Is the Baltic Dry Canary telling us something?

The US economy continues to grow at a cracking pace, or so we are told again and again. Unemployment is down to record lows, and the stock market is back to record highs. Corporate profits are at record highs, and the (US) economy grew at 4.2% in the second quarter of 2018. Europe continues to grow, at least that is the message, Brexit or not. Not one month ago, the Baltic Exchange Dry Index (BDIY), a key measure of the cost of transport and a bellwether of international trade volumes, was at an annual high of $1774.

Is there anything to suggest that all is not well?

Officially, all is good in Economy-Land. Unless you are in the Emerging Markets (EM) where all is going to hell in a handcart. And if you do watch the BDIY as I suggested last month, you may have reason to worry.

https://www.bloomberg.com/quote/BDIY:IND

Years of Growth Ahead?

Some time ago (18 August 2017) I asked if the collapse of the employment participation rate during and after the Great Recession of 2008 had actually set the US up for years of economic growth as ejected labour re-entered the market, creating a multi-year pool of “new” labor. Was the unemployment rate artificially low due to the definitions used to define “unemployed”, and was there, in fact, a giant pool of untapped labour just waiting to be absorbed?

Certainly, European economies have had a chronic underemployment problem for the past twenty years, so there should be no shortage of labour, unless your production is in Germany (a problem that was supposed to be solved through the importation of millions of ‘refugee’ migrants to provide the new working underclass). 

Or black Swans a swimming?

Or, as I pointed out last month (6 August 2018) are there too many Black Swans flocking, ready for the first to set off a global contagion? Some are pointing to the ongoing EM route and collapse of so many international currencies (Turkish Lira, Argentine Peso to name two) as the “Black Swan de jour” that may cause contagion in developed markets. Are the US markets being kept artificially buoyant with cash fleeing EM countries? 

Or, are tariffs actually beginning to impact? Or, the EM route simply an indicator of the level of international uncertainty, with tariffs being one re-enforcing element?

If tariffs and the EM markets are all part of the same flock of Black Swans, then we should be able to see the rot in international trade. 

On the 6th of August I wrote:

"We need to keep watching indicators from around the world, and look for specific activities. The Baltic Dry Index provides a good indicator for us to watch. In the past moths, the Index has risen from $1250 to over $1700 now. The Baltic Dry Index provides a reliable surrogate for global trade volatility, with higher trade volumes increasing the cost of freight, and falling freight volumes driving down the BDIY."

And so I have been watching the Baltic Dry Index, and it has not been pretty. In the month since I wrote the above, the BDIY has fallen from an annual high of $1774 down to $1477 today (6 September 2018), representing a 16% fall in that month.

As a reminder, the BDIY is a measure of the cost of freight, and as such is an indicator of volumes of international trade in terms of shipping. It is reasonable to expect the BDIY to rise and fall over time due to total shipping capacity, with fleets expanding too quickly for anticipated growth in trade resulting in a slowly lowering BDIY, and fleets falling as uneconomic ships are retired from the fleets and scrapped resulting a slowly gaining BDIY. But that is for the long-term trend line only.

What we have seen this year is the BDIY increase significantly in the second quarter, just as tariffs were being mooted, but before they were actually brought into force. As I speculated in early August, the robust second-quarter GDP print could have been a factor of forward-purchasing and inventory padding to ride-out any transitory tariff impact. If that were the case, I suggested that we would see a fall in trade volumes in the third quarter, with the BDIY providing an early warning sign of such a fall in trade.

We are now seeing that fall, and while one month and a 16% fall could be a transitory fluctuation, it could also be an indicator that trade volumes are being hit, and we should expect a must worse third quarter GDP print.

If the BDIY continues to fall, it will be the clearest sign yet that the tariffs are biting, and that trade volumes are indeed falling.

Even as the BDIY was increasing through July, the Netherlands Bureau for Economic Policy Analysis was reporting that global trade volumes fell in June (I await the July figures).

As I said in early August, I will continue to watch the BDIY, as this may be one of our best canaries in the global trade coal mine.

Risk Geography and Waterfalls

“Row, row, row your boat, gently down the stream”. Gently is pleasant and enjoyable, if you know where the rocks are, if you have an idea of the flow of water, and if there are no waterfalls. Knowing where the hazards are at each point along the river, where the bank is too wide, or where the fallen trees are, and then deciding the path, is all part of Risk Management. Most important are knowing where and how to navigate the rapids, and not being thrown over the waterfall.

Not seeing all the swirling currents, the rocks, and the potential drops is akin to missing material risks.

Have you ever been faced with the occurrence of an event that was both material to the business, and yet was not on your radar (or risk register)? That rock in the river and that thumping, scraping feeling and sound when the boat hits that rock. It happens, and it is personally painful when it does. It is difficult to look an executive team in the eyes and say “we, I mean, I missed that one”. Once you’ve done that, the question is “what else are we missing?”

Faced with that situation, and after being assured “we ALL missed it”, I asked myself what process I could put in place to reduce the likelihood of such a mistake in future.

This has led me to thinking about systemic risks and Black Swans as much as thinking about “internal” risks that might have been missed. This post provides an outline of my methodology change to improve completeness of risk consideration, with a focus on material risks.

Exploring the Black Swan world

Over the past few weeks, I’ve published a number of posts on both Risk Management (operational level) and Global Economic conditions and Black Swans. What can, and should, Risk Managers be doing concretely to address these risks?

The first step, of course, is to acknowledge that there are potential systemic risks, and that the enterprise needs to be considering these, macro and micro. Internal resilience is as important as is a level of prudential preparation to weather external shocks.

For example, would the entities investment portfolio as managed by the treasury function, stand up to a “Mark-to-Market” post an event that resulted in bonds demanding a 5% additional return? Are banking agreements sufficient to ensure continuity of payments in the event of the failure of a key financial intermediary?

Risk Appetite and Acceptance

Risk Management cannot identify all risks, internal and external, and cannot prioritise those risks in a vacuum. Senior management (and the Board for validation) should be confirming the risk universe, the risk hierarchy, and should be determining the level of acceptable risk. This is the Risk Appetite, and provides a foundation for acceptance of the residual risk position acceptable to management and the Board.

Of course, understanding the Risk Appetite for anyparticular risk requires understanding of the risks, the identification of the gross potential impact, an assessment of likelihood of occurrence, the current situation in relation to the control environment, and more importantly, the acceptable final risk position (“target” risk score).

The “Target” risk score, or the Risk Appetite for a particular risk, should only be set and accepted by someone with the authority to accept that final risk position. Anyone else “accepting” that risk is doing so on behalf of the shareholders, and  very probably is doing so significantly outside the level of authority that the shareholders have vested in that person. Thus the need for a Delegation of RiskAuthority.

Seeing the “Same Thing”

One of the most difficult activities is the identification of all material risks, internal and external. Lists and brainstorming seem to be the most common ways that these sets of risks are identified. And of course generic lists by industry are readily available online, modifiable to your business. These lists reflect a range of risks at a period in time, from the perspective of the list compiler. The next step to get past the list and identify the hidden or out-of-mind risks.

All risk identification must start with the objectives of the business, even before the structure of the business. From there, a common model is needed, that all participants in the risk identification process are either familiar with, or can easily map to their experience and knowledge of the business.

While it cannot be said that all participants in the risk identification process will be familiar with all aspects of the Balance Sheet or Cash Flow statement, there is a very good probability that they will be very familiar with their areas, and how those areas impact discrete elements of the Balance Sheet of Cash Flow.

Victoria, Iguazu or Angel

A remarkable thing about waterfalls is that if you carefully measure all the water that comes in at the top, minus mist and vapour, the amount of water that comes out the bottom end is the same. So with Balance Sheets and Cash Flow statements. The totals in, minus items and added items, equals the amounts “going out”.

A tool that I have found useful for the identification of risks, and to ensure a conversation about risk with senior management is the use of the waterfall diagram. Each element can be de-constructed to whatever level of detail is required, but the inputs, minus and plus interesting other “stuff”, equal the outcomes or outputs. 

The example above provides a very basic (and imaginary) Cash Flow statement for a commercial and industrial company. It would look fundamentally different for a financial institution or insurance business. But in all companies, regardless of industry, after revenues and various costs, we have the output: Net Income.

Every element along the way, to a greater or lesser extent, inputs and outputs, contribute to the eventual result. More important, if each element represents a set of definable business objectives, then each element provides us with a specific area of potential risk. For example, a business objective like “complaints per X-thousand customers” relates to specific elements such as SGA (Sales, General and Administration Expenses), or in Insurance and Financial Services entities, in their Compliance costs as well as SGA.

Let’s add some geography

A waterfall itself is influenced by factors well beyond the flows of water. The height of the drop, the width of the flow, the internal structure of the river and terrain around it all contribute. So we need to be considering all these facets when looking at our waterfall. Certainly, we have experts internally on the type, flow and quantity of water (internal factors), but how about our understanding of the shoreline and associated geography (external factors).

Risk Identification and associated Risk Assessment need to consider all these factors, or critical risks (I must keep remembering to say “risks and opportunities”) will be missed - critical risks that have a fundamental baring on the likelihood of the business achieving its objectives.

While the metaphor may be imperfect, it does provide a framework.

If we want to ensure that we have identified as many of the material risks as possible, then we need to look at each element of the Waterfall, and consider both the external and internal contributors to that element. In so doing, we identify the potential risks to the achievement of each of those elements.

For a manufacturing and distribution company, the cost of distribution is a material component of the Cost of Goods Sold, and therefore any risks impacting distribution should be included. Consideration of the impact of the sub elements of distribution can be used to determine what specific risk mitigations should be put in place.

In the 2000s, a major FMCG (Fast Moving Consumer Goods) company did not adequately consider distribution costs, or more importantly, the impact of changes in fuel costs as an element of their distribution costs. When fuel costs rose, so did their distribution costs, significantly. Net Income suffered badly.

The inclusion of the potential for an external risk (increased fuel costs) occurring may have suggested the need for mitigation in the form of forward hedging of fuel costs, or hedging of transportation costs for rail costs.

Flipping the Waterfall diagram on its side, and we have an excellent tool to help us identify “missed” risks. While we did not use this exact presentation, we did use the waterfall diagram a year ago, and it helps us focus on, and in some cases identify, material risks.

It also enables the people with the most knowledge of each waterfall element the opportunity to discuss their elements, the make-up and breakdown of the elements, and to confirm the associated key risks. In addition, it supports challenge and common agreement of the material risks.

In the example above, Internal and External components of the waterfall element are listed, and discussed to confirm that associated risks have been identified. Quantification of the materiality of the risks was a secondary task, but by using this methodology, it was easy for the participants to understand quickly how any change in the one of the waterfall elements impacts the overall performance of the business.

Of course, at the core of a successful risk identification (and confirmation - this should be done annually at least) is ensuring the widest range of people are involved. This most especially includes subject matter experts on each of the element of the waterfall, and representation from Internal Audit to ensure a common risk universe is agreed.

The result is likely to be a much better aligned assessment of risk against business objectives.

Flocking Black Swans

Thinking and talking about "Black Swans" as unexpected or unforeseen market or economic events has become almost blase, yet the use of the term in this context is quite new, dating to Taleb's analysis of the 2008 financial crisis. Now almost anything that we don't (or didn't) see coming is a "Black Swan".

How many of these Black Swans are actually unforeseen? How many are simply emerging risks that have come to fruition? Should we really be unprepared for these events?

Right now, without even adding meteors or pandemics, I can list a series of potential Black Swans, any of which could have a serious impact on the global economy. These range from Tariffs/Trade War to Brexit induced recessions in the UK and Europe, to Emerging Market credit crises or Chinese economic woes. It reminds me, again, of one of my favourite phrases: "It is easy to predict the future; getting the dates right it the difficult part".

And so the question; When? Some of these Black Swans could be brewing now, and may already have caused the underlying damage that will only be apparent with hindsight. Others may eventuate at any time. 

Flocks

When considering Black Swans, the most important difference between "reality" and the concept is that Black Swans, the birds, stand out because they tend to be a solitary, and are not intermingled in flocks of White Swans. 

Swans, while solitary, do pair and can be seen in bevies, eyrars, or even gargles or herds, especially on the River Thames, where all "mute" or unmarked swans are property of the Queen (Act of Swans, 1482). Each year the Upping of the Swans takes place in the third week of July, when over a section of the Themes, all swans are caught, inspected, given a health check, and then released. 

All this to say that we think of Black Swans (back to the the economic events) as singular events, when in reality they cluster, or to use some of the collective nouns for swans, there could be a "bank of (black) swans", or even a "whiteness of (black) swans". The initiating event may not even be readily apparent during the period of crisis. 

Contagion

So which was the primary cause of the Global Financial Crisis: the collapse in values due to the MBS/CDO sub-prime collapse, or the resulting impact of Mark-to-Market and resulting impact on the capital value of financial institutions? It could be argued, and was, that as financial institutions typically match their assets to their liabilities from a duration perspective, they were holding securities that were to be held to maturity, and therefore there was not financial impact unless they were required to sell their bond holdings.

The point is that any of a number of Black Swans may arrive concurrently or with only a few months between. Some will create the conditions that bring about additional crisis.

So to timing

As mentioned above, it is quite possible that some of our Black Swans have already inflicted the damage, and we are simply waiting for the evidence to come through - the evidence that may push some other situations over the edge.

The Trade War, Emerging Market debt, and the Chinese Economy are good examples of potential contagion. 

The recent +4.1% GDP change print for the US is being presented as a great result, but is it a reflection of underlying economic strength, or a reaction to threats of higher costs from tariffs? I do not know the answer, and we will only know with certainly at the next GDP print in October, just in time for the mid-terms.

One thing we do know is that the tariffs and global uncertainty aremdriving the value of the US$ higher, imposing additional costs on Emerging Markets while also suppressing US exports. This is supporting an expansion of the US trade deficit, and is hitting Emerging Market bonds with significantly higher costs.

So if, and it remains a big "if", the GDP print this past quarter is a reflection of anticipation of the impact of tariff and a Trade War, then we will know for certain in three months. But the damage will already be done, and the US economy may well have flipped into recession by then.

Equally, the Trade War may drive another potential Black Swan; an Emerging Markets financial crisis. Certainly that crisis may arrive all by itself, with an end-of-credit-cycle unwinding of EM opportunities as US, UK and EU treasuries are forced to pay higher yields, and a consequent "flight to safety".

Mixed in with all of this, there is the potential Black Swan of a serious credit squeeze in China, resulting in another huge stimulus program, and a potential draw-down of US treasuries to pay for the stimulus. When Russia sold almost $50 billion in US treasuries earlier in 2018, US 10-year rates jumped to 3.1% from a around 2.9%. What would be the impact of a $100 or $200 sale of US treasuries by China as part of a stimulus programme?

Let's guess at timing

We need to keep watching  indicators from around the world, and look for specific activities. The Baltic Dry Index provides a good indicator for us to watch. In the past moths, the Index has risen from $1250 to over $1700 now. The Baltic Dry Index provides a reliable surrogate for global trade volatility, with higher trade volumes increasing the cost of freight, and falling freight volumes driving down the BDI. 

It is also is a close to real-time indicator, with pricing of freight being highly sensitive to the actual trade volumes and projected volumes. 

I will be watching that over the next three months, looking to see if the Index remains high, or if as I suspect, pre-tariff activity will taper off, and we will see the Index fall.