Tag: Macroeconomics

The real risk is the unknowable, not the unknown

Image Source: BBC Wildlife

I was discussing the SVB blowup situation yesterday with one of my friends who manages the public markets portfolio for a large family office. He and I both have deep financial services backgrounds, having worked across diverse services & asset classes (VC, PE, public markets, Investment Banking, debt etc.). Both of us came to the same conclusion regarding what has unfolded:

Given the complexity of financial markets, with many direct & indirect stakeholders, influencers, interconnections, interdependencies, manual & robo decision engines at play, it’s almost impossible for even the smartest operating teams & regulators to stay on top of systemic risks building up across thousands of organizations in our financial system.

Of course, this risk management challenge gets further exacerbated in pure capitalist markets such as the US, that consciously allow free market cycles, driven by excessive greed followed by excessive fear, to play out without much intervention.

Going beyond the macro discourse around SVB, of which there is enough now in the media & on Twitter, I want to highlight one learning that all of us need to pay attention to from this episode – the real risk in most things in life is in the “unknowable”, not the “unknown”.

What does this mean? In most planning exercises we do around risk management both professionally (eg. what’s the sensitivity around my company’s 2023 revenue?) & personally (if I plan to do a startup, how much personal runway do I need to be able to operate without a salary?), we focus mainly on outlining the “unknowns” – variations in outcomes of visible & obvious elements. Things like revenue from existing customers, attrition of top performers, house rent, holiday budgets etc.

Planning for unknowns is largely driven by first-order thinking. This includes the classic sensitivity analysis playbook of (1) listing out all obvious elements of the game, (2) thinking of a range of values for them (best case/ likely case/ worse case) & (3) using these values as inputs to model out various output scenarios that consequently drive the overall decision-making process.

But if most organizations & individuals follow this kind of solid decision-making framework, why is the real-world full of surprising blow-ups – bank runs, hedge fund unravels, fast-growing companies unexpectedly going bankrupt etc.?

It’s because the real world is a complex adaptive system with emotion-driven humans as actors. Michael Mauboussin, legendary analyst, academic & public markets investor, beautifully outlined the qualities of this type of system in his recent conversation with Tim Ferris:

So, “complex” means lots of agents. Those could be neurons in your brain, ants in an ant colony, people in a city, whatever it is. “Adaptive” means that those agents operate with decision rules. They think about how the world works, and so they go out in there and try to do their thing. And as the environment changes, they change their decision rules. So that’s the adaptive part, their decision rules that are attempting to be appropriate for the environment. And then, “system” is the whole is greater than the sum of the parts. It’s very difficult to understand how a system works, an emergent system works, by looking at the underlying components.

Michael Mauboussin

In such a system, while some risks fall under “unknowns”, a majority of them are “unknowable” given the system is self-evolving & therefore, impossible to predict at a granular level. Many words are used to describe these unknowables – edge cases, tail events, black swans etc.

Even if we do get some additional visibility into a few of these probabilistic unknowables & can foresee their 1st-order impact to an extent, their 2nd & 3rd order effects are really hard to model out.

Given this context, classic risk management approaches work well most of the time, until they don’t. And when they don’t, participants are caught unaware, unprepared, & often facing the Risk of Ruin.

So, how can organizations & individuals prepare better to deal with the unknowables? The following steps can help:

  1. Start by recognizing the presence of “unknowables” – a major first step is to acknowledge one’s ignorance, & consciously keep overconfidence bias at bay by reminding oneself that even after all this data & analysis, there is a lot that is just not possible to predict. Approaching risk management with humility & in defense mode creates a conducive mindset for this.

2. Add a significant “Margin of Safety” on top of your analysis – while a rigorous Sensitivity Analysis will cover the unknowns well, adding a Margin of Safety goes a long way in providing a buffer for the unknowables. How much of it you want to add depends on context but given we live in a highly risky world, it should be significant enough. As an example, legendary value investors like Buffet & Munger insist on a 50% Margin of Safety while buying public securities (buying at half of the intrinsic value of a company).

Btw, this isn’t anything new. Engineers who design everything from trains & storage tanks to nuclear reactors & space shuttles, recognize error rates in their assumptions & therefore, always include an “allowance” in their computations. Millions of lives depend on this method!

3. Routinely stress-test & update your assumptions – with software continuing to eat the world at an exponential pace, cycles are becoming shorter & feedback loops quicker. The Fed raised rates from under 0.5% in Mar’22 to ~5% in less than a year! With information transmitted in real-time, especially via networks like Twitter, & decisions manifested at the push of a button, we saw how SVB unraveled in literally a day. Given this speed of change, it’s important to frequently stress-test your state-of-state, accounting for changes in external & internal environments & updating your assumptions (esp. Margin of Safety) accordingly.

While the Treasury, the Fed & FDIC have joined forces to save everyone impacted by this specific SVB case, most of us can’t count on such White Knights bailing out our families or our startups each time. A pragmatic & defensive risk management approach that accounts for unknowables, incorporates a healthy Margin of Safety, & includes periodic stress testing, can help us cope with outlier events & keep us in the game.

Subscribe

to my weekly newsletter where in addition to my long-form posts, I will also share a weekly recap of all my social posts & writings, what I loved to read & watch that week + other useful insights & analysis exclusively for my subscribers.

What is needed to pay the Covid stimulus bill?

More innovation, creativity & business-building, leading to a new wave of growth!! Here’s how it works.

Yesterday, I read an awesome article by Morgan Housel on how the US (or any nation for that matter) is expected to manage trillions of new national debt that is getting created due to this crisis. It traces events back from WW II and has some really interesting insights.

Essentially, national debt is different from the “personal” debt of individuals. The latter have finite career spans and lives; therefore, debt has a repayment end-date. Nations have an infinite life span and can technically remain indebted indefinitely, even with rising debt.

For nations, debt management, not repayment, is the key concern. As long as nominal GDP growth is higher than the budget deficit growth, the debt/GDP ratio will keep doing down. So, the focus becomes “growing out of debt”, not reducing debt.

Here’s how the US managed its WW II debt:

  1. Due to the war, Govt. debt as % of GDP rose from ~20% in 1929 to ~120% in 1946.
  2. Post-war, tax rates were kept high: a) tax as % of GDP rose from ~8% pre-war to ~14% avg. post-war till now, b) top marginal tax rate rose from ~24% pre-war to 80–90% levels post-war for about 20 years.
  3. So, even though spending as % of GDP kept increasing from ~3% levels pre-WW I to ~17% for 80 years post-WW II, debt/ GDP ratio kept falling.

That’s how the war debt effectively got “paid off”, even with high annual fiscal deficits. It never really got repaid in the traditional finance sense, but the US grew out of it by increasing GDP at a faster rate than debt, via unlocking innovation & creativity.

Morgan’s article predicts a high likelihood of tax rates increasing over the coming years, with a simultaneous increase in Govt. spending to drive growth. There is a post-WW II like economic scenario possible where deficit keeps rising but is also accompanied by faster GDP growth.

My Take: $10 trillion+ of stimulus is unavoidable, as is ongoing welfare benefits for the next several quarters, maybe even years. The bet then is — can the US maintain its democratic, innovation & entrepreneurial DNA to unlock the next wave of economic productivity-led growth? If it’s able to do this — GDP growth outpacing debt growth, this COVID debt will again be maintained and eventually outgrown out of, over this generation.

My bet is YES, there is an extremely high likelihood that this will happen. There will be medium-term pain for all of us. And yes, a more equitable redistribution of wealth will be an ongoing policy challenge. But, based on my socio-economic experience as an immigrant and thinking at a fundamental level, I believe that the US is still the most strongly positioned nation globally to unlock the next phase of human ingenuity & creativity for our planet.

A combination of democratic values, civil liberties, technical innovation, entrepreneurship, and access to capital is extremely potent. Besides the US, I don’t see any nation in the world that offers this holistic combination in a compelling way. Even with all its challenges around economic inequality, social divide and a currently-unimpressive political landscape, over the long term, I expect the US to emerge stronger from this crisis.

Geo-economic themes for 2019 & beyond

Recently, I came across two talks by Ruchir Sharma (Head of Emerging Markets and Chief Global Strategist at Morgan Stanley), where he outlined some key geo-economic themes for 2019 & the upcoming decade (Asia Society, NDTV). While I am a big Nassim Nicholas Taleb fan and as a result, don’t care much for macro-predictions or extrapolations by economists, I do like to follow Ruchir’s work mainly because: 1) he presents really interesting data sets, which I can use to draw my own conclusions/ implications, and 2) he is someone who deeply covers both the East and the West. I do think it’s important for both founders and early-stage investors to at least keep an eye on global geo-politico-economic themes as they do impact tech businesses over the long term.

Here are the top 10 themes as presented by Ruchir. I find the supporting datasets particularly fascinating and therefore, have included their snapshots from the NDTV video. Am also including ‘MY TAKE’ for each theme, at least wherever I have a strong view.

  1. Peak America — Is America’s Decade Coming to an End?

This decade has clearly been America’s — as per Ruchir, while the US economy is ~25% of global GDP, its stock market cap is ~55% of global stock market value. Over last decade, while most major stock markets globally have given flat or minimal returns, the US stock market has tripled in value and is at a 100 year high compared to rest of the world.

Interestingly, Ruchir has identified a trend wherein every decade has some sort of a global economic theme that dominates investor interest. However, that theme never gets repeated in the following decade. As per his analysis, the US has ‘peaked’ in both economic and financial terms, and therefore, could see a slowdown starting 2019 and spilling over to the next decade.

MY TAKE: Clarifying the time frame being considered for this analysis is really important. In the short-term — yes, I would agree with Ruchir. With what one sees on the ground (excess liquidity all over, over-optimism at large, tech stocks bull run), it does seem like we are near or at the peak of the economic cycle and over next 24 months, various indicators will definitely tighten. However, over the long term (10yrs+), I continue to be extremely bullish on the US, mainly because of my belief in its inherently-entrepreneurial & innovation-driven economic and social fabric. My personal view is — US will continue to attract global knowledge talent for several decades to come (irrespective of political cyclicality), will lead in IP-driven innovation & deep-tech, and will surely be one of the leaders of whatever wave(s) that happen next (crypto, blockchain, AI & beyond).

2. Rise of Anti-Bubbles

Ruchir defines ‘Anti-Bubbles’ as countries where, despite healthy economic indicators, their GDP is surprisingly, lesser than the market cap of some of the top US tech companies. This, to him, doesn’t make sense. He feels that once the current tech wave slows down, the Anti-Bubble markets that have been unfairly neglected in favor of US tech stocks, will start seeing huge capital inflows.

Just to give a sense of how much global investors have been prioritizing US tech stocks over entire countries — India’s total GDP is less than the FAANG combined market cap.

MY TAKE: ‘Anti-Bubbles’ is a very interesting concept. While I understand where Ruchir is coming from in macro-economic terms, I think there is a larger point here — to me, technology is changing the very nature of the way our world operates & is segmented. Concepts like defined nation-states, insular GDPs, trade borders etc. are being disrupted right in front of us. To keep pace, traditional economic metrics and analysis methods also need to evolve to correctly reflect the updated realities of how markets, economies and societies are going to operate going forward. That’s where the gap is right now!

3. Why Global Interest Rates Can’t Rise Much

Global debt has risen from ~2x GDP in 2000 to >3x in 2018, with China borrowing the most since the 2008 crisis. Given these high debt levels, global interest rates can’t rise beyond a certain level, as central banks need to avoid large-scale repayment failures.

MY TAKE: No particular comments.

4. De-globalization

Trade as a % of global GDP has come down from ~60% in 2008 to ~55% in 2018. There has been a backlash against globalization all across the world this past decade, with protectionism on the rise across countries. Most notable example is the ongoing trade war between US & China.

Interestingly, there are a bunch of Asian countries that are benefiting from this trade war, including Vietnam & Bangladesh. US companies are now shifting their backend supply chains from 100% China, to diversified across multiple manufacturing centers, especially in SE Asia.

MY TAKE: I have a few specific inputs on this theme:

A) Globalization is beyond the control of politicians. Beyond creating short-medium term barriers, they can’t fight the power of technology (the Internet) and stop global citizens from interacting & trading with each other. The real issue is — how do governments create policies to ensure that all sections of society benefit from globalization. Stopping globalization is not the answer, ensuring equitable distribution of its fruits definitely is!

B) The geo-political trend of countries standing up to China is going to get even stronger in coming years. Given China has an openly aggressive international posture politically, economically and militarily, I expect its disputes with rivals such as US, India, Japan, Korea & certain countries in SE Asia to continue.

C) As China transforms its economy from manufacturing-based to consumption-based, countries such as Vietnam, Thailand, Bangladesh and India really stand to benefit from global companies diversifying-out their procurement from China.

5. The Anti-Establishment Wave

There is a clear trend of right-wing political parties coming to power across multiple countries. Interestingly, the average age of world leaders has also steadily been going up.

MY TAKE: No particular comments.

6. Fiscal Indiscipline Rising Everywhere

Global avg. Fiscal Deficit as % of GDP has gone up from ~2.25% in 2013 to ~3% in 2019(P). Case in point is India, where farm loan waivers have increased massively since 2016.

China spends 3x of India in terms of capital investments. While India has focused on waivers & subsidies at the cost of govt. spending on infrastructure, China has doubled down on investments & capital spending to drive growth.

MY TAKE: No particular comments.

7. India Still a One-Engine Economy

India’s growth is primarily driven by domestic consumption. As per Ruchir, it’s hard to consistently grow at 8%+ just with a consumption-based economic engine. Like China, India needs an investment-based engine as well, to complement consumption.

Another concern related to India— with rising consumption, household debt is also rising significantly.

MY TAKE: India’s consumer story is probably one of the most attractive investment areas in the world. Most startup activity is also in this space, be it eCommerce, payments, entertainment or food delivery.

Personally, I wouldn’t worry too much about the household debt situation as current debt levels are still far below developed markets and also, India has a strong savings culture that counter-balances the debt issue.

As a tech founder & investor, I would like other sectors of India such as enterprise software, manufacturing, agri etc. to also catch up with consumption, in terms of growth & investment attractiveness.

8. Growing ‘Tech-lash’

Tech has been the least regulated space across the globe, particularly in the US. This is changing now, as lawmakers realize the impact of these technologies and the need to study & better regulate them.

MY TAKE: Personally, I welcome constructive regulations that make tech companies more responsible towards consumers on issues such as privacy, harassment, data security, financial scams etc. The power of tech in our lives is only going to grow; it would be foolish to assume that it can be left unbridled. In fact, clear, non-ambiguous and forward-looking regulations will create a more sustainable environment for emerging technologies such as blockchain & crypto, AR, VR etc. to flourish.

9. Next US-China battle Will be All About Tech

MY TAKE: Frankly, the only country giving serious competition to the US in new-tech is China. Having developed a walled-garden Internet ecosystem that has spawned local giants (Alibaba, Tencent, Baidu etc.) rivaling the likes of Google & Facebook in scale & market cap, China is now focused on becoming an AI leader. I believe issues such as weak IP protection, outrageous data control and walled-off ecosystems, combined with an aggressive international political stance at a country level, will lead to significant headwinds for Chinese companies looking to expand globally. This is where US tech companies will continue to have an edge, followed by players from the EU, India and SE Asia.

10. King USD No More

The dollar has had a fantastic ride over last few years, backed by solid economic & financial performance from the US. Ruchir feels that the USD has peaked and will get weaker going forward.

MY TAKE: am no currency expert so have no comments :).

To Conclude:

My big takeaway from Ruchir Sharma’s top 10 themes for 2019 is that we are at or near the top of the economic cycle in the US. Excess liquidity & tech has been the main driver of this decade-long bull cycle, and given natural cyclicality, could see a cool-down period over next 12–36 months (which would be good for everyone, I think). In the short term, makes sense to proactively manage for this potential upcoming volatility by diversifying, both from a career and personal finance perspective. Personally, I continue to be a long-term bull on the US, primarily because of my confidence in its inherent entrepreneurial innovation engine & continued ability to attract the best global talent.

China has had a fantastic last decade domestically; however, I see major headwinds for it from a globalization perspective. Having seen its tech prowess, talent pool and national focus from close quarters, I wouldn’t discount China’s ability to pull another growth rabbit out of its hat (similar to manufacturing in the 90s and Internet-consumption in the 2000s). Maybe AI?

India continues to have a strong domestic consumption story, and will continue to chug along. It’s a democratic and highly heterogenous country — given fragmentation & high degree of local complexity across multiple elements, it’s hard to see it growing at China-like levels (which can only result from a China-like centralized political system). Which is fine, as India will continue to grow sustainably & by-consensus. Ideally, would like to see the Indian economy unlock one more major engine of growth — enterprise software for the world? Domestic manufacturing? Commercial use of space?

Overall, looks like we are in for an interesting 2019, and the decade ahead!

Source: all data snapshots are from Ruchir Sharma’s NDTV interview.