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Ryan Vanzo
Ryan Vanzo
Articles (160) 

5 Reasons Why Seth Klarman Is Nervous About 2020

The guru is bearish on the year to come

September 04, 2019 | About:

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 so­cietal 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.”

Read more here:

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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About the author:

Ryan Vanzo
Ryan has a finance degree from Bentley University with experience at multiple mutual funds doing fundamental research.

Rating: 4.4/5 (8 votes)

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Comments

Cowboy77
Cowboy77 - 1 month ago    Report SPAM

"Klarman also said recent multitrillion-dollar tax cuts have exacerbated budget deficits in the U.S."

Revenue increased after the tax cuts just like they always do and always have. How does that increase the deficit? Spending is the problem but Klarman, like Dalio, hates Trump and I believe it skews their thinking. I share many of his concerns but tax revenue isn't one of them.

CP30
CP30 - 1 month ago    Report SPAM

@Cowbow77

"Revenue increased after the tax cuts just like they always do and always have. How does that increase the deficit? Spending is the problem but Klarman, like Dalio, hates Trump and I believe it skews their thinking. I share many of his concerns but tax revenue isn't one of them."

Yes, but did revenues increase as much as they could have? In an economy that is doing well, revenue increases should/could theoretically be higher. Tax cuts shouldn't be used when everything is going very well. It only juices an economy that is already juiced and adds to overvaluations at the cost of additional borrowing to fund the spending. Tax cuts should be used when you need to put that money back into private hands to spur growth (along with low interest rates). Borrow money at low rates, give tax cuts, etc -> growth. Once everything is going well, remove the tax cuts and replenish that borrowed money that was used to originally fund the tax cuts.

Cowboy77
Cowboy77 - 1 month ago    Report SPAM

"Tax cuts should be used when you need to put that money back into private hands to spur growth"

Putting money "back" in private hands? It was "taken" from us to begin with. The amount of money just squandered by our government should be enough reason to not let them have it in first place. Tax revenue is not the problem. Spending is the problem.

Nevertheless, I disagree with your premise that somehow we take in less revenue due to the tax cuts. Thomas Sowell would strongly disagree with you on that statement as the facts prove otherwise.

Thomas Macpherson
Thomas Macpherson premium member - 1 month ago

We thought this was interesting in Nintai. Here are the Federal tax receipts from 2005.

FY 2020 - $3.64 trillion, budgeted.
FY 2019 - $3.44 trillion, estimated.
FY 2018 - $3.33 trillion.
FY 2017 - $3.32 trillion.
FY 2016 - $3.27 trillion.
FY 2015 - $3.25 trillion.
FY 2014 - $3.02 trillion.
FY 2013 - $2.77 trillion.
FY 2012 - $2.45 trillion.
FY 2011 - $2.30 trillion.
FY 2010 - $2.16 trillion.
FY 2009 - $2.10 trillion.
FY 2008 - $2.52 trillion.
FY 2007 - $2.57 trillion.
FY 2006 - $2.4 trillion.
FY 2005 - $2.15 trillion.

Ryan Vanzo
Ryan Vanzo premium member - 1 month ago

@CP30 you seem to be arguing based on economics while @Cowboy77 seems to be arguing based on principles. Likely won't find much alignment here given the goals are different.

@Thomas thanks for the data. Aligns generally with current tax receipts from the Fed (link below). Although FRED shows a decline in tax receipts following the tax cut, which are only recently approaching pre-cut levels.

https://fred.stlouisfed.org/series/W006RC1Q027SBEA

stephenbaker
Stephenbaker - 1 month ago    Report SPAM

Someone please explain why demanding a level playing field with our trading partners is "isolationist" and "populist". If we somehow succeed, how is this bearish for the future?

batbeer2
Batbeer2 premium member - 1 month ago

>> Someone please explain why demanding a level playing field with our trading partners is "isolationist" and "populist".

It's not.

But perhaps you can explain how (as you implicitly claim) the playing field is skewed against the US?

You will have a tough time proving US workers are more productive than any other. As long as they're not, the US doesn't deserve and won't have a trade surplus. There's a reason US consumers prefer foreign goods. Yes, there are things the US does better but the list is short. Important but short.

The nonsense about how China keeps its currency low artificially doesn't count. If US politicians feel this gives China an unfair advantage, what's stopping them from devaluing the dollar? A depressed Chinese currency is simply another way of saying Chinese workers are willing to work for less. What's more, the Chinese central bank has interest rates higher than the US's. That policy props up the Renminbi versus the USD.

stephenbaker
Stephenbaker - 1 month ago    Report SPAM

Hi Batbeer,

It is not difficult to prove that China has been openly stealing our technology. I agree with you regarding so-called currency manipulation (what country doesn't do it?). Moreover the objective should really not be a trade surplus or deficit - the outcome should be based in large part on availability, quality, pricing, supply, demand, etc... Whether we wind up with a surplus or deficit is only a result of more important factors.

swnyc2
Swnyc2 - 1 month ago    Report SPAM

What really matters is not how much the government taxes or how much the government spends. But rather the value the government gets for what it spends. If people saw good value in government spending (reduced commuting times, cleaner air/water, cures for cancer, etc) people would complain a lot less.

Regarding China, the main problem isn't trade deficits or currency manipulation. Rather, it's the fact that China's economic system is dominated by state owned enterprises and distorted by communist party controls. China does not respect intellectual property because it benefits much more by stealing than it stands to lose. Today, no company can negotiate fair trade terms with China. That's why the U.S. government should and needs to step in. We can argue about whether the U.S is doing the best job at attaining the goal of fairer trade, but we should all at least acknowledge that something needs to be done.

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