Economic discussion during the [fourth] quarter was dominated by the surprise election of Donald Trump, adding to the growing support for populist platforms following the Brexit vote earlier this year. The expected reduction in taxes and regulation combined with fiscal stimulus from infrastructure-related projects has caused both growth and inflation expectations to increase around the world. This optimism has been tempered by the potential negative impact on global economic growth associated with the protectionist measures promised by the new president. From our side, we feel that a pro-business administration will likely have a positive impact on business spending and investment. Foreign policy remains a wildcard, especially in regard to China. We view president Trump’s personality as being in sharp contrast to that of his Chinese counterparts, which could lead to considerable friction as the two superpowers clash for economic and military control of Southeast Asia. Following the election, I have been asked by multiple investors what impact the Trump election might have on the current portfolio. We stress that we have no special insight, but take some comfort in knowing that all portfolio companies are headquartered in the U.S. and generate in excess of 95% of their revenues and cash flows domestically.
In December, the Federal Reserve increased the Federal funds rate 25 bps to a range of 0.50%-0.75% and also suggested that it anticipates three interest rate increases in 2017. The Fed’s 2017 projections are likely to be more reliable than 2016 forecasts (where the Fed predicted four rates hikes only to raise rates once). The Trump victory and expected fiscal stimulus package have provided the Fed with additional conviction that government spending will help spur economic growth and increase inflation. As apolitical as the Fed might claim to be, we find it unlikely that a Yellen-led Fed will be as accommodating on monetary policy going forward given Trump’s prior critiques of the Fed’s reluctance to raise rates. Even without a Trump stimulus boost, the unemployment rate ended the year at 4.7% and most core inflation measures are hovering near or above the Fed’s 2.0% target for price stability, suggesting that a return to a normal interest rate policy is long overdue.
While predicting interest rates is exceedingly difficult, we continue to feel that a sharp increase in interest rates is the largest risk facing our economy. The extended period of ultra-low interest rates has incentivized governments, corporations, and individuals to take on too much debt while also resulting in elevated prices across asset classes as investors bid up risky assets in an effort to meet nominal return targets. In a world with too much financial leverage, a sharp increase in interest rates would be especially damaging as entities would be forced to refinance maturing debt at much higher rates (if they are able to refinance at all). We have attempted to protect our portfolio by purchasing companies with little to no debt and an owned asset base. While no asset class would likely be spared from a sharp increase in government bond rates, our portfolio of unlevered companies with significant owned assets would face little refinancing/interest rate risk while the owned assets of these companies could help mitigate the impact of higher inflation.
One of my favorite financial cartoons provides an interesting example on the dangers of financial leverage. The cartoon was published during the depth of the Great Recession when many over-leveraged companies were facing bankruptcy. It shows a small factory operating in the countryside with the caption reading “I wonder if Wall Street still thinks my balance sheet is inefficient.” Interestingly, the vast majority of companies in our portfolio might be considered to have inefficient balance sheets. The primary consideration here is that interest payments on debt are tax-deductible whereas equity dividends are not. Thus the tax laws of the United States incentivize corporations to issue debt in order to lower their cost of capital. While the tax-deductible status of interest payments helps bankers collect fees and improves leveraged buyout returns, it also reduces the financial stability of the United States. Although the structure would be difficult to enforce, removing this deduction would likely result in less leverage at the corporate level and a safer financial system. On the downside, such a rule change might also increase our competition from other investment firms.
The above post has been excerpted from a recent letter of Gate City Capital Management.
Performance for the period from September 2011 through August 2014 has undergone an Examination by Spicer Jeffries LLP. Performance for the period from September 2014 through December 2015 has undergone an Audit by Spicer Jeffries LLP. Performance for 2016 is unaudited. The performance results presented above reflect the reinvestment of interest, dividends and capital gains. The Fund did not charge any fees prior to September 2014. The results shown prior to September 2014 do not reflect the deduction of costs, including management fees, that would have been payable to manage the portfolio and that would have reduced the portfolio’s returns. Actual performance results will be reduced by fees including, but not limited to, investment management fees and other costs such as custodial, reporting, evaluation and advisory services. The net compounded impact of the deduction of such fees over time will be affected by the amount of the fees, the time period and investment performance. Specific calculations of net of fees performance can be provided upon request.