Dan Loeb’s Macro Outlook and Event Risks for 2018

Third Point Fourth Quarter 2017 Investor Letter, January 22, 2018

Annual Review

  • In 2017, generated returns of 18.1%; equities contributed 93% of total return
  • Top 10 winners included 3 industrials position, 2 consumer names, 2 technology investments, 2 financials holdings, and a healthcare investment
  • Credit portfolio also provided gains despite a rich market, returning 17.1% on average exposure versus the IBOXX HY Index’s 6.3% return
  • In 2017, single name shorting effort was good, generating only -7% in losses relative to S&P’s 21.8% gain
  • Dedicated short selling team did even better, with absolute returns of 13% and 35% of alpha by focusing on idiosyncratic factors ranging from misleading accounting to outright fraud to trends across industries such as: the confluence of oversupply and waning demand; the loss of pricing power due to changing consumer behavior and the disruptive effects of technology; and, the exhaustion of equity stories based on serial acquisition behavior, earnings adjustments, excessive cost cutting, and financial engineering
    • Believe that the prolonged environment of low interest rates has likely created excess capacity in many industries and that this will have unintended consequences for companies’ pricing power and margins, creating an abundant opportunity set for short-selling in 2018 and beyond

Macro Review and Outlook

  • Strong global growth, tepid inflation and the rollback of the Administrative State created a benign environment for equity investing in 2017
  • Global growth was boosted by easing financial conditions resulting from the Fed’s decision not to follow through on its expected rate hikes and by China’s credit and fiscal stimulus
  • While growth was a natural outcome of easing financial conditions, the big macro surprise of 2017 was the reversal of the upward trajectory of US core inflation
    • This turnabout – coupled with the stalling tax and health care reform legislation earlier in the year – was a recipe for the consensus trades of early 2017 to go wrong
    • Contrary to expectations, USD plunged, US rates failed to march higher, tech put up its best year since 2009, and US equities fared strongly against their foreign peers, especially in risk-adjusted terms
  • For 2018, the key question is to what extent the benign environment can persist. While growth is unlikely to accelerate much further, easy financial conditions and pending fiscal stimulus can sustain growth around current levels
  • Inflation is likely to drift up only modestly and remain at or below central bank targets
  • In the US, we see indications that the favorable backdrop for our investment approach will continue due to a variety of factors: easy financial conditions, tax cuts and fiscal spending, increased capex, and deregulation
  • Specifically, we think that:
    • Easing financial conditions are a key pillar of growth. The current US financial conditions impulse of ~1.0% is the greatest since 2009 and expected to support growth near the current above-trend pace during at least the first half of 2018
    • The tax cut and increases in fiscal spending could boost GDP growth by ~1.0% (relative to trend growth of ~2.0%). The key point is that a gradually waning financial conditions impulse over the course of 2018 can be offset by a fiscal stimulus impulse, which thereby can keep growth at an above-trend pace for longer
    • Capex has room to surprise to the upside in 2018 for a variety of reasons. The economy is entering the later part of the cycle, during which rising wages tend to accelerate capex. FCF is high while CEO confidence and capex intention surveys are at their most bullish levels since 2004. The recent tax deal further incentivizes capex through a) its stimulation of aggregate demand, which leads to higher investment via a feedback loop, b) the cut in the corporate tax rate, which increases the after-tax return on capital, and c) accelerated depreciation allowances. With low- to mid-single digits nominal capex growth embedded in bottom-up estimates, the bar for positive surprises is low. Higher capex could galvanize a cyclical rise in productivity, which has recently started to rebound from generationally-low levels
    • The impact of deregulation is difficult to estimate but important to study. Trump administration has promised that its ratio of eliminated regulations to new ones will be 2:1 and, so far, it seems to be on track to meet this goal. Bank regulation is unlikely to become tougher and might relax at the margin, as in the case of Volcker Rule. Deregulation could lift potential growth, possibly at the cost of increasing financial stability risk later down the road
  • Although we do not fear a recession now, “event risks” need to be considered. 4 issues we are most closely watching are:
    • The unusually favorable combination of accelerating growth and tepid inflation seen in 2017 is unlikely to repeat. Historically, the best time for markets is when growth is accelerating. Since growth is already at a high level, further acceleration is less likely. That means that average returns will likely be lower and volatility higher this year than in 2017
    • While inflation is likely to drift up only gradually, as the events of 2017 have shown, forecasting inflation is anything but simple and the market’s reaction to higher-than-expected inflation readings is hard to predict. Low inflation has been a critical support for the market because it has allowed the Fed to be unhurried in its rate normalization, which has kept long-term rates subdued. We are watching closely to see how a tightening labor market and recently announced wage hikes will shape the future path of inflation. Labor’s inability to gain pricing power so far in this cycle has been a key pillar of the market’s bullish equity story
    • Earnings growth has been strong, supporting the market and P/E multiples. In both absolute terms and relative to expectations, the momentum of earnings growth is at a peak and its normalization could create greater volatility compared with the tranquility of 2017
    • The odds of a recession over the next one to two years are low due to a) the current strong level of growth supported by easy financial conditions, b) the growth support from tax cuts and fiscal spending, c) the low level of the real Funds rate, and d) the lack of major macroeconomic imbalances such as excess credit growth or overinvestment. Sometimes, however, recessions are caused by unanticipated events. A recession would come as a surprise to investors and would likely lead to a substantial market decline given the expansion in valuations in recent years and the concern that the Fed would not have enough ammunition to sufficiently stimulate the economy

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