Ardevora Quarterly Review - Second quarter 2018

Trump’s no joke

The UK is in the middle of a heat-wave and Ronaldo is now wearing a Juventus shirt. I spent a week in Australia and was cold. The world feels unfamiliar.

We all use systems of belief to make sense of the world. Our core beliefs are deeply embedded and tough to shake; the outer layers of the system act as firebreaks between what we feel is true, and messy unreasoned reality. I don’t expect to see Ronaldo in a black and white shirt, but acknowledging it as reality isn’t too hard. Ronaldo in a white shirt is a weakly held, outer layer heuristic, which I am quite willing to let go if pressured too much. Ronaldo being superior to Messi is a deeper belief which is unshaken by a Juventus shirt.

We are most prone to bias when our belief systems are under assault. In my experience people don’t like letting go of their view of how things should be in the face of contrary evidence. They sacrifice weakly held subsidiary beliefs first to protect their more deeply held ones. Orthodoxy is entrenched. Orthodoxy requires violent jolts to melt away. Like when too many things stop making sense anymore.

I have a belief markets create collective intelligence. A market can be made up of individual idiots, but the sum of all of the idiots can end up being pretty smart. I also believe it is possible to trust stock markets to be rewarding under most circumstances, despite it being right not to trust most of the individuals who run the businesses you collectively put your faith in. These are, I think, quite challenging beliefs to hold as they seem to contain paradoxical contradictions. Trump strikes me as another such paradox.

I have been in Australia seeing some of our clients. They asked me what I was worried about. I usually have a mild sense of optimism about stock markets. I think it helps to cope with the emotionally draining process of trusting in stock markets to be uncomfortably rewarding. It also helps when you have an investment approach sceptical of trust elsewhere. It is uncomfortable investing in stocks where you don’t really trust the management (we rely on our ability to spot the transient conditions which make them safer than usual). Also it’s tough coping with the daily grind of not really trusting your own judgment that much. If you don’t trust your own judgment you spend a lot of time looking for the next mistake, and you expect to make lots of them (which is why we have over 200 positions in our portfolios). There is always a sneaking suspicion there is a stock in the portfolio that is about to make you look foolish. This time, however, I didn’t seem to lack for topics of anxiety.

Three rattled off my tongue in quick succession. Fiscal stimulus, inflation and trade wars. Two of these are courtesy of Trump – he really is an unusually anxiety creating person. All three instinctively cause me anxiety because they look difficult to predict – complex with few clear reference points for inference.

Trump and fiscal policy

Trump has unleashed a fiscal stimulus package on the US economy. Its timing looks poor. The Fed is moving interest rates up, believing the economy is over the 2008-09 meltdown. Unemployment is low. Almost a decade of uninterrupted economic growth has been achieved. But Trump, like populist leaders in Italy, was voted in to do something different. Too many people believe the economic recovery since 2009 has passed them by. In real terms, it looks like it has. Voters want change; they want to feel better off and a politically distant central bank pulling the levers of the economy doesn’t look likely to deliver that change. Trump represents a challenge to the orthodoxy laid down over thirty years ago, an accepted wisdom based on a belief that politicians could not be trusted with the levers of economic management (and only central bankers could). It is the war of fiscal vs monetary policy. The last orthodoxy was accepted after a damaging surge in inflation. Now, most people don’t care about inflation.

Italy is still a mess and who knows if the new government can deliver within the EU straitjacket. Trump, however, is less encumbered, and he is starting to have an effect. A year ago the prospects for US retailers looked bleak. Poor weather, delayed tax refunds and the structural onslaught of online retailing had triggered trauma across a wide range of companies. Dystopian visions of empty, crumbling shopping malls loomed large. A year later and most of this seems forgotten. Easy comparisons, as two of the transient causes for distress unwound, and the pull of fiscal stimulus has swamped any negative undertow from Amazon and co. The rebound in US retailers is the first sign Trump’s domestic policy shift is “working”. But unless Trump keeps adding fiscal fuel to the fire, what will happen in 2019, as comparisons get tougher and people keep shifting to online? If you are stock pickers like us, this is traumatic. Company management always claim current success is down to their unique abilities and those of their businesses. When everyone is doing well it becomes harder to discern the good ones from the bad (superficially, they all look good). We suspect the tide will metaphorically go out for some in 2019.

 Inflation

A more lively US consumer and near full employment should put upward pressure on wages. Once wage pressure gets entrenched, inflation usually follows. We haven’t seen inflation for quite a while. We haven’t seen accelerating inflation for a really long time. Prices have been jumping in a wider range of things. We have had price jumps since 2009, but this time it feels different.

We look at a lot of stocks. We have noticed more excuses from managers about cost pressures in more places than before. There seems to be a convergence of previously isolated pockets of cost pressure. Businesses used to be able to navigate around narrow sources of cost pressure (a raw material here, oil price there). Now there is more layering, or compounding of pressure. The signs are still tentative, but we think we have noticed more businesses stutter on profit margins; businesses which previously found it easy to push margins up by holding prices and cutting costs.

Macro statistics don’t suggest much wage pressure. We aren’t sure they give a clear picture. Average wages are not going up much, but we suspect a mixed effect under the surface. A lot of newer jobs are in “gig-economy” areas where wage per head is low. Anecdotally more “normal” jobs are seeing wage rises.

We have also noticed more prices spiking. A raft of commodity type chemical prices went up and have stayed surprisingly high. The price of high grade iron ore has recently done the same. Neither seem to make sense from a global demand point of view. Usually you expect spiky prices when demand is surprisingly strong, but global growth has been pretty tepid. If it isn’t demand then it must be supply. A bit of digging reveals the most likely source as China. China has shifted priorities over the last few years. It has aggressively targeted overleveraged, poorly performing basic industries in two ways. First, it has encouraged debt restructurings. Second, it has significantly tightened environmental restrictions. The latter has placed an additional cost squeeze on poor businesses. Commodity chemicals and steel (both potentially heavy polluters if not managed properly) have seen a lot of stress. Steel is especially interesting. It looks like China has closed a lot of high cost steel capacity – we can only infer this as it is difficult to get official statistics. Instinctively you would expect this to be good for the steel price, but potentially bad for the iron ore price. However, the high grade iron ore price has also gone up. High grade iron ore is much more efficient and less polluting for steel makers; it has taken market share from low grade iron ore.

One area that has caught our attention recently is pulp. About a year ago, China placed tight restrictions on the import of recycled paper, due to tighter environmental regulations. Recycled paper is dirty and requires labour-intensive sorting and cleaning to allow it to be re-pulped. Most western countries collect far more dirty waste paper than they recycle. Around half of their dirty paper was sold to China. China doesn’t want it anymore. The price of recycled paper has plummeted, but no one else seems to want it. This is because the cost of getting it into a fit state for re-pulping is very high. Recycled pulp has had a big impact on the industry. Effectively it has created a lengthy period of structural oversupply. Twenty years of downward pressure on pulp prices has led to a radical reshaping of the paper and packaging industry. The accepted business model has shifted from full vertical integration (to insulate your business from unexpected spikes in raw materials) to specialisation. Now there are a relatively small number of distrusted old-fashioned pulp makers left. They tend to have their pulping plants close to their wood plantations, and have struggled to make decent returns. Lots of superficially better-looking downstream packaging companies, which have their plants close to their customers, have no capital tied up in raw materials and have found it cheap and easy to buy pulp on the open market. All of a sudden this doesn’t look so smart. The pulp price has been moving up since the Chinese change in importing recycled paper. The supply of conventional pulp looks pretty inelastic. This is another source of cost pressure for a lot of industries as the use of packaging is everywhere.

There is a risk we are being biased: just looking for evidence of multiple sources of new inflationary pressure may make them easier to see. Hence we are not tempted to make bold forecasts about imminent accelerating inflation. However we are scanning our stocks for signs of unpleasant cost pressure. Companies will try and tell us they are transitory, but it is probably safer to assume they are not.

So we suspect inflationary pressure is building and it’s starting to get into wages. This is what a populist leader like Trump should want. It is also what a debt swamped economy should want. But it isn’t necessarily what a central bank or a bondholder would want. Also, the way accelerating inflation feeds through individual companies is quite hard to predict. Essentially it comes down to relative pricing power. A business which is able to resist pricing pressure from its suppliers, but finds it easier to pass price rises on to its customers should be fine; reverse the logic and you are in trouble.

 Trade wars

If there is a consensus out there it is about trade wars. Everyone (apart from Trump) seems to accept that trade wars are bad. It is tempting to believe this is another example of Trump as a delusional joke. This is a risky assumption.

The easiest assumptions to believe are the ones you should question the most – they are harder to accept if you are wrong. Trump is no joke. He polarises but he is popular. He is part of a popular movement and the distrust of central bank orthodoxy should not be dismissed lightly. If the US economy is booming when the next election comes around the incumbent presidential advantage may be difficult to shake. If you can entertain the notion that Trump is not a joke, then what about his rhetoric on trade wars? Perhaps this deserves closer scrutiny as well.

We have not had anything looking like a trade war for almost a century. The accepted wisdom of trade wars as bad leans heavily on the argument that trade wars were a significant cause of the Great Depression. But is this a valid reference period and are Trump’s actions really so alarming?

Trump has clearly put a marker down, which fundamentally pivots the way the world views America. Overtly pushing domestic self-interest, targeting Intellectual Property theft and inequitable trade treatment (even if they reside in friendly trading blocs like EU and Canada) is an abrupt shift. Perhaps all Trump is doing is upping the pressure for other countries to act like free trade partners, not just talk the free trade talk. I really didn’t think I could entertain such a thought, but on closer scrutiny the veneer of “Free Trade” hides a lot. Most of us know free trade, in its pure sense, doesn’t exist. It is an illusion that we have had decades of free trade. Tariffs are an outmoded, crude weapon in trade, but other subtler ones are prevalent. Localised regulations and standards have long hindered trade and favoured local production. Duties, excises and costly convoluted paperwork make shipping goods across national boundaries complex and expensive. The more I look at Trump’s policies the less they seem like a joke. The man is difficult to stomach but his radical policies may be what are needed after decades of drift.

 Conclusion

All three issues are complex with outcomes which are difficult to forecast. If fiscal stimulus is gaining momentum, not just in the US, but also in the EU and in China, what will it mean for inflation? If inflation is coming back how will it impact industries long used to a benign environment for costs? Entrenched orthodoxies are being challenged. Central banks weren’t independent 50 years ago. Only after the inflation boom of 1960-80s did orthodoxy shift. Trade war rhetoric was common until the 1930s, now it is taboo. But we don’t have free trade. Inflammatory talk of tariffs may cause trade to grind to a halt or it may trigger a raft of freer trade rules. The contrarian in me is drawn to a possibility that the outcomes may not be as bad as feared (since everything currently is framed so negatively).

For the portfolios, inflation vexes us the most. Regardless of what happens we think it is safest to hunt for companies that protect us against inflation. This means pricing power and preferably some growth to drive potential operating leverage; otherwise tread carefully. Next it is US fiscal policy. It creates confusion at a stock level. On trade wars and tariffs, we think the only way to cope is to watch and be flexible about one’s views. It may be bad, but it may, dare we say it, be good. Only time will tell. It helps not to be too entrenched in your belief system; to be prepared to kick against orthodoxy if its time is up.


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Previous Commentaries

Quarterly Commentary Period ending March 2018
Annual Commentary Period ending December 2017
Quarterly Commentary Period ending September 2017
Quarterly Commentary Period ending June 2017

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