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Bram de Haas
Bram de Haas
Articles (272)  | Author's Website |

Dan Loeb's Market Oulook for 2018 And Beyond

A look at how his market outlook is changing through 2018

August 06, 2018 | About:

Daniel Loeb (Trades, Portfolio) of Third Point LLC is one of the better-known and most aggressive activists. He also made a timely pivot away from a value focus and included more growth stocks, which kept him ahead of many pure value investors over the past few years. I reviewed his quarterly letter last quarter as well in which he said:

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

"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."

From his current quarterly letter it appears Loeb is slighlty less worried as we're halfway through the year. His market outlook can be summed up in four somewhat controversial points (all emphasis is mine):

"...our view of the current economic backdrop is: 1) US growth will remain buoyed at a high level due to the fiscal stimulus impulse from spending increases coming into the system. Barring an escalation of trade conflict, most of the deceleration in the global manufacturing cycle is likely behind us; 2) inflation has remained stable in the first half of the year, with little sign of impending acceleration, despite a record low unemployment rate; 3) the cycle can extend longer than many people think as companies are in good shape, particularly in the US, and the consumer is strong while carrying only modest debt levels; and, 4) equities are not expensive at 16x forward earnings."

There are very few people who believe the fiscal stimulus will do nothing. However, many argue it will have a short-lived effect because it is mostly a one-time boost. In addition, Loeb sees U.S. growth, barring a trade conflict, while one could argue we already have one on our hands.

Loeb sees few signs of accelating inflation. I agree, but this is a key danger nonetheless. I want to be prepared. By the time inflation would be raging, there wouldn't be any good trades to protect against it anymore.

I expected a downturn by now and still think it could be here in 2019. I don't understand why Loeb believes companies are in good shape. True, they are showing record levels of earnings, but these would quickly dissapear in a recession. Meanwhile, balance sheets are stretched, with companies carrying 2007 levels of debt. That debt will still be there in the next recession unless it's addressed.

I get the argument that equities are modestly priced at forward earnings. Forward earnings jumped because of very strong earnings reports, which deflated the price-earnings ratio of the S&P 500. However, pretty much everything is going right: There are low financing costs, low energy costs, low basic material costs, little wage growth and not a lot of inflation. That gets us to these record earnings figures. If earnings were to come down, as record profit margins come down to more reasonable levels, multiples get stretched again. If we look at a more trustworthy metrics like the Shiller P/E, we see it is trading 92.6% above the historical mean:

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"The risk of recession in the next year remains low and, without this concern weighing heavily on markets and with the tailwinds we have described, we believe equities should go higher but at a moderate pace. While our case for continued favorable conditions is sound, we recognize that the calculus is more fragile than it was a year ago. The single most important factor to follow is Fed action. If the Fed is determined to “kill the patient” through aggressive intervention in the form of rate hikes then the current health of the patient is irrelevant. If the Fed continues at its current pace, it will have tightened by ~3% (or even ~4% if one includes its roll-off of quantitative easing measures) by the end of 2019. Tightening of that magnitude has almost always resulted in recession. While we believe this well-seasoned Fed understands exactly the tightrope it is walking, the risk of destructive action is not zero."

Just like Howard Marks (Trades, Portfolio), who singled out the same primary risk, Loeb is most fearful of sustained rate hikes. As long as inflation remains subdued, I expect the Fed to slow down if its policies start to affect markets. This is one of the reasons why inflation is so scary to me. We don't need hyperinflation for it to bring markets down. If inflation only gets to a level (3% or higher) where it starts forcing the Fed's hand, that can tip markets. Then we would get reacquainted with the stagflation scenarios that we've feared in the past. But there are three more important fears:

"Beyond this, markets could be upset by several factors, including: 1) an escalating trade war. At this point, we are not concerned about the impact on the economy from the current tariff tit-for-tat, but an out-of-control battle could inject fear and caution into markets. More important, and less well-understood, is that a trade war threatens the margin structure of the S&P 500. Since 2000, 100% of margin expansion has been driven by manufacturers (e.g. technology, capital goods, etc.). We estimate that global value chains have driven between one-quarter and one-third of this expansion. Thus, a trade war that results in substantial increases in labor costs or even disruption to the current system could meaningfully reduce a key element of corporate profitability; 2) any growth acceleration will be less strong than in 2017 and is likely to be concentrated in the US, an unfavorable comparison to the previous year that may encourage pessimism; and, 3) increasing signs of inflation, given the tight labor market."

I'm not convinced the pressure on the margin structure of the S&P 500 isn't well understood. This pressure is why investors fear tariffs. But Third Point's estimate of attributing one-third or one-fourth to globalization is an interesting figure. That gives us a concrete idea of what a trade war could do. Given that the market trades at lofty multiples, margin erosion can cause a lot of damage in terms of dollars lost. Something to keep in mind.

The tight labor market is definitely starting to have an effect, and Loeb is 100% right to be concerned here.

Overall, Loeb seems to be slightly less concerned than he was in 2018, although he does indicate several key risks and is especially watchful of the Fed's actions.

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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