuries of relevant combined experience. However, that does not mean that we have succumbed to the “seen it all” fallacy. We know that there are, and always will be, new factors to take into account in our underwriting of the large, complex risks in which we specialize. Jaded we are not! As for being overwhelmed, our carefully focused approach enables us to filter out the informational dross and distraction that constitute an increasing problem.

The Awbury Team

Banks fail (or have to be rescued), but P&C (re)insurance companies just soldier on…

In most financial systems (with Bermuda being an interesting exception), banks dominate the financial landscape in terms of their absolute and relative scale and economic importance. We witnessed the potential consequences of that during the Great Financial Crisis, when highly-leveraged, under-capitalized banks had to be bailed-out by public money (i.e., the taxpayers) on a huge scale- something whose effects still linger even now.

Of course, over the past 10 years, regulation and re-capitalization have significantly strengthened many banks’ financial position, even if sustainable business models still elude quite a number of mainly European banks. However, the fact remains that, in the fractional reserve banking system which is still the dominant model, any bank needs to maintain a highly-leveraged business structure in order to generate the returns which shareholders expect and is inherently subject to the risk of a “run” if confidence falls.

There are now increasing signs that regulation fatigue, political amnesia and pandering to vested interests are leading to pro-cyclical, rather than the necessary anti-cyclical behaviour amongst regulators in the world’s largest financial market- the US- at a time when both the credit and businesses cycles are potentially approaching a reversal, even if not another “crash”. In fact, changes in regulation can fuel a boom- consider what happened after the repeal of the Glass-Steagall act.

As we are seeing now, risk also tends to migrate away from the regulated to the unregulated components of the financial system- as the rise of so-called “shadow banking” and “FinTech” demonstrates, further obscuring sources of potential trouble. If regulators do not pay attention and “follow the money”, they are, in essence, condoning a rise in systemic risk.

And while the phrase “This Time is Different” is not yet being uttered as a general mantra, the longer time passes without even a recession, the greater the risk that people, including “experts”, will start to believe that the beast of the Business Cycle has finally been tamed, with excuses being made to justify that belief, even in the face of contra-indicators. One can already observe this is the debate going about the “meaning” of the recent US yield curve inversion.

Compare that scenario with that of the (re)insurance industry. While (re)insurers may carry some leverage (usually at the holding company level, not at regulated subsidiaries), the cost of, or risk of withdrawal of funding is rarely an issue. Similarly, they are not subject to liquidity puts, nor deposit outflows. What happened to AIG in 2008 is the exception that proves the rule, yet its core insurance businesses were able to continue to meet their obligations without stress, in an environment that was potentially chaotic.

In reality, in the absence of fraud or serious mismanagement of pricing, aggregations and reserves, diversified P&C (re)insurers very rarely fail. This is not a reason to be complacent, nor to assert that such a thing cannot happen. However, the evidence built over many decades and business cycles is clear. Companies’ business models may become obsolete, or they may have reserving issues, but even then the consequence is usually an orderly run-off, rather than precipitate failure.

The key distinction between banking and (re)insurance is that duration mismatch is a necessary element of any banking system but not present in the re/insurance industry. While both industries have to pay close attention to their ability to cover realized losses and ensure adequate levels of risk capital (equity or the equivalent), only banks have to deal with the embedded liquidity risk that comes from that duration mismatch.

At Awbury, even though the quality of our partner (re)insurers is very high, and they are all large, diversified P&C businesses, we constantly monitor their financial performance and condition, because we believe that one should never assume that “received wisdom” cannot change; and we would be doing our clients a disservice if we did not maintain vigilance.

The Awbury Team

Fragile Five or Shaky Six?

Readers may be beginning to think that we are a little obsessive about oil. However, while money may make the World go round, without oil the global economy would also come, literally, to a grinding halt. It pays to keep a close eye on what is happening in the oil markets, because surprises and “shocks” have a tendency to reoccur with some frequency, often as the result of a geo-political event or trend.

There is much debate about whether supply and demand for crude oil will be in balance in the near to medium term and perhaps maintain some sort of floor under the current pricing of both the Brent and WTI benchmark crude oil blends. One thing we know is that any forecast of oil prices is usually wrong because of all the factors which can influence that all important supply/demand balance.

One can enumerate a catalogue, including:

– US shale or “tight” oil production levels continuing to grow, and whether the US will become structurally a net exporter of crude oil
– The transition away from internal combustion powered vehicles
– Alternative energy sources, such as solar and wind
– The price levels petro-states need to balance their budgets
– OPEC’s (and its allies such as Russia’s) willingness and ability to enforce production level quotas
– Economic slowdown in the PRC and elsewhere
– Political crises in the Middle East and Persian Gulf

Geopolitics is always in the mix, which is where the Fragile Five and Shaky Six come in. The former comprises Angola, Iran, Libya, Nigeria and Venezuela. The latter adds Algeria, a surprise late-comer in the wake of the political disturbances set off by the supposed determination of the ailing Bouteflika to run for a fifth term as President (on behalf of Le Pouvoir, or Deep State) and then his abrupt withdrawal. Bear in mind that in 2017, these 6 countries exported some 8MM barrels per day, or just over 8% of global production according to ENI’s 2018 World Oil Outlook. While, the 6 may not all see significant reductions at once, Iran’s exports are being constrained by US sanctions; Nigeria is increasingly unstable; Libya is anarchic; and Venezuela’s PDVSA is in freefall. Stable they are not.

Yet, the US, in the guise of the EIA, apparently blithely still expects a global surplus through until the end of 2020- and the forward curve for WTI is essentially flat out to the end of 2020, if not in slight backwardation- presumably relying on growth forecasts for US shale oil production and increasing exports.

Such lack of expected volatility and “received wisdom” always makes us skeptical. Of course, life would be easier if the forecasts were accurate. Historically, the US could generally lean on key allies such as Saudi Arabia, to “do the right thing” and turn on the taps. However, that relationship is now dysfunctional (being polite) and the Saudis have a new (entirely self-interested and untrustworthy) “friend” in Russia, which is more than happy to be given the opportunity to administer another “poke in the eye” to the US’s perceived interests. This is compounded by the fact that the Saudis see themselves as in a potentially existential battle with the US shale oil industry over who is the “swing producer” and at what price levels. In fact, the shift in the US’ overall position from a net importer to a potential net exporter is already beginning to have “second order” effect in terms of its policy decisions affecting the Middle East, including the State of Israel. And, in the meantime, the opaque policy- and decision-making process in the PRC always has the potential for the unexpected.

At Awbury, we take the view that one should never assume stability and predictability in crude oil prices (or those of any other commodity, for that matter), and that it is essential to closely examine and stress any risk that involves a direct or indirect exposure, to ensure that one is not “negatively surprised” when volatility returns. To do otherwise would be remarkably naïve.

The Awbury Team