Friday, April 10, 2020

Black Swans and the post-coronavirus Economy

"The problem with experts is that they do not know what they do not know."
― Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable

The phrase "black swan" derives from a Latin expression from the 2nd-century Roman poet Juvenal's characterization of something being "rara avis in terris nigroque simillima cygno" ("a rare bird in the lands and very much like a black swan.").

When Juvenal wrote this, the black swan was presumed not to exist. The importance of the metaphor lies in its analogy to the fragility of any system of thought.  You can undo a set of conclusions once you can disprove any of its fundamental postulates. 

In 1697, Dutch explorers led by Willem de Vlamingh became the first Europeans to see black swans, in Western Australia. The term subsequently metamorphosed to connote the idea that a perceived impossibility might later be disproven.

A few days ago, I was reading the Estate agents Knight Frank's Economic prediction about Coronavirus's impact on the housing market. Knight Frank confidently predict that ‘House sales in the UK will collapse this year as the coronavirus pandemic puts the property market into a deep freeze. But prices will fall by only 3% and will rebound next year.’

My immediate thought was, how can they be this certain? Plus, isn't it a bit like going to a casino and asking the croupier whether playing roulette is a good idea’.

I am as wise as Socrates in only one way, and that is 'that I know that I know nothing'. However, at this juncture, I trust the Economist Nassim Taleb more than I do a bunch of estate agents. Just to get their new evaluation in perspective, this is what Knight Frank predicted in December 2019.

In 2000 Nassim wrote that the problem with the financial markets was that they treated their data and models like it was science. But their financial models always miss vital information that means that their analysis will always lack scientific rigour. Nassim Taleb speculated how the markets would handle a random, entirely unpredictable event and less than a year later we had 9/11. 

Then in 2007 in his classic book Nassim Nicholas Taleb talked about how the financial system was vulnerable to black swan events:

“Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race “looking out for its best interests,” as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.” (extract from the book).

Initially, when he wrote 'Black Swan', he was booed off stage by eminent economists and ostracized by the financial community.
Then in 2008, the entire global financial system collapsed and had to be bailed out to the tune of thirteen trillion US dollars.

Nassim Taleb argued recently in the New Yorker that this current pandemic is not actually a black swan since to use Donald Rumsfeld's terminology this was a 'known unknown' not an 'unknown unknown'. Nevertheless, it's still a risk factor that was hard to predict and certainly, no mainstream analysts were predicting this pandemic or factoring it into their Financial modelling, prior to December 2019.

Therefore, I would be sceptical of any financial analyst writing with confidence about the future. His salary is paid by those who benefit from them putting one view across to us.

Wide-scale negative equity in the UK housing market?

*There is still a fundamental imbalance in the UK housing market, at least in the places where people want to live. The housing stock has always lagged behind growing demand, pushing up prices in the long term well beyond inflation. 

In the short term, a drop looks inevitable, as the lockdown, or lockdowns will hammer incomes and GDP when the cost of housing already claims a much larger share of disposable income than in the past.  

Where the price level will settle, and when it might pick up, is anyone's guess. The real pain will be felt by those going into negative equity, not able through reduced income to pay down the mortgage, and unable to sell without triggering bankruptcy.

This would also apply to heavily geared buy-to-let landlords, facing falling rental income but with fixed debt repayments. Those who have taken on mortgages at large multiples of income or landlords who have relied on substantial capital gains to protect against insolvency will, or ought to be, very worried at the moment.*

*acknowledgement to my father, Sir Kenneth Parker, retired High Court Judge, who is currently working for various government organisations, for this observation.