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Forest Fires (and the Trump Election) Reduce Tail Risks

February 23, 2017 | Multi-Asset

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Up until the late 1960s forest fires were generally believed to be detrimental for forests and management policies were aimed at suppressing fires as quickly as possible. However, an unintended consequence of these policies was that the fires that did take hold were larger and more destructive.

Indeed, without the healthy burn of an occasional small fire, vegetation is able to grow, which increases combustible triggers and leads to fires of larger magnitude. Empirical research has shown that the distribution of forest fires follows what is known as a “power law” distribution, which essentially means that fewer fires result in larger fires when they do occur. A simple graphical depiction of this distribution and a simulated forest fire model are shown below.

This forest ecosystem property is referred to as self-organized criticality—under the guise of stability the system converges towards a critical state that is highly unstable. Other natural phenomena, such as avalanches and earthquakes, have similar properties.

Until the last U.S. presidential election, political insiders were very successful at restricting political competition and putting off potential populist fires.

Therefore, the more successful the suppression of all forest fires, the larger the subsequent fires will be. Until the last U.S. presidential election, by utilizing techniques such as gerrymandering or enforcing arcane rules in the primary process designed to keep outsiders away, political insiders were very successful at restricting political competition and putting off potential populist fires.

Despite the rising strength of the Tea Party, the Republican Party kept nominating political insiders, such as John McCain and Mitt Romney, for presidential elections. The Democratic Party was even more successful in insulating itself during this most recent presidential campaign, selecting Hillary Clinton through its primary process—a candidate who is the archetypical Washington insider. The result was the Donald Trump election “forest fire.” What can we learn from this?

Lesson #1

From a risk management standpoint, the first lesson we can retain from this forest fire analogy is that the election of Trump will reduce—rather than increase—any potential tail risks associated with the new U.S. administration's policies.

While the economic and foreign policies of the U.S. are undoubtedly less predictable now than they would have been under Clinton, electing a traditional political insider would have postponed, rather than extinguished, the brewing anger of the American middle class.

Surges of populism—like forest fires—are useful to democracies. They reduce the threat of larger fires in the future. Still, forest fires have unpleasant consequences and, if uncontrolled, can cause significant harm. But the absence of fire and the growth of combustible materials may be even more dangerous.

Surges of populism—like forest fires—are useful to democracies. They reduce the threat of larger fires in the future.

Lesson #2

The second lesson is that it is more important to monitor vegetation growth rather than predicting sparks when trying to assess the danger associated with future fires.

It is difficult to know exactly what policies President Trump will push, never mind what he will actually be able to pass through Congress. It is easier to assess what his policies won't be: controlling the growth in U.S. public debt, for example, is nowhere near the top of Trump's lengthy agenda.

From this perspective, growth in public debt not only in the U.S. but across developed markets provides potential combustible ingredients for a fire in fixed income markets. As we have written about previously, unprecedented central bank monetary policies created an environment where interest rates were not a function of long-term supply and demand for capital, but rather a function of central bankers' desire to support short-term economic activity. Such unconventional policies may have been helpful short-term tools in the aftermath of the global financial crisis and the European sovereign debt crisis, but they have also introduced distortions in the allocation of capital (or mal-investments).

Lastly, if investors look across the world for places where vegetation is overgrown, European Union (EU) institutions are certainly in need of a trim. Over the last 30 years, EU institutions have increased in size and complexity and now look like a disjointed accumulation of rules and regulations over a heterogeneous set of countries. Brexit may be the first fire to reduce some of this vegetation, albeit with a fairly low-intensity, somewhat lengthy (~2-year) blaze.

So, while we are optimistic regarding the nascent economic recovery that is currently taking place in Europe, we are also very aware of the magnitude of the tail risks associated with the possible election of a populist leader in the upcoming elections in France or in the Netherlands.