2016 was a fascinating year in the markets with a variety of shifting forces and the possible emergence of a major new economic paradigm that could shake up the league tables of the most successful investors of the past decade. The year began with fear over a new potential global recession following the commodity price crashes of 2015. Evidence was mounting that the industrial sectors of the economy were already in recession and that the weakness could easily spread to the consumer. Luxury goods spending was dropping precipitously and fears mounted that broader consumer spending would be the next shoe to drop. Equity markets sold off sharply in Q1, and beneath the surface, many individual stocks were worse—some quickly losing 25%-50% of their value. We stress-tested our long investments in a variety of recession scenarios that, in most cases, reinforced our confidence that they were discounted sufficiently to withstand an economic downturn. Unlike most of the stock selloffs of the past 10 years, correlation was low with some stocks holding up well as others sold off steeply. We used this opportunity to add about 15 points of net exposure, adding to longs in quality situations that we felt were unfairly punished.
Markets had rebounded somewhat by late spring until Brexit became the next pivotal event of the year. The surprising vote quickly resurfaced lingering questions about the viability of the EU and reinforced the notion that there was perhaps clout in the political groundswell that was brewing in the U.S. Republican primary process. Would the U.K. be stronger or weaker outside the EU? Would they really leave, or would the divorce be watered down or delayed? Did the Brexit vote have predictive power for the U.S. election since nationalism was now possibly a global phenomenon? We are not political scientists, but as a practical matter, the ensuing market selloff presented us with a range of specific opportunities to assess whether the severe amount of value extinguished by Brexit (in some cases additive to the Q1 selloff) was justified or not. Therefore, we merged political-scenario assessments with financial modeling and found a few situations where the market-implied negative impact of Brexit was much larger than we thought it would be. During early summer, we added meaningfully to a European luxury goods company and a global auto company whose stocks had been hit with the one-two punches of recession and Brexit panic. Brexit impact needed to be analyzed on a custom company-by-company basis in the context of: 1. It wouldn’t be implemented immediately, 2. Its provisions may be watered down, 3. Companies impacted may adapt successfully and, 4. Some companies could actually benefit from Brexit.
Next came the U.S. election. The outcome was not widely anticipated in mainstream discourse—nor, in fact, by us. The interaction between financial markets and election outcomes have been studied ad nauseam, and the relationship/predictive power to the broader market appears mostly inconsequential long term. We have generally preferred fundamental micro business analysis to attempting to predict politics. That is still true.
This election, however, was unusual. It now feels like an important demarcation zone has emerged between two very different economic regimes; it really may be different this time. A variety of pendulums have been swinging unabated for quite some time; assuming they start to simultaneously reverse as the new approach in Washington suggests, it’s important to reflect on what investing approaches might be rewarded in the next paradigm. To wit, are forces of inflation finally kicking in after nearly a decade of deflationary fears? Is the super-cycle bull market in government bonds coming to an end with ultra-low interest rates giving way to an era of scarcer, higher-priced capital? Are we about to enter an era of wide-sweeping deregulation? Is the long-running globalism-nationalism cycle about to turn back toward national interests backed by tariffs? Will the proposed U.S. corporate tax redesign transform incentives and spur capital flows? Is an era favoring big business changing to favor small business? Do fertile conditions now exist for a global M&A wave driving consolidation across industries? We think the answer to all of these questions—at least to varying degrees—is yes. If so, asset classes and investment approaches that have worked well over the last decade may not be optimal for the next decade. Macro investing is likely to give way to micro investing, and the trend to passive indexing may have gone so far as to cede the advantage back to skilled active management. There has been a lot of turnover in investment organizations, and it could well be that some of the people who left the industry in frustration years ago are now in a better position skill-wise to outperform the current crop of incumbent managers.
The forces currently aligning in favor of pro-business policies, corporate tax reform, deregulation and the normalizing of interest rates (if measured vs. spiking) have the potential to be meaningful positives for equities. For the first time in modern political history, business people will be running the Executive Branch, and they will have congressional majorities mostly aligned with them. This is uncharted territory and it will be a fascinating experiment—creative destruction to some while risky/frightening to others. The wild-card potential in foreign policy and social-program arenas cannot be ignored, but it seems likely at least that policy moves in aggregate will be economically stimulating. Proposed corporate tax reform seeks to bring the U.S. rate down from the highest in the world to a 15-20% rate, while also allowing parked foreign capital to come home cheaply. Additionally, the change would allow expensing of capital investment while disallowing the deduction of interest on debt. By our rough calculations, proposed changes to the U.S. tax code could add substantially (10-30%) to the intrinsic value of full-taxpaying companies while simultaneously changing incentives to repatriate foreign-parked capital back to the U.S. and spark capital investment. Many of our long holdings would benefit from the features of this tax proposal. We tend to own small- and mid-sized companies which are full-rate taxpayers, which don’t benefit from large interest deductions and/or which are reinvesting in large capital projects that would become eligible for full expensing of capital investment. Deregulation will serve to lower costs as well as lift uncertainty that has kept many corporate projects in mothballs or on drawing boards. Border-tax adjustments are an unknown in the contemplated new tax regime, possibly creating penalties for goods that are made elsewhere and imported into the U.S. Companies that have complex global supply chains (such as global auto companies) may face higher costs and new complications to planning. Companies that have mostly domestic assets/supply chains and make stuff in the U.S. should be insulated or even advantaged. On first assessment, we appear to have investments with an offsetting mix of impacts and don’t see major risk from border-tax changes.
After a very long bull market, long-term government bond returns have turned negative recently, leaving investors close to flat over two years. Hundreds of billions to trillions in potential outflows from this heavily invested asset class could occur if interest rates normalize upwards. Some of this capital would likely move toward equities, which offer growth and pricing power to protect against inflation. This confluence of forces combined with decreasing equity-market correlation suggests a rising premium will be placed on equity selection skill.
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.