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Bram de Haas
Bram de Haas
Articles (333)  | Author's Website |

Dan Loeb's Outlook for 2018

Third Point published its quarterly letter including a market outlook for 2018

February 18, 2018 | About:

Third Point just released its fourth quarter 2017 letter including an annual review. The Offshore Fund generated +18.1% -- a very good result given its average net long exposure was only 68%. The full letter is embedded below, but I wanted to highlight a few key paragraphs that illustrate Third Point's outlook for 2018. Quotations are clearly marked and followed by my commentary.

It is an especially interesting letter as Loeb's attitude can be described as tentatively bullish. He seems acutely aware of a few key dangers but also identifies many bullish drivers and doesn't seem fazed by valuations as much as his peers. Or as Loeb puts it:

"For 2018, the key question is to what extent the benign environment can persist."

To me, this seems extremely unlikely based on the Fed's current trajectory but Loeb thinks about these issues in a more nuanced way:

"Growth is unlikely to accelerate much further, easy financial conditions and pending fiscal stimulus can sustain growth around current levels. Inflation is likely to drift up only modestly and remain at or below central bank targets. In the U.S., where we are primarily focused, we see indications that the favorable backdrop for our investment approach will continue due to a variety of factors: easy financial conditions, tax cuts and fiscal spending, increased capex, and deregulation."

Loeb identifes four key positives:

"1) Easing financial conditions are a key pillar of growth. The current U.S. financial conditions impulse of ~1.0% is the greatest since 2009 and expected to support growth near the current above-trend pace during at least the first half of 2018."

We are already a couple months into 2018, so he may be right. But I'm expecting even anticipated Fed moves could kill market momentum. If we see substantial inflation and the Fed needs to step it up, I'd say that force should overwhelm market momentum.

"2) The tax cut and increases in fiscal spending could boost GDP growth by ~1.0% (relative to trend growth of ~2.0%). The key point is that a gradually waning financial conditions impulse over the course of 2018 can be offset by a fiscal stimulus impulse, which thereby can keep growth at an above-trend pace for longer."

The tax cut has passed and I readily agree this is going to have an effect. However, much of the assets corporations have held oversees have been invested in U.S. treasuries and investment grade U.S. bonds. The selling pressure here could have weird effects on costs of capital. While the corporate rate is also down this doesn't benefit the large caps as much as it does the small caps. Today, the large and mega caps are really carrying the banner for the stock market. The benefit also accrues mostly over time while the degredation in U.S. government solvability has been immediate. On the fiscal stimulus I'm hopeful but it seems a strecht to expect an effect in 2018.

"3) Capex has room to surprise to the upside in 2018 for a variety of reasons. The economy is entering the later part of the cycle, during which rising wages tend to accelerate capex. Free cash flow is high while CEO confidence and capex intention surveys are at their most bullish levels since 2004. The recent tax deal further incentivizes capex through a) its stimulation of aggregate demand, which leads to higher investment via a feedback loop, b) the cut in the corporate tax rate, which increases the after-tax return on capital, and c) accelerated depreciation allowances. With low- to mid-single digits nominal capex growth embedded in bottom-up estimates, the bar for positive surprises is low. Higher capex could galvanize a cyclical rise in productivity, which has recently started to rebound from generationally-low levels."

I think Loeb is exactly right here. I've only recently started to appreciate the varied implications of tax reform. The above emphasis is mine.

"4) The impact of deregulation is difficult to estimate but important to study. The Trump administration has promised that its ratio of eliminated regulations to new ones will be 2:1 and, so far, it seems to be on track to meet this goal. Bank regulation is unlikely to become tougher and might relax at the margin, as in the case of the Volcker Rule. Deregulation could lift potential growth, possibly at the cost of increasing financial stability risk later down the road."

Loeb calls out the Volcker rule specifically. I'd say that as far as banking goes the effect isn't hard to estimate at all. Regulation greatly increased the safety of the financial system and it wrung a lot of return on invested capital out of banking. If you look at return on assets of banking in periods after regulation was tightented its noticeably lower. Meanwhile, return on assets expands as it is loosened. That continues until the banking sector blows up. We've seen several of these cycles in U.S. banking.

4 Key Risks Loeb identifies

Key risks identified by Loeb in quotations. Emphasis has been added by me.

"1) The unusually favorable combination of accelerating growth and tepid inflation seen in 2017 is unlikely to repeat. Historically, the best time for markets is when growth is accelerating. Since growth is already at a high level, further acceleration is less likely. That means that average returns will likely be lower and volatility higher this year than in 2017."

If that's your expectation is it worth the potential risk to be out there with a big long exposure?

"2) While inflation is likely to drift up only gradually, as the events of 2017 have shown, forecasting inflation is anything but simple and the market's reaction to higher-than-expected inflation readings is hard to predict. Low inflation has been a critical support for the market because it has allowed the Fed to be unhurried in its rate normalization, which has kept long-term rates subdued. We are watching closely to see how a tightening labor market and recently announced wage hikes will shape the future path of inflation. Labor's inability to gain pricing power so far in this cycle has been a key pillar of the market's bullish equity story."

With the U.S. having a record number of outstanding job openings, a very low unemployment rate and a government that's been anti-immigration I would not be surprised at all if wage growth will overshoot. That's just one part of inflation. Commodities have been trending up with oil almost hitting $70. Then there's the sudden weakening of the dollar and I find the inflation expectations below 3% somewhat puzzling.

3) Earnings growth has been strong, supporting the market and P/E multiples. In both absolute terms and relative to expectations, the momentum of earnings growth is at a peak and its normalization could create greater volatility compared with the tranquility of 2017.

Agreed.

4) The odds of a recession over the next one to two years are low due to: the current strong level of growth supported by easy financial conditions, the growth support from tax cuts and fiscal spending, the low level of the real Funds rate, and the lack of major macroeconomic imbalances such as excess credit growth or overinvestment. Sometimes, however, recessions are caused by unanticipated events.

A recession would come as a surprise to investors and would likely lead to a substantial market decline given the expansion in valuations in recent years and the concern that the Fed would not have enough ammunition to sufficiently stimulate the economy.

Loeb does a great job laying out key positives as well as key risks in the macro environment. They really scare me but he seems relatively unfazed. Although Third Point always got short positions that mitigate risk the net long exposure is substantial. Loeb thinks focusing on event-driven names, short selling and special situations will help absorb possible blows from the market as well as generate alpha. I'm not sure that sort of positioning is going to lead to good results but its part of what I'm doing as well. In a desperate attempt to generate returns while being mindful of the risks that are out there.

Disclosure: No positions.

About the author:

Bram de Haas
Bram de Haas is the managing editor of The Black Swan Portfolio.

Visit Bram de Haas's Website


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