5 Fat Tails for 2017
I’m a venture capital investor because I’m an optimist. A core part of venture capital is looking for positive extreme surprises to the consensus, or positive fat tails. Put simply, riding big waves.
But it’s just as important to be aware of potential negative fat tails, the big wipeouts.
Politics created the biggest surprises last year. I brought up 5 potential negative fat tails to watch in early 2016 with a key caveat being a focus on finance, business and economics, avoiding other areas like politics. Clearly I should have spent more time on broader issues.
This year’s list takes into account a broader range of forces, although still with a primary emphasis on the implication for finance, business and economics.
This is not a list of predictions and this is not a moral endorsement of these scenarios.
1. Globalization crashes
The Scenario
There is quite a bit of discussion of the potential risk of a trade war, though most of it focuses on relatively moderate outcomes. What if one or more of the major global countries believe we are already in a trade war? What if new policies result in a tit for tat negative spiral of higher barriers to trade?
That starts to look like globalization crashing, not simply a trade war. It would mean global exports and imports falling by at least 20% from current levels over several years.
It’s happened before. Here’s what it looked like.
Implications and Risks
All individuals would be negatively impacted through fewer jobs and less choice, possibly with also lower quality products at higher prices. Smuggling would become a bigger business, leading to a larger underground economy. This could potentially lead to a separate “war on smuggling” if it becomes a large enough problem, especially in terms of tax revenues.
Businesses that are purely domestically focused would benefit due to less competition from overseas. The impact on global businesses would vary. Companies with many local entities in different countries would potentially benefit in some cases because they would operate as local entities, but in other cases even with local operations they may face explicit or implicit barriers, either from their host or home country.
The largest negative impact would be on global businesses in a single global location with many export markets and companies that have created a global supply chain focused on efficiency without flexibility.
Risk reduction strategies
A globalization crash would probably result in job losses everywhere at the aggregate level and there would likely be more effort made by consumers to work together against excessive power by domestic business power. Trade unions and consumer groups would gain momentum over time.
Businesses with multiple locations and a flexible approach already would likely have to invest more time and energy into adapting to changing conditions, probably with the need of more local partnerships.
Businesses with only a single location for the global market and a large export business should at least be exploring scenarios of a second or third location. Companies with an optimized global supply chain should similarly be looking at building in more flexibility even though it may mean lower efficiency.
Fresco Approach
We believe in a flexible and adaptive structure. If there is a globalization crash, then being flexible and adaptive is more valuable than being simply efficient. We’re not hoping for a globalization crash though it’s better to be prepared in case it happens.
Further questions
Would a globalization crash result in countries focused on individual isolation or a fundamental re-alignment of trade blocs or something completely new? Would a globalization crash increase or decrease the power of nation states compared to other parts of society? How would the impact be different on entrepreneurs compared to large companies?
2. Sharp and large interest rate increase
The Scenario
A combination of changes in monetary and fiscal policy combined with a rising uncertainty premium could create a rapid and significant rise in interest rates and bond yields globally. This would cover government bonds, related agencies and corporate bonds. This would probably be accompanied by a rising US dollar.
3-Month Treasury Bill rates were low for many years until 1947. Then the trend was basically up until 1979. The recent uptick is tiny and 2017 may be early to get worried, but it’s worth watching.
Implications and risks
The rise in interest rates and bond yields would have a direct negative impact on borrowers. At the country level, the highest risk would be the combination of large debt and a reliance on external capital. On the consumer side, the negative impact would be on housing loans, auto loans and student loans. On the corporate side, high yield bond markets could simply shut down.
A strong US dollar would also have important consequences. As with previous cycles of a strong US dollar, the tighter credit conditions would have knock-on effects on countries and companies with unhedged currency liabilities. In many cases these are now derivatives and so do not even show up as debt on balance sheets. The currency impact would also have implications on relative export trends. Countries with stronger currencies would face export headwinds. Countries with weaker currencies would in theory have an export benefit. However, the weakest currencies would be in the most financial trouble, so an extremely weak currency would be a sign of significant problems, not of strength.
The relative value of cash would increase with finally a return on holding cash in the bank. Investors in bonds would be negatively impacted, which may be a particularly big shock after more than 35 years of outsized gains. The perception that bonds are a safe asset would be challenged.
Through the direct and indirect linkages, the negative impact would spill over to public equity, private equity and venture capital markets. This would mean lower valuations across the board and likely a capital financing freeze.
Risk reduction strategy
For borrowers, now would be the time to lock in long-dated debt with fixed rates if possible. Avoid cross-currency debt or other unhedged currency exposure. If a banker approaches you with a complex derivative, don’t walk away — run.
For bond investors, it’s worth exploring other investment alternatives. Cash is the most obvious target but also it’s worth being aware that cash may not be as safe as it appears at first glance. Counterintuitively, long-dated private investments are also worth considering precisely because they can create value throughout the cycle. The main thing in this scenario is to get out of bonds.
For companies raising capital in bond or equity markets, the focus should be on ensuring strong relationships with investors. It’s important to be aware that the cost of debt and equity could increase substantially, so internally generated capital becomes meaningfully more attractive, exponentially so if you end up with no access to external capital.
Fresco Approach
We don’t invest in traditional bonds and don’t borrow debt. Our startup investments do sometimes take the form of convertible notes but these have more characteristics of equity than debt. Our funds are denominated in US dollars.
We always encourage our startups to at least have a path to self-sufficiency. Of course, it doesn’t always work out as planned but this has a much better chance of succeeding than relying on being lucky. Beyond self-sufficiency, we spend a lot of time with our startups connecting them to best fit investors who are aligned for the long-term.
Our limited partners understand well that they are investing in long-term funds. We stay away from short-term hot money. This means that we have rejected investors. While this approach may have slowed our growth in the boom times, we believe it will serve as a competitive edge if the fundraising environment freezes.
Further questions
Would a massive rise in bond yields trigger a large wave of sovereign debt defaults? Would a rush to cash by investors trigger a “war on cash” by governments? Would central bank independence be severely compromised?
3. End of the Euro
The Scenario
Change is discontinuous, and so while it is tempting to think that the end of the Euro could be a gradual and orderly process, history suggests that a traumatic and sudden end is a real possibility. Most likely, the end would be triggered by politics in one or more of the major countries opting out. Regardless of which one, this would then create a domino effect with other countries following, creating a reversal of closer integration for more than 70 years. The end of the Euro would most likely be accompanied by accelerated restrictions on migration, trade and capital flows.
Implications and risks
While the Euro itself is important, the closing of borders to migration, trade and capital flows could be even more significant. The net impact on economic activity would be negative both in terms of direct effects and also increased uncertainty.
There would be intense financial stress in the financially weaker countries immediately, leading to a natural potential for bank runs unless governments step in to prevent deposit holders from withdrawing their cash. The velocity of money would slow significantly and it’s possible that barter becomes popular.
A Euro breakup would likely lead to a rise in the US dollar as capital seeks to avoid uncertainty. Some countries would probably seek to impose capital controls to stop the outflow of funds.
Fresco Approach
Our portfolio companies have been able to create in jobs in Europe by taking a global perspective of talent. In case the Euro ends, the need for job creation would only increase. Therefore, even with restrictions on migration, trade and investment, it is highly likely that job creation would remain a focus area and startups would be welcome as long at they could create new jobs.
Further questions
Which countries would react by creating inflation if they were able to regain control over a national central bank? Would new economic country groups emerge? Would the trend of nationalism lead to further breakdowns among existing countries?
4. Tech backlash
The scenario
Many people have already identified the tech industry as a key driver of global inequality and politicians could amplify this wave by introducing aggressive regulations to increase government powers and reduce the growing role of the tech sector. Reporters could uncover large ethical scandals at some of the most prominent global tech companies. A global cyberwar would add to the concerns for both consumers and organizations.
Implications and risks
Reduced demand would have a negative trickle down impact on the overall tech industry, leading to slower growth and increased competition. Startup exits would skew towards smaller M&A deals at lower valuations. The increased competition would drive out weaker competitors while the survivors would need to place more emphasis on sustainable business models with less reliance on external funding. Increased regulation would help larger incumbent tech companies and increase barriers to entry for new startups in certain areas.
Fresco Approach
Part of investing in venture capital is going through cycles. This scenario would clearly have a negative impact on short-term growth opportunities and exits. Conversely, for the ultimate survivors, the harsher environment would lead to less competition for talent and more sustainable business models. Valuations for new investment capital would be lower, counterbalancing the negative impact of lower exit valuations. Our philosophy is absolutely to invest and manage throughout the cycle.
Further questions
Would this lead to less tech innovation? Would the ethical scandals help to increase transparency in the tech industry? Would global inequality decrease?
5. Cities in crisis
The Scenario
Increased polarization would continue to the extreme with widespread violence in large cities globally and a self-destructive cycle driven by intense coverage across all forms of media. With each new city, the coverage would encourage people in more cities to join, even when the issues are nuanced and unique at the local level.
Implications and risks
The obvious immediate risk is the potential violence itself. The reality is likely to vary significantly city by city, with some cities tipping over the edge to severe destruction while others may be able to recover quickly.
The follow-on risks are a counter reaction to reduce civil liberties globally by governments and a more aggressive stance overall to protect national interests. There would be an obvious negative impact on privacy and a less obvious weakening of institutions. Non-governmental organizations would also likely find more restrictions on their activities.
The final impact would be the development of a larger variety of anti-governmental groups globally with various aims, all using new technology and a distributed network approach, leading to a constant cat and mouse game between governments and these groups.
Fresco Approach
In any scenario of violence, the first goal would have to be safety. Beyond that, our philosophy is to support entrepreneurs building a new future, so that core mission would not change. We would of course have to adapt to changing circumstances in terms of day to day operations.
Further questions
How long would this scenario last? Would this reverse the global urbanization trend? How would global travel be impacted?
Stay resilient
2017 will start to feel the first real implications of political changes in 2016 across society, the economy, and everyday life. We should expect surprises.
Of course, being resilient is just the start. At Fresco Capital our focus is on building stronger and more successful global ecosystems. If you are interested to work with us in some way, get in touch.
