Wednesday, January 27, 2010

My #1 Black Swan In 2010

While the whole black swan thing sounds interesting, how are we to make a conscious effort to incorporate it into our analysis? Let's look again at Taleb's thesis:
... the existence and occurrence of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations. Taleb regards almost all major scientific discoveries, historical events, and artistic accomplishments as "black swans"—undirected and unpredicted. He gives the rise of the Internet, the personal computer, World War 1, and the September 11 2001 attacks as examples of Black Swan Events. To a large extent, the subprime crisis is another prime example of a Black Swan.

"What we call here a Black Swan (and capitalize it) is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable. I stop and summarize the triplet: rarity, extreme impact, and retrospective (though not prospective) predictability. A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives."

Taleb contends that banks and trading firms are very vulnerable to hazardous Black Swan Events and are exposed to losses beyond that predicted by their defective models.

Taleb's Ten Principles for a Black Swan Robust World

Taleb enumerates ten principles for building systems that are robust to Black Swan Events (my comments in brackets):

  1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. (We cannot allow financial firms to get so big that they cannot be allowed to collapse on its own. We cannot allow a domino effect owing to firms getting too big. Big financial firms need to be broken down into smaller units. In that respect, Obama is taking a leaf from Taleb's book by trying to reform some of the banking practices - consumer banking to be separated from investment banking. IBs to have a strict guideline on leverage to be used for proprietary trading and deal management.)
  2. No socialisation of losses and privatisation of gain. (US banks, insurance firms and automakers are prime examples of this. Malaysia and many other nations have been guilty of this as well. If companies were badly managed, they should be allowed to fail.)
  3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. (The funny part was Taleb putting in the phrase "and crashed it", because if a person drove a bus blindfolded and did not crash it, that person must have very special abilities and hence can be trusted to further drive buses. This rule of thumb points to decision makers who have acted recklessly, e.g. CEOs of many mortgage companies; the rating agencies; even Greenspan ... to be never considered for a similar position. In Malaysia, so many CEOs have proven themselves to be inept, thankfully most were not reckless, but still we need to be more vigilant to engage suitable performers and not to always give greenhorns a go at the top job without a good track record managing smaller units.)
  4. Do not let someone making an "incentive" bonus manage a nuclear plant – or your financial risks. (This one is key. We always give incentivised bonuses to managers based on profits or ROE. Take the investment bankers, their bonuses are linked directly to profits generated, and not accounting for the amount of risk and/or leverage deployed. I give you an even better example, which financial firm in the US had the best ROE in 2007 .... you'd never guess it, its Lehman Brothers. We have to rethink how we reward employees, not just in profits generated but also on "safety measures" i.e. no time bombs being created - hence we should include a hefty penalty on cost of capital and leverage deployed on profits generated, plus I would want bonuses tied more closely to "net margins improvements" and staff turnover ratio.)
  5. Counter-balance complexity with simplicity.
  6. Do not give children sticks of dynamite, even if they come with a warning. (Many local councils, even government bodies have been left holding lots of derivative contracts which puts their firms at a very high risk, without a proper assessment of the gravity of the exposure. Even firms like Citic got trashed. More regulations should be put in place on the kind of contracts companies can enter into, maybe some firms should never be allowed to even enter into any new fangled instruments unless board approval has been obtained. Accounting rules should have more detailed reporting standards enforced on all companies who have entered into these derivative contracts, so that investors can better assessed the risks.)
  7. Only Ponzi schemes should depend on confidence. Governments should never need to "restore confidence". (This one, I do not agree with Taleb. When consumer confidence is dented to a pulp, we need to have the "spender of last resort" come in to keep the velocity of money going. Confidence is a huge thing, the lack of it translate to risk-aversion. Governments and regulating bodies are not there to always maintain a bullish market, but they are there to ensure that things do not get whacked to both extremes of the pendulum. You have to restore confidence when things got so hairy following the subprime crisis, if not, the social cost could be too enormous to recover from.)
  8. Do not give an addict more drugs if he has withdrawal pains. (Taleb must be quite against the amount of bailout funding given to firms. I do agree certain firms have gotten too big to fail but there were many that should be allowed to fail.)
  9. Citizens should not depend on financial assets or fallible "expert" advice for their retirement.
  10. Make an omelette with the broken eggs.
So, what's my #1 Black Swan so far for 2010? I have a few, but I will share with you the one on the top of my list. Japanese yen may go in for a huge devaluation in 2010. During the risk aversion period, many people flocked to the yen currency. Seriously, for an economy still grappling with the excesses of the late 80s and early 90s, and going into a deflationary mode, you don't need a strong currency.

Why is this a black swan? Most people assume that Japan should not have a strong currency. Its zero interest rate policy has not been working but most will assume that it may go back from 90 to 100 at the most vis-a-vis the USD. The biggest catalyst has to be the mega government deficit that Japan has. Japan being Japan is doing tai-chi on that issue. The tons of fiscal stimulus pumping over the last few years have not budge the economy. The budget deficit is unsustainable.

S&P: The outlook on Japan was revised to negative on diminishing economic policy flexibility, and ratings were affirmed at AA/A-1+. At a forecasted 100% of GDP at fiscal year end March 31, 2010, Japan’s net general government debt burden is among the highest for rated sovereigns. The ratio of gross government financial debt to GDP is already around 170% on a general government basis (i.e. central and local government and social security funds) and is the highest by far among developed countries (OECD average was 75% in 2007). Moreover, the policies of the new Democratic Party of Japan (DPJ) government point to a slower pace of fiscal consolidation than previously expected. Combined with other social policies that are not likely to raise medium-term trend growth and with persistent deflationary pressures, Japan’s net general government debt-to-GDP ratio may peak at 115% of GDP over the next several years.

Many think that the yen carry trade is done by big hedge funds, but there are a substantial number of Japanese individuals who have borrowed in yen to invest overseas. A weaker yen will reverse that trend.

The key here is many think Japan's fiscal deterioration is a given but also note that Japan has a AA long term rating. A catalyst could come from a few rating agencies downgrading Japan, or Bank of Japan engineering (or allowing) the yen to fall. A major catalyst should be if/when they decide to make a landmark decision on how to tackle their outstanding debt. Its a time bomb because the yen's un-natural strength is largely due to the subprime mess but is dragging Japan into a recession if its allowed to continue. The shock could be exogenous (e.g., a rating agency putting a major AAA-rated country on negative watch) or endogenous (e.g., failure to match supply and demand on a major sovereign issuance). These fears actually emerged on several occasions in 2009, but were not amplified by massive sell-offs as occurred in 1994, despite far higher volatility this time around. The actual catalyst may not even have to come in a downgrade of Japan's ratings, it could be triggered by a major downgrade of another country's sovereign rating.

In 2009, downgrades and debt auction failures in countries like the UK, Greece, Ireland and Spain were reminders that advanced economies are not immune to being reprimanded for "poor fiscal fundamentals This year, the "pervasive negative big issues" should be: a weak economic recovery and an aging population, translating to a focus on the increase of the debt burden of many advanced economies, including the U.S., UK, Japan and several eurozone countries.

The weaker yen should happen because Japan does not have foreign currency debt, and the "devaluation" would not hinder their debt absolute value. Key implication of all estimates of Japan's debt is that without increasing the national tax burden (i.e., tax and social security costs)—which is relatively low compared to other major countries—it is impossible to sustain public finances. Unfortunately, raising taxes would curb already weak domestic demand.

Wafer-thin interest rates make it cheap to issue bonds, but the Japanese have decreasing incentive to invest in Japanese government bonds. If Japan must start selling more debt to the foreign market, interest rates may rise to attract any investors. If the market demands an interest rate of anything more than 3.5% then Japan will not have the [tax] revenue to service its debt. Even without a weak economy, Japan's debt numbers are set to get worse because of its aging population and underfunded public pension fund.

Not all black swans are negative events, and in this case, I think the yen can go back to 120 level, literally overnight. When that happens, we will have a chain reaction:
- Japanese stock markets will boom as exporters benefit immediately and companies can be a lot more competitive
- A sharp rise in FDI both short and long term into all types of Japanese assets
- Many Japanese exporters have come to terms with the strong yen over the last 10 years by expanding overseas. The net effect of this yen weakness will reverse the trend and cause more Japanese companies to reinvest in Japanese operations and manufacturing
- BOJ will start to raise interest rates, which will be a good thing really all around
- Exporters in same competitive categories in other countries could see a temporary sell down in their shares

p/s photos: Angelababy

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