Seth Klarman (Trades, Portfolio)’s Baupost Group is one of the most respected asset managers in the world. In many ways, the guru's multi-decade track record rivals only the likes of Warren Buffett (Trades, Portfolio) and Prem Watsa (Trades, Portfolio).
If you’ve been paying attention, it should be clear that Klarman is growing increasingly nervous about the future. His 22-page annual letter to investors—which was shared heavily at Davos this year—described several key headwinds the global economy could face in 2020.
Here are Klarman’s biggest worries about the year ahead.
Rampant populism
Wealth inequality is fueling a surge in populism, Klarman believes. This could have damning long-term effects in how we do business. “It can’t be business as usual amid constant protests, riots, shutdowns and escalating social tensions,” Klarman wrote. “Social cohesion is essential for those who have capital to invest.”
When you combine a disenfranchised electorate with political elites, the results can be disastrous. “Politicians tend to follow the polls instead of their hearts or brains,” Klarman wrote. “They listen more to political consultants than to voters. Our short-term-maximizing politicians fail to tackle longer-term soĂ‚Âcietal challenges such as climate change or unaffordable entitlement programs and the resultant on- and off-balance-sheet liabilities.”
Ultimately, the guru isn’t optimistic that social unrest will ease anytime soon. “It is not hard to imagine worsening social unrest among a generation that is falling behind economically and feels betrayed by a massive national debt that was incurred without any obvious benefit to them,” he concluded.
Other hedge fund stalwarts agree. Ray Dalio (Trades, Portfolio) recently published an essay saying that “disparity in wealth, especially when accompanied by disparity in values, leads to increasing conflict and, in the government, that manifests itself in the form of populism of the left and populism of the right and often in revolutions of one sort or another.”
Government intervention
Klarman is also worried about the U.S. government's intervention into markets, particularly to combat the inexorable effects of automation. Over time, he argues, automation will occur whether governments welcome it or not. Spending to fight automation will, at best, end in a Pyrrhic victory. It will leave the country with industries and businesses that aren’t competitive on a global basis.
“President Trump may be able to temporarily hold off the sweep of automation and globalization by cajoling companies to keep jobs at home, but bolstering inefficient and uncompetitive enterprises is likely to only temporarily stave off market forces,” he wrote.
Klarman is also worried about protectionist trade policies that are shaping how U.S. businesses plan and operate. He argues the long-term impact of interventionist trade policies will ultimately hurt the economy and standards of living.
“While they might be popular, the reason the U.S. long ago abandoned protectionist trade policies is because they not only don’t work, they actually leave society worse off.”
Klarman argues that as the U.S. further isolates itself, the future direction of global policy grows increasingly uncertain. “As the post-World War II international order continued to erode,” Klarman wrote, “the markets ignored the longer-term implications of a more isolated America, a world increasingly adrift and global leadership up for grabs.”
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Rising deficits
Klarman also said recent multitrillion-dollar tax cuts have exacerbated budget deficits in the U.S. “The Trump tax cuts could drive government deficits considerably higher,” he said. If interest rates continue to rise, the economy could be in trouble.
“The large 2001 Bush tax cuts, for example, fueled income inequality while triggering huge federal budget deficits,” Klarman wrote. “Rising interest rates alone would balloon the federal deficit, because interest payments on the massive outstanding government debt would skyrocket from today’s artificially low levels.”
Sovereign debt
In connection with rising deficits, Klarman is worried that increased levels of sovereign debt may ultimately result in panic, though it’s not yet clear when that panic might hit.
“There is no way to know how much debt is too much, but America will inevitably reach an inflection point whereupon a suddenly more skeptical debt market will refuse to continue to lend to us at rates we can afford.” But just because we don’t know exactly when the tipping point will come doesn’t mean investors shouldn’t be prepared. “By the time such a crisis hits, it will likely be too late to get our house in order,” he said.
Most worryingly, the sovereign debt crisis could spell the end for the U.S. dollar as the world’s reserve currency.
“In 2018, the U.S. budget deficit soared to nearly $900 billion and could top one trillion dollars in 2019, a sorry consequence of the 2017 tax cuts that were funded with borrowed money. Growing deficits have ballooned the national debt, which by year-end hit a record $21.9 trillion (with potentially multiples of that in off-the-books entitlement promises), this while debt costs are suppressed by low interest rate policies. Approving massive tax cuts and generating the resultant huge deficits so late in the economic cycle while unemployment is so low seems particularly irresponsible, as there is little room for new fiscal stimulus if and when the economy softens. While the U.S. dollar maintains its de facto reserve currency status, this is a privilege (America’s exorbitant privilege, it was once called) never to be taken for granted. The nation’s fiscal irresponsibility jeopardizes this status, which has allowed Americans to live beyond our means for a long time without paying any price.”
“The seeds of the next major financial crisis (or the one after that) may well be found in today’s sovereign debt levels,” Klarman concluded.
Investors are too trusting
In 2017, Klarman wrote a letter outlining his concern that most investors have simply become too complacent. This is a classic phenomenon during bull markets—investors forget the lessons of the past. “When adversity is absent, investors become complacent. They assume good times will continue, and they grow careless about risk, perceiving it through rose-colored lenses,” he wrote.
Klarman highlighted three “traps” that investors are yet again buying into:
- Greed and fear, which incentivize investors to do the wrong thing at every turn.
- Aggressive brokers, investment bankers and traders who routinely promise more than they can deliver.
- A myopic focus on short-term performance over long-term risk.
The perennial traps, in combination with rising populism, government intervention, budget deficits and sovereign debt loads, make for an uneasy future. “If things go wrong, we could find ourselves at the beginning of a lengthy decline in dollar hegemony, a rapid rise in interest rates and inflation, and global angst,” Klarman wrote.
For now, it looks like he’s putting his money where his mouth is. Reports suggest Baupost’s portfolio fund is currently “more than 30%” cash.
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