In each year’s letter, we discuss and update you on our practice of identifying low-probability events where consensus is so strong in one direction that the market-implied probability of the opposite happening is near zero. Our “MLP Meets Charles Ponzi” contrarian theme played out in dramatic fashion in 2015 and we decided to retire it. “Crowd in the Cloud” remains outstanding with few cracks appearing yet. The one new contrarian theme this year is “The Great Bond Unwind.”
Crowd in the Cloud
Cloud based computing has attracted an excess of capital, entrants and enthusiasm, setting the stage for a wave of failures.
Consensus View (2015): Cloud computing is a compelling and proven model for efficiently allocating IT capital, bandwidth and resources among users, obviating the need to own and manage expensive complex systems in-house. The trend of converting in-house IT to cloud-based IT is in its early stages and the future is very promising for hundreds of cloud computing providers across many industry verticals. Large investments now by providers will pay off in the future.
Alternative View (2015): We agree strongly with the advantages of this new business model but in practice observe many upstart cloud computing ventures struggling to gain scale. The typical venture adopts a vertical niche, claims expertise, wraps the cloud halo around itself and then proceeds to invest large capital up front in the hopes that enough customers will sign up and pay a recurring subscription fee.
Update/Resolution: The market leaders continue to perform well, while the second- and third-tier players continue to access capital and invest in growth. M&A has also kept sub-scale players operating. Stay tuned.
The Great Bond Unwind
The epically long bull market in government bonds may have reached a final crescendo last year—what if a reversion to long-term historical interest rates happens rapidly/disruptively?
Consensus View (2016): The ultra-low yields on government debt are a reflection of deflationary economies and demand for a perceived safe place to park capital. Earning 2.5% on 10-year money is acceptable because of a general lack of growth and yield available elsewhere at acceptable risk. These instruments are an essential/foundational component of any institutional asset allocation.
Alternative View (2016): Many prognosticators have attempted to call the peak of this market for years and failed, so it is not without reluctance that we venture a macro call. However, signs of economic growth and inflation are emerging after a long period of stagnation; labor markets are finally tightening. The yields on bonds are so low that investors (e.g. pension funds) cannot fulfill their objectives owning them. They offer no inflation protection at a time when inflation may re-emerge. Government bonds are a heavily-invested and widely-owned asset class, often held by passive investors who don’t have long enough memories to understand the ravages of inflation. Perpetual deficits and debt-financed government spending may require continual issuance of more debt supply just at the time that investors shift their focus to other asset classes, leading to a faster reversion to rates which have prevailed over a longer 50-year cycle. If the 10-year Treasury Note were to revert to a 5% yield and the 30-year to a 7% yield, the magnitude of value loss would be staggering and likely create shock waves across financial markets. Interestingly, downside protection to unusually large downward moves in government bond prices can be purchased quite cheaply given the placid consensus; thus, like most of our contrarian themes over the years, we are positioned to benefit strongly if we are right without risking a meaningful drag if we are wrong on the outcome or timing.
Update/Resolution: New theme. Stay tuned.
This post has been excerpted from the Crawford Capital Partners Q4 2016 Letter to Partners.
This update is for informational purposes only and should not be construed as investment, legal, tax or other advice. This letter is not intended as, and does not constitute, an offer to sell any securities or a solicitation of any person or any order to purchase any securities, which can only be made by accredited investors and qualified clients by means of the Fund’s Offering Memorandum, Limited Partnership Agreement and Subscription Documents, which describe, among other things, the risks of making an investment in the Fund. Investments in the Fund are subject to risks and uncertainties, including the risk of loss of principal as described in the Fund’s Offering Memorandum. Investors are encouraged to read the Offering Memorandum and direct any questions to management of the Fund prior to investing. There can be no assurance that the Fund’s objectives will be met or that losses will not be incurred. Past performance is no guarantee of future results. Holdings identified do not represent all of the securities purchased, sold, or recommended for advisory clients. This document is confidential and intended solely for investors and their agents.