Black swans and grey rhinos

John Abernethy
John Abernethy
Director
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As equity markets currently rise, they do so into a resounding chorus of concerns and perceived risks.

The consideration of risks and concerns is legitimate when investing. No one should invest without understanding the risks involved. Then having considered the risks the investment decision should be based on the potential return. Simply stated, Does the potential return justify the risk?

In most cases, an investor will have a number of investments which have different risk profiles. It is the expansion of the number and type of investment (diversification) that offsets the risks of (individual) investments underperforming or going wrong.

Warren Buffett on risk and volatility:
"We regard volatility as a measure of risk to be nuts. And the reason it's used is because the people that are teaching want to talk about risk. And the truth is, they don't know how to measure it in business. I mean, that would be part of our course on how to value a business. It would also be, how risky is the business? And we think about that in terms of every business we buy. And risk with us relates to -- Well, it relates to several possibilities. One is the risk of permanent capital loss. And then the other risk is just an inadequate return on the kind of capital we put in. It does not relate to volatility at all."

Warren Buffett, oracle of Omaha

Source: CEO Magazine

The definition and the calculation of risk involve both qualitative and quantitative analysis. For instance, we know equities are higher risk than say, term deposits (quantitative analysis), but the calculation of the risk presented by individual sectors on the sharemarket is based on both quantitative and qualitative analysis (maybe 50:50). When we delve into individual company analysis, then more qualitative analysis is required and particularly in defining valuation and therefore the likely return.

This introduction takes us to the consideration of big risk and big trends.

Clearly, the bigger risks are those that come out “of the blue” and therefore exhibit a significant surprise factor. They are called “black swan” events, a term popularised by  Nassim Nicholas Taleb, and generally defined as an extremely negative event or occurrence that is impossibly difficult to predict. The central idea that Taleb articulated in his book, The Black Swan, is that rare events cannot be accurately estimated from empirical observation since they are rare.

The onset of COVID-19 is now recognised as a “black swan” event (although some might argue that it was “an accident waiting to happen” and many (including Bill Gates) had warned of the dangers of global pandemic years ago. It is our view that this black swan event led to “black swan” responses (so to speak). Whilst the COVID-19 pandemic was a shock, the responses, both fiscal and monetary, were not.

Our point is this. Whilst “black swan” events potentially range from being catastrophic to simply serious, we are concerned with the question, What are the possible responses of global organisations, governments, central banks, bureaucrats and regulators? 

With COVID-19, the responses have, in the main, been huge (apart from a few countries like Brazil, where the risks have been consistently underplayed by President Jair Bolsonaro) and we can observe that the responses (fiscal, monetary and regulatory) have moved the world economy back into a strong economic growth cycle. 

For example, the chart below shows the enormous fiscal response being undertaken by the new US Biden Administration. By mid-March 2021, the US fiscal deficit was recorded as US$1 trillion higher than the FY20 deficit. Further, in the FY20 deficit, we see that by June that deficit was US$1.5 trillion higher than any previous deficit.

The fiscal response was and is truly extraordinary (and a marked contrast to the far smaller response to the GFC by the Obama Administration), and investors had to anticipate such a response to avoid panicking and selling at the bottom of the equity market in March 2020. Similarly, an investor (more likely an asset manager) had to avoid panicking into making a strategically ruinous asset allocation decision to weigh heavily into low yielding bonds. 

Hopefully, the above illuminates why the identification of risks and events cannot be superficial. It requires deep analysis and thought on the likely consequential responses of those who have the power to formulate and direct policy. An understanding of history, politics, economics, science, geography and even the cultural “zeitgeist” is often essential in calling market responses right.

Many of the so-called “black swan” events delve into the “grey rhino” category simply because their possibility has been identified. A “grey rhino” event is commonly defined as:

A highly probable, high impact yet neglected threat: kin to both the elephant in the room and the improbable and unforeseeable black swan. Grey rhinos are not random surprises, but occur after a series of warnings and visible evidence.

A deeply unfortunate grey rhino event is currently unfolding in India. As COVID-19 takes hold in the subcontinent, it does so as a highly likely event given the onset of COVID-19 around the world. With 1.38 billion people, extensive poverty and crowding in urban slums, poor medical infrastructure and governed under a democratic system, the risk of a catastrophic event were high.

Across in China with 1.44 billion people, with a higher standard of living, fast-developing medical infrastructure and a draconian central administration system, the risk was managed far more aggressively.

The above analysis does not imply admiration for centralised and anti-democratic government in China; it merely illustrates how analysis must be employed to identify consequential risk. Understanding the likely reaction or response of government, access to resources, cultural (including religion, which certainly has played a part in the spread of the virus in India), political and infrastructural limitations, will ultimately drive the outcome. In an investment context it is the prediction of likely consequential outcomes that is tremendously important in determining investment entry and exit points.  

Source: RBA Chart Pack, May 2021

Two big grey rhinos


The two hot topics at present that are widely reported and debated in the press are the risk of inflation and the risk of a China/Western world confrontation.

The risk of inflation is ever-present simply because every western central bank is claiming to be targeting sustained inflation of 2% per annum. They are also targeting a sustaining of this rate (above 2%) for a period (maybe a year or two) before they will be inclined to adjust up cash rates.

In Australia, we have cash rates of just 0.1% and also 3-year bonds with a targeted rate of 0.1%. (In March 2020, the RBA announced a target for the yield on the 3-year Australian Government bond of 0.25%, but then in November 2020, it reduced the target rate to 0.1%.) Today these rates are well below the recorded inflation rates of about 1%.


Our point is this. Interest rate settings across the western world are below the observed inflation rate. Inflation is likely to rise across the world to about 2% in the next few years. It may even go higher for a period; the Fed talks about “transitory inflation”. However, there is no reason to believe that interest rates that today do not at least match inflation (as they did in the past) will suddenly be adjusted upwards to meet a higher inflation rate. Why predict that when the central banks are telling you that it will not happen? It is the consequential action that is more important than the prediction of inflation.


Source: RBA 

Thinking about China and its problematic relationship with the western world (no more so than with Australia), we are increasingly being drawn into the idea that China will invade Taiwan. However, if they did so then China would set off a chain of events that would likely result in major trade sanctions and the real risk of a regional conflict that draws in the US (and therefore quite possibly Australia, Canada and European allies).

The consequences of an invasion of Taiwan (with its 26 million people) would be immense and so the thought is – Why do it? Or more importantly, Is there a better way for China to achieve an outcome for taking over Taiwan without conflict?

The answer to this conundrum possibly lies in an observation of the capacity of the western media (traditional, online and social) to undertake excessive speculation and scare-mongering. Perhaps Xi Jinping’s government is undertaking strategic military manoeuvres designed to create an impression of heightened risk of war, but with the real covert objective of starving Taiwan of western capital and therefore growth.   

So the real decision for the West will be this — does it supply 26 million people with unlimited capital to sustain itself against its neighbour with 1.44 billion people? If the decision is yes, then it will be a government and foreign policy decision rather than a commercial decision and that may not be sustainable. 

A longer-term grey rhino – renewable energy


Projections in this forecast may be somewhat controversial – and should be seen as representing one particular view. Long range forecasts are by their nature highly uncertain and based on assumptions and conjecture.
 
Nevertheless, it is likely we will see a dramatic shift toward renewable energy over the next decade. Particularly in the US and Europe, we are in the early stages of transition to an electrification of the power grid and green energy, and there are strong tailwinds that could drive growth through 2030 and beyond. Environmental concerns, automation and artificial intelligence are all contributing to strong growth in renewables — pushing costs down while boosting productivity and efficiency. Renewable energy has historically been perceived as expensive, impractical and unprofitable — but that is changing rapidly. 
 
The relative decline of oil, gas and coal and the rise of solar and wind will have enormous implications for traditional producers (like Australia) and present serious challenges to politicians and businesses for years to come.

Source: Capital Group, “The World in 2030: Ten Predictions for Long Term Investors”, April 2021

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Clime invests with a quality bias and a strong valuation discipline. Our approach seeks to deliver strong risk-adjusted returns by investing in a portfolio of high-quality Australian companies that are attractively priced, while assuming a lower level of total risk.

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