Wash my car…

The “Lava Jato” (Car Wash) bribery and corruption saga continues to unfold in Brazil, with its impact and scope seemingly ever wider, giving the impression that corruption must be endemic throughout the Brazilian economy. Debate continues as to whether it is merely the largest corruption scandal in Brazilian history, or in the world.

The catalogue of politicians and business leaders who have been implicated or toppled from power is, indeed, extraordinary, with the current President at some risk of being impeached and removed from office because of his own alleged involvement in at least condoning bribery.

And all this has taken place against an economic background that has seen Brazil suffer its worst recession since the Great Depression. So Brazil must be an economic and political “basket case”, não?

Well, not so fast. The Brazil of today, with all its faults and issues, is not the hyperinflationary and autocratic state it once was, well within living memory.

Firstly, in spite of seemingly never-ending setbacks, the economy has begun to crawl its way out of recession in the last quarter, growing by 1% after 8 consecutive quarters of contraction, helped by a bumper soybean crop.

Secondly, the state’s government and governance structure has not collapsed. While the extent of political corruption may be astonishing, the judiciary has become relentless in investigating and punishing it; while those in power have not been able or effective in thwarting due process, even if some have tried. The previous President was impeached and her iconic predecessor, Lula, was himself unable to resist investigation for corruption.

Thirdly, in a world in which demand for protein in all its forms is rising inexorably, Brazilian agribusinesses produce what the world wants, even if they can fall victim to scandals over tainted meat, or the vagaries of commodities pricing.

Fourthly, the Federal Government has begun to reform the ridiculously expensive pensions system, and other areas of government expenditure. There are no certainties, but the fact that the attempt has been made in the face of political turmoil, recession, and a complex parliamentary ecosystem does show that there is room for some sense of “what needs to be done” to prevail.

Fifthly, Brazil is much less vulnerable than most to a currency crisis, as barely 2% of its sovereign debt is denominated in foreign currency.

Sixthly, the central bank is competent and appears free from political manipulation.

Of course, none of these factors means that the future is certain; but, as always, the negative weighs upon perceptions more than the positive, affecting judgements made and actions taken. We would never say that there is no risk in Brazilian exposure, but we do believe that one has to take into account all relevant factors to create an informed decision.

At Awbury, we are constantly monitoring, assessing and re-assessing the key political economies across the globe, looking for connections and correlations that could have an impact on the business we write, so that we can create effective mitigants that will minimize the risk of an unexpected outcome. It is all part of our obsession with effective risk management.

The Awbury Team


So, you think you are real…

So, you think you are real…

The phrase “but in the real world” is one that is intended to convey that the speaker is asserting that his or her knowledge and experience are in contrast to a statement that contradicts or ignores reality.

Yet, what is reality?

In a world in which artificial intelligence and “virtual reality” are being incorporated into ever-widening roles or functions, how can anyone be certain that they are dealing with “the real”? What are the boundaries? After all, the famous Turing Test posits that, if a computer can convince a human interlocutor that its behaviour is indistinguishable from that of a human, it has, at least to some extent, artificial intelligence.

And if an artificial intelligence is a form of artificial mind, and virtual reality is an artificial world, and we humans interact with both, arguably we are making them real, because we are incorporating them into how we act, think and behave in what we term the real world. Descartes used his “evil demon” thought experiment to raise the possibility that everything that we think is real is, in fact, an illusion; while there are a number of high profile individuals in the world of technology who also raise the question of whether our entire world is a construct of some vastly superior civilization- think The Matrix on a cocktail of LSD and steroids!

To add to your sense of disassociation, if a simulated world is just a world produced by digital information, and human beings are the product of the digital information encoded into our DNA, to what extent can we say that we are “real”? If we are simply “code”, then that code could be uploaded into a different environment. After all, work is already under way on giving an individual the chance of immortality by uploading his or her mind into an electronic storage system, enabling an emulation that would supposedly run much faster than it does on the messy biological version we have now (now, apparently, the “meatspace”). Of course, all this begs the question of “Quis custodiet ipsos custodes”- who will keep an eye on those in charge of the process?

Before, Dear Reader, you think that the Awbury Team has completely “lost it”, there is a serious side to all this seemingly hallucinogenic sophistry.

All reality, including yours and ours, is grounded in information. Whether we live in a Newtonian or quantum mechanical world, the underlying physics is grounded in information, yet also real; based upon models created by individuals and validated by observation and empirical testing (until a better representation refutes it!) However, as more and more economic and social activity switches to the “virtual and cyber world”, the boundaries between what is real and what is not become increasingly blurred. As such, the nature of risks will become increasingly “virtual”; influenced by events or environments that may not be “real” at all, or only partially so.

Therefore, Awbury’s ability to continue to succeed and remain relevant is based not only upon remaining grounded in the real world, understanding its nature and boundaries, but also in being able to conceptualize “virtual” risks, and construct, manage and understand the appropriate range of models that will enable us to identify and assess opportunities and risks in all their forms. We just have to avoid allowing the models to appear so elegant, self-referential and perfect that they distract us from the fact that our world, whether real or not, has limitations and boundaries in terms of what we humans can perceive. Some factors may simply not be capable of observation, so one has to make assumptions grounded in reality- whatever that is!

The Awbury Team


Comparative Advantage or Cumulative Disadvantage…

The Ricardian concept of comparative advantage (now some 200 years old) is a long-standing component of economic models; and supports many elements of public policy, such as the benefits of international trade making all the parties involved ultimately better off.

In contrast, the economists Angus Deaton and Ann Case have begun to articulate what one might be termed (with apologies to them both) a theory of cumulative disadvantage, as the result of which whole segments of a population group are effectively condemned to perpetuate a cycle in which its members are constrained from reaching their potential by a range of cultural, societal, educational and health factors.

Perhaps fancifully, we thought we would consider these two concepts in the context of the (re)insurance industry; and highlight some potential contrasting outcomes. Sentiment as to whether companies should specialize, or seek to provide as broad a range of products as possible tends to go in cycles; but what, in a (re)insurance company is a true comparative advantage? We would argue that it is the ability to write business that consistently generates high quality, risk-adjusted premium income, where losses are carefully controlled and manageable. Sadly, as results over the past few years have shown, as in 2016 when the US industry suffered a cumulative underwriting loss, far too many businesses are unable to differentiate themselves, with the result that a “good outcome” is now being able to keep one’s Combined Ratio below 100%. If one thinks about it, it is rather odd that a business should consider itself lucky to break even in the application of what is supposed to be its core competence. Where is the comparative advantage in that?

And to compound the lack, in most cases, of a comparative advantage, we shall move on the cumulative disadvantages now “enjoyed” by most (re)insurance industry participants. The continuing surfeit of capital seems to compel many to find a use for it, or contort their business model so that they do not “lose out” (think of the asset management industry’s obsession with “Assets Under Management”), which leads to erosion of discipline and being picked off in terms of pricing available in commoditized business lines. Add to this a byzantine and often opaque cost structure, which can consume an inordinate share of the revenue stream; the potential for disruption by actors who have no attachment to received wisdom and are willing to ignore “standard practice; plus uncertainty about the likely loss experience of new business lines, such as “cyber” and one has a reasonable facsimile of cumulative disadvantage.

How then to break the cycle?

Comparative advantage is only relevant if the underlying activity in which one engages is sustainably profitable. Clearly, it makes no sense to be the best there is in a particular industry if the core activity results in value destruction, or fails to earn its true cost of capital . So, the need exists for the P&C (re)insurance industry to consider some deep and fundamental changes to its business model if it is to overcome cumulative disadvantage.

We’d be more than happy to explain our interpretation of comparative advantage!

The Awbury Team


When the music stopped…

It is a truism that the older one becomes, the faster time seems to pass. So, it is a rather sobering thought that it is now some 10 years since the onset of the Great Financial Crisis was presaged by the failure of various hedge funds with significant exposure to sub-prime “investments”, RBS’s ridiculously expensive acquisition of the bulk of what was then ABN-AMRO, Chuck Prince’s notorious comment that: “As long as the music is playing, you’ve got to get up and dance”, and the dawn of the iPhone era. In Mr. Prince’s comment one could not have a better example of the dangers of behavioural “herding” and a failure to acknowledge risk- seemingly a characteristic then imprinted in the banking industry’s collective DNA.

Of course, it all ended rather badly for too many, both the guilty and the innocent; and we are still dealing with the consequences.

Rather than catalogue yet again the supposed causes, one question to consider is whether anything has really changed fundamentally in a way that actually makes the world a safer place economically, and societies financially more secure. Yes, banks have much more capital in the form of pure equity; regulation is stricter and more comprehensive; curbs on supposedly more risky activities have been imposed; and retribution levied in the form of fines and levies. Yet, it is hard to argue that the culture has changed, or that incentives are now properly aligned to minimize the risk of malfeasance; while the mind-numbing scale and complexity of all the rules and regulations (even assuming their implementation can be agreed upon) favours wary compliance over comprehensive and thoughtful risk management.

Are banks safer? Are financial crises less likely? In much of the so-called West, they are probably more cautious , as well as resentful that the need for more equity, combined with still distorted monetary policies reduces their ability to earn returns above their true cost of capital, while the cat-and-mouse games that are the now regular stress tests reduce their ability to game the system. Paradoxically, these may reduce the probability of another Minsky Moment. And yet, history teaches that one clear warning sign of future mayhem is not so much the absolute level of debt within an economy, but rather its rate of growth, which is why (as we have written before), the PRC’s opaque, distorted and politicized financial system is such a concern. Perhaps there’s a disaster movie title in there: “It came from the East”.

Another good thing is that, so far, the phrase “this time is different” is not yet in common use, and the masters of the universe no longer bestride bank trading floors in quite the same way- so one should probably look for signs of a “cult” arising around a particular sub-sector of the financial industry as a harbinger of future problems.

At Awbury, we are long-time students of financial and economic history. We have to be in order to have the context in which to underwrite thoroughly the risks we accept. However, we are also understand that to assess risk(s) one has to look forward, not back; and that the obvious risks are never the ones to worry about, but rather the potential combinations and correlations of seemingly dispersed triggers.

So, yes, we are paranoid, never complacent! Banks may appear safe; and the banking industry generally safer; but somewhere the seeds of the next financial crisis are germinating…

The Awbury Team


Puerto Rico- no longer so rich or full of promise…

The past week saw the formal start of the largest insolvency in the history of the US “muni” market, when the Commonwealth of Puerto Rico (PR) finally ran out of time to reach a settlement with its creditors and filed for the equivalent of bankruptcy. If one takes into account both funded debt and unfunded pensions and similar obligations, the “headline number” could be up to USD 120BN.

We would find it hard to believe that anyone should be surprised at this outcome, as the Commonwealth’s economy has been in recession for years, while it has lost many of its most productive citizens to emigration to the mainland US. Arguments about who is responsible for the “mess” will no doubt continue to rage, but what matters now is to find a mechanism that enables, rather than hinders, an orderly restructuring of PR’s obligations, which are notoriously complex in structure. In this regard, PR has been singularly unfortunate, being “neither fish nor fowl”. As an unincorporated territory of the US, it neither had access to the established Chapter 9 municipal bankruptcy procedures, nor the sovereign ability as a State to default unilaterally. As a result, it has been the victim of an unwieldy political compromise under the so-called PROMESA legislation passed by the US Congress, whose consequences became visible this week, when the PR government, having run out of time under Title VI of PROMESA to negotiate a consensual restructuring, had to resort to Title III and seek restructuring through the Federal Courts- but not the Federal Bankruptcy Courts. As such, there are no precedents for what the outcome may be. The lawyers will get richer, and the final determination will almost certainly be fought all the way to the US Supreme Court.

While there will be furious litigation over the ranking and priority of PR’s General Obligations versus those of government-related bodies such as COFINA and PREPA, the Fiscal Plan approved in March by the Board now overseeing the process, assumes that cash available to service PR’s debt obligations (i.e., ignoring the insolvent pension scheme) will cover less than 30% of the contractual amounts due over the years to 2027. Of course, this is just a forecast, and almost certainly has little basis in reality, given all the other factors that will come into play.

Not surprisingly, the monolines and quasi-monolines who fell over themselves in the past to “wrap” PR’s obligations and, as a result, have billions of dollars of potential exposure (close to USD 30BN in nominal terms for Assured Guaranty, AMBAC and MBIA, according to a CreditSights estimate) are starting to express concern about the fact that there seems to be a “lack of adult supervision” in how matters have been conducted. This is hardly surprising in the context of the scale of their potential exposure, the complete uncertainty over what will happen next, and the Oversight Board’s “ranging shot” on the level of potential haircuts to creditors holding the bonds they have insured.

From Awbury’s point of view, writing multiple policies with large exposures at slender margins on supposed “tail risks” with a single trigger is hardly a rational approach to long-term value creation and sustainability. The recent history of finance is littered with the corpses and casualties of that approach. Rather, we seek those opportunities (and we are able to be patient in the manner of Warren Buffett) where the need is based upon a set of circumstances in which cost is not the consideration, but rather the provision of a carefully-crafted, bespoke solution with proper alignment of interests.

Naturally, we shall continue to follow the PR saga as it unfolds, as there may well be interesting opportunities that result from it.

The Awbury Team


And the stubborn shall inherit the Earth…

As readers may know, Tyler Cowen is something of a “rock star” so far as economists go, as well as being a serial iconoclast. So, his recent extended essay, “Stubborn Attachments” A Vision for a Society of Free, Prosperous and Responsible Individuals has begun receiving critical attention.

At Awbury, we consider it dangerous to subscribe to a fixed economic dogma, being empiricists as well as pragmatists. We think it important to keep ourselves properly informed about the latest thinking on a broad range of subjects, including economics, or rather “political economy”, because of the impact on markets and behaviour, as well as being the potential source of opportunity

Professor Cowen’s essay posits that much of the world has lost its way in terms of creating prosperity and respecting the rights and liberties of individuals, and the reference to “stubborn attachments” in the essay’s title is to what achieving his goals may require.

In many ways, the essay is a philosophical tract rather than an economic prescription; but that does not lessen its relevance in terms of provoking the need for the reader to engage in a review of his or her own beliefs and values, and of “received wisdom”. Skepticism is a virtue; and even if the scientific method is now accepted as the main form of obtaining knowledge, paradoxically the outcome is often the realization that there is no simple or defensible answer- particularly in the realm of, say, macro-economics.

It was once thought possible for a human being to master the sum of human knowledge. Anyone who believes that now would be considered delusional, and no matter how learned or intelligent an individual is, his or her level of understanding of the world beyond a relatively narrow scope is going to be limited, and further hampered by the mind’s tendency to be irrational. We do not quite stumble around blindly, but believing that we clearly “know the answer” rarely ends well.

And, as Professor Cowen emphasizes, while being suitably skeptical, we also need to believe in something, because otherwise there is no order, and society cannot function in a way that improves the human condition; which, even if one is a libertarian, is rationally the goal of any civilized society. Selfish nihilism does not really have a good track record. Of course, economists do have a tendency to believe that “satisfying people’s preferences” is the fundamental value; but, again, that rather ignores the fact that individuals generally recognize that achieving their own goals requires the cooperation of others, unless one wishes to be the ascetic at the top of the pillar who deliberately rejects society and its constraints. A pluralistic, collaborative approach, while often messy, is, in reality, a necessary condition for most complex societies to function and develop.

Perhaps controversially (given recent experiences with neo-liberalism), Professor Cowen states that Ayn Rand best understood how the combination of capital, labour and natural resources, driven by the creative individual mind, underpin whatever our civilization has achieved. After all, for millennia before the first Industrial Revolution, the rate of economic growth in most societies was so slow (and unequally distributed”) that Hobbes’ characterization of most individual’s lives as “solitary, poor, nasty, brutish and short” was rather too accurate.

So, there is a constant tension between the fact that truly exceptional individuals do make a difference to the development and success of a society and the reality that robust societies are pluralistic, rather than monomaniacal. “Great Leaps Forward” have the habit of killing rather a lot of humanity. Value is only truly created by the complex interaction of, as Professor Cowen says “systems, networks, norms [and] policies, not the psychoses of one individual.

At Awbury, as well as always seeking to remain in the forefront of developing actionable intellectual property and creating value for our clients, partners and ourselves, we also recognize that cooperation and the proper alignment of interests are fundamental to our success.

We’re rather stubborn about that.

The Awbury Team


A Chinese Puzzle- something has to give…

While the state of the relationship between the US and the PRC, is undoubtedly the single most important bilateral relationship in the world, and the subject of much heated rhetoric about trade balances, currency manipulation and protectionism, even if the recent meeting between their respective leaders avoided such controversy, it is worth bearing in mind that the Middle Kingdom’s geopolitical stance and economic health matter far more broadly.

In this post, we shall focus on economics and finance. To say that the signals are “mixed” is an understatement.

On the one hand, firms such as Morgan Stanley have recently argued that the PRC will escape the notorious “middle income trap” to join the likes of South Korea and Japan as a high income economy. On the other, concerns exist that a combination of trade protectionism and demographics will thwart a necessary shift from an export-led to a domestic consumption-based economy if the PRC is to continue to increase its GDP at anything remotely resembling current levels. Add in the fact that economic statistics on the PRC’s economy and the health of its financial system are somewhat “opaque”, to be polite, and one has the makings of an unexpected systemic shock which would undoubtedly transmit to the wider global economy and financial system.

However, the FT’s Martin Wolf (“Chinese finance is storing up trouble for the rest of the world”) has recently made the case that the current emphasis on trade is missing the point. Rather than worrying so much about current account deficits or surpluses and trade flows, one should pay attention to the PRC’s capital account and the pressures building within the domestic financial system. While the precise levels disclosed may be “fudged”, there seems to be little doubt that the level of debt (at least 250% of GDP) and its above-trend rate of growth, when coupled with uncertainty about the quality of assets and a potential “Ponzi scheme” within the “wealth management products” sector of an unstable and poorly-controlled shadow banking system are factors that point to real fragility.

Yet, because the PRC still imposes capital controls (and has recently attempted to tighten them) in the face of a domestic savings rate that far outpaces the domestic economy’s ability to absorb it, there is a real imbalance within its economy in terms of capital being allocated into productive investments, versus being “wasted”, and constant pressure to export capital somehow.

So, the question arises as to how the PRC’s government (which is notoriously sensitive about maintaining “stability”, and whose legitimacy depends upon delivering ever-rising living standards) will handle the rising internal pressures to invest outside the country in ways that are not masked and distorted by the current need to circumvent exchange controls, or obtain bureaucratic approvals. The fall in reported foreign exchange reserves by USD 1TN (sic) between mid-2014 and early 2017 is a signal of such tensions.

In reality, the PRC’s government faces a dilemma, because if it continues to impose capital controls, while trying to curb excessive credit, it risks its much-vaunted ability to “manage” growth potentially being compromised, with all the adverse political consequences that entails; whereas, if it relaxes those controls it risks destabilizing its already fragile financial system, while also transmitting that fragility (because of its scale) to the wider global financial system. In short, failing to integrate risks internal stability, while allowing more integration not only risks internal stability, but also that of the wider world.

Such issues require careful and calibrated management, not soundbites or rhetoric “for domestic consumption”- whether in the PRC or the US.

At Awbury, we believe that, while there are significant opportunities in carefully-selected risks in the PRC and Asia as a whole, accepting them without understanding the wider context and the real macroeconomic and geopolitical factors that have longer term consequences is simply foolish.

The Awbury Team