‘There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know.’
Donald Rumsfeld
A career in providing investment services involves building a clear understanding of risk. The link between risk and reward is integral to this and, of course, you shouldn't invest unless you have developed a clear appreciation of the potential downside as well as the potential upside.
That's why I've always struggled to understand the logic of insurance underwriting. In so many areas of insurance, once a risk has been identified it is simply excluded from the policy: whether it's subsidence for house insurance, or a medical exposure for health insurance.
The disaster which is currently overtaking Los Angeles must be presenting real challenges for the insurance industry. On Sunday, private forecaster Accuweather increased its preliminary estimate of financial losses from the wildfires to between $250bn-$275bn, and uncontrolled fires continue to rage across the city. On Friday, Reuters was reporting potential insurance claims of over $20 billion, but I suspect that is scratching the surface of what's to come. It's not surprising that comments about uninsurability are starting to swirl around this incredibly valuable area of real estate.
Meanwhile a Christian Aid report published last week charted the worst climate disasters of 2024, assessing their insurance costs as at least $200 billion..
The financial market implications of the disaster in Los Angeles are real and direct, and many will have looked at the ravaged city and compared it to the war-torn disaster that is Gaza. Not many will have had the benefit of insurance there.
But how far can insurance pick up the pieces before its losses start digging into investment market stability? At the end of the day, those underwriters rely on having a strong base of invested assets, and the premiums that they earn are normally an added bonus to build onto conventional capital gains and dividends. When shocks like Los Angeles hit the system, those underlying investments must be sold.
It's worth, therefore, considering how many other unanticipated shocks we are likely to impose on financial market stability as we venture into the unknown, in so many areas.
It's just a few days now before the biggest unknown entity takes up his mantle as U.S. President. I say ‘unknown’ because his first four years in office will provide little guidance for his actions in this second term, apart from a much-enhanced feeling of self-importance. We've all heard his aggressive and extreme statements, and we know that he likes to keep everyone guessing as to what he'll really do — but looking beyond the short-term euphoria of U.S. stock markets which have already experienced their glee at his election at the end of last year, have they really taken on board the shocks that he and his team could unleash on financial stability between now and 2029?
Whether it's his plans for huge tariffs which could seriously damage world trade — and the Chinese appetite for buying American debt — or his plans for muscular annexation of neighbouring countries such as Greenland, Panama and Canada, or his oft-repeated climate change denials in pursuit of fossil fuels, any of these could seriously undermine markets.
Democracy can grant incoming administrations the illusion of unlimited power, but financial markets can undermine that invincibility at a stroke. Maybe that's why former President Clinton’s political strategist James Carville once remarked that, if reincarnated, he ‘would like to come back as the bond market — you can intimidate everybody’.
You have to go back quite a long way to find a major public sector financial crisis. 2008 was a banking crisis: in my view, the culmination of twenty years’ experience of merging the roles of principal and agent, thereby introducing a scale of greed resulting from that conflict of interest with which the banks could not cope.
The Millennial crisis was caused by massive overvaluation of the tech sector, with large amounts of capital absorbed by excessive marketing spending.
Localised crises such as the collapse of the British pound caused by regimented alignment to the Euro in the early 1990s were more a reflection of trying to resist the currency market, which can be every bit as powerful as the bond markets.
So, you have to return to 1987 to find serious bond market destabilisation, and perhaps that reflects the fact that inflation and interest rates have seen persistent reductions over thirty years prior to the pandemic and the ostracisation of Russia following its invasion of Ukraine.
So, what could seriously spook international bond markets in 2025?
You need to look at historic collapses such as the 1930s to find the answer: the fear that a substantial nation may renege on its sovereign debt liabilities. Because of the sheer scale of public sector debts and deficits today, that risk cannot be ignored and may be partly what’s driving long-dated bond yields upwards at present.
The Times comes up with some great cartoons in its main editorial pages, pulling together the absurdity of some aspects of everyday news with vivid illustrations; and reflecting the old saying that, ‘many a true word is spoken in jest’.
Last Friday their cartoon showed Trump dancing with the American people as symbolised by the Statue of Liberty under a vivid orange-red skyline. The cartoon was headed ‘LA LA LAND’, and Trump was brandishing his instruction, ‘DRILL, BABY DRILL!’.
The new U.S. administration will have to be very careful not to allow its headstrong and often ridiculous announcements to get the better of it. The American people may have locked in their choice for the next four years, but there's no such insurance for the bond market — it can strike at any time.
Gavin Oldham OBE
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