Centre Street Cambridge Corporation - July 2023 - cscc1013meta name="keywords" content="Commentary July 2023

n interesting article appearing in the Financial Times recently questioned whether the U.S. was becoming “uninsurable” owing to the effects of climate change. Already major insurance companies have limited their coverage or pulled entirely out of property insurance markets in several states, including Florida, Louisiana, and California, where exposure to natural disasters such as hurricanes and wildfires is becoming unaffordable for companies whose business is to protect against unexpected calamity. As such catastrophes have become more frequent, predictable, and costly, the companies determined that no reasonable insurance premium level would compensate for the increasing risk of enormous claims.

Along with the growing frequency and severity of climatic events, other factors have also contributed to rising insurer liabilities. While building in areas prone to wildfires and flooding represents long-standing trends in population movement and suburban sprawl, the rate of increase in the cost of replacing destroyed property has accelerated dramatically in just a few years — up over half since 2019. Insurer actions taken in response to these developments impact large numbers of people (over 75% of Florida's population lives in coastal areas, for example), prompting a determined response from political authorities to shield their constituents from what market realities are forcing on the private companies. Policies ranging from government-provided insurance to restrictions on the methods insurance companies can use to determine rates have been enacted. These policies effectively subsidize people who choose to live near the beach, on floodplains, or on dry hillsides in California, making property insurance more affordable for them than a logical economic analysis suggests that it should be. Yet even with the subsidy, premiums in those areas are still multiples of the national average.

We have long questioned the wisdom (not to mention the fairness) of requiring average taxpayers to underwrite such benefits for people who are often significantly more able to afford them, or to provide publicly-funded support for activities that might be wisely abandoned. This is risk-taking with other people's money, and by reducing risk for private actors it also distorts capital allocation in an economy by encouraging the diversion of resources to areas that a rational analysis would consider unattractive investments. A decision to support, or at least protect, such activities, provides an advantage over other possibly wiser solutions to the same problem. In the case of property in natural disaster-prone areas, a more economically-sound solution might be to build (and rebuild) elsewhere.

The FT article provided an example of the distortions which can occur when one attempts to interfere with the ordinary workings of Adam Smith’s “invisible hand.” Miami has been experiencing a building boom despite periodic flooding due to rising sea levels. A local resident noted that many new property owners are so wealthy that they aren't bothered by the prospect of their homes being destroyed in twenty years. It hardly seems fair that this particular segment of the population should enjoy reduced insurance expense and risk, when average Florida (and U.S.) taxpayers bear the cost of those benefits.

Concluding this discussion of insurance, these organizations represent one of the mechanisms through which the “invisible hand” operates: people motivated by the imperative to save themselves money think deeply about risks that most of us may not even be aware of. Like the proverbial canary in a coal mine, where insurance companies refuse to step in, it would be wise for the rest of us to fear to tread as well. When they abandon a major market (nuclear power, for example), policymakers and the rest of us should pay attention.

Discounted insurance is one form of subsidy; others are more pervasive and perhaps even more corrosive in their effects. The tax deduction for corporate interest as well as tax breaks for certain fund managers, for example, encourage the use of debt, and, by introducing the potential for lucrative gains to investment firms into the return equation, may contribute to less rational investment decision-making. For many years corporations, even those in risky industries such as air travel, have issued debt to buy in their own shares, rather than investing in their businesses. Motivations for this practice may include managements' desire to boost the value of their stock options (fewer shares outstanding means higher earnings per share, and presumably a higher stock price), but one wonders if company CFOs would be so keen to issue bonds if the interest were not a tax-deductible expense (note that the interest deduction for personal loans taken out by individuals ended 35 years ago). In the name of “balance sheet efficiency,” American industry now rests on a large debt pile, increasing financial risk that in a future economic downturn (perhaps one that the U.S. could not bail itself out of) could wreak havoc. As for the fund manager tax break (known as “carried interest”), this is quite simply a gift to wealthy fund managers with no real economic justification.

One of the biggest government subsidies is the tax deduction for mortgage interest. Arguably contributing to vast suburban sprawl in the U.S., as well as the “too much house” phenomenon, real estate market analysis also indicates that it tends to inflate home prices. People have been known to buy a house with the tax deduction in mind, without giving proper thought to the financial burden and risk being assumed, or to housing’s relatively poor record as a long-term investment. The fairness issue also plays a role as the mortgage interest deduction, while available to all homeowners, mostly favors citizens in higher tax brackets, not to mention the homebuilding industry.

There may be a few cases in which subsidies can be justified by promoting worthy societal goals, such as the transition to cleaner energy. Nevertheless, we have doubts about subsidies’ efficacy over the long run. Tools which might best be temporary expedients tend to become entrenched and difficult to dislodge when no longer necessary, and over time they tend to benefit narrow segments of the population who may least need them. A better alternative to supporting a favored industry — green energy, for example — might be to end subsidies for related sectors, such as fossil fuels, particularly as some renewable energy sources have become strongly competitive.

One of the major Wall Street banks has published an outlook for changes in the relative standings of national economies and the impact of these changes on capital markets, for the next fifty years. Since such firms usually focus on predicting what will happen over the next three months, we were skeptical of their conclusions. In fact, no one can predict what the world will be like in 50 years, any more than 50 years ago, on the cusp of a major energy crisis and not long after Nixon’s first trip to Beijing, anyone would have suspected that the U.S. would continue to be a major (and perhaps even more important) energy producer, or that China would be rivalling America as an economic and growing military power on the world stage. Yet, at the same time, in our thinking about investments, we must look to the future, and often with an indefinite time horizon. We do so against a backdrop of study of the history of securities markets over many decades to gain an important perspective regarding events that affect the values of one's holdings, and how the opportunities and risks in earlier times played out. A knowledge of history inoculates against blindly accepting opinions and forecasts (which rarely come to pass, or if they do, fail to do so at the appointed time). Above all it teaches us to be alert to and have respect for the unexpected events that upset our assumptions about how markets work. At best we can assume that economic and market forces will ebb and flow as they always have, creating opportunities for investment or disinvestment along the way. The bank in question's conclusion, on the other hand — to buy equities everywhere now because in 50 years they will all be a lot higher — simply projects a past record onto the future. Besides showing a lack of historical perspective, such thinking violates a basic maxim of Wall Street, namely that a past record may not be indicative of future results.

Despite a year of rising interest rates and fears of cataclysmic consequences from a borrowing limit standoff in the U.S., stock markets rose smartly, with the S&P 500 gaining nearly 17% (including dividends) in the first six months of 2023, one of the strongest showings in twenty years. While this certainly looks impressive (and if you own an index fund it feels great), market observers have pointed out that only seven issues accounted for all the gain. Outside of his half dozen or so stocks — all but one in a tech sector pumped up by speculation surrounding artificial intelligence — the broader equities list was essentially unchanged, making for the most concentrated market in 50 years, according to one report. We have been here before, in 1999 to be exact, when technology companies similarly dominated the market indexes. Indeed, concentration has occurred periodically in market history — 1929, 1973 (the “Nifty Fifty”), 1999 — as well as today. The aftermath of these episodes of focused interest offers an important example of the proper use of history we alluded to above: in the long run those who chose to chase “performance” by buying the favored few, although it may have seemed like a good idea at the time, suffered significant losses. Paying a high price can turn even the most exciting and widely accepted new technology into a poor investment experience.