“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
From
an early age, we’re taught that money is not a “polite” topic of conversation –
even within families. Often, there is an emotional overlay to family financial
discussions that can add another layer of complication.
That
is reflected in the reality that less than 40 percent of North Americans
have an up-to-date will or estate plan. This is an increasingly urgent issue
given that a major intergenerational wealth transfer will take place over the
next 20 years, and its beneficiaries may not be well-prepared to manage it on
their own.
As
a trusted advisor, here are ARS’ five top tips for you and your family to
both become better educated and to break the taboo around discussing money:
Start saving and investing earlier in life. Your older self will thank you!
Avoid surprises at all costs. Strive to be more involved in your financial well-being, focused on long-term planning, mindful of short-term gratification and disciplined with your commitment to those plans.
Begin financial conversations with your family, starting with an initial discussion about shared values, goals and priorities.
Assemble a team of trusted advisors comprised of an investment advisor, a trust and estate attorney, and an accountant. Remember to regularly review and update important documents (e.g., your wills, beneficiary forms, trusts and estate documents).
Having a meaningful discussion about money is just the beginning! Plan to keep family members updated and try to gather for a regular review once a year.
In
a 2019 survey, we asked respondents about how their life goals aligned with
their financial goals. Looking back, what would you tell your younger self
about saving and investing? How well are you communicating that insight with
your family? What are your priorities going forward? Please click above
for a summary of the results and key takeaways.
“We live in an era of disruption
in which powerful global forces are changing how we live and work. The rise of
China, India, and other emerging economies; the rapid spread of digital
technologies; the growing challenges to globalization; and, in some countries,
the splintering of long-held social contracts are all roiling business, the
economy, and society. These and other global trends offer considerable new
opportunities to companies, sectors, countries, and individuals that embrace
them successfully—but the downside for those who cannot keep up has also grown
disproportionately.”
– McKinsey Global Institute Report, January 2019
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. These secular themes are continuing technological advances and the powerful demographic shifts involving aging, automation and inequality. Climate change is becoming a more actionable investment theme across all equity strategies, and investment professionals may have to play catch up. These three themes will have profound implications for investment strategy and are closely linked to other important factors including the adjustments in monetary policy, fiscal policy, debt burdens, political disequilibrium, geopolitical conflicts and deflationary global forces. 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.
While impeachment proceedings, the Phase I deal with China, and the Iran situation have dominated the news flow so far this year, the market has instead continued to react favorably to the outlook for improving corporate earnings and lower-for-longer low interest rates. Notwithstanding negative headlines, we continue to view the United States as the standout economy due to the underlying strength of consumer spending, the efforts of state and local governments to invest in infrastructure and other critical programs, and the potential for corporations to significantly increase capital spending. Consequently, we continue to view the U.S. equity market as superior to foreign markets on a risk/reward basis. In the current environment, client portfolios should continue to emphasize many of the leading companies including healthcare companies, large cloud-service providers, display, telecommunications, mobile communications companies, semiconductor
capital equipment companies and chip manufacturers, as well as cyber, software, and defense companies. In this Outlook, we will discuss the investment implications of three of the most powerful forces that are reshaping our world. We believe the rate of change is in an accelerating state, and that this will force investors, policymakers and business leaders to come to grips with the implications of these changes so that they will not be left behind. Legacy companies must transition to adjust to the changing environment, and their success or failure will result in a revaluation of the businesses, which sets the stage for potential shifts in market leadership. To the degree that this environment fosters original thinking, active management should become more important than passive management.
The Third Wave of Technology: The Start of the Transformational Phase
“Technological
change is not additive; it is ecological. A new technology does not merely add
something; it changes everything.”
– Neil Postman, American educator
In the past, we have written extensively about the Third Wave (see Chart 1) and the coming transformative opportunity that 5G would deliver for consumers and businesses. 5G is moving from pilot programs to becoming a reality as it moves to full deployment over time. This is a game changer in our view as the way we live and work is about to undergo unprecedented change. By solving complex data and storage problems and the latency issue, 5G facilitates breakthrough technologies and their applications that were once unimaginable. Many of the benefits of this transformation will be less transparent than the obvious download speeds of data and videos on our devices. But no less important, it will help drive down production costs for the products and services in daily use. This in turn fosters more innovation.
To help our readers understand the power of 5G and the related technological advances we focus on the healthcare industry which will be one of the biggest and most immediate beneficiaries. As many are aware, the $3.3 trillion of annual healthcare costs in the United States represent an estimated 16% of GDP, which is double most other developed nations. Technological advances should enable the U.S. to reduce costs and improve the delivery of health services, while extending average life expectancy. There are three major benefits that technology brings to the industry—more accessible and better treatment, improved care and efficiency, and software-specific programs to improve overall care and disease control. In the coming years, we will see new applications of predictive healthcare and the introduction of more personalized prevention and treatments to ensure better outcomes for individual patients.
Big Data Capabilities and Storage: One of the key inefficiencies in the healthcare system is the management, access and retrieval of medical records. Moving to an electronic health record system will address some inefficiencies as data entry into a computerized system is much less time-consuming than are paper-based systems. One study from the University of Michigan estimates that this switch alone could reduce the cost of outpatient care by 3%. Cloud storage of data helps improve efficiency and accessibility while reducing wastage. This also facilitates the research and development of new treatment protocols and lifesaving pharmaceutical formulations. As patient data is highly valuable, the critical weaknesses of electronic health record systems are being addressed such as security and data protection. According to some estimates, stolen health credentials have 10–20 times the value of credit card data.
Artificial Intelligence: A recent study published in Nature Medicine highlighted how doctors are using artificial intelligence (AI) during brain surgery to diagnose tumors with slightly greater accuracy, but in less than two and half minutes compared to 20 to 30 minutes by a pathologist. The greater speed and accuracy offered by AI means the patient will spend less time under anesthesia, while allowing surgeons to detect and remove otherwise undetectable tumor tissue according to the study.
Genomic Research and Personalized Services: According to the National Human Genome Research Institute, technological advances are lowering the cost of sequencing a human genome which fell from $14 million in 2006 to about $1000 in 2016, and costs continue to decline. Genomics is the study of a person’s genes (the genome) including interactions of those genes with each other and with the person’s environment. A genome is an organism’s complete set of DNA. As the costs of genomic sequencing continue to decline, it opens the way for personalized treatment and medical programs designed for an individual’s specific genetic makeup. While there are many ethical issues surrounding genetic research, the potential to lower costs, improve outcomes and extend lives is significant.
Wearable Technology: Continued advances in wearable technology will help transform healthcare by allowing doctors to more quickly and accurately diagnose, treat, and prevent debilitating health conditions, while increasing patients’ access to care. Healthcare is a major point of emphasis for research by Apple and Alphabet (Google) among others, and wearable devices are a significant potential revenue opportunity for many companies. Wearable devices are being designed to target the most common chronic diseases including heart disease, diabetes, hypertension, and respiratory diseases. Other types of wearable technology being introduced include: wireless headsets for EEG (electroencephalogram) tests which are less invasive; eye lens implants to help restore or improve eyesight; bionic suits to help workers lifting heavy weights in repetitive movements or the elderly being more ambulatory; and for robotics to assist doctors and nurses treat life-threatening health issues. Also being tested are smart scanners that can check someone’s vital signs with a simple touch of the forehead, and at some point in this decade, ingestible nanochips could help doctors monitor the body’s internal systems.
These are just a few of the many ways the healthcare industry will be reinvented in the future, and there will be many more advances involving the use of artificial intelligence, machine learning and blockchain technologies that will improve and extend our lives.
How Demographic Shifts Are Reshaping Our World
“Demographics,
automation and inequality have the potential to dramatically reshape our world
in the 2020s and beyond… In the next decade, they will combine to create an
economic climate of increasing extremes but may also trigger a decade-plus
investment boom. In the U.S., a new wave of investment in automation could
stimulate as much as $8 trillion in incremental investments.”
– Excerpt from the Bain Consulting report, “Labor 2030: The Collison of Demographics, Automation and Inequality”
The unusual combination of rapidly aging populations, increasing workplace automation, and worsening income inequality will provide complex and interconnected challenges for policymakers for years to come. Changes in the demographic characteristics of a society have important implications for the structure of the workforce, government policy, and the overall economic outlook as most of the world’s leading economies are facing major headwinds from the demographic decline. According to data from World Population Prospects: the 2019 Revision, “by 2050, one in six people in the world will be over age 65 (16%), up from one in 11 in 2019 (9%)… In 2018, for the first time in history, persons aged 65 or above outnumbered children under five years of age globally. The number of persons aged 80 years or over is projected to triple, from 143 million in 2019 to 426 million in 2050.” This is the result of three factors – increases in life expectancy, declining fertility rates and unusual emigration patterns. Chart 2 highlights the projected trends toward an aging society as published in the United Nations report, World Population Prospects 2019.
As the world population ages, the Potential Support Ratio (PSR), or the ratio of the working-age population, 15 to 64, per one person 65 and older will become more important for investors. In 1950, the global PSR was 10.1 and it has dropped to 6.3 in 2019. By 2050 the PSRs are projected to be substantially lower at 3.5. The problem is most acute in Eastern and South-Eastern Asia with 261 million people aged 65 and over in 2019, Europe and North America (200 million), and Central and Southern Asia (119 million). By 2050, the United Nations forecasts the number of older persons doubling from 703 million to 1.5 billion. Concurrently, the birth rates in most developed nations are declining. According to a recent United Nations report, “The unprecedented shift towards a larger proportion of older persons and concomitant declines in workers is gradually and inexorably necessitating redesign of national economies.”
As a result of the demographic shifts, we anticipate greater social strains as governments are forced to address rising and, in many cases, unsustainable pension and healthcare obligations. As the yellow vest demonstrations in France have shown, the demonstrators do not want any adverse changes to their pension benefits, and one proposed change that was heavily criticized was raising the retirement age by only 2 years. The fact is that many of the future pension and healthcare obligations will not be able to be met without either lowering future benefits and/or raising taxes considerably due to fiscal constraints on governments in most developed nations. In addition, the aging issue will require a massive adjustment in the labor force that will necessitate greater use of automation, artificial intelligence solutions, and robotics in a variety of job functions in both the manufacturing and service sectors. New jobs will be created, jobs will be lost, and industries transformed in the process. This adjustment will create supply and demand imbalances in the work force for specific jobs, sometimes creating wage inflation for jobs in tight labor markets and sometimes leading to significant job elimination. There will be both inflationary and deflationary aspects of this shift that will pose additional challenges for monetary and fiscal policy.
Ironically, many nations may need to attract immigrants in order to have enough labor and consumption to drive economic growth and help meet future obligations, which for some countries would require a reversal of recent anti-immigration policies. Initially income inequality will likely be exacerbated as a result of the shift in the workplace as low-skilled, less-educated workers as well as older workers may not be as able to develop the skills required to compete for the better paying jobs. This low-interest rate environment enables businesses to be able to continue to invest in automation and lower labor costs through additional headcount reductions. This may push governments to consider skills-retraining and apprentice programs in conjunction with the private sector, a revamp of the educational system and ultimately to consider implementing some type of universal guaranteed income program.
Climate Change – We’re on the Eve of Destruction
“Climate
crises in the next 30 years might resemble financial crises of recent decades:
potentially quite destructive, largely unpredictable, and given the powerful
underlying causes, inevitable.”
– Greg
Ip, Wall Street Journal, January 17, 2020
From shifting weather patterns that threaten food production, to the terrible fires in Australia, to rising sea levels that increase the risk of flooding, among other problems, the impacts of climate change are being felt on every continent on an unprecedented scale. The problem is both man-made and due to natural causes and will require a multi-decade transition to address it. Attempts by governments to moderate the effects of climate change by controlling human activity are being undercut by the melting of the Arctic ice shield—250 billion tons of ice in 2019 alone—and the melting of the permafrost which is adding carbon dioxide and methane back into the atmosphere. There was a record melting of the permafrost in 2019, and this is critical as the melting causes erosion, the disappearance of lakes, landslides and ground subsidence. Whether you agree with the scientists or not, what is clear to the investment community is that changes in climate are having an immediate impact on supply chains, industries, living standards, water systems, food sourcing, global finance, and where people will live.
From an investment perspective, climate change is forcing immediate planning and spending that had previously been postponed. Capital spending related to climate change is going to be a much more important factor in economic activity this decade and beyond. This is forcing state, local, and federal governments as well as the private sector to respond with smart investment strategies. In many cases, it will require the continuation of low interest rates for an even longer period and greater investment spending which has repercussions for monetary and fiscal policy in a world already heavily indebted. Critically, the spending will be coming at a time when the global interest rate structure (the cost of capital) has never been lower, providing governments an ideal borrowing opportunity.
Our research efforts are focusing on the United States electrical grid and infrastructure systems as one of the most critical and immediate areas of need. The Fourth National Climate Assessment, released in 2018, noted, “Infrastructure currently designed for historical climate conditions is more vulnerable to future weather extremes and climate change.” Failure to address the nation’s grid will result in more problems like those experienced in California in the past year with rolling blackouts and wildfires. The current grid system in the U.S. is made up of three grids that are not well integrated. And one of the key issues will be transmitting energy between regions efficiently, particularly from the Southwest to the Northeast as well as from sparsely populated areas with energy supply surplus to more densely populated areas in supply deficit. The aging electrical grid system requires downtime to cool its transformers, and the shift to electric vehicles combined with rapid growth of the cloud and 5G would overwhelm the system as it stands today. The utilities are aware of the need to upgrade the electrical grid system, and four of them have announced capital expenditure plans in aggregate of more than $100 billion over the next three years. Our research continues to identify the companies benefiting from climate-related expenditures, especially those companies providing infrastructure solutions for the utility, pipeline, energy and communications industries.
As government and business leaders gather at the World Economic Forum Annual Meeting in Davos, the calls for action on climate are growing as evidenced by the theme for the event which is Stakeholders for a Cohesive and Sustainable World. Business leaders are paying attention as demonstrated by the recent pledge by Microsoft to become carbon negative in its emissions by 2030 and remove the amount of carbon it has emitted over the decades by 2050. This is a recognition of its role as a corporate leader in addressing the problem. Importantly for investors, the steps taken to address climate change will factor heavily into the valuations of companies going forward with some being helped and others being negatively impacted.
Investment Implications – Be Cautious and Opportunistic
“The
future depends on what you do today.”
– Mahatma Gandhi
On the surface, the conditions described above might lead investors to be pessimistic about the prospects for the U.S. and global economies, and therefore the markets. However, it is these conditions that may very well set the stage for an extension of the current economic expansion, and perhaps an even longer run for this bull market notwithstanding the possibility of a near-term pullback. The reason for the more positive view is a continuation of the present low-growth, low-interest rate and deflation-prone environment which will enable the Federal Reserve and other central banks to continue their accommodative interest rate policies and avoid impeding capital flows. Barring a significant shift in the outlook for inflation, which we do not anticipate at this time, the Federal Reserve must work to keep interest rates low for the foreseeable future, and that would continue to provide a favorable backdrop for equity investing.
While much has been made of the income and wealth inequality experienced around the world, there is a similar dynamic playing out with corporations. The leading companies are prospering, and the rest are less so. Why? Because these companies are more productive, and the resulting productivity leads to higher earnings and better pay for employees. These companies tend to have better balance sheets and access to capital, enabling them to invest more heavily, and therefore enhance their productivity, grow market share, and ultimately increase shareholder value. Investors should focus on companies with “embedded advantages” over their peers. The leading technology companies offer excellent examples of businesses with embedded advantages. Alphabet, the parent of Google, dominates the worldwide search market ex-China. While there is talk of increased regulatory scrutiny and higher taxes for companies like Google, this would likely reduce the ability of others to compete by raising the cost of doing business and increasing the barriers to entry. There are companies with these embedded advantages in several industries that are benefiting from the secular themes described in this Outlook, and that is where investors should focus their dollars. It is for this reason that we feel the investment environment is set to favor active 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. Companies with solid, above-market dividend yields should continue to be rewarded under these conditions.
There are always risks to the economic outlook and that is certainly the case today. Aside from the ever-present geopolitical risks, the risk of a massive cyber-attack on the U.S. infrastructure, government institutions or the financial system, or the risk of policy missteps, among the key risks that would change our positive views would be a sharp rise in inflation and in the U.S. dollar. As the world economy remains both fragile and fluid as highlighted by the coronavirus epidemic, we continue to be opportunistic and cautious in our investment approach. Climate change has now come to the fore as a secular trend. It now represents an immediate, multi-year investment opportunity. 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.
Today’s investors must adjust to a global economy unlike any previously experienced. There is no historical precedent for the post-financial crisis economy, and one need look no further than the more than $12 trillion of government bonds currently carrying negative yields. The convergence of these unprecedented economic conditions with unconventional monetary policy, insufficient fiscal policy responses, and a changing market structure are challenging many investment strategies dependent on historical precedent. Volatility and uncertainty are two defining characteristics of a deflation-prone global economy marked by low growth and low interest rates. At the same time, growing economic divergences, populist politics and changing terms of global trade are contributing to significant shifts in investor sentiment, which in turn impact short-term security valuations. Bear in mind, the more negative the sentiment, the better the value for the buyer. Conversely, more positive sentiment can lead to greater overvaluation in individual stocks or the overall market. This is important because securities trade in an auction market that has inherent inefficiencies which lead to the mispricing of securities. These mispricings create opportunities for investors who have the ability to correctly define the macroeconomic conditions and the willingness to go against popular sentiment. The distinct economic, political and social dynamics of the current environment leads us to question whether investors can adapt to this new investment paradigm.
To remind our readers, the purpose of the ARS Outlooks is to define the forces affecting the global economy and to identify the beneficiaries of the key secular trends. The Outlook is the foundation of our investment philosophy and process. We employ a long-term, investment-oriented approach, and avoid short-term speculation. We do not attempt to make predictions with unwarranted precision, but rather work to determine those outcomes that should have the highest probability of success. Our focus is to define the secular beneficiaries of the global environment and then the outlook for the three fundamental elements of securities valuation — corporate earnings, interest rates and inflation rates. Once we determine the sectors and industries that should most benefit, our team conducts fundamental research to determine which U.S.-publicly listed companies represent the best values for client portfolios. We are seeking to buy the most assets, earnings and cash flows in the beneficiaries of the global economy. Our research focuses on those businesses that generate significant free cash flow as it represents what companies actually have left at the end of the day. Cash flow is what drives a business and its ability to invest in the future and to reward investors through dividends and share buybacks. We are less concerned about reported earnings which are a creation of accounting rules. The job of investment professionals is to make their best judgment on the future earnings power of the businesses they own.
In this piece, we will describe why investors cannot compare the current expansion to past cycles, why governments must become the spenders of last resort, the implications of changes to the structure of the market and where capital is likely to flow in the new investment paradigm. While the current environment is likely to remain volatile and uncertain, we expect the U.S. and global economies to improve in the coming quarters. Efforts by central banks to stimulate growth, including the recent rate cuts by the Federal Reserve and others, typically take 2-3 quarters to work through the system. Additionally, we remain positive on the secular trends that we have identified and highlighted in recent Outlooks. While policy missteps always remain a risk for the global system, we believe that the secular trends we have identified will continue to be the principle drivers of economic activity for the foreseeable future.
Why You Cannot Compare the Current Expansion to Past Cycles?
The current economic expansion, which is the longest in U.S. history, has many distinct characteristics when compared to past cycles. The post-WWII global economic system was defined by monetary controls, administered prices, fixed exchange rates, and cost-of-living wage adjustments in labor contracts with inflationary tendencies, among other forces. In 1973, President Nixon introduced floating exchange rates where currency rates are determined by the markets. Subsequently, governments moved to managed exchange rates, also called “dirty floats”, whereby a country’s central bank intervened to raise or lower the value of its currency. From a geopolitical perspective, two important multilateral governing institutions introduced between 1948 and 1949 were the North Atlantic Treaty Organization (NATO) for defense purposes and the General Agreement on Tariffs and Trade (GATT) which was introduced to help guide international trade in the post-war period. GATT was the predecessor to the World Trade Organization (WTO) which was officially launched in 1995. In the 1970s, cost-of-living wage adjustments combined with higher oil prices stemming from the 1973 oil embargo created extensive inflationary conditions. This led then Federal Reserve Chair Paul Volcker to use monetary policy to dramatically raise interest rates to curb the inflation which peaked at 14.8% in March of 1980.
The fed funds rate peaked at 20% in June of that year. In general, economic expansions end because the economy becomes overheated causing central banks to raise interest rates in response. At the same time, spikes in oil prices often accompanied rising economic activity which put even greater strains on the system.
Current conditions are very different from past expansions especially at this late stage of a business cycle because we are running a massive federal government deficit at the wrong time. Moreover, much has changed in the past decade to challenge the post-WWII norms that make comparisons with previous cycles questionable. In response to the 2008 global financial crisis, the world’s leading central banks embarked on accommodative monetary policy programs unlike any previously conducted. These actions have resulted in the lowest level of interest rates in most investors’ lifetimes. At no time in history has the Federal Reserve lowered interest rates at this late stage in an expansion with the economy at full employment, interest rates already near record lows and deficits legislated to exceed $1 trillion for many years. This move is without precedent. In the past, an attack on the Saudi oil fields, like the one experienced recently, would have led to a sharp increase in oil prices and created a significant strain on importing nations and consumers. However, this time prices rose for about two weeks before declining as U.S. oil production continues at record levels of over 12 million barrels a day. Perhaps the two most important differences in the economic and political conditions today are that the global economy is more deflation-prone than in past periods and that the United States has pulled back from its global leadership role. The latter policy change has important geopolitical implications as it has undermined a critical decades-old system. In addition, the Administration’s policies are leading to fundamental changes in global supply chains for corporations and strategic alliances among nations.
There are four secular deflationary forces present that have not been as characteristic in past expansions as they are today. These are technology-driven disruption, debt, demographics and deficits. The worst thing that can happen to an economy is a deflationary spiral, to which the aforementioned deflationary forces contribute, as those conditions are hard to reverse. Inflationary cycles are easier to manage since the central bank can raise interest rates as Mr. Volcker did in the 1980s. Most economists and quantitative investors use statistics of past cycles to compare to this one, but the past statistics are of little practical use because the same conditions are not present today. Decades ago, interest rates were 14-15%, now the 10-year treasury is yielding 1.9%. When yields are high, capitalization rates tend to be low, when yields are low, the reverse is true. A capitalization rate is the rate at which the market calculates the value of current earnings of a company. This has important implications for securities valuation and is a key reason why the stock markets are flirting with record highs even in the face of political and economic uncertainty.
Why Do Governments Need to Become the Spenders of Last Resort?
“We all know what to do, we just don’t know how to get reelected after we do it.”
– Jean-Claude Juncker, the outgoing president of the European Commission
Why are most advanced economies growing at near stall speeds despite central banks pulling all the levers at their disposal? The answer is that the current problems cannot be solved by monetary policy alone, and that the fiscal policy responses of advanced nations has been woefully inadequate. As Mr. Juncker states clearly, politics are holding back the economy. Additionally, the trade war is retarding capital expenditures, debt and uncertainty are weighing on consumer spending, and monetary accommodation is showing diminishing effectiveness in generating economic activity. The post-crisis goal of monetary policy was to increase asset values to stimulate economic growth and make the debt problems more manageable. However, there were unintended consequences including growing income inequality that resulted from the failure of politicians to introduce the fiscal stimulus required to address the many needs of a rapidly changing world. The growing frustration with governments is evidenced by the street protests in Hong Kong, Chile, Spain, Lebanon, Bolivia, Iraq, and Russia to name just a few. This failure of elected officials to act responsibility is also a major reason for the political divisiveness in the U.S., U.K. and Europe. The outgoing European Central Bank President Mario Draghi summed up the problem succinctly with his recent comment, “If fiscal policy had been in place, or would be put in place, the side-effects of our monetary policy would be much less, the actions of our decisions today would be much faster and therefore the need to keep in place some of these measures would be much less.”
What should happen now? There are three sources of spending in an economy – consumers, corporations and governments. Today, governments need to act to become the spender of last resort in order to counter the deflationary pressures and stimulate growth. The good news is that there are several important initiatives that could be implemented immediately, and these are in areas of greatest need in most advanced nations. To start, governments should make significant investments in our physical, digital and educational infrastructures. As the former head of the International Monetary Fund and incoming ECB President Christine LaGarde said recently, “Those that have the room to maneuver, that’s to say Germany, the Netherlands, why not use that budget surplus and invest in infrastructure? Why not invest in education? Why not invest in innovation, to allow for a better rebalancing?” Advanced nations share the same challenges, but few politicians have the courage to risk reelection in order to do the right thing. France’s President Macron is one who has gone against the grain by attempting significant reforms, and his efforts are starting to bear fruit. Maybe this will encourage others to follow suit.
In the United States, there are an estimated 7.1 million job openings which highlights the significant mismatch between available workers and the skills required for the jobs of the new economy. A recent survey from the National Federation of Independent Businesses reveals that 88% of small business owners hiring, or trying to hire, reported few or no “qualified” applicants. In response, the U.S. government should partner with leading businesses to create apprenticeship programs to help address the skills gap. Governments should work with our public universities to revamp the curriculums to better prepare graduates for the jobs of the future and not those of the past. Free tuition, as it has been proposed by some Presidential candidates, will not be useful without some changes as many recent graduates feel they are not properly prepared to enter the workforce and are saddled with an average of $28,000 or more in debt. In our May 6, 2019 Outlook, we discussed in some detail initiatives that should be considered by our elected officials to foster a higher and more sustainable rate of growth.
How Do the Changes in the Structure of the Markets Impact Investment Thinking?
In our September 18, 2018 Outlook, we addressed the key changes that are impacting the structure of the equity market in the United States. The most significant changes include the significant drop in the number of publicly traded companies, the concentration of power of leading corporations, the explosive growth in the number of investment vehicles available, the growing influence of private equity and the technological advances such as artificial intelligence, machine learning and high speed trading that are redefining the market’s mechanics and investment approaches. Many businesses which would have become public in the past now have much greater access to private capital from either venture capital or private equity investors. This means that a business can remain private and avoid the regulatory burdens of being a publicly listed company. Bear in mind that private equity firms are sitting with an estimated $1.7 trillion of uninvested capital and continue to raise record amounts of cash. Another factor impacting the structure of the market is the growing influence of passive investments in index funds and exchange traded funds (ETFs).
Passive investment strategies influence sentiment and encourage a “follow the herd mentality.” This is evidenced by the significant movement of capital out of equities (even as the indices have reached record levels) and into bonds which currently offer only modest yields at best. Investors seem to have forgotten that the bull market in bonds has been going on since 1981, while the bull market in stocks has been going on since 2009. This would indicate to us that the risks of bonds may be underestimated by market participants while the risks of equity investing may be overestimated. In a recent survey of Barron’s Big Money poll of institutional investors, bullish sentiment was at or near a record low. If this sentiment changes and there is a reversal in flows back into equities, then the market in 2020 may provide even higher returns than anticipated for those who act ahead of the crowd. The prevalence of short-term thinking is another factor that investors must consider as capital is built over time through the ownership of businesses, not through quick return schemes. While more and more market participants are making decisions based primarily on price and popularity, our decisions continue to be business-driven, based on our judgment of the outlook for cash flow and earnings growth. While our core principles for investing will not change, the application of those principles must always take into account changes in the environment. We believe it is prudent to assess the current environment with a clear eye and without preconceived notions about the present based on past experiences. As Warren Buffet once said, “The stock market is a device for transferring money from the impatient to the patient.”
Where is Capital Likely to Flow in this New Paradigm?
“It is impossible to produce superior performance unless you do something different from the majority.”
– John Templeton
Capital will flow to the problem solvers of a low-growth and low-interest-rate world. The social, economic and political forces shaping the new investment paradigm described in this Outlook will require investors to adjust in at least three ways – asset allocation, return expectations across asset classes, and their views of liquidity. Asset allocation is determined by the relative risk/reward of cash, bonds and stocks. Low interest rates have been punishing savers and pension funds encouraging each to assume higher risk to achieve required rates of return. Pension plan managers, especially of public funds, have been forced to lower their return expectations, and the plans will require greater annual contributions going forward. This comes at a time when U.S. public pension funds are already facing an estimated $4.4 trillion funding shortfall. In our view, the search for higher yields has pushed investors to assume higher risks than may be suitable for many. When interest rates were higher, pension plan sponsors could achieve a significant portion of the required returns from bond yields that are no longer available. This makes quality dividend growers an attractive alternative.
Given the growth in private equity assets to over $4 trillion, it seems appropriate to share some thoughts in this area. Private equity plays an important role in the markets as it provides capital to businesses that might not be developed sufficiently for the public markets. When less capital was available for private equity deals, there were better opportunities to achieve outsized returns. However, several major public pension funds recently lowered their excess return expectations for private equity over public equities from 3% down to 1.5%. For those focused on private equity, this year’s failed IPOs and the Softbank investment in WeWork provided an excellent reminder that private valuations are also driven by sentiment. Softbank saw the value of its investment go from $47 billion a few months ago down to $7 billion. Many investors consider private equity to be a less volatile investment, but this false sense of security is due to the lack of daily pricing. Investors in WeWork might not agree given the swift change in valuation. Finally, we would remind investors that liquidity matters most when it is needed, and it is often needed when least expected. Private equity can play an important role in investors’ portfolios, but one should make sure the characteristics of the investment match the investor’s risk appetite and liquidity needs.
The three primary beneficiaries of the Outlook are companies with above-average revenue growth in a low-growth world, companies with stable, above-market dividend yields in a low-interest-rate environment and special situation companies including publicly traded small capitalization companies. While the economic outlook remains both volatile and uncertain, the secular drivers about which we have written for several quarters remain intact with the beneficiaries continuing to attract capital. The major areas of emphasis for portfolio holdings include:
Quality dividend growers – We have identified a portfolio of high-quality companies with strong balance sheets, good growth and which pay dividends at above market rates. The dividend yields are nearly 1% higher than the 1.95% yield of S&P 500 and the 1.9% yield on the 10-year U.S. treasury bond.
Quality growth companies – One of the key implications for investors is that companies with above average revenue growth can command premium valuations as they are less reliant on a strong economy. This opportunity includes technology companies that are benefiting from unprecedented innovation which we see accelerating in the next 36 months. ARS is focused on cloud, 5G, cyber security, software services, semiconductors and capital equipment, display, telecommunications, mobile communications, network infrastructure, connectivity solutions providers, and beneficiaries of autonomous driving. We also favor select defense and materials companies as well as specially defined healthcare investments due to favorable demographic trends and technological advances.
Company-specific stories – (including some smaller capitalization investments) with compelling valuations and strong company-specific catalysts or growth drivers. Furthermore, in this environment, companies with strong balance sheets should continue to prosper as cash allows these businesses to invest in increased productivity, new growth initiatives as well as to return capital to shareholders. Please refer to our recent Outlooks for more specifics on these themes.
Our Outlook describes an environment unlike any investors have ever experienced. The U.S. and global economies should experience higher growth into 2020 and the expansion should continue for some time. Any tariff relief will release the pressure on the global economy allowing capital expenditures to increase and the outlook for corporate profit growth to improve. In turn, this could result in interest rates rising somewhat as many investors shift from bonds back into equities at a seasonally strong time for equity investing. Those equity investors who have been on the sidelines will be under pressure to invest cash. This could result in stronger equity returns than many currently anticipate in coming quarters. One can be 100 percent invested in any environment if one can correctly define it. However, the dynamics present today are very fluid and volatile, making being fully invested somewhat less appropriate in our view. Today, it pays to have some cash reserves, not as a market call, but to take advantage of the opportunities presented by market volatility. We remain optimistic about the prospects of building capital in the coming quarters but believe investors should focus on striking the appropriate balance between risk, reward, and liquidity. As legendary investor, Seth Klarman reminds us, “Investors should always keep in mind that the most important metric is not the returns achieved but the returns weighed against the risks incurred. Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.”