Carlson Capital: Border Adjustment Tax Would Lead To “Global Depression”
In their latest quarterly letter, Carlson Capital’s Black Diamond Thematic Fund (which was up 9.27% in Q4 and up net 19% in 2016) portfolio managers Richard Maraviglia and Matt Barkoff, who unlike Carl Icahn, Stanley Druckenmiller, Dan Loeb and most of the market, turned rather bearish weeks into the Trump victory, warn that “we may be looking at the grisly spectacle of stagflation”, echoing ongoing warnings from virtually all major banks that the market is wildly overpriced:
If the economy slows down against expectations it will have little effect on the upward direction of inflation. The rationale of inflation was cost-push and supply side constraints not demand side stimulus. Thus, we may be looking at the grisly spectacle of stagflation with the equity market on the highest cyclically adjusted valuations ever.
The two PMs are especially concerned about an imminent stagflationary episode, coupled with a concurrent recession, for the following reasons:
“Based on rising commodity prices and the more than one hundred percent year-on-year increase in crude oil, also an (OPEC) supply issue, we expect inflation to rise quite sharply perhaps as high as five percent over the next year. Anytime over the last thirty years that oil has risen one hundred percent year-on-year and long end interest rates are up one hundred percent year-on-year with a strong dollar, the US economy has slowed down often into recession. It squeezes consumer real purchasing power, slows real consumer spending at a time when export growth could slow given uncertainty over new, undecided policies and a less competitive currency. This is a global phenomenon; Japan has an extremely low unemployment rate too. The Eurozone and UK CPIs are destined to accelerate also.”
Needless to say the fund is bearish, and here is the reason why in its own words:
Politics and history feature heavily in our thinking as we begin the year. We see a variety of factors that could cause macro deceleration just at the moment when investors have been dragged kicking and screaming into cyclical positioning, a place in which they are not truly comfortable. We further see much more dramatic risk from China. The combination offers attractive optionality to defensive positioning that is now under owned and attractively priced. As it relates to the Trump rally, we could argue that there were several drivers. The first was seasonality into year end. The second was the enforced bond-equity rotation which we suspect could be over in the short term. Third, fourth and fifth would be policy themes: corporate tax reform, infrastructure spending and broad deregulation. It was notable that in his first press conference there was no mention of any of these but rather unprompted criticism of the pharmaceutical industry.
Setting aside intra-market rotations, we note that hedge funds are really long the market right now. Recent CFTC data showed large US futures buying by hedge funds. Net futures positioning is now above the 80th percentile. Recent prime brokerage data showed net leverage +6.5 percent above the trailing twelve month average and is now close to a twelve month high.
In short, euphoria: “Sentiment is bullish; inflation is deemed to be a good thing despite the points we have made here. The Merrill Lynch Survey shows that we are in the euphoria stage:”
As it remains a constant topic du jour the hedge fund also touched on China, saying “monetary policy is tightening as interest rates in China have risen by almost one hundred basis points since the US election. Rising interest rates have caused a slowdown in corporate bond issuance. We would expect that Chinese New Year starting on January 27th will cause a further spike in rates.
Due to the pressure that rising interest rates will have on GDP given China’s leverage will reach three times GDP by 2018.
Thus, if China remains committed to a stable currency, it means tighter economic policy and downside to data now that government fixed-asset investment has begun to fall back to pre-February 2016 stimulus levels. The simplest way to observe this is through Shanghai house prices, which have just turned negative.
Carlson also has some thoughts on the current rate hiking cycle, which it views as further justifying the fund’s bearish posture:
Prior letters have been focused on the Fed and the implications of the rate hike cycle. These implications have not gone away, but have perhaps been forgotten and the path will be difficult to reverse. Regardless of current opinion, the truth is that tightening cycles almost always cause multiple contractions. The only exception was a six month period at the beginning of the chart below in 1987…
Next, some market observations: “we note that the market is rising on ever-decreasing breadth. In the second week of January when the averages made new highs, only 3.5 percent of securities closed at a fifty-two-week high. This was one of the smallest readings in decades. The average over one hundred years is almost fifty percent. The last two times breadth was this weak was in July 1999 and March 24, 2000.”
Unlike Horseman, which suffered a big drop in the last two months of 2016, Carlson is boasting with a nearly 19% return for 2016 despite “a short beta position of 34.5%.”
The fund remains short. We produced a return of 18.95 percent net of all fees in 2016 despite averaging a short beta position of 34.5 percent on average throughout the year by capturing important rotations based on our macro analysis. This amounted to a 3.34 Sharpe ratio for the fourth quarter and 1.64 for the year. We see more of these alpha transitions to come going forward but expect that we can also capture beta at some point in the first quarter of 2017. Volatility is here to stay and we also expect to be somewhat volatile and accept it as a cost of doing business and will attempt to control risk as much as possible while expressing our views.
Finally, and as the title suggests, the biggest risk according to Carlson’s PM is the US trade deficit, and specifically how the proposed Border Adjustment Mechanism would impact both the global economy and stocks:
We cannot overstate the impact of a declining US trade deficit and this is why we spent a large part of the letter discussing it. If the border adjustment mechanism is implemented as proposed we think it will cause a global depression and a major equity market decline. It is still unclear whether it will happen but at the very least we expect that US trade policy will put downward pressure on global growth. When this becomes apparent commodities will correct meaningfully and we will reinvest in inflation beneficiaries. Until then we are short cyclicality with what we assess to be tremendous risk-reward optionality through semiconductors, industrials and miners.
Full letter below: