Italy- Dolce Far Niente…NOT!

With Italian President Mattarella effectively refusing to grant a mandate to Prime Minister designate, Giuseppe Conte, because of the coalition of Five Star Movement (5SM)/Lega Nord (LG)’s choice of an avowedly “Euro-skeptic” Finance Minister, and granting a mandate to another “technocrat”, there is renewed turmoil within Italian politics, particularly as the President’s decision has no apparent precedent in post-1945 Italian politics.

To say that this latest outcome of the elections held earlier this year was unexpected would be an understatement- as current financial market reactions emphasize. On the face of it, the origins, core support and political platforms of each of 5SM and LN “should” have made their ability to agree on forming a governing coalition implausible to say the least, which just shows that there are plenty of “fat tails” still lurking in the democratic process- as further demonstrated by the Italian president’s subsequent actions.

Therefore, it is worth examining some issues which may arise, not just for Italy, but for the EU, should a 5SM/LN government ultimately take power, as may still happen after another round of elections likely to be called for later this year.

Firstly, both parties are demonstrably skeptical of the value to Italy of being a (founding) member of the EU, as well as of the Euro as its currency. As is now a matter of some notoriety, a leaked earlier draft of a purported coalition agreement suggested not only leaving the Euro (and even the EU), but also asking the European Central Bank (ECB) to “forgive” some EUR 250BN (sic) of sovereign debt.

Secondly, the Prime Minister designate, Giuseppe Conte, assuming he gets a second chance, is an academic, which begs the question of exactly who would be in charge of a 5SM/LG coalition government. How the supposed head of government would actually be able to enforce policy, when faced by two party leaders used to their own way remains to be seen. Conte was a compromise, and clearly “disposable”.

Thirdly, a 5SM/LG government would be likely to have very fraught relationships with both the European Commission and the ECB, as its coalition members regard themselves as “fac[ing] continuous attacks from unelected Eurocrats” and seek overtly to overturn the BRRD governing how bank insolvencies are managed, while suggesting that recovery of debts from retail debtors should require judicial sanction. In a context in which the EU is already faced with Brexit, as well as the increasing illiberalism and defiance of the Polish and Hungarian governments, the addition of Italy to the “defiant” category would serve only to increase instability. The rejected first-choice Finance Minister amply demonstrates the point.

Fourthly, while 5SM wishes to introduce a basic income for all citizens, the LN wishes to slash and consolidate tax rates, aiming to grow out of austerity and somehow manage to avoid increasing Italy’s budgetary deficits and borrowing levels. As the phrase goes, “something has to give”.

Of course, the Republic of Italy has a decades-long history of problematic governance (as well as, more recently, economic underperformance), and it would be easy to dismiss the latest events as “no worse than before”. Perhaps they are. However, there does appear to be an increasing risk that a new coalition government, led by two parties who do not subscribe to many of the expected norms, and have minimal to no track record of responsible and pragmatic economic management, would create a climate of increased confrontation with its EU peers, and engage (because of Italy’s importance to the “European Project”) in a dangerous game of seeing who would “blink first” in order to achieve its goals. Pretending that somehow the norms will prevail has echoes of the Weimar Republic.

The Awbury Team are long-standing students of political instability and its potential consequences, bearing in mind that such scenarios bring opportunity as well threats, so we shall be watching closely as the drama continues to unfold.

The Awbury Team

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Geo-politics and the art of randomness…

Trying to predict trends across the geopolitical landscape is always interesting, particularly when there is so much noise around, which makes determining what is material and potentially threatening into an exercise in probability-weighted scenario analysis.

Some examples:

Italy: will the pending coalition government of Five Star Movement and Lega Nord, become a comedy of errors or commedia dell’arte?

Malaysia: will Dr. Mahathir Mohamad really be willing to curb his hitherto autocratic tendencies and cede his role to his former protégé and nemesis, Anwar Ibrahim?

Argentina: a call for help to the IMF. Will it result in stabilization, or political defeat for economic reforms?

North Korea: who knew that a hitherto hermit hereditary dictator could be so charming, as well as deeply paranoid (not without reason)?

ZTE: political target; collateral damage; or the excuse for a rapprochement between the US and the PRC?

Of course, history is littered with examples of events that, while noteworthy, did not seem that important at the time, but turned out to have momentous consequences:

– Germany facilitating Lenin’s return to Russia in 1917
– Just another political assassination in Sarajevo in 1914
– Nixon’s visit to China in 1972
– The fashion for garage workshops in the Bay Area in the 1970s

As Kierkegaard said: “Life can only be understood backwards, but must be lived forwards”- at least in this universe. Discerning those events or factors which are truly important is far from simple.

All this makes the life of an underwriter an exciting one, as he or she tries to decide whether what is happening is just a sideshow and distraction; a mask for hidden trends; the first order in a subsequent cascade; or the emergence of a new category of risk.

The ZTE situation is worth pondering. While supply chain risk is not exactly something new, the fact that a significant PRC manufacturer was essentially put out of business overnight through unconstrained executive diktat, and then potentially given a stay of execution on further whim, is evidence that applying logic and rational thought to risk assessment is not always enough. Arguably, there should now be a “ premium” (and not of the beneficial sort) applied to any obligor that is a potential hostage to political fortune and caprice, and not just in relation to the US, as other governments are more than capable of such actions.

And what is one to make of underwriting the risks of exposure to a company, Tesla, whose CEO and dominant shareholder decides that “joking” very publicly about impending bankruptcy, or refusing to answer “boneheaded” questions is an appropriate exercise of management discretion? This may seem containable in risk terms- but, given the Cult of Elon, the failure of Tesla would almost certainly have not just direct industry impact, but also reverberate well beyond the United States, for example potentially calling into question market assumptions for cobalt demand and pricing (and thus affecting the DRC).

Amidst all the cacophony, the Awbury Team continues to focus on originating, analyzing, structuring and pricing risks that are highly unlikely to be “side-swiped by randomness”; ensuring that returns contain an ample safety margin; while constantly scanning our environment for changes that could be material with a view to keeping well ahead of the arc of creative destruction.

The Awbury Team

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Red Dragons and Bald Eagles…

The range of conflicts and confrontations between the US and the PRC seems ever present in the news headlines, with reaction following action in what seems like an endless loop. Of course, Russian revanchism; machinations on the Korean peninsula; and the various potential “flashpoints” in and around the Middle East add further layers of distraction.

However, the tensions between the US and the PRC amount to rather more than headlines, “sound bites” and political posturing- it is all much more serious than that, as the US, a constitutional democracy, is dealing with an unconstrained autocracy, which does not even subscribe to the rule of law.

A contest is clearly under way between the world’s two largest economies for supremacy over whatever global power structure they wish to create, or allow to exist. After World War II, the former Soviet Union and its satellites clearly lost a prior battle with the US, no matter what President Putin and his sycophants and fellow travelers may think, during a period when the PRC was first walled-off from the wider world and then internally-focused on re-building its industrial base and infrastructure. Until quite recently, the PRC had adhered to the approach formulated by Deng Xiaping of “keeping a cool head and maintaining a low profile”; and even the PRC’s current President (and now paramount leader) Xi Jinping would state that the PRC was no threat to anyone.

Now, in a scenario exacerbated by the “zero-sum” approach to international relations adopted by the current Administration, the PRC’s leadership is starting to push back, seemingly confident that it has the support of its vast population (over which it is re-exerting ever more control); knowing that the entangled supply chains and expansion plans of many US businesses lead back to the PRC; and relishing the fact that, through its treatment of them, the US seems now to go out of its way to weaken the support of its supposed allies.

Of course, this is not to say that a direct “kinetic” confrontation is inevitable; nor that the PRC seeks an outright “trade war” with the US (which any rational person realizes benefits neither party, nor the wider world economy). Nevertheless, the tone has changed, with both sides increasingly testing and probing the other to understand how far a particular course can be followed before provoking a reaction. A prime example of this is the increasing “fact” that the South China Sea is now a maritime buffer zone for the PRC, which clearly intends to force the US’s Pacific Fleet out of being able to control the area in the event of war (say, provoked by a PRC decision finally to “incorporate” Taiwan into the Middle Kingdom). No doubt, many interesting war games are being conducted by the general staffs of both the PRC and the US.

The optimistic scenario would have the US and the PRC realizing that co-operation is better than confrontation, particularly given how intertwined their economies truly are. A more pessimistic one would be the PRC’s leadership taking the view (not unreasonably) that its own population is far better conditioned to bear pain, than that of the US, and at some point no longer seeking compromise in the face of what it might consider provocations, or the attempted humiliation by one great power of another. So, the real question becomes: at what point does either party believe that it has the ability to “win” an outright confrontation, and what means will it choose to do so? A direct military confrontation is possible (as there is an increasing range of “flashpoints”); but a more likely scenario is a combination of economic “warfare”, cyber-confrontation, and proxy wars of the sort fought between the US and the former Soviet Union.

At some point, we are likely to find out.

Naturally, the Awbury team maintains a close watch on geo-politics and economic factors in order to assess how they may impinge on the risks we have or may choose to accept within our portfolio and to ensure that, at all times, the ratio of risk to reward remains acceptable.

The Awbury Team

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Cultural appropriation…

While any self-respecting (re)insurer would not be taken seriously without a risk management process that established a Risk Appetite, set Risk Limits, and carefully managed potential aggregations across various factors and product lines, there is one area in which it can be somewhat harder to discern a company’s approach- namely, its Risk Culture, whose purpose should be to ensure that the enterprise not only survives, but prospers and achieves its objectives.

Unlike Mission Statements, articulations of Risk Culture tend not to be published, so one is often left guessing. What is also interesting is that formal definitions of what a Risk Culture is tend to be value neutral- for example (from RIMS) : “values, beliefs, knowledge, attitudes and understanding about risk shared by a group of people with a common purpose…”; which begs the question of what such a statement can be expected to clarify or signal, other than some commonality.

In reality, of course, any such statement is pointless without an overlay of judgement, as well as effective transmission both within and external to an enterprise where appropriate- and its content has to be applied.

So, how does one inculcate and embed a Risk Culture?

Firstly, the tone has to be set at the top, as a Risk Culture is a sub-set of an entity’s overall culture (and, in fact, co-dependent with it): it amounts to a “soft” control. If the consistent behaviour of a Board and senior managers does not set an example, it is naïve to expect that anyone else will pay much attention. The individuals responsible have to have a clear idea of the standards they expect to be adhered to, including by themselves, and a mechanism for ensuring that they are adhered to.

Secondly, expecting that individuals will all act ethically and appropriately at all times in the absence of factors other than their innate sense of what is “right” can be misguided: not because anyone should be considered amoral a priori, but rather because external factors and influences are important. “Good” people can do bad things and still consider themselves “good” because their value judgements have been influenced by factors such as fatigue, the “slippery slope” from minor to more serious transgressions, misplaced organizational loyalty, or inappropriate incentives. Therefore, the rules and goals of what is acceptable or expected have to be obvious, even if they are not set out in detail.

Thirdly, how the “culture” is safeguarded and transmitted is also important. In a (re)insurer, this responsibility will usually be assigned to the CRO, who will need to employ different approaches depending upon circumstances, because no single technique will be sufficient. So, the CRO will need to coach and build relationships; offer expert advice; be a steward of culture and ethics; and be willing to challenge decisions or behaviours that may adversely impact the entity’s success or reputation. Therefore, the role, particularly in a large, complex organization, is a demanding one, requiring a broad range of skills and attributes.

Everyone likes to believe that their organization’s Risk Culture is “fit for purpose”, but this can be difficult to demonstrate, as the concept can seem rather amorphous. As Andrew Bailey, Chief Executive of the FCA commented; “Culture is “everywhere and nowhere”… [it is] an outcome more than an input”

At Awbury, we are fortunate to have, in essence, grown together as a cohesive unit in building our business and franchise. We all interact frequently and comprehensively, and so are direct custodians of each other’s actions, individually and collectively. Given that our reputations and livelihood are inextricably and directly linked to the group’s continuing success, we believe that our culture and Risk Culture have become innate and inseparable. Of course, being Awbury, we would never assume that our approach is “the best”, nor that we should consider it immutable. However, we do believe that it is fit for purpose.

The Awbury Team

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The company as a cult…

One could argue that the first significant example of the company as a cult phenomenon was in the early 18th Century, when the South Sea Company (while fraudulent) managed to transfix a population; destabilize government; and set back the progress of legal reform of corporate structures for many decades.

Since then, the phenomenon has appeared periodically, often at times of financial and economic change and disruption, almost as if investors and others are seeking for some form of confirmation of belief that “X” company is going to change the world.

While corporations are legally “persons” in most jurisdictions, that “personality” is abstract and dispersed, meaning that it often comes to be represented by one or more human beings- often a charismatic individual who created and built the business- or creates a culture that is designed to foster what one might call a cult mentality. So-called Multi-level Marketing companies (MLMs) such as Herbalife and Amway are examples of the latter form.

Of course, bankers, analysts and institutional investors tend to pride themselves on being cynical and clear-eyed. However, they are also (so far) human. This means that they can be lured into behaving as if members of a cult of “true-believers”, either by suspending judgement or by being manipulated into ignoring harsh realities.

Often this is not intentional, but the result of “herd behaviour”, in which it becomes awkward to take a contrary view.

Nevertheless, not all “corporate cults” are malign or fraudulent. While the early Ford Motor Corporation under Henry Ford; The House of Morgan under JP Morgan; or General Motors under Arthur Sloan were demonstrably inseparable from the characters of their founders, none could properly be regarded as deliberately “cult like”, although the way in which Sloan built GM arguably led to the modern cult of “management” as an end in itself. Even Standard Oil under John D. Rockefeller, ruthless as he was, essentially enabled much of the United States’ economic power.

More recently, the growth of the “technological age” has been led by a number of businesses which clearly achieved cult status at their peak- for example, Microsoft as lead by Bill Gates (who has managed to transition to the philanthropist role without too much opprobrium), or Apple under the late and legendary Steve Jobs. Both companies, while still powerful, no longer attract the same status.

At present, we would suggest that, in the US at least, two companies, Amazon and Tesla, have the makings of a “cult” (and compare Alibaba in the PRC under Jack Ma), while Google and Facebook, although powerful, simply do not attract the same perception.

There is little doubt that Jeff Bezos is a brilliant business man, nor that the company he created is inextricably identified with and gets the benefit of the doubt when its strategy or performance are opaque. Similarly, Tesla is inseparable from Elon Musk, who has demonstrably achieved cult status, because any other company which persistently underperformed both expectations and promises made would have been already consigned the remaindered section of history. This does not mean that Tesla will not ultimately succeed; simply that its CEO is able to persuade most investors and potential sources of funding that there will, most certainly, be “jam tomorrow”.

And if one wishes to observe perhaps that most enduring corporate cult, one only has to think of Berkshire Hathaway and the “Sage of Omaha”. The epithet says it all!

At Awbury, while we believe that a strong corporate culture is generally a good thing, and that a charismatic leader may also help, being of a naturally skeptical nature, and having been around for a sufficiently long time to have seen the consequences of the suspension of critical faculties in many areas, we take the view that a corporation’s actual performance, competitive position, financial capacity and liquidity are what really matter. We are very wary of unsubstantiated charisma.

The Awbury Team

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Energy or Entropy…

There is, of course, much debate at present about the rate at which energy generation will switch from using hydrocarbon-based to other “alternative” forms, such as solar, wind and tidal- a so-called energy transition.

As a result, the work of a Manitoba-based Czech academic, Vaclav Smil, is gaining increasing attention; being already quietly influential amongst policy-makers. To paraphrase, Smil’s basic thesis, there have been three major energy transitions during the time of Humanity’s existence. First came mastery of fire (using energy from the sun stored in plants); second, farming (which converted solar energy into food); and, third, industrialization, which cycled through coal, then oil, then natural gas to power machines.

Now, according to Smil, we are struggling with the fourth transition, towards using energy sources that use the sun’s direct energy flows, rather than those trapped in hydrocarbon deposits, and do not emit carbon dioxide.

Ironically, whereas previously transitions have involved attempts to move towards use of more energy-dense materials- using Smil’s term- the current transition entails moving back down the power density spectrum. He considers nuclear power a “successful failure”, as it has become (with a few exceptions such as in the PRC) stalled by cost and safety concerns.

As Smil points out, it is all very well deciding to replace hydrocarbons with other sources, but generating the equivalent levels of energy to maintain current economic output could entail using 100 and perhaps a 1,000 times more land area to do so, which will create its own concerns and negative economic and political consequences.

So, predicting the rate and scale of the fourth transition is much more difficult than many forecasts (even those with a range of outcomes) assume, because the core hydrocarbons (coal, oil, natural gas) still supply 90% of primary energy, a level which is actually higher than in 2000, when nuclear energy and hydro-power were more important contributors than they are now. In other words, assumptions that hydrocarbon dependency can rapidly decrease are simply wrong, with generations rather than decades the more likely timeframe for a significant change to occur.

Naturally, such issues cannot be divorced from those of climate change and the impact upon it of a relentless desire for growth, which underpins all modern, fossil-fueled economies. More growth requires more use of hydrocarbons, as well as of fertilizers, particularly as developing economies move up the energy use spectrum, while at the same time demanding more resource intensive foodstuffs, such as meat. These factors mean that, in the absence of what one might term a fundamental change in approach, the chances of any material near-term reduction in global hydrocarbon use actually occurring are quite remote. Some fresh breakthrough in energy technologies such as cheap and reliable energy storage would be required to shift the transition.

In reality, all predictions and models of the future energy sources and uses are inherently unstable, and better seen as no more than indicative of likely trends. Requiring or expecting certainty is simply foolish.

At Awbury, we are constantly updating our own view of over-arching trends that can have wide impact, recognizing that one has to build uncertainty and redundancy into any risk model if one is to avoid being “mentally captured” by a particularly plausible and overly neat paradigm. In other words, we have learnt to deal with entropy.

The Awbury Team

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Uncritical belief can be dangerous…

The recent announcement of the actions of the SEC against various executives of Theranos (as well as the company) for alleged fraudulent behaviour towards investors had the Awbury team reminiscing about the various examples of corporate malfeasance that we have seen over the decades, and whether there are any common themes.

Of course, hindsight is a wonderful mental faculty; but, over the years, the Team’s members have learnt that, while some events come out of nowhere (Barings’ collapse in 1995 being a good example), others offer markers or warnings signs.

So, here are a few of our ”favourites”.

The smartest guys in the room were supposed to be from Enron, as they went about creating new business models and developing new financing structures. Unfortunately, it turned out that what was reported publicly was far from representing the true state of the company’s finances. Having essentially lost the trust of regulators and capital markets, the company was forced to file for bankruptcy in December 2001, and was subsequently broken up, while its auditor, Arthur Andersen, also did not survive the debacle.

A year later, Worldcom, a major US communications provider, imploded when its internal audit department uncovered massive fraud based on accounting manipulation of expenses (leading to underreporting) and inflation of revenues. Its CEO, Bernie Ebbers ended up in jail, and we have this scandal to thank for the Sarbanes-Oxley Act (SarbOx), beloved by all corporate executives.

For a little more exoticism, in 2003, it turned out that EUR 4BN of funds supposedly held in an account with Bank of America on behalf of an Italian dairy company, Parmalat, did not exist, which then led to the discovery that, at EUR 14.3BN, Parmalat’s debts were some 8 times what it had disclosed. A long investigation determined that there had been an elaborate scheme created by Parmalat’s senior executives to deceive investors about the true state of Parmalat’s finances. The irony here is that Parmalat was a decent business, which managed to survive and was eventually re-listed as a public company.

And naturally, we cannot resist mentioning that, also in 2003, Freddie Mac, one of the 2 entities that underpin the US residential mortgage market, was found by the SEC to have mis-stated earnings to the extent of USD 5BN, leading to the firing of much of its then senior management.

Perhaps the “poster child” for recent corporate fraud is the Madoff case- a scheme that would have made Ponzi proud- in which a long-respected and influential money manager managed to conceal that his investment management business had simply been paying investors returns out of their own capital or money from new investors. Disturbingly, he was only caught because he admitted what he had been doing to his sons, who turned him in to the SEC. With hindsight, the reason for his ability to generate smooth returns year-in-year out became blindingly obvious- they were fictitious.

In the case of Theranos, questions had been raised by investigative journalists about the true efficacy of its blood analysis systems, and the company also fell afoul of the FDA, so perhaps the writing was on the wall before the most recent disclosures, but it is telling that the company had still managed to retain the support of a roster of influential directors and advisers, yet had few medical professionals on its Board.

While each situation is different, there are some factors which seem to recur over time: one or more “charismatic” leaders; a lack of normal checks and balances; over-concentrated control; the use of or attempt to influence political actors and regulators; suspension of disbelief by those who should know better; over-complexity or a “story” that is a little too pat; greed and the misalignment of interests. Paradoxically, discovery often appears to be a relief for those involved, as the burden of pretense no longer has to be sustained.

The type of events described above are the stuff of nightmares for risks managers and underwriters, because they contravene the fundamental tenet upon which business is founded, which is trust. At Awbury, we are sufficiently skeptical and experienced to understand that, while one can never achieve certainty (and pretending such things is hubristic folly), one can try to minimize the risk of being caught by such events by focusing on alignment of interests, the validity and verification of track records, and the fact that if something looks too good to be true it probably is.

However, that still does not mean that we sleep soundly at night!

The Awbury Team

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