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Author: Aaron Jacobstein
Investing in an Uncommon Period in History: Are You Positioned for What Lies Ahead?
Executive Summary
The global economy is undergoing tremendous changes requiring investors to step back and take a fresh look at their portfolio positioning. The complexity of the current environment is challenging traditional investment thinking regarding the impact of monetary and fiscal policy on inflation, interest rates, and corporate profits, especially given the potential for change stemming from the introduction of generative AI and the ongoing issues with the climate transition. This piece explores the divergence between the market’s expectations for rate cuts and what the Federal Reserve is most likely to do, a key differentiator between the market and ARS. Our consistent stance has been that rates would remain elevated for a longer duration than the market expected, a view that has gained greater acceptance in recent days. The United States economy and businesses remain standout opportunities, and we expect capital flows to continue to favor the U.S. and its leading companies. Today, investor portfolios should emphasize sectors such as industrials, materials, healthcare, energy, and technology, and active versus passive management. Given the differences of this period versus previous ones, we believe that investors need to rethink their portfolio positioning.
“Think about the race of artificial intelligence … think about the geopolitical tension and the threat of fragmentation we will have to deal with over the next years. The higher debt levels after the pandemic and the energy price hikes, which has shrunk our fiscal space to finance transformation, and given … little growth perspective of the global economy. Has 2023 given me hope? … I would put it this way: It was a call for action because we have to rearrange some policies and … probably we are at the beginning of an era of new structural reforms.”
– German Finance Minister Christian Lindner, January 19, 2024
We are living at a point in history unlike any other. The aftermath of the events of the past 15 years has exposed cracks in the foundation of the world order, the global economy, and the markets. However, the negative sentiment which is so pervasive in society today is also overshadowing investment opportunities that will reshape industries and foster a necessary productivity boom as we enter the age of accelerated computing and generative AI. At the same time, the global economy is transitioning to one which may best be characterized by a return to more historic levels of interest rates while we experience major geopolitical, economic, and social transformations. This shift is forcing governments, businesses, and consumers to adjust to the highest interest rates seen since 2008. Yet unexpected to many, the global economy has proven more resilient than many economists had anticipated as growth has surprised to the upside, inflation has moderated, and employment has remained strong. With concerns regarding the upcoming U.S. election, the further escalation of conflicts, elevated levels of debt, worsening demographics and immigration issues, this is certainly plenty for investors to contemplate.
Throughout our 53-year history, ARS has often seen the world through a different lens than other investors which has led to portfolios with differentiated holdings and sector weightings versus the typical institutional portfolio. We believe that today, many investors could be asking the wrong questions regarding the economy and the markets as they are hoping for further support from central bank policy to boost returns by cutting interest rates. Many investors rely on thought processes and computer models that are grounded in past cycles. However, this approach has led to inaccurate conclusions, as they do not account for the significant differences in the current environment compared to those in the past. The next few years will continue to be unlike any previously experienced since these transformations have important implications for public and private capital expenditures, consumption, and investments. Market participants should ask themselves: Is my portfolio invested based on market hopes and anticipations or is it aligned with what is more likely to happen?
Are We Asking the Right Questions?
“We have a strong economy. Growth is going on at a solid pace. The labor market is strong: 3.7% unemployment. With the economy strong like that, we feel like we can approach the question of when to begin to reduce interest rates carefully.”
– Jerome Powell, Chair of the Federal Reserve, February 4, 2024
For some time now, most market participants have been asking “how soon and by how much is the Fed going to cut rates?” but the better question is “why should the Fed cut rates now?” The Federal Reserve’s mandate is to achieve maximum employment and price stability while maintaining economic growth. Based on those measures the U.S. economy is in surprisingly good shape. The just- released Consumer Price Index (CPI) and Producer Price Index (PPI) reports indicated that the inflation fight is not yet won as the January numbers came in above market expectations. Chair Powell’s remarks reiterated the views expressed in our January Outlook as we felt the market’s expectations for rate cuts were not consistent with our read of the economy and the Fed. The challenge for the Federal Reserve is that they do not know where interest rate policy should be set so as not to be too restrictive or too expansionary, in order to achieve its goals. Since the December meeting, market participants have dialed back expectations for the amount of interest rate cuts from 1.75% to around 1.00% for the year. Clearly, the market got ahead of itself as the Fed member’s December Summary of Economic Projections only called for 0.75% reduction, or three 0.25% cuts.
The Fed does not embark on a policy change of lowering interest rates without a valid reason, and while reasonable people can disagree, Chair Powell believes that the timing is not yet right to begin reducing rates and ARS agrees. Both monetary and fiscal policy work with long lags, meaning its impact may not be felt for 12–24 months, and the market has underappreciated the continued strength of the economy given the massive scale and duration of approved fiscal spending programs. That does not mean that the Fed might not need to lower rates at some point, but there are three key factors that market participants may not be weighing enough. First, the markets may be missing the scale and the impact of the monetary and fiscal support provided to the U.S. system since the pandemic. This includes the several trillion dollars of support from the Infrastructure Investment and Jobs Act, Inflation Reduction Act, the Chips and Science Act, and the National Defense Authorization Act which will see funding of projects continuing for several more years with additional spending from the private sector and state and local governments. Second, the markets held the belief that monetary policy tightening, such as what we have experienced during the past 24, months always causes a recession. It also typically causes a financial crisis like the one narrowly avoided last year with Silicon Valley Bank. The post-pandemic period has seen industry after industry experience some slowing and, for many, a recession. It is just that the impact has not all hit at the same time allowing the economy to continue to grow above expectations. Finally, the U.S. consumer today is vastly different from past periods as more baby boomers are moving into retirement with $75 trillion in net worth and time on their hands to spend it. While many families are struggling with paying bills and have seen their excess savings drawn down considerably, the boomers can continue to be significant spenders and help to offset some of the slower spending of others. Moreover, the federal government will continue to spend, offsetting any potential weakness in consumer spending.
Why Does This Matter for Investors?
2024 ARS focuses its research efforts on defining the global environment and identifying undervalued businesses that stand to benefit. Why so much focus on monetary and fiscal policy and, in particular, the outlook for inflation, interest rates, and corporate profits? It is because the basis for securities valuation is dependent on these three inputs. The following are our current views on each.
Inflation — There are many reasons the Fed may not be motivated to cut rates as it has made excellent progress on bringing inflation down towards its 2% target while maintaining solid growth and full employment. If the Fed is too aggressive on rate cuts, it could further stoke inflationary pressures by stimulating more spending. Additionally, the problems of China and Germany, two of the world’s biggest manufacturers, have helped strengthen the U.S. dollar which means that U.S. imports cost fewer dollars, in effect lowering prices, thereby helping to do some of the Fed’s work. Finally, labor shortages and increasing wages for 2024 will put upward pressure on costs and inflation, reinforcing the Fed’s patient stance on lowering rates.
Chart 1. U.S. Fed Funds, 10-year Treasury and 30-year Fixed Mortgage Rates 1971 to Today
Interest rates — What would cutting interest rates do at this time? In the near term, it would be good for short-term growth, for the markets by expanding price/earnings multiples, for new homebuyers as well as highly indebted companies and governments. However, it would also likely reignite inflationary pressures which the Fed is determined to avoid. Chart 1 illustrates the levels for the Federal Funds Effective Rate, the market yield on 10-year treasuries, and the 30-year Fixed Rate Mortgage average since 1971. While current rate levels are high compared to the experience of the past 15 years, they are not high on a historical basis. Given current conditions, it is not likely that we will see rates trend much higher, but also not much lower barring a major event or a significant policy misstep.
Chart 2. U.S. Corporate Profits Before Tax
Corporate profits — A question for investors to consider this year is “can markets produce another year of positive returns given the economic headwinds?” Chart 2 illustrates U.S. pre-tax profits growth from the 1940s to today. What is particularly impressive is the tremendous profit growth in recent years given the challenges of the post-Great Financial Crisis (GFC) period as pre-tax profits jumped from $1.9 trillion in 2006 to $3.6 trillion last year. That jump does not yet take into account the additional profitability that companies will realize with the productivity increases coming from generative AI and other technological advances. After an almost 15-year period of massive monetary and fiscal policy stimulus providing tailwinds for corporate profits, the tighter money conditions that exist today will favor those companies with strong balance sheets, competitive moats, and relatively inelastic demand for their products. Many large corporations have announced layoffs and other efficiency initiatives designed to manage profitability in what many CEOs are projecting to be a challenging environment. Notwithstanding this, we are excited about the opportunities to invest in select sectors, industries, and companies. Coming into the new year, ARS felt investors would experience positive returns from many U.S. equities, and nothing has transpired to date to change that view.
Are You Positioned for What Lies Ahead?
“One of the most striking aspects of the generative AI revolution is that it is just getting started. Its main drivers — computing power, data, talent, and funding — are compounding at a scale and speed that will accentuate its disruptive forces. No wonder it has risen to the top of the agenda for chief executives in an ever-increasing number of companies and industries.”
– Mohammod El-Erian, President of Queens College, Cambridge, and advisor to Allianz and Gramercy. Financial Times, February 15, 2024.
What the markets will do in the near term is anybody’s guess, but it is in times like these that businesses innovate and adapt to create new opportunities for investors to build and protect capital. Many investors have no problem investing when the markets have a clear direction as they tend to just follow the crowd. However, this is not one of those times since current market dynamics favor individual stock selection over index investing, and the United States market over most global markets.
Moving forward, ARS expects a prolonged global low-growth environment with big opportunities for a limited number of countries and companies. The countries that will benefit will be those with relatively favorable demographics, fiscal policies to support the ongoing transitions, access to capital, dependable sources of energy, national corporate champions driving the technological revolution, and low dependence on adversary nations for key resources. ARS sees the world through a different lens than most investment firms, and that results in highly differentiated portfolios as reflected by our overweights in the energy sector; industrials sector including defense and reindustrialization beneficiaries; materials sector which is critical to technological leadership, the energy transition, and national security; healthcare sector which stands out as a leading beneficiary of generative AI, and the technology sector with a focus on cloud, data infrastructure, semiconductor chips, and capital equipment providers.
We favor companies that are among the leading beneficiaries of the reindustrialization of the U.S. economy, those that are driving productivity increases to offset rising labor costs, enhancing healthcare outcomes, and those that are critical to national security. A fundamental theme is the growing demand for and use of advanced technology to increase productivity, lower costs and raise living standards. Additionally, the businesses that will reward investors in 2024 will be those with relative inelasticity of demand for their products. We expect corporate earnings to continue to increase, but the benefits will not necessarily flow to all companies equally. Investors should anticipate periods of volatility, but since we anticipate rising corporate earnings, it should not be a surprise to see the markets continue to make new highs in 2024.
Published by the ARS Investment Policy Committee:
Stephen Burke, Sean Lawless, Nitin Sacheti, Greg Kops, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor, Tom Winnick.
The information and opinions in this report were prepared by ARS Investment Partners, LLC (“ARS”). Information, opinions and estimates contained in this report reflect a judgment at its original date and are subject to change. This report may contain forward-looking statements and projections that are based on our current beliefs and assumptions and on information currently available that we believe to be reasonable. However, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements.
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What Matters Now: The World Is Changing, Is Your Portfolio Positioned For It?
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What Matters Now: Reasons to be Bullish in 2024
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The Restart and the Rebuild
“This crisis will test our political system, our grit, our patriotism and our willingness to sacrifice for the common good. We will emerge stronger only if we are able to reshape our policies so that, while still retaining the magic dynamism of capitalism, they are responsive to dramatically different circumstances… Our nation will never be the same, but we can emerge stronger and retain our role as a global leader – if we are smart about the rebuilding to come.”
– Henry Paulson, former U.S. Treasury Secretary, Chairman of the Paulson Institute and Co-Chairman of the Aspen Economic Strategy Group
In our January 24th Outlook, we wrote that “As a new decade dawns, the rate and magnitude of the coming changes will require investors to identify and embrace the most investable themes in a world that may at times feel un-investable. To protect and build capital in this type of environment, investors should focus on the primary beneficiaries of a few critical secular themes in the new decade of disruption and avoid the companies that are being disrupted that are being disrupted… Successful investing in the coming year will require a high level of conviction at a time when many aspects of our lives could be experiencing significant change.” When we wrote that Outlook, we did not anticipate the COVID-19 pandemic or the political, economic, and social challenges that the virus has presented. Today the United States is faced with a crisis the likes of which we have not previously experienced, with historic levels of unemployment, rising debts and deficits, a record number of small businesses at risk of closures and bankruptcy which potentially adds to growing inequality. Many are trying to envision how we can safely restart, recover, and then rebuild a better and more balanced economy, particularly considering the political dysfunction that exists today.
The COVID-19 pandemic is testing the world in ways it has not been tested previously. This crisis has accelerated and augmented many of the positive and negative trends which were in place prior to the pandemic and that continue to impact so many aspects of our lives. A positive resolution will require both a short-term solution to achieve a successful restart and then a longer-term one to address the problems that are either being created or worsened by the pandemic. A successful restart will require a medical solution – testing, treatment and vaccination – to arrest the disease, a financial solution to provide a bridge from lockdown through the restart to the next normal, and an economic solution to prevent a global depression. Once a successful restart is underway, we will need a multi-pronged approach to address the three most significant longer-term issues involving debt and deficits, inequality and shifting geopolitical alliances. For far too many, the economic and emotional damage that will result from the pandemic will be felt for decades if past pandemics can serve as a guide. In this Outlook, we will address the most frequently asked questions we are receiving from investors and ones we are asking ourselves as an investment team.
How do you reconcile the difference between the terrible unemployment and other economic numbers with the stock market rebound?
Given the unprecedented nature of the COVID-19 virus and the resulting actions to shut down economic activity, it is no surprise that the United States and global economic activity has ground to a halt this quarter and that the stock market experienced a sudden and severe decline in March. What has surprised many on Main Street and Wall Street has been the dramatic rebound in stocks given the uncertainty still present in the system, leaving many to wonder what to make of the disconnect. A key element of support for the economy and the markets has been the massive monetary and fiscal response from central banks and governments in the United States and globally. On May 25th, Japan announced an additional fiscal stimulus of over $1 trillion and is now targeting aggregate stimulus of 40% of its Gross Domestic Product (GDP). This has had the short-term effect of replacing some lost income for workers and revenues for businesses, while offsetting some of the decline in GDP lost due to the virus. This much global stimulus will result in further increasing asset values. It is important for investors to bear in mind that the stock market is a discounting mechanism based on future expectations of better times. The market is anticipating the resumption of economic activity; the development of effective testing, treatment, and a vaccine; and the intermediate-term benefits of the massive monetary and fiscal policy initiatives being introduced. The economic effects of fiscal and monetary policy initiatives usually take between 12-24 months to work through the system, while the financial impacts are immediate. It is also appropriate to mention that the reopening of the economy should gradually bring the unemployment numbers back down from the current 20% level. We anticipate continued market volatility as most pandemics do not get resolved quickly. Based on studies of past pandemics and other crises, investors should expect that the economic and social impact will be felt for years or even decades.
What are the implications of rising debt and deficits?
Rising debt and deficits matter for the economy and investors, but these need to be kept in context of the unique dynamics present in the system. Typically, rising deficits are inflationary, but conditions today clearly are without precedent. Before the pandemic hit, for example, the United States had an economy that was ripe for inflation with full employment at 3.5%, while the U.S. was running a fiscal deficit of more than $1 trillion and growing, and yet the economy was more deflation prone than inflation prone which is why we never got the inflation that many anticipated. The present level of deficit spending has been a replacement for lost wages and revenues, while past deficit spending had been additive to economic activity. Additionally, quite a few investors also misunderstood that the pre-COVID corporate spending that was taking place was to increase productivity to gain market share and lower costs which is the antidote to inflation.
When it comes to the level of debt, what matters more than the total amount is the cost of servicing the debt which given today’s interest rate environment is near zero. As shown in the chart, the federal debt in 2000 was $3.4 trillion with servicing costs of $223 billion. Today, we have over 7x the amount of debt but only 1.7x the interest costs. Investors should also be aware that as existing debt (carrying a higher interest rate) matures, the reissuance is being financed at significantly lower cost. There are three major implications of the levels of debt and deficits for the United States. The first is that the Federal Reserve is able to work to keep interest rates low for a very long time as long as inflationary pressures are not an issue. The second is that it will be very difficult to raise taxes in a meaningful way anytime soon without slowing growth and risking another downturn. The third is that if the current deflationary pressures persist, the market will not force interest rates higher, and that will keep debt servicing costs relatively low and manageable, giving government the latitude for further deficit spending including pro-growth infrastructure programs.
Given the political divide and the problems you are describing, how can we govern effectively?
“When times are tough and people are frustrated and angry and uncertain, the politics of constant conflict may be good, but what is good politics does not necessarily work in the real world. What works in the real world is cooperation.”
– William J. Clinton, 42nd President of the United States of America
The pandemic and its aftereffects will add an additional level of complexity for both the Republican and the Democratic party leaders as the traditional platforms will not work to address the multitude of long-term problems we are facing today. Crises are the times to put partisan politics aside and focus on our nation’s most critical needs. These include developing a plan to provide additional relief for those in need right now, creating an effective path to reopening and laying the foundation to rebuild a better, more resilient economy that is more inclusive for our entire society and essential for our future. Just as increasing productivity is the antidote to inflation, societal inclusivity is the antidote to confrontational partisan politics. Regardless of who wins the election, the traditional approaches of either party simply won’t work given the pandemic-related economic and social damage that is being done, the growing inequality, the geopolitical instability that exists today and could grow, and the rising levels of debt and deficits. The United States needs a long-term plan to which our nation can commit to regardless of which party is leading as policies based on two-year election cycles have contributed to putting our nation in this mess to begin with. As Jean Claude Juncker of the European Commission once said, “We all know what to do, we don’t know how to get re-elected once we do it.”
So, what needs to be done? First, Congress needs to draft a bipartisan plan to provide a path to achieving a more steady and fair economy, not solely for the next election cycle but for future generations. This plan should have mission-critical initiatives that should be implemented regardless of which party is in office. Second, as we suggested in a recent Outlook, the federal budget should be separated into an operating budget and an investment budget to allow for smart, strategic investments in our areas of most critical need as highlighted in the new plan. Third, the U.S. needs to develop and fund a massive multi-year infrastructure initiative focusing on our healthcare, education, digital and physical infrastructure. This is a need that can no longer be postponed and would go a long way to creating a more inclusive, stronger, and therefore, more resilient economy. It would accomplish two important long-term goals. It would address the inequality problem which otherwise will be intensified by the policies being implemented. The resulting growth will lay the foundation our country’s needs to eventually bring the deficits and debt down in relation to the size of the growing economy. Fourth, we need to rework our tax system to make it fairer, and also need realize that the current backdrop makes raising taxes inappropriate at this time, beyond closing some loopholes, given the financial challenges facing so many individuals and businesses.
There is too much of a singular focus on taxes for big corporations, given that tax policies targeting one segment often have significant unintended consequences for other parts of the economy. Fifth, we need to champion corporations that are strategically vital to our future prosperity, but to do so in a way that ensures that they are acting in an appropriate manner. It is our businesses, both large and small, and innovation that have allowed the U.S. to prosper. To that end, we would encourage a more collaborative and a less punitive approach from some in Washington, while encouraging more public-private partnerships to address the many complex issues facing the nation. Finally, we need our young adults to step forward to become the next “greatest generation” and lead us with new ideas and a renewed spirit of cooperation placing practical solutions ahead of ideology.
With the current level of uncertainty, what should investors do now?
“Out of intense complexities, intense simplicities emerge.”
– Sir Winston Churchill, former Prime Minster of the United Kingdom
As a result of the extraordinary nature of the COVID-19 world, many market participants are struggling to make sense of the markets given the level of uncertainty, complexity and growing geopolitical risks, particularly with China as well as the need to better address climate change. During times like this it helps to take a step back to assess the bigger picture and not get caught up in the news cycles about the crisis. Investors should recognize that the virus is creating a two-tiered market between those that are providing solutions during this difficult time and those that are being more negatively impacted. Obviously some e-commerce companies are doing well right now, but in every crisis we see new businesses emerge and old ones disappear. It has been this way throughout history and will be this time as well.
A relatively small number of companies are prospering, and many others are struggling. Why? Because these companies have embedded advantages including scale, stronger balance sheets and better access to capital enabling them to invest more heavily to increase productivity through investments in innovation and technology advances. This, in turn, leads to higher earnings, better pay for employees, stronger market share, and ultimately greater shareholder value. Investors should focus on companies with “embedded advantages” over their peers. It is for this reason that we feel the investment environment is set to favor active investment management over passive management, and high conviction strategies over more diversified strategies. Additionally, the low-interest rate environment favors companies with strong balance sheets, good business models, and the ability to raise their dividends.
There are always risks to the economic outlook and that is certainly the case today. Among the key risks that would change our positive views would be a sharp rise in inflation and the exchange rate for U.S. dollar. As the world economy remains both fragile and fluid, we continue to be both opportunistic and cautious in our investment approach. As we said at the start of this piece, the powerful shifts in the global economy are creating large opportunities, and well-selected equities should reward investors over the next several years. There are investable ideas present in virtually all market environments, and investors should be able to achieve both absolute and relative returns over time by owning the businesses that are the beneficiaries of the secular trends.
What Matters Now: Why Today’s Greater Complexity Demands Higher Conviction
What Matters Now – The Lockdown’s Lasting Impacts
COVID-19 – The Problem, The Response and The Post-Pandemic World
“Leaders are dealing with the crisis on a largely national basis, but the virus’ society-dissolving effects do not recognize borders. While the assault on human health will – hopefully – be temporary in nature, the political and economic upheaval it has unleashed could last for generations. No country, not even the U.S., can in a purely national effort overcome the virus. Addressing the necessities of the moment must ultimately be coupled with a global collaborative vision and program. If we cannot do both in tandem, we will face the worst of each.”
– Henry A. Kissinger, excerpts from WSJ Op-ed, April 3, 2020
The COVID-19 pandemic has presented us with an extraordinary medical, economic and social challenge the likes of which no one has previously experienced. The virus has changed almost every aspect of our lives and threatened our economic security, but it has also taken too many lives with many more to follow. There is no way to minimize the global tragedy, but we are heartened by the resolve of people all over the world, especially health care professionals and other essential workers, as we battle through this difficult period. We want to remind each of our clients that we are here to guide you through your specific challenges, and to convey our appreciation for the concerns that have been expressed for the health and safety of our team. We are fortunate to have such terrific clients and value the trust placed in us each day. While we continue to work on a remote basis, we assure everyone that we are here to assist through this difficult period. To that end, we are going to be publishing shorter, more frequent Outlooks until the spread of this disease is arrested to keep everyone informed of our latest thinking as the situation remains very fluid. This note will frame the key problems facing policymakers, the scope of the monetary and fiscal policy response, what the post-pandemic world may result in and the investment implications.
Framing the Problem
The coronavirus pandemic and mandated lockdowns imposed by governments around the world have pushed the global economy into the sharpest downturn since the Great Depression. The challenge for policymakers has been in three key areas – offering income replacement for those who lose their jobs, making available loans and grants to offset revenue loss for companies, particularly small businesses, and providing liquidity to allow the economy and capital markets to function properly. As a result of shutdowns, businesses are laying off employees at a rate and scale that is unprecedented. For the week ending March 21st, U.S. unemployment claims were 3.28 million persons which was 4.7x the highest recorded total of 695,000 back in 1982. The jobless claims then doubled for the week ending March 28th with 6.6 million reported which brought the unemployment rate over 10%. The unemployment figure may well exceed 20% if the lockdown is more prolonged. It is important to note that once the lockdown is reversed unemployment will decline rapidly. It is for this reason that St. Louis Federal Reserve Bank President James Bullard said he expected that the unemployment rate may spike up to around 30% but will decline rapidly in the subsequent quarters possibly returning to 4% levels as business activity resumes. It is clear that the combination of job losses, business shutdowns and the overall slowdown in the economy will reduce personal consumption, business investment and trade. Therefore, it has been up to the government to minimize the damage through monetary and fiscal policy.
Addressing the Policy Response
As discussed above, policymakers are working to minimize the negative effects of the COVID-19 pandemic with a focus on keeping the capital markets functioning properly, getting money into the hands of the unemployed and helping minimize small business failures. The global commitments from central banks and governments are estimated to be in excess of 13% of global GDP which is roughly $90 trillion and could exceed 20% of global GDP depending on the timing of scientific breakthroughs. The United States has initially committed over $5 trillion or more than 20% of U.S. GDP. In late March, the Federal Reserve responded to pricing issues in the fixed income markets which were functioning in a disorderly fashion. The Fed acted quickly to inject liquidity into the system with a commitment of more than $2 trillion to start and a promise to do whatever is necessary to support the economy. We would commend Fed Chair Jay Powell and the Board of Governors for their decisive and extensive response, having clearly learned from the 2008 experience. Given the limitations of interest rate policy in a near-zero-rate environment, Congress needed to act to address those who were losing their jobs or experiencing wage reductions and to try to prevent businesses from closing that would not have without the mandated lockdown. The initial commitment by the House and Senate was estimated to be between $2-2.5 trillion. It remains to be seen whether the money will get to those who need it most – the unemployed and the small businesses – in a timely fashion. Congress is already drafting additional proposals including one to extend or expand new unemployment benefits and provide additional support to protect small businesses. These programs have been defensive and reactive.
Future programs will be designed to foster growth and put the nation back on the offensive. Most importantly, we have come to the point where we can anticipate the long overdue program to address our nation’s healthcare, educational, digital and physical infrastructure. In that respect, we would propose that the United States Federal budget be split between an investment side and an expenditure side. The infrastructure budget would be in the investment category and each program would be evaluated for its expected return on investment. This would allow for future programs to be better funded and assessed on their merits.
Thoughts on the Post-Pandemic World
The pandemic has significantly changed our daily lives and could well transform the way we live, learn, govern and work after it has run its course. As long-term investors, we must make judgments as to what the post- pandemic world might look like so that we can invest not just for the next quarter or two, but for the next several years. Here are our initial thoughts on some of the changes in the behaviors of consumers, businesses and governments.
For consumers, we see a greater focus on lowering household debt, increasing savings rates, and changes in where we live and how we work. With students of all ages being forced to learn online, we see an acceleration of the changes occurring within our educational system and broadening of student internet access. We are already experiencing a necessary increase in telemedicine which we expect to accelerate as well as more personalized medical approaches that will incorporate more advanced medical technologies. We should expect to see greater use of medical rapid-testing technology to enable the public to gain access to such places as theme parks, sporting events, concerts, museums and even office buildings. From a business perspective, it is likely that more companies will support increased remote work arrangements which have important implications for the commercial real estate market and for increased use of technology as businesses look to reduce high-cost office space. Corporations will seek to create more flexible and resilient supply chains, bringing back to the United States production of some critical parts of supply chains to avoid future disruptions due to trade conflicts or shutdowns such as we are currently experiencing. We also could see the relationship between government and business altered considerably for some industries due to the bailouts and loan programs as well as for national security reasons. Furthermore, the path to growth will likely require sizable public-private partnerships, both domestic and cross-border, to address national needs such as infrastructure, cyber- defense and healthcare. As the quote from former Secretary of State Henry Kissinger points out, governments will need to be more collaborative and that begins with the U.S. and China. Depending on the behavior of global leaders, we may see closer relationships with other nations, a further fragmenting of the post-WWII global order, greater strains on the European Union project and renewed calls for modernizing the role of global institutions such as the WTO (World Trade Organization) and the United Nations. A failure to address the growing inequality issue, which is being exacerbated by the pandemic, could lead to serious social instability, and now is the time for government, business and public to act.
Investing for the Near-Term and Beyond
As we said in our March 23rd Outlook, things will get worse before they get better, but they will certainly get better once we begin to arrest the spread of the virus. In terms of sequencing, we believe that the stock market will begin the bottoming process as the trajectory of new cases begins to decline and likely well before the economy itself bottoms. The recent focus for client portfolios has been to use the market pullback to upgrade quality, fine-tune sector and industry weightings and avoid the companies that are heavily indebted. We have been initiating new positions in high-quality companies that previously were selling at considerably higher valuations, while harvesting tax losses in securities we still like but believe the risk/reward in holding them is not as favorable.
While no one can say with any precision where we go from here, there are a few questions the investment team is asking to help guide us in navigating the near term and longer term.
- What is the length of shutdown and severity of the economic damage?
- Will the policy response be effective and what are the possible unintended consequences?
- How difficult will it be to restart the economy and begin to return to growth?
- And finally, what does this mean for individual companies and industries?
Based on our preliminary views of what the post-pandemic world might look like, our portfolios will continue to reflect many of the same themes we have emphasized for the past few years. The impact of the virus has not only reinforced our convictions but has also augmented these themes. ARS portfolios will continue to emphasize healthcare companies, focusing on biotech/bioscience, pharmaceutical and high tech testing equipment among other areas; technology companies including cloud, 5G, semiconductors and capital equipment, cybersecurity, AI (Artificial Intelligence) and machine learning; companies with strong balance sheets and quality dividends; defense companies as the world is not getting any safer; and a few special situation companies that will benefit from an increase in post-crisis merger and acquisition activity. We favor the U.S. economy over the rest of the world and the U.S. stock market over other markets. There are some unique opportunities being created in the U.S. stock market, and we suggest that those waiting for an opportunity to participate should begin to incrementally build positions in world-class companies with a view to adding on future price declines. Given the nature of the world today, we favor a cautious and measured but still opportunistic approach to investing. Disciplined investors who are taking a longer-term view should be well rewarded.
COVID-19, the Market, and Your Portfolio
From Wuhan to Wall Street to Main Street:
“Think of what is happening as a huge paradigm shift for economies, institutions and social norms and practices that, critically, are not wired for such a phenomenon. It requires us to understand the dynamics, not only to navigate them well but also to avoid behaviors that make the situation a lot worse.”
– Mohamed El Erian
In just two short months, the world as we knew it has changed as a result of the worst global pandemic since the Spanish Flu in 1918. Coming into the year, we were positive on the outlook for the U.S. economy and the secular themes we have defined in previous Outlooks, a view that was confirmed by the positive economic numbers and the stock market returns through mid-February. However, we did not anticipate the outbreak of the Coronavirus (COVID-19) which started in Wuhan, China and subsequently has morphed into a global pandemic. This has turned the longest bull market in U.S. history into a bear market in just about one month. The pandemic has served as a painful reminder of the interconnections and interdependencies of the world, and has exposed many of the economic, political and social vulnerabilities which had been building up in the global system since the financial crisis. We expect the economy to get worse before it gets better, but it will surely get better. Furthermore, the uncertainty and fear many are feeling are now creating substantial opportunities in the equity markets. The market decline has left some of America’s best and most valuable corporations selling for unusually attractive valuations today.
It is important to understand that the actions by governments and businesses to prevent the spread of the virus are purposefully disruptive to global commerce as they are protecting the populations at the expense of short-term production, spending and growth. The U.S. economy, which continued to be quite strong coming into the year, is now falling into a recession. Because the impact of the coronavirus will not be shared equally as small businesses and employees in certain industries will bear the brunt of the pain, the federal government proposals are targeting these segments as many small businesses are already closing and the unemployment rate is rising rapidly. Some businesses will only recover a portion of the lost revenue, but others like those in the entertainment, restaurant, travel and hospitality industries will take longer to recover. That is why for some businesses the economic impact might be characterized as a slowdown, while for others a recession, and for a few a depression as more than a few industries and companies will be more permanently impacted.
While we do not in any way minimize the severity of the coronavirus, we would underscore that its economic impact will be temporary in nature as it is the result of severe, short-term supply and demand disruptions around the world rather than a collapse of the global banking system as we experienced in 2008. The recent “whatever it takes” policy initiatives by the Federal Reserve to ensure liquidity for the system is unprecedented in scale and only strengthens our view that interest rates are likely to stay low for the foreseeable future. In spite of this and other recent monetary policy actions, central bankers now have a more limited toolkit with which to stimulate growth. Therefore, fiscal policy has to and will be playing a major role. Many European countries are recommending fiscal responses of 1% of gross domestic product (GDP), and we expect them to be required do more. In the United States, Democrats and Republicans are negotiating a massive stimulus well in excess of $1.5 trillion. Unless the U.S. can stop the contagion sooner than later, the cost to the government may be much higher, possibly in the $4-5 trillion range. For perspective, the U.S. GDP was forecast to be just over $21 trillion for 2020.
One solution we would propose requires a two-pronged approach. First would be an immediate one-month shutdown in the U.S. of non-essential services to stop the contagion in its tracks, similar to what has been done in China. This would allow the government to arrest the spread of the virus sooner and to get the proper testing and health support services in place, while allowing our world-class pharmaceutical companies and universities’ research laboratories to buy some more time to develop a treatment and eventually a vaccine to counter the virus. Next, the government could focus on getting businesses and industries crippled by the crisis as well as those who become unemployed back on the road to recovery. Congress could grant the Treasury the ability to borrow from the Federal Reserve whatever amounts would be required to support and heal the economy. The financial resources that the government has are almost unlimited as long as the Treasury is given the powers to borrow directly from the Federal Reserve rather than in the open market which would tend to have the effect of pushing interest rates higher. The Federal Reserve Bank, which has a balance sheet already in excess of $4 trillion, is more than capable of providing additional large sums of money. We believe these steps would stop a pandemic recession from triggering a financial recession and support a more rapid economic recovery.
We expect the equity markets to bottom concurrent with the spread of the disease abating but before we see the economy improving. At the same time, investors will likely be feeling maximum discomfort with the economic outlook. Therefore, we would caution investors against overreacting to such conditions. We hold above-average cash balances to take advantage, in a measured way, of the values being presented over the coming period. Importantly, we are confident that the secular themes defined in recent? Outlooks – technology disruption, improvements in healthcare, defense to protect against global instability, quality growth in a low-growth economy, those with strong balance sheets and companies with safe dividends in a low-interest-rate world – not only remain intact but are being reinforced and even augmented by the conditions of the global economy. While we are not by any means calling a market bottom, we have come so far so fast that we expect that investors who are patient, disciplined and opportunistic with owning and buying quality growth companies and those with safe dividends will be rewarded. Going forward, we believe that this crisis will change many of the aspects of the way we live, learn and work.
During this once-in-a-100-year event, we want to remind our clients that in times like these it is paramount not to let fear and panic drive investment behavior. Market declines are always difficult to experience but keeping perspective and focusing on goals are critical to successful investing. This in no way minimizes the recent declines in accounts but serves as a reminder that successful investing always requires taking a longer-term view.
“Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market.” ?
– Benjamin Graham, legendary investor and father of Graham & Dodd value investing