I well remember the questions a year ago, after I published my annual Budget Outlook, ‘Budgeting for the Great Unknown in 2018 – 2020‘. Many readers found it difficult to believe that global interest rates could rise significantly, or that China’s economy would slow and that protectionism would rise under the influence of Populist politicians.
MY ANNUAL BUDGET OUTLOOK WILL BE PUBLISHED NEXT WEEK
Next week, I will publish my annual Budget Outlook, covering the 2019-2021 period. The aim, as always, will be to challenge conventional wisdom when this seems to be heading in the wrong direction.
Before publishing the new Outlook each year, I always like to review my previous forecast. Past performance may not be a perfect guide to the future, but it is the best we have:
The 2007 Outlook ‘Budgeting for a Downturn‘, and 2008′s ‘Budgeting for Survival’ meant I was one of the few to forecast the 2008 Crisis. 2009′s ‘Budgeting for a New Normal’ was then more positive than the consensus, suggesting “2010 should be a better year, as demand grows in line with a recovery in global GDP“. Please click here if you would like to download a free copy of all the Budget Outlooks.
THE 2017 OUTLOOK WARNED OF 4 KEY RISKS
My argument last year was essentially that confidence had given way to complacency, and in some cases to arrogance, when it came to planning for the future. “What could possibly go wrong?” seemed to be the prevailing mantra. I therefore suggested that, on the contrary, we were moving into a Great Unknown and highlighted 4 key risks:
- Rising interest rates would start to spark a debt crisis
- China would slow as President Xi moved to tackle the lending bubble
- Protectionism was on the rise around the world
- Populist appeal was increasing as people lost faith in the elites
A year later, these are now well on the way to becoming consensus views.
- Debt crises have erupted around the world in G20 countries such as Turkey and Argentina, and are “bubbling under” in a large number of other major economies such as China, Italy, Japan, UK and USA. Nobody knows how all the debt created over the past 10 years can be repaid. But the IMF reported earlier this year that total world debt has now reached $164tn – more than twice the size of global GDP
- China’s economy in Q3 saw its slowest level of GDP growth since Q1 2009 with shadow bank lending down by $557bn in the year to September versus 2017. Within China, the property bubble has begun to burst, with new home loans in Shanghai down 77% in H1. And this was before the trade war has really begun, so further slowdown seems inevitable
- Protectionism is on the rise in countries such as the USA, where it would would have seemed impossible only a few years ago. Nobody even mentions the Doha trade round any more, and President Trump’s trade deal with Canada and Mexico specifically targets so-called ‘non-market economies’ such as China, with the threat of losing access to US markets if they do deals with China
- Brexit is worth a separate heading, as it marks the area where consensus thinking has reversed most dramatically over the past year, just as I had forecast in the Outlook:
“At the moment, most companies and investors seem to be ignoring these developments, assuming that in the end, sense will prevail. But what if they are wrong? It seems highly likely, for example, that the UK will end up with a “hard Brexit” in March 2019 with no EU trade deal and no transition period to enable businesses to adjust.
“Today’s Populist politicians don’t seem to care about these risks. For them, the allure of arguing for “no deal”, if they can’t get exactly what they want, is very powerful. So it would seem sensible for executives to spend time understanding exactly how their business might be impacted if today’s global supply chains came to an end.”
- Populism is starting to dominate the agenda in an increasing number of countries. A year ago, many assumed that “wiser heads” would restrain President Trump’s Populist agenda, but instead he has surrounded himself with like-minded advisers; Italy now has a Populist government; Germany’s Alternativ für Deutschland made major gains in last year’s election, and in Bavaria last week.
The last 10 years have proved that stimulus programmes cannot substitute for a lack of babies. They generate debt mountains instead of sustainable demand, and so make the problems worse, not better. As a result, voters start to listen to Populists, who offer seemingly simple solutions to the problems which have been ignored by the elites.
Next week, I will look at what may happen in the 2019 – 2021 period, as we enter the endgame for the policy failures of the past decade.
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Europe’s petrochemical sector must prepare now for the trade war, US start-ups, Brexit and the circular economy, as I discuss in this interview with Will Beacham of ICIS news at the European Petrochemical Association Conference.
With higher tariff barriers going up between the US and China, the market in Europe is likely to experience an influx of polymers and other chemicals from exporters looking for a new home for their production, International eChem chairman, Paul Hodges said.
Speaking on the sidelines of the European Petrochemical Association’s annual meeting in Vienna, he said: “The thing we have to watch out for is displaced product which can’t go from the US any more to China and therefore will likely come to Europe.”
In addition to polyethylene, there is an indirect effect as domestic demand in China is also falling, he said, leaving other Asian producers which usually export there to also seek new markets and targeting Europe.
“The US isn’t buying so many consumer goods from China any more – and that seems to be the case because container ships going from China to the US for Thanksgiving and Christmas aren’t full. So NE and SE Asian chemical producers haven’t got the business they expect in China and are exporting to Europe instead. We don’t know how disruptive this will be but it has quite a lot of potential.”
US polymer start-ups
Hodges believes that the new US polymer capacities will go ahead even if the demand is not there for the product. This is because the ethane feedstocks they use need to be extracted by the producers and sellers of natural gas who must remove ethane from the gas stream to make it safe.
For these producers some of the cost advantages have already disappeared because of rising ethane prices.
“The exports of US ethane are adding one or two more crackers to the total. And without sufficient capacity ethane prices have become higher and more volatile.”
Hodges points out that pricing power is being lost as poor demand means producers cannot pass on the effect of rising oil prices. “Margins are being hit with some falling by 50-60%,” he said.
EU targets mean that all plastic packaging must be capable of being recycled, reused or composted in Europe by 2025. For the industry this could be a huge opportunity, but only if it acts fast, said Hodges: “We have to develop the technology that allows that to happen. We will need the [regulatory] approvals and if we don’t get moving in the next 12-18 months we are in trouble.”
According to Hodges: “We are in the end game for Brexit. We talk to senior politicians from both sides who don’t think there is a parliamentary majority for any Brexit option.”
He fears that if no deal can be agreed there is a chance the UK will refuse to pay its £39bn divorce bill.
“Then what happens to chemical regulation and transport? Although the bigger companies have made preparations, only one in seven in the supply chains are getting prepared,” he added. This is why we have launched ReadyforBrexit.
You can listen to the full podcast interview by clicking here.
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This is the Labor Day weekend in the USA – the traditional start of the mid-term election campaign. And just as in September 2016, the Real Clear Politics poll shows that most voters feel their country is going in the wrong direction. The demographic influences that I highlighted then are also becoming ever-more important with time:
“Demographics, as in 1960 and 1980, are therefore likely to be a critical influence in November’s election:
- Median age in 1960 was just 30, and 29 in 1964. Young people are by nature optimistic about the future, believing anything can be achieved – and their support was critical for the Great Society project
- Median age was still only 30 years in 1980. The Boomers were joining the Wealth Creator 25 – 54 generation in large numbers. They were keen to join the Reagan revolution and eliminate barriers
- Today, however, median age is nearly 50% higher at 38 years, and the average Boomer is aged 61.. The candidates are not mirroring Kennedy/Johnson and Reagan/Bush in focusing on the need to remove barriers. Indeed, Trump’s signature policy is to build a wall”
2 years later, the median age is still increasing, and the average Boomer is aged 63.
But there is one major change from 2 years ago. Then, President Obama had a positive approval rating at 50.7%. But today, President Trump has a negative approval rate of 53.9%.
This has clear consequences for the likely outcome of the mid-terms, with the latest FiveThirtyEight poll suggesting the Democrats have a 3 in 4 chance of winning control of the House. In turn, of course, this increases the risk of impeachment for Trump and makes it even more difficult for him to stop the Mueller investigation. We therefore have to assume that Trump will do everything he can to reduce this risk over the next few weeks.
Americans are not alone in feeling that their country is heading in the wrong direction, as the latest survey (above) for IPSOS Mori confirms. And they have been feeling this for a long time – as I noted back in November 2016:
- “China, Saudi Arabia, India, Argentina, Peru, Canada and Russia are the only countries to record a positive feeling
- The other 18 are increasingly desperate for change“
Today Malaysia, S Korea, Serbia and Chile have moved into the positive camp. But Argentina, Peru and Russia have gone negative. And if we narrow down to the world’s ‘Top 10’ economies:
- 7 of them are negative – 53% of Italians, 59% of Americans, 63% of Japanese, 66% of Germans, 67% of British, 73% of French and 85% of Brazilians
- Only 3 are positive – 91% of Chinese, 67% of Indians and 52% of Canadians
There is a clear message here, as the median ages of the ‘Unhappy 7’ are also continuing to rise:
- Median Japanese age is 47.3 years; Italy is 45.5; Germany is 43.8; France is 41.4, Britain is 40.5; US is 38.1, (Brazil is unhappy because of economic/political chaos, and is the exception that proves the rule at 32 years)
- By contrast, China’s media age is 37.4 years, India is 27.9 (Canada is the exception at 42.2 years)
The key issue is summarised in the 3rd slide from a BBC poll, which shows that 3 out of 4 people in the world believe their country has become divided. More than half believe it is more divided than 10 years ago.
There is also a clear correlation with the demographic data:
- 35% of Japanese, 67% of Italians, 66% of Germans, 54% of French, 65% of British, 57% of Americans and 46% of Brazilians see their country as more divided than 10 years ago
- Only 10% of Chinese, 13% of Indians and 35% of Canadians feel this way
POLITICIANS ARE INCREASINGLY FOCUSED ON ‘DIVIDE AND RULE’
One might have expected that politicians would be working to remove these barriers. But the trend since 2016 has been in the opposite direction. Older people have historically always been less optimistic about the future than the young. And the Populists from both the left and right have been ruthless in exploiting this fact.
This trend has major implications for companies and investors. As long-standing readers will remember, very few people agreed with my suggestion in September 2015 that Trump could win the US Presidency and that political risk was moving up the agenda. As one normally friendly commentator wrote:
“Hodges’ predictions are relevant to companies, he says, because of the likelihood of political change leading to political risk:
- The economic success of the BabyBoomer-led SuperCycle meant that politics as such took a back seat. People no longer needed to argue over “who got what” as there seemed to be plenty for everyone. But today, those happy days are receding into history – hence the growing arguments over inequality and relative income levels
- Companies and investors have had little experience of how such debates can impact them in recent decades. They now need to move quickly up the learning curve. Political risk is becoming a major issue, as it was before the 1990s
“Of course a prediction skeptic like me would say this, but I have a very, very, very difficult time imagining that populist movements could have significant traction in the U.S. Congress in passing legislation that would seriously affect companies and investors.” (my emphasis)
Yet 3 years later, this has now happened on a major scale – impacting a growing range of industries and countries.
As the mid-term campaigning moves into its final weeks, we must therefore assume that Trump will focus on further consolidating his base vote. Further tariffs on China, and the completion of the pull-out from the Iran nuclear deal are almost certain as a result. Canada is being threatened in the NAFTA talks, and it would be no surprise if he increases the economic pressure against the US’s other key allies in the G7 countries, given the major row at June’s G7 Summit.
Anyone who still hope that Trump might be bluffing, and that the world will soon return to “business as usual”, is likely to have an unpleasant shock in the weeks ahead.
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I was interviewed on Friday about the likely impact of President Trump’s trade wars on the global chemical industry by Will Beacham, deputy editor of ICIS Chemical Business. His interview is below.
The introduction on Friday of trade tariffs by China and the US is the first step in a trade war that could turn into a global polyethylene (PE) price war as the wave of new US production is sent to new markets, likely Europe.
Paul Hodges, chairman at London-based International eChem, said that around 6m tonnes/year of new US PE capacity has to find a home and, with China largely out of reach, the obvious destination would be Europe, where the surplus production will put downward pressure on prices there and around the world.
“The main hit from a trade war is going to be the US PE expansions – clearly it is being targeted so the opportunity to export to China is sharply reduced,” said Hodges. “But this won’t just be a US problem because they will still want to move their product – it has got to come to Europe as there is no surplus demand in Asia, the Middle East or Latin America.”
He added that this first wave of tariffs were a wake-up call to those who thought globalisation was going to continue as it did in the past. “We have reached a tipping point where we have to expect that trade wars are more rather than less likely”, he said.
“If you assume the US production will come onstream, then where will those 6m tonnes of product go? It can’t go to China, it can’t go to Latin America as that is too small a market, the Middle East is in surplus, Africa is too small – so Europe is the only place,” said Hodges.
US PE producers that are integrated up to the wellhead need to extract ethane in order to monetise their gas production:
- These producers will continue to export happily at whatever price because essentially the ethane is a distressed product and has to be sold
- However, non-integrated players’ margins could come under pressure.
In Europe, there is a parallel to the US, said Hodges, as regional production is generally tied into refineries.
Naphtha is a relatively small part of the product flow from a refinery, so prices can go down quite a long way before you start to think about cutting back on refinery operating rates.
“The risk for the second half of this year and 2019 is that you have two heavyweights in the boxing ring – one integrated back to the gas wellhead in the US and the other refinery-integrated in Europe – and people get squeezed in between,” he added.
EUROPE VALUE CHAINS
Hodges pointed out that if cracker operating rates decline in Europe it will hit all the other product streams such as propylene, butadiene (BD) and pygas. There are tremendous knock-on risks across all the value chains, not just ethylene.
“This won’t happen this year, but if it continues and gets worse over the next 12-18 months, do you start to look at cracker shutdowns in Europe? What will the implications be for people relying on those crackers for feedstocks?” said Hodges. “It’s a hornet’s nest of unintended consequences: people don’t send a ship load of PE to Europe expecting it to shut down a PP plant.”
Hodges urged the industry to make contingency plans now to manage these future risks. European producers will have to think about how they protect feedstock supplies for value chains on a Europe-wide and country basis so that pipelines are not shut down.
“You’d have to focus on a number of core hubs and reinvest in those to give the infrastructure you need for the future. You need to do it now – while there is time to take action,” he said. “You might end up spending money you don’t need to spend, but that’s much better than waking up and realising you don’t have a feedstock supply,” he said.
According to ICIS data, the US is forecast to export a total of 1.37m tonnes of low density polyethylene (LDPE), high density polyethylene (HDPE) and low linear density polyethylene (LLDPE) to China (see LLDPE map above). Although HDPE is not included in the current tariffs, it could be added later, according to Hodges.
He added that a price war in PE would impact other polymers because of inter-polymer competition. It may only be 5-10% that is substituted, but to lose that amount of volume at the margin would be quite significant.
He described the trade war as a paradigm shift for the whole global industry as the era of globalisation switches to regional and nationalism. “I’m worried that a lot of people in this industry have grown up with globalisation and they assume that is how it is,” he said.
Trade policy and geopolitics are like a chess game with lots of moving pieces and the approach is that you give up something in order to gain more, he added. This has been a very successful approach by the US since the Second World War, when it implemented the Marshall Plan or ‘European Recovery Plan’. Almost the equivalent of $110bn in today’s money was invested to rebuild the continent.
“This boosted the European economy in order to make it a bigger import market for US exports. Trade expands opportunities and the overall economy. There may be some short-term successes going into a trade war but ultimately the US economy will lose,” Hodges conclude.
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As China’s shadow banking is reined in, the impact on the global economy is already clear, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
China’s shadow banking sector has been a major source of speculative lending to the global economy. But 2018 has seen it entering its end-game, as our first chart shows, collapsing by 64% in renminbi terms in January to April from the same period last year (by $274bn in dollar terms).
The start of the year is usually a peak period for lending, with banks getting new quotas for the year.
The downturn was also noteworthy as it marked the end of China’s lending bubble, which began in 2009 after the financial crisis. Before then, China’s total social financing (TSF), which includes official and shadow lending, had averaged 2 times gross domestic product in the period from 2002 to 2008. But between 2009 and 2013, it jumped to 3.2 times GDP as China’s stimulus programme took off.
It is no accident, for example, that China’s Tier 1 cities boast some of the highest house price-to-earnings ratios in the world or, indeed, that Chinese buyers have dominated key areas of the global property market in recent years.
The picture began to change with the start of President Xi Jinping’s first term in 2013, as our second chart confirms. Shadow banking’s share of TSF has since fallen from nearly 50% to just 15% by April, almost back to the 8% level of 2002. TSF had already slowed to 2.4 times GDP in 2014 to 2017.
The start of Mr Xi’s second term has seen him in effect take charge of the economy through the mechanism of his central leading groups. He has also been able to place his supporters in key positions to help ensure alignment as the policy changes are rolled out.
This year’s lending data are therefore likely to set a precedent for the future, rather than being a one-off blip. Although some of the shadow lending was reabsorbed in the official sector, TSF actually fell 14% ($110bn) in the first four months of the year. Already the economy is noticing the impact. Auto sales, for example, which at the height of the stimulus programme grew more than 50% in 2009 and by a third in 2010, have seen just 3% growth so far this year.
The downturn also confirms the importance of Mr Xi’s decision to make “financial deleveraging” the first of his promised “three tough battles” to secure China’s goal of becoming a “moderately prosperous society” by 2020, as we discussed in February.
It maps on to the IMF’s warning in its latest Global Stability Financial Report that:
“In China, regulators have taken a number of steps to reduce risks in the financial system. Despite these efforts, however, vulnerabilities remain elevated. The use of leverage and liquidity transformation in risky investment products remains widespread, with risks residing in opaque corners of the financial system.”
The problems relate to the close linkage between China’s Rmb250tn ($40tn) banking sector and the shadow banks, through its exposure to the Rmb75tn off-balance-sheet investment vehicles. The recent decision to create a new Banking and Insurance Regulatory Commission is another sign of the changes under way, as this will eliminate the previous opportunity for arbitrage created by the existence of separate standards in the banking and insurance industries for the same activity, such as leasing.
As the IMF’s chart below highlights, lightly regulated vehicles have played a critical role in China’s credit boom. Banks, for example, have been able to use the shadow sector to repackage high-risk credit investments as low-risk retail savings products, which are then made available in turn to consumers at the touch of their smartphone button. This development has heightened liquidity risks among the small and medium-sized banks, whose reliance on short-term non-deposit funding remains high. The IMF notes, for example, that “more than 80% of outstanding wealth management products are billed as low risk”.
Mr Xi clearly knows he faces a tough battle to rein-in leverage, given the creativity that has been shown by the banks in ramping up their lending over the past decade. The stimulus programme has also created its own supporters in the construction and related industries, as large amounts of cash have been washing around China’s property markets, and finding its way into overseas markets.
But Mr Xi is now China’s most powerful leader since Mao, and it would seem unwise to bet against him succeeding with his deleveraging objective, even if it does create short-term pain for the economy as shadow banking is brought back under control.
As Gabriel Wildau has reported, the official sector is already under pressure from Beijing to boost its capital base. Analysts are suggesting that $170bn of new capital may be required by the mid-sized banks, whilst Moody’s estimates the four megabanks may require more than double this amount by 2025 in terms of “special debt” to meet new Financial Stability Board rules.
Essentially, therefore, China’s lending bubble is now history and the tide of capital flows is reversing. It is therefore no surprise that global interest rates are now on the rise, with the US 10-year rate breaking through 3%. Investors and companies might be well advised to prepare for some big shocks ahead. As Warren Buffett once wisely remarked, it is “only when the tide goes out, do you discover who’s been swimming naked”.
Paul Hodges and Daniël de Blocq van Scheltinga publish The pH Report.
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There should be no surprise that President Trump has launched his trade war with China. The real surprise is that financial markets, and business leaders, are so surprised it is happening. He was, after all, elected on a platform that called for a trade war, as I noted originally back in November 2016 – and many times since, even just last month.
Nor is it a surprise that China has chosen to target chemicals in its proposed list of products for retaliation. As my colleague John Richardson has noted:
“On Tuesday, China’s reaction to that first round of $50bn US tariffs included proposed tariffs of 25% on US exports of low and linear-low density polyethylene. The same tariffs could also be levied on US polycarbonate, polyvinyl chloride, plastic products in general, acrylonitrile, catalysts, lubricants, epoxy resin, acrylic polymers, vinyl polymers, polyamides (nylon) and surfactants.”
China, unlike almost everyone else it seems, has used the past 15 months to prepare for Trump’s trade war. So they are naturally targeting the chemicals industry – which was a great supporter of Trump in the early days, and has also come to depend on China for much of its growth.
They will have seen this December 2016 photo of Dow Chemicals CEO, Andrew Liveris, joining Trump at a victory rally in Michigan.
They will also have read Liveris’ tribute to the new President, when announcing the opening of a new R&D centre in Michigan:
“This decision is because of this man and these policies,” Mr. Liveris said from the stage of the 6,000-seat Deltaplex Arena here, adding, “I tingle with pride listening to you.”
The fact that Liveris stepped down last year as head of Trump’s manufacturing council will also have been noticed in Beijing, but clearly did not change their strategy.
FINANCIAL MARKETS EXPECT THE FED TO BE A FAIRY GODMOTHER
Industry now has a few weeks left to plan for the inevitable. But if history is any guide, many business people will fail to take advantage of this narrowing window of opportunity. Instead, like most investors, they will continue with “business as usual”. The problem is simple:
- A whole generation has grown up expecting the central banks to act as a fairy godmother
- Whenever markets have moved downwards, Fed Chairmen and others have showered them with cash
- Therefore the winning strategy for the past 20 years and more has been to “buy on the dips”
- Similarly, industry no longer bothers with genuine scenario analysis, where bad things can and do happen
Another key factor in this developing drama is that not all the actors are equally important. China seems to have been initially wrong-footed, for example, by placing its trust in Treasury Secretary, Steve Mnuchin, and US Ambassador to China, Terry Branstad, to argue its case. They might appear on paper to be the right people to lobby, but at the end of the day, they are simply messengers – not the ones deciding policy.
The key people are the US Trade Representative, Robert Lighthizer, and his aide, Peter Navarro. They are now being joined by arch-hawk John Bolton, who in his role as National Security Advisor can be expected to play a key role – along with newly appointed Secretary of State, Mike Pompeo. Like everything in the Trump White House, Lighthizer’s power comes from his relationship with the President, as the Wall Street Journal describes:
“To Mr. Trump, Mr. Lighthizer was a kindred spirit on trade—and one who shuns the limelight. The two men, who have a similar chip-on-the-shoulder sense of humor, bonded. Mr. Lighthizer caught rides to his Florida home on Air Force One. Mr. Trump summons Mr. Lighthizer regularly to the Oval Office to discuss trade matters, administration officials say.”
THE NEXT 6 MONTHS WILL BE A WAKE-UP CALL FOR MANY
The past 18 months have in many ways been a repeat of the 2007-8 period, when I was told my warnings of a subprime crisis were simply alarmist. This complacency even lasted into October 2008, after the Lehman collapse, when senior executives were still telling me the problems were “only financial” and wouldn’t impact “the real world”.
Similarly, I have been told since September 2015, when I first began warning of the dangers posed by populism in the US and Europe, that I “didn’t understand”. It was clear, I was told, that Trump could “never” become the Republican candidate and could “never ever” become President – and if he did, then Congress would “never ever ever” allow him to take charge of trade policy. Similarly, I was being told in March 2016 that the UK would “never” vote for Brexit.
I also understand why so many friends and colleagues have been blindsided by these developments, as I discussed in the same September 2015 post:
“The economic success of the BabyBoomer-led SuperCycle meant that politics as such took a back seat. People no longer needed to argue over “who got what” as there seemed to be plenty for everyone. But today, those happy days are receding into history – hence the growing arguments over inequality and relative income levels.
“Companies and investors have had little experience of how such debates can impact them in recent decades. They now need to move quickly up the learning curve. Political risk is becoming a major issue, as it was before the 1990s.”
TIME TO DEVELOP PROPER SCENARIOS ANALYSIS
Nobody can forecast everything in detail over the next 6 months, let alone the next few years. And it is very easy to mock if one detail of the scenario analysis turns out to be wrong. But the point of scenario analysis is not to try and forecast every detail. It is instead to give you time to prepare, and to think of alternative strategies.
Just imagine, for example, if you had taken seriously my September 2015 warning about the rise of populism:
- Think about all the decisions you wouldn’t have made, if you had really believed that Trump could become President and Brexit could happen in the UK?
- Think of all the decisions you would have made instead, to create options in case these developments occurred?
I understand that you may worry about being mocked for being “stupid” and “alarmist”. But you should simply remind the mockers of the lesson learnt by insurer Aetna’s CEO, from his failure to undertake proper scenario analysis, as he described in November 2016:
“When Aetna ran through post-election expectations, the idea that Donald J. Trump would win the presidency and that Republicans would control both chambers of Congress seemed so implausible that it was not even in play. We started with a fresh piece of paper yesterday — we had no idea how to approach it. What we would have spent months doing if we thought it was even remotely possible, we had to do in a day.”
There is no doubt that he was the one feeling stupid, then.
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