Don’t just think about it, apply it (quickly!)…

Since the Industrial Revolution, the rate of growth of the world’s aggregate economic output has been extraordinary (https://ourworldindata.org/grapher/world-gdp-over-the-last-two-millennia), with the slope of the graph going from the almost horizontal to the almost vertical. There are many reasons for this, but a key one has been the increase in productivity, as fundamental scientific discoveries were converted into an iterative series of technological and process applications that enabled capital to be transformed into ever growing wealth, even if often unequally. In essence, most of the world “levelled up”.

As with reasons for growth, there is debate about why productivity varies over time and by geography. And vary it does. As economist Robert Gordon has shown, real US GDP per hour increased from an average of 1.79% per annum between 1870 and 1920, to 2.82% per hour between 1920 and 1970, only to fall back to 1.62% between 1970 and 2014.  A 1% annual variation may not seem much, but, because of the effect of compounding it matters.

And now, in the midst of a pandemic, there is much debate about whether a virtual and distributed workforce will be more or less productive. Frankly, it is too early to tell, as there is anecdotal evidence each way.

However that may be, productivity matters. It is clearly linked in some way to step changes or new directions in scientific knowledge; but pure science (which is undertaken for its own sake) has no economic value unless one does something with it. Knowledge has to be applied. In the supposed “golden age” of productivity, from 1920 to 1970, that was often through the medium of the corporate research laboratory, such as IBM, DuPont, Merck, Xerox PARC, and Bell Labs. Those milieu transformed basic science into technologies or products that have made the world what it is today, and which we now take for granted.

Nevertheless, there is a nagging sense that all is not well. Somehow quantity no longer seems to produce the same quality. Why is much debated, and is too large a subject for a blog post. What matters is somehow finding a better way to convert knowledge into applied intellectual capital. Without that, knowledge is just knowledge.

Consider, for example, the (re)insurance industry. Essential, knowledge-based, full of highly-educated and very smart individuals. And yet…

Somehow the industry is often still slow to incorporate, adapt and apply new knowledge, or to develop effective new products and processes. As a  result, it moves sideways, or improves incrementally at best, and sometimes goes backwards- at least so far as it appears to the outside world. As we have written before, according to a McKinsey study, many companies in the industry actually destroy, rather than create value, barely earning their cost of capital. Now the industry faces numerous challenges, some of which may prove existential if it proves unable to address, manage and mitigate them.

For Awbury, the creation and application of intellectual capital to create value-added products is a fundamental part of our “corporate DNA”. It is what our client base expects and demands. We do not pretend to be “better”, or that knowledge is an end in itself; but we do understand that thinking needs to be transformed into doing, rather than endlessly refined, discussed and debated.

The Awbury Team

Fiscal insurance and the Reckoning…

Continuing the theme of our previous post (“Are you feeling (financially) repressed yet…?”), we now examine the issues posed by the pandemic from another perspective- that of fiscal policy and sustainable levels of government debt.

The level of fiscal support or “stimulus” to their economies being provided by governments  across much of the developed world already far-exceeds those seen in the wake of the GFC. Yet it is not really a “stimulus” (as HSBC pointed out in a recent paper entitled “Borrowing from the Future”): in reality it is insurance- a pay-out intended to help the recipient recover from an unexpected disaster, or economic CAT caused by an combination of a highly-contagious virus and subsequent government actions. However, the difference from insurance as such is that many governments do not have reserves set aside to address such an eventuality. Instead, they rely of the unique coercive power of the state to raise revenues through taxation, which, of course, ultimately depends upon the ability of its underlying economy not only to generate wealth sufficient to pay those taxes, but do so in ways that do not themselves inhibit wealth creation.

The general absence of a reserve means that in reality most governments (except those that have specific funds to act as a buffer against a decline in future revenues, such as most “petro-states”) raise the necessary funds in the short term through issuing debt in one form or another, to be repaid from future tax revenues.

The long-term downward trend in absolute and marginal levels of taxation across much of the world, coupled with rising (and now accelerated) ratios of government debt to GDP to levels not usually seen outside wartime, means that there is going to be a reckoning, because the pandemic will result in “economic scarring” in ways that are still unclear, but almost certain.

The scale and persistence of such “scarring” matters, because the intention behind the “insurance payout” by a government during the pandemic is to preserve not just income levels but to avoid the loss of future productive capacity in the economy. If the “scarring” is worse than expected, this will lead, amongst other things, to lower tax revenues and fewer jobs, and so likely lengthen the period over which government budget deficits persist at elevated levels, leading to more borrowing. Of course, this issue also has to be viewed in the context of the level of nominal interest rates on sovereign debt, when set against the nominal rate of growth in the same economy. As long as the latter exceeds the former, debt servicing is sustainable.

The situation is further complicated by the fact that the shape and trajectory of any economic recovery from the pandemic is still unclear for most economies. Anything other than a “sharp V” or “truncated U” means that the “scarring” will be real, while the recent general decline in many economies’ productivity is also cause for concern, particularly if it proves to be secular rather than cyclical.

Taking all the factors into account, any forecasts are merely estimates of possible scenarios. It is far too early to make any robust forecasts, so one has to remain wary about the build-up of the risks within economies, which always arise when a sovereign’s ability to raise and service its obligations becomes impaired. For Awbury, this is just another component in our systematic and continuing assessment of all the potential risks that may have a material impact on our existing portfolio and future business.

As Morgan Housel recently said: “Wounds heal; scars last”.

The Awbury Team

Are you feeling (financially) repressed yet?

One of the major conundrums in the wake of the GFC has been why inflation has not yet risen consistently from barely above c.1% in most major economies in the wake of all the central bank “pump-priming” and Quantitative Easing (QE). The catalogue of “experts” forecasting a doom-loop of rising inflation and even hyper-inflation is a long, and by now largely discredited one.

Of course, one can be very wrong for a very long time, and then suddenly right as the narrative flips. There is just the slight intervening problem of being thoroughly ignored and discredited, although usually without suffering the fate of Cassandra, beyond reputational “death”.

However, we have been reading an interesting note by the Man Institute, entitled (The Inflation Regime Roadmap) which discusses how inflation, and good old-fashioned “financial repression” may return.

One basic problem is that inflation can have a range of causes beyond the “money-printing” that tends to obsess monetarists, as well as be curbed by off-setting factors, as has almost certainly been the case since the end of the GFC. However, as the balance shifts, this can (apparently suddenly) cause inflation to spike upwards. Reasons can range from supply/demand imbalances in an underlying economy to changes in the relative bargaining power of labour versus capital, to commodity-based “shocks” (as in the early to mid-1970s). Unfortunately, focusing on what happened on the previous occasion, or a particular path is naïve because it is invariably the unforeseen or unexpected that triggers the shift.

And different constituencies suffer disparate outcomes depending upon both scale and direction (inflation, disinflation or deflation), which makes the situation even more complicated.

However, for major fixed income investors, such as (re)insurers, a particular concern is financial repression, accompanied by negative real interest rates- i.e., where interest rates are manipulated by governments and central banks to be low in nominal terms (or even negative, as we have seen post-GFC), in an environment in which inflation starts rising. At present, central banks are more concerned with deflation and aggregate levels of demand than they are about inflation, with the pandemic seeing remarkable levels of fiscal relaxation and the creation of available money in the system to try to mitigate or prevent economic harm. As a result, nominal rates are at or close to historically low levels across the EU, US and Japan and many other jurisdictions, which makes it very hard for any (re)insurer to generate levels of Net Investment Income (NII) to act as a buffer against recent and continuing weak underwriting results.

Whether in government bonds, munis or high-grade corporates, both yields and spreads achievable on the re-investment of income and maturing portfolio assets remain low, which means that it is ever harder to mask the volatility that also flows through the P&L and Equity accounts from changes in market values.

At Awbury, we have long been aware of both the issues and the need for a solution. Therefore, we have designed and successfully implemented for the past several years a range of products which specifically address a (re)insurer’s need both to generate high quality premium flows, and to remove volatility. We believe that these products are tailor-made for today’s environment, and are happy to discuss them further with those interested in solving a demonstrable problem.

The Awbury Team

So, how much uncertainty can you stomach…?

One of life’s enduring paradoxes is that human beings crave certainty, but are beset by a reality in which the arc of the future is inherently unknowable. This often creates cognitive dissonance. We want to persuade ourselves that we can predict what is to come; yet (if we think about it) recognize that as being impossible beyond certain parameters (and even those can be upended, as the outcome of the pandemic has shown).

We like to think that the natural order of things is both stability and progress in our world; yet recorded history is full of discontinuities in which what had been gained was (often) irretrievably lost for at least some cohort that thought it was secure- whether Roman citizens in the twilight Rome’s empire; Greek-speaking Byzantines in 1453; numerous African polities during the era of European colonization; the Russian aristocracy and intelligentsia during the Russian Revolution; or those singled out as “class enemies” during the Cultural Revolution in Communist China. The list is long. And now we have a global pandemic which may well disrupt and shatter the expectations of whole swathes of society.

How then can one both acknowledge and control all this in the context of managing risk?

Firstly, by understanding that just because everyone else agrees with us does not mean that we must be right. Being comfortable and secure in one’s certainty is an almost certain predictor of failure when thin tails prove to be fat.

Secondly, by realizing that there is no shame in expressing doubt. It is a sign of intellectual humility, which is an essential trait in anyone who seeks to forecast future outcomes.

Thirdly, (to quote Howard Marks of Oaktree), by accepting that we must make decisions regarding the future without knowing it.

Fourthly, by recognizing that the conditionality of the future exhibits both path dependencies and randomness, which can combine to produce outcomes that are wholly unexpected

And, finally, by taking comfort from the fact that that much of what we all do is a function of judgement, and not just expertise. Professing that one is “an expert” means nothing, and is often delusional.

In reality, the future is the result of our collective effort and interaction with each other and with the world in general. That may sound trite, but it is the truth. Events such the onset of the SARS-COV-2 virus may be random (in human terms) or not, but they then have consequences as we have seen. So we have, in responding both modified and created our own future, a fact over which we have some control.

To build a business founded on sourcing, structuring, placing and managing complex credit, economic and financial risks, one can hardly abdicate any decision-making processes, and metaphorically just “throw darts at the dartboard” hoping that the ratio of bullseyes to singles proves adequate! However, one can assess probabilities, identify parameters, and learn to understand how complex systems interact in order to build and test a thesis as to why a particular risk/reward in both sound and (most importantly) bounded to the downside. At Awbury, that is what we do every day. We live with inherent uncertainty, and navigate our path through it.

The Awbury Team