Newsletter - 2023 Predictions: Results

My name is Max Rudolph. My focus is enterprise risk management, emerging risks and scenario planning. I also do research projects and read quite a bit about financial and historical topics. I try to find examples of history repeating itself through similar cycles. I am a private investor focused on individual stock selection and value investing techniques, stymied recently by the massive subsidization government has provided to the markets.

My process developed through credentials from the Society of Actuaries and CFA Institute, living in Omaha so following Warren Buffett and Charlie Munger. I believe you can reduce risk and increase return simultaneously using contrarian techniques. I believe the pie is ever-growing, that win-win with customers is attainable and should be the goal. I try very hard not to chase yield.

Even before I started posting newsletters and predictions, I have tried to alert others to emerging risks. In 1999 it was solvency risk for life insurers due to a fall in interest rates below guarantees. In 2004 it was about pandemics and their likely shocks to the economy. In 2005 I expressed concern about growth in account value driven products backed by RMBS securities and reduced exposure to both. In 2015 I wrote again about interest rate scenarios (both directions), and in 2019 I wrote about low growth scenarios. In 2023 I expect to release a paper about the drivers of economic growth.

Results: In November I released Demographics and Productivity: Drivers of Economic Growth https://www.soa.org/resources/research-reports/2023/demographics-productivity-drivers-econgrowth/ .

Recent interests include complexity theory, behavioral economics, resiliency and climate change. I occasionally tweet @maxrudolph. I am an adjunct professor teaching online graduate level investment and risk courses at Creighton University. Results: I have 25 scheduled in January 2024 to take the Intro to ERM Foundations course I developed.

?Each January I post my predictions for the year. These are not predictions in the classic sense. Treat them more like scenarios that you should build resilience against to survive over the long term.

?Late in the year I review and compare results against what actually happened. These documents are released publicly on my LinkedIn and twitter pages.

?Disclosure - please remember that these predictions are for fun and to encourage deeper thinking across topics, their interactions and long time horizons. If I really knew what was going to happen, I would not share that information with you! My writing is meant to be educational in nature and does not constitute investment advice. You must make your own personal investment and risk decisions, considering your unique financial circumstances, and not hold others (especially me) responsible for your own financial planning or lack thereof. If you don’t accept these conditions, you should stop reading now. Keep in mind that this is NOT investment advice. For those still with me, Enjoy!

Predictions for 2023

We are now half way to the next US Presidential election, transitioning from a period where Democrats held the Presidency and both chambers of Congress (slim majority in the Senate) to one where the Republicans now hold a slim majority in the House. The Supreme Court is moving away from the public’s wishes – how long will that last? The pandemic is more active than many want to acknowledge and long COVID is becoming of greater concern. We’ll know more about how long it will last as China emerges from its headstrong path out of lockdown. The IRA legislation will make progress against climate change but events will continue to increase globally. The full story of crypto, when it finally emerges, will confirm my choice to stay away. Either supply chains have been rebuilt in remarkable time or food insecurity will arrive to spark regional conflict.

Results: Lots to unpack here but generally was right. China had a surge of cases but, surprisingly to me, did not create new variations of the virus. The US Congress is an embarrassment. Biden’s tenure is better than I expected but his PR is poor. Bitcoin has more than doubled in 2023 but the Sam Bankman-Fried trial showed how disjointed the crypto space remains. It makes me wonder if the recent spike is due to money laundering challenges following the Hamas attacks. There is still a vacuum of adults in the room at the highest levels of government and the Supreme Court’s credibility is now at risk. The “Originalists” don’t make any sense to me. Why would we want to act as if we were in 1790? We’re not. While we continue to build out sustainable energy options but grow our use of energy even faster. The need for massive amounts of energy by artificial intelligence is not being discussed, and should be. Same with the increase in carbon dioxide due to the wars in Ukraine and Israel/Gaza. With the onset of an El Nino event the next year or two is going to be filled with extreme weather events.

?Inflation is likely to be driven higher by wages, leading to a technological revolution involving artificial intelligence that replaces many menial jobs previously held by immigrants. Government and corporate debt becomes a cash flow issue as interest rates bounce off zero. The next move for the markets will reflect lower earnings and a lack of ownership in government. There is no adult in the room.

Results: generally right, but the narrow rally continues. The magnificent 7 continue to dominate the other 493 in the S&P500 index. Inflation is lower while government debt continues to increase at very fast rates. GDP was up but due to government spending – how does this generate investment to drive future growth?

General happenings

Elected leaders have abdicated their responsibility of the economy to central banks in order to garner votes through increased spending and debt levels. The financial markets continue to move toward a major correction at least as large as that seen in 2022. There is a risk of currency default, but only if Germany or the UK show leadership. If the Velocity of money starts to increase that is a bad sign and will confirm that Modern Monetary Theory (MMT) is not the answer. Joe Biden is now a lame duck despite his performance above expectations so far. Results: now hearing a term for loose fiscal policy when monetary policy is trying to tighten – fiscal dominance. VM has started to increase, now at 1.326 from a low of 1.128 in 2020.

?I tend to think farther out on the time horizon than most, and I see scenarios that scare me. One where bullies with guns (including in the US) take what they want, destroying the economy and civilization as we know it (think Mad Max). The Fourth Turning, published in 1997, shows additional signs of its appearance each year. I eagerly await Neil Howe’s new book, due out in July 2023, that is expected to extend these findings to current time. Results: The Fourth Turning is Here was released but I have not read it. Several interviews with Neil Howe provided good background. I want him to address what happens if we “lose” the war that he anticipates. The minimal number of data points he uses could be survivor bias, especially is we move away from the rights of property ownership.

?Climate change will continue to be the most important topic of this century. Attribution science is being used to publicize the impact on extreme weather events. Engineering solutions will become more common, but disinformation continues to convince the uninformed. Results: attribution is being done for more weather events, and quicker. The story is more nuanced than people realize. Geoengineering solutions are being used to greenwash, often with more spent on PR than on the engineering. Transparency and independent review are needed.

?There are many years where I see similarities to our current situation.

• 1938 leading up to war, 4th Turning
• 1973 nifty 50, many years of guns and butter set the table for stagflation
• 1890s gilded age, bribe politicians to get what you want
• 1859 prelude to civil war – scariest of the comparisons, 4th Turning
• 1929 melt-up before collapse
• 1921 leaving pandemic but otherwise very different – interesting comparison

?Quantitative tightening (QT) has begun. How long before the economy stalls due to demographics and climate change? One fear is that the Fed pivots back to easing, leading to currency devaluation and losing reserve currency status. Combined with war supplies being used in Ukraine and not replenished, the US is at risk of adversaries providing additional stresses in multiple locations including Taiwan, Iran and eastern Europe. South America will start to improve economically (Biden success story?) and will reduce pressure on immigration. Results: in honor of Charlie Munger, we need to invert the question and ask what we can do to keep immigrants in their home country? Where we have imposed tariffs, people want to leave so they can provide for their families. The process of sourcing away from Asia and toward the Americas should be good for the people in this hemisphere. Simple measures can and should be taken that will relieve the pressure on the southern border.

?Good advice today remains to reduce debt wherever possible, in personal loans and in the companies they buy. Relaxed loan covenants are a problem and floating rate debt issued to zombie companies has now come due. Anything collateralized or issued by shadow banks like private equity (especially with embedded capital calls) should be avoided in asset classes. Keep it simple at this late point in the cycle. Understand what you are buying. Buy dividend producing assets, but don’t be greedy. Don’t use leverage (including derivatives unless they are a true hedge). Don’t be the sucker at the table. If passive investment strategies beat active strategies during times of expansion, they will underperform during a tightening period. Expect defaults to rise, especially on new asset classes that have enjoyed a honeymoon period over the last 10 years. Results: the number of originators of leveraged loans and other shadow bank high yield offerings has ballooned, typically a sign of excess.

?Regional conflicts will increase in this decade, with a broader war possible. The methods of war are evolving, with anti-tank weapons and star link satellites changing the rules. It is very important to have strong leadership. Perhaps, like Abraham Lincoln and Franklin Roosevelt did in the past, someone will grow into the role. It’s important that our leaders be good people or this will become a problem for the country. Resources and their shortages in certain regions will drive regional conflict. Fresh water in the Himalayas and Alps, rare earths and the lack of fossil fuels in China will all be points of contention. Climatic events are happening more often, with mitigation and repair costs taking money away from real solutions. Results: the Israeli/Gaza conflict has simmered for so long we started to ignore it. No longer. Other potential conflicts will heat up as peacekeepers are kept busy. Drones, both inexpensive off-the-shelf and complex and expensive, are playing a large role in the Ukraine conflict and redefining the concept of war.

?Spillover diseases, whether they are from COVID mutations, Ebola or permafrost melting are all scenarios to be concerned about. These risks move with great velocity.

?Melting ice in the Arctic forces a feedback loop tied to the albedo effect. Light ice that reflects is replaced by open ocean that absorbs radiation. The permafrost contains frozen and captured methane that is not modeled in the current IPCC scenarios. As the permafrost melts it releases methane, sometimes exploding and creating sinkholes or lakes. Of greater concern is the methane that is in gaseous form below the permafrost. Like a burst dam this could trigger a global catastrophe. These are feedback loops, so more melting leads to more GHG, which leads to more melting…

?The political climate in the US and abroad continues to be at a crossroads. I hope Churchill was right that we will do the right thing after exhausting all the other options. I worry about violence against people who believe in the rule of law and property rights – it seems like whoever has the most lawyers wins today. All it takes is a rumor and someone being in the wrong place at the wrong time to trigger a deadly event (or more). The early efforts in the House resemble Keystone Cops skits, making the debt ceiling likely the most important legislative battle of the year.

?Outlier (Qualitative) Scenarios

Here are some outlier scenarios I think are more likely to happen than consensus in the next several years (some may not happen for a decade or more). Due to the long-term nature of these scenarios, in some years this list might not change or only slightly be tweaked. Examples focus on the US but these are worldwide risks.

• Cyber-terrorism or physical attack impacts the banking system or shuts down the power grid – concerns that a sovereign nation will attack
• Space junk knocks out a satellite used for public communications or military – star link adds potential resiliency
• Microplastics create die-off of food source or human mortality/morbidity https://www.actrisk.com/newsletter-category/quarter-4-2022/ Results: birds that live on oceans for most of their life are susceptible, especially chicks.
• Alternating atmospheric rivers and drought create havoc on west coast – seems more likely as jet stream weakens. Results: some California reservoirs are now full, but Lake Pow4ell and Lake Mead continue to concern with low levels on the other side of the mountains.
• A severe earthquake (or volcanic eruption) hits California, St. Louis or Seattle Results: new article https://www.actrisk.com/newsletter-category/quarter-2-2023/
• Super-volcano becomes active somewhere in the world (e.g., Yellowstone) or Ring of Fire becomes active around the Pacific https://www.actrisk.com/newsletter-category/quarter-3-2022/
• Magnetic poles switch between north and south: longer time horizon
• Carrington event knocks out electronics on a wide scale with an EMP (naturally occurring electromagnetic pulse, likely due to a solar storm) https://www.actrisk.com/newsletter-category/quarter-2-2022/
• Fracking is declared illegal due to environmental and health impact – changes Middle Eastern balance and currency value
• China erupts in civil war or regional conflict with a neighbor over resources – likely fresh water, carbon-based energy or sea-going route Results: poor demographics, commercial real estate foreclosures and high debt are forcing the issue in China.
• Democracy loses its hold on America – elected officials leave only after a coup or assassination. Results: we seem to inexplicably be moving in this direction.
• Eurozone breaks apart – could be north/south, poor countries/rich countries or just kicking out individual members (beyond Brexit); impacts reserve currency discussion if Germany leave the EU
• US business opportunities are used to lessen the southern migration border issue
• A spillover virus develops drug/vaccine resistance and is transmissible by air – COVID plus. Alternatively, a once controlled disease (e.g., polio) becomes common again as vaccine avoidance takes hold. Results: Measles outbreaks are increasing and severe COVID-19 cases are predominately found among the unvaccinated (95% of children).
• Antibiotics fail to work against a common bacterial infection – soccer moms create bubbles around their kids (antimicrobial resistance) https://www.actrisk.com/newsletter-category/quarter-1-2022/
• Iran encourages regional conflict and becomes the Middle East’s consolidating superpower against Saudi Arabia
• Water resources trigger a regional conflict
• S&P500 down 20-30% from YE22, combined with double recent bond defaults and real estate collapse in large coastal cities.
• GDP down for 3 consecutive years.
• Climate change leads south Florida to become unlivable due to heat and sea level rise (also true in other locations, e.g., Bangladesh, Mediterranean). Results: Climate migration plans need to be developed. https://www.actrisk.com/newsletter-category/quarter-3-2023/ Mortgages beyond 10 years in coastal cities should be avoided.
• Loss of insect biodiversity leads to unanticipated consequences and food insecurity
• Risk managers should seek out other activities with unanticipated consequences – learn about higher order thinking and complex adaptive systems

?While I tweaked some of these, there were no major additions.

?These predictions were made in January 2023.

• Politics and currency wars: Prediction – The next few years will be difficult economically. The financial stimulative system (at least for monetary policy) needs to clear, and a recession or worse is the likely result. The risk is supply chain inflation and earning shortfalls. Investors should reduce margin and invest in companies with low debt. Cyber-attacks will evolve after a poor showing in the Ukraine war. In the US a moderate third party could emerge behind a charismatic leader. The Republicans must show they can address economic issues successfully or run the risk of doing poorly in the 2024 election. Result: the banking crisis in spring 2023 forced a break from tightening monetary policy, delaying a recession. The Republicans have added social issues to their headwinds for 2024 after Roe v. Wade was overturned.
• Geopolitical: China has passed peak power and will be stressed as their economy slows and population shrinks and ages. They have used debt poorly. We are moving toward a regime of regional trade pacts. When communities don’t interact there is greater tension and little opportunity for release, making conflict more likely.
• Stocks and general economic conditions: Levels of many stocks need to fall, likely as stimulus is unwound. I continue to avoid bonds except Treasuries and iBonds. Both extremes should be part of stress tests, high inflation due to debt and deflation due to demographics. As I get close to retirement it is a scary situation as our greatest risk is one we have no control over, devaluation/default of the dollar. I like dividend stocks (not crazy high yields) and companies using cost-plus pricing (e.g., defense contractors, utilities) but they have high valuations. I dislike (and vote against) board members over age 67, with past connections to disgraced companies like Enron or their facilitator consultants, and those who don’t own more shares in the company than I do (and proxy shares don’t count – they are not aligned with my interests). Results: I have added CDs to the mix with a 2 year ladder, making sure to monitor FDIC exposure limits. I have more in money market funds than I would like but it’s hard to argue with returns over 5% that are non-callable.
• Unemployment: Women have lost years’ worth of gains as they took ownership of child care during the pandemic. Older workers have retired and their skill sets deteriorated quickly. They can’t go back to the same jobs they had. We need to develop ways for the gig economy to encourage movement between jobs – today loss of seniority, mortgage and health care are road blocks. Perhaps we will move to portable defined benefit pensions, where the firm or individual pays into an annuity payable at retirement. Many service workers have multiple jobs – the unemployment rate may need to be interpreted before making policy. Results: I’ll be looking at a personal health insurance policy soon so will likely have something to say about coordinating with investments soon.
• Residential home market: lack of supply, home inflation and mortgage rates are making it hard for young adults to buy their first house. A recession will lower both. Apartments are being overbuilt. Will the new ones be young family friendly with parks or be repurposed since there is too much supply?
• Oil: WTI oil at the end of 2022 was about $80 per barrel, after a volatile year. I have no ability to predict the price of oil, but expect it to be driven by the impact of war/sanctions. Don’t forget that it is tied closely to currency risk. Results: stable oil prices continue to confound me. US supply increases are helping to offset problems elsewhere but it still seems like the price should be higher.
• Credit risk: I worry about collateralized assets and debt issued by shadow banks like private equity, with potential spillover effects as capital calls, margin calls and redemptions are met by selling quality assets. Results: everyone from the NAIC to IMF to rating agencies are writing papers that focus on private equity risk in the insurance space. Traders and optimizers love rules-based regulatory regimes.
• Currency/Inflation/Interest rates: IF a country adopts a realistic monetary policy, their currency will strengthen against the dollar. Germany is a candidate if they leave the EU or possibly the UK. In the meantime, it’s hard to predict currencies. In the long run demographics are destiny. We should be encouraging development of an immigration plan, welcoming those forced from their homelands. Aging populations need service workers that are typically immigrants.
• Fed policy: unwinding the last 15 years of stimulus is going to be hard so buckle up.
• Tax policy: There is growing pressure to address inequality, but no one sees taxes as part of the solution. The cap should be taken off Social Security contributions (ee/er). This would help collect taxes by focusing only on those with high salaries. This will improve inequality as companies also pay the tax and will have incentives to reduce CEO pay.

Emerging Risks – Concerns

• Infectious disease – Increased resistance to antibiotics (e.g., tuberculosis, staph infections or pneumonia), coronaviruses, influenza, Ebola (and similar spillover diseases), and avian flu types that are transmissible by air are all a concern, as would be variants that impact younger ages (also watch disability for virus long haulers). Permafrost melting may hold additional bacteria and virus surprises. Vector (often mosquito) borne diseases are moving north and west in the US as areas further north remain free of frost and allow insects to survive winter. The holiday cold snap across the Midwest may have slowed progress in 2023. China’s rapid unlocking is likely to create new variants, and some could be more lethal. I still think the ultimate COVID result is as the common cold, but it is taking multiple years to get there and am surprised that none of the prognosticators consider this. After all, previous pandemics didn’t last longer than 2-3 years. China hopefully is its last hurrah as a higher percentage of those alive will have immunity from the virus or vaccine.
• Global warming – unexpected side effects from instability like new viral/bacterial attacks, coastal flooding, wildfire/flooding, record cold and heat, more concentrated coastal storms at unusual times of year, stronger and more frequent convective storms, snow bombs, shifting weather patterns that impact farming through changes to the jet stream, shrinking Arctic ice flow. Farming is getting harder every year and food security is at risk. In many places drought is intensifying and lasting longer between breaks or alternates with flooding. A melting Greenland ice sheet adds fresh water to the Gulf Stream, decreasing salinity and keeping the water from sinking as part of the conveyer belt so important to warming northern Europe. Genetically modified foods may be the only thing that adapts quickly enough. We’ll continue to see extinctions as conditions change too quickly for most species to adapt. Accessibility of insurance and premium levels can provide incentives to mitigate risks.
• Misinformation – if someone is cherry picking dates to make a point ask them to produce a historical chart with the data. It appears that the 1998 peak El Nino year is being repeated based on 2016. A picture tells a thousand words.

• Scenarios should be developed for the impact of a super volcano event. Local impacts will combine with global food insecurity as crops fail for multiple years.
• Earthquakes, storms and drought – the US is overdue for a major quake on the west coast and areas not normally thought of for seismic activity due to long dormant periods (e.g., Seattle, St. Louis, New York City) are well into their cycle. Will the west coast risk increase with the arrival of atmospheric rivers? There is no longer a season when wildfires are not common in areas such as California and Australia, and other regions in the US are also at risk due to the pine beetle infestation. The weak jet stream leads to hurricanes and lesser storms sitting over a single spot and inundating it while it is dry just a short distance away, along with pulling cold further south and creating a feedback loop as warm air is sent north.
• Levee failures in California and on major waterways, water poisoning in big cities, cyber hackers, transportation of oil and oil-based products via rail through urban centers (e.g., downtown Chicago) are all regional risks. Drones can be equipped with explosives or could carry a vial of anthrax to a high altitude and released.

• Malthus – he got it nearly right https://www.soa.org/globalassets/assets/files/static-pages/research/opportunities/environmental-essays.pdf Too many people, not enough resources – How do complex systems interact based on changing and fast-moving inputs? We should look at GDP per capita growth, focusing on productivity growth and immigration management. In the long run we are more susceptible to war, famine and disease at current or greater population levels and this interacts with climate change issues.
• Student loans – the courts will decide if debt forgiveness plans are implemented, but economic growth will slow if they are not. Those who served in government have fulfilled their part of the bargain. Those who are in low wage jobs have little chance of paying them back, and stresses will reduce their contributions to society.
• Concentration risk – this will be a hot topic over the next few years. Whether it is power at the top of an organization (moron/hubris risk – I recently watched streaming shows about Theranos and Madoff – two similarities are that they compartmentalized knowledge so only one or two people at the top knew what was really going on), short term liquidity, assets under management, geographic focus or silo risk focus. Too much concentration in too few entities, locations or people is a big risk. The likelihood of a risk blowing up increases with leverage. Identifying concentrated exposures should be a focus during strategic planning efforts for companies and families. Less focus should be put on econometric models and more on simple exposures and their downside impacts. Clustering, where several independent events occur within a short period of time, will drive solvency and bankruptcy. Companies should rank their risk exposures and determine how many events they can survive (comparing to risk appetite).
• Terrorism – in the US, political extremists are active. I am currently worried about both foreign cyber hackers and domestic idiots with guns who think another community has unfair advantages. Disinformation works when people don’t take the time to do their own research – it’s like investors who follow meme stocks (speculators).

Top Actuarial Issues

• Defined benefit plan valuation and de-risking – valuation methods should be revamped to balance each year for both private and public plans. Assumed returns remain much too high. Scenario testing (not just Monte Carlo) should be required. Fiduciary standards should require conservatism in pension assumptions. Bailouts don’t help in the long run because it sets expectations.
• ORSA implementation – ORSA, both required and voluntary, and rating agency views of ERM will become more important following a recession.
• Product design – gross exposure is more important during a crisis, while net exposure (after hedging) drives results in normal times. Dynamic assumptions need to be revisited along with correlated assumptions like interest rates and defaults for floating rate debt. Insurers should avoid systemic risks and focus on risks that follow the law of large numbers where their expertise lies.
• Socioeconomic claims – regulators should allow insurers to collect socioeconomic data from policy holders to determine premium rates. Indirect COVID deaths should be studied using these full data sets.
• Health care – Antivaxxers are leading us toward antibiotic resistant bacteria. We continue to not be prepared for an influenza pandemic despite accurate predictions from 10 years ago of the impact on supply chains and assets. The CDC should include economic experts as part of their pandemic planning team. Results: the longer a virus circulates the more likely it is to evolve in ways that make vaccines ineffective.
• Over-reliance on the normal distribution – life/health actuaries should learn more about power laws as they represent tail distributions better than bell-shaped (normal) distributions.

2017 Predictions

I posted my first annual financial predictions in 2007. Each year I look back five years and share interesting comments I made that seem interesting in hindsight. I have deleted sections but not changed the wording in what remains. In many respects my thoughts are similar today.

?Low rates driven by monetary policy have changed incentives. Central banks, by keeping rates low and following quantitative easing programs, encouraged projects that were short term in nature as well as various financial engineering attempts to grow profit metrics.

?In South America assets are leaving, helping to create a real estate bubble in south Florida.

?El Nino has ended, so the next several years will trend to lower temperatures than 2015-6. This does not mean the earth is not continuing to warm, and individuals should look at the total data set graphically whenever possible. The climate deniers are expert at cherry picking data.

?China’s need for its fleet to have an exit to the Pacific will make it tense in Asia for the immediate future.

Outlier (Qualitative) Scenarios

• A virus develops drug resistance and becomes transmissible by air
• Climate change leads south Florida to become unlivable and becomes a leading indicator for other changes (reduced biodiversity, sea level rise, increased strength of convective storms)

Emerging Risks - Concerns

• I expect the dollar to continue to strengthen against China, Europe and Japan.
• We’ll continue to see extinctions as conditions change too quickly for most species to adapt.

?Hopefully these annual letters look at things from a slightly different perspective than you see from others and make you think. That is my goal.

?Happy New Year!

?Warning and disclaimer: The information provided in this newsletter is the opinion of Max Rudolph and is provided for general information only. It should not be considered investment advice. Information from a variety of sources should be reviewed and considered before decisions are made by the individual investor. My opinions may have already changed, so you don’t want to rely on them. Have fun!