SUI Generis Investment Partners April 2016 letter on free trade policies, titled, “This Means War.”
March 2016 carried with it one of the strongest upward moves in equity markets in recent memory and for many the tumult of the first seven weeks of the year is now water under the bridge. We’re now quite worried about the negative long term implications of the excessively loose monetary policy that seems to have fueled the equity rally. And though these are very uncertain times we can be certain of one thing, the market does not care one bit that we’re worried. We often say that we don’t get paid to be bullish or bearish, we get paid to be right; so it’s only fair to use this expression when we’re wrong (more on this in a second). While we can certainly make the argument that we are currently “right” about any number of important indicators that one would assume influence the stock market (feeble economic data the world over, declining corporate earnings against stretched valuations, a broken oil and gas sector, currency manipulation, etc.), for the time being the only thing that seems to matter is which particular central banker is giving the most dovish communique.
Circling back around to being “wrong” on stocks and what that means to our Fund, we remained net short of equities throughout the month of March and steadily increased our short position as the month and the rally wore on. While most would assume that being short a market that moved aggressively higher would yield negative performance, such is not the case here. In spite of our bearish positioning the Sui Generis Investment Partners Master LP posted another positive month, our 5th in a row. As always, we believe the strength of our portfolio is a function of our investment process and this allows us to be directionally “wrong” on the market for periods of time and still make our clients money. This actually makes us much happier than being “right” and making money, because that’s assumed.
Sui Generis – Free Trade
This month we want to dig into what we think will be a major market narrative for the foreseeable future…. free trade. The concept of a currency war has been bandied about for years as monetary policy has become more prevalent in the eight years since the global financial crisis. What we find particularly interesting is that the goal of weakening one’s currency by lowering interest rates has gone from implied to explicit. Those in charge of central banks no longer even pretend that they’re not engaging in competitive devaluation. Japanese Finance Minister Taro Aso amusingly demonstrated this last week with his response to the Yen’s rapid rise, calling it “undesirable”. The public use of such strong language no doubt means JCB will lower interest rates even further into negative territory in an attempt to weaken the Yen in relation to Japan’s major trading partners. We don’t need to go too far into how long we think the currency games will persist, because we believe we have figured out the global arena in which these games will manifest themselves over the coming months and years; trade.
Exceptionally loose monetary policy has been the tool of choice to combat anemic economic growth around the world for the last eight years. The forces of these policies have combined to produce a global environment that has attracted a more radical breed of politician in recent years. These non-establishment candidates have built momentum on the backs of an electorate that is tired of seeing little return for their respective tax dollars. The succession of social movements is telling; the Tea Party, Occupy and Black Lives Matter can all be connected to the fact that life hasn’t improved since the global financial crisis as promised. Household income in the US is still below 2007 levels. The 2016 election seems to have taken on even greater significance as the populace is looking for someone to blame, the protectionist backlash could be nigh.
Do a quick Google search of “Carrier Air Conditioner Layoffs” to find the recent Youtube clip of a large room of people being told en masse that they would be losing their jobs as production will be moving to Mexico. As much as Martin Shkreli became the flashpoint for the public backlash against pharmaceutical pricing practices that has created many casualties (See: Valeant), we believe the unfortunate fate of these Carrier employees (recorded and viewed nearly four million times) seems to be the tipping point for anti-trade sentiment.
One might assume that the far left-of-center Bernie Sanders or Donald Trump and his bombastic calls for “fair trade” would be outliers, but the truth of the matter is that the opinions of the four leading presidential candidates in the United States are indistinguishable from one another when it comes to trade. Republican and Democratic candidates alike are leaning on protectionist rhetoric as a pillar of their economic plan and all have publicly opposed the recently created Trans-Pacific Partnership. We believe that once the candidates are selected and the proper campaign begins, the rhetoric will be loud enough to be a headwind for valuations in those industries that have been dependent on accommodative trade policy and tax avoidance. But at the end of the day political rhetoric is just that, and if all campaign promises came to fruition, the world would resemble a very different place than it is today. So is this a trade to put on solely for the election? We don’t think so.
One need only to look for some historical context to understand why we think there could really be something here. In August of 1971, the United States government under Richard Nixon imposed (amongst other things) an across the board “import surcharge” of 10% in response to what it viewed as currency manipulation. We dare you to read about the environment leading up to what became known as “the Nixon shock” and not see the similarities between then and now. Of course there are differences and additional complexities today but these words, spoken on August 15th 1971 by President Nixon, sound as though they could come from any candidate in 2016, “I am taking one further step…to improve our balance of payments, and to increase jobs for Americans. As a temporary measure, I am today imposing an additional tax of 10% on goods imported into the United States…It is an action to make certain that American products will not be at a disadvantage because of unfair exchange rates. When the unfair treatment is ended, the import tax will end as well. As a result of these actions, the product of American labor will be more competitive, and the unfair edge that some of our foreign competition has will be removed. This is a major reason why our trade balance has eroded over the past 15 years”
Of course there are no certainties that our concept of a currency war evolving into a trade war will play out and we’re not suggesting that the next President will rip up trade agreements. Given that our base case for President is still Hillary Clinton it’s entirely possible that things could remain the status quo a year from now. But we can’t see a great deal of upside in the names we will focus on, which essentially means we’re giving ourselves a low risk option on their decline should the campaigning get aggressively protectionist, and even more torque if trade policy actually begins to change.
So what sectors make the most sense here and how exactly are we planning to make our investors money by getting short the world’s established trade framework? Look for some of the defining characteristics of this bull market, then avoid them. Has the company seen a considerable decrease in the amount of tax it pays? Avoid. Has the company seen their margins expand to all-time highs on the back of outsourcing? Stay away. Is the company banking on major Asian growth in its outlook? Look out. Think volume; automotive names, other large manufacturers that have offshored their production and the railways. The rails are of particular interest to us given their dependence on volumes into and out of ports and their tight correlation with trade activity. Industries like textiles that benefit from both low tariffs and low effective tax rates seem particularly vulnerable going forward given their exposure to negative sentiment surrounding both trade and tax avoidance, the latter being very topical after the publishing of the Panama Papers. The point we would like you take from this is that we see companies with a great deal of uncertainty ahead of them trading at what we believe are excessive valuations. The anti-trade chorus is getting louder in the United States and by the time it gets to be deafening we suspect this will have already been a very profitable trade. If you would like to discuss this idea further, please feel free to be in touch.
The Sui Generis Team