Author: Aaron Jacobstein

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.”

“Our main expectation is not at all that we are expecting a recession. I did mention that there are these risks and we are monitoring them very carefully, and we are conducting policy in a way that will address them, but no I would not see a recession as the most likely outcome for the United States or the world for that matter.”

– Jerome Powell, Federal Reserve Chairman in a speech in Zurich
on 9/6/19

“What should I do now?” is one of the questions most frequently asked by our clients today. Many are trying to adjust to dramatic changes in the terms of global trade, geopolitical instability, and considerable shifts in monetary and probable fiscal policy initiatives against the backdrop of a slowing global economy. Amid growing talk of a possible recession, the recent drone attack on Saudi oil fields, the sharp drop in government bond yields, street protests and currency devaluations, it is easy to understand how investors could feel confused and uneasy. However, it is our strong belief that those very concerns as well as the relative strength of the U.S. and the growing economic divergences are clearly defining the best relative opportunities for investors. To be sure, there are valid reasons that the current economic and political climate is causing concerns for investors, but our base case is for the slow-growth expansion of the United States to continue for some time barring a major policy misstep. We view the recent yield inversion in U.S. Treasury Bonds as a reflection of the negative interest rate and currency issues of other nations as well as the strength of the United States economy rather than the traditional warning sign of a nearing recession. Given the character of the post-financial crisis global economy, we have been and continue to be in uncharted waters.

Based on current conditions, our answer to the “What now?” question is that this continues to be a time to be both appropriately cautious and opportunistic in order to take advantage of the mispricings of quality businesses that naturally occur in periods of heightened volatility. Today, investor focus should continue to be on companies that can grow revenues at an above-market rate, those with strong balance sheets that provide stable and growing dividends that are yielding more than bonds and the overall market, and those that are special situations including the beneficiaries of the many merger and acquisition transactions taking place. Additionally, many companies with higher-than-desired debt levels are taking advantage of the sharp decline in interest rates to refinance their debts and thereby increase shareholder value.

In these times of greater volatility and uncertainty, the typical investor tends to be more inclined to reduce equity exposure or pull out of the market rather than take advantage of the opportunities being presented. That is a speculative market-based approach rather than an investment-based approach, and generally leads to significantly lower long-term returns.  Investors should always be focused on finding the best relative opportunities consistent with their specific goals and objectives. While growing social stresses, political divisiveness and trade tensions will likely remain top-of-mind issues, they should not lead to all-or-nothing market decisions as the best opportunities to build capital are born out of periods of great uncertainty.

Why Growing Economic Divergences Are Driving Significant Capital Flows Into the United States

“Global growth is sluggish and precarious, but it does not have to be this way because some of this is self-inflicted.”

– International Money Fund (IMF), World Economic Outlook, July 2019

As illustrated in Chart 1, the United States economy remains a standout due to the combination of relatively strong Gross Domestic Product (GDP) and population growth as well as our strong consumer spending, manageable debt levels and dynamic businesses. However, it is not without its own challenges. China and India, which have had strong growth rates and rising middle classes, are each struggling with their own country-specific social, political and economic issues that are contributing to a slowdown in their growth. Europe is challenged by flawed monetary and institutional structures, slow growth and difficult demographic issues. Europe’s economic growth continues to deteriorate, and the slowdown in German manufacturing suggests further challenges lie ahead. Germany is the economic engine of Europe, and concerns about its growth have spurred discussions of the need for significant fiscal stimulus. Japan, the world’s third largest economy, has had three decades of economic problems and is also plagued by a major demographic challenge as its population is forecast to decline by up to one million people per year over the next two decades. Slowing population growth in China and leading developed nations is a significant factor in the slow-growth and deflation-prone environment we have been writing about for several years. Adding to the divergences is the weakening of global currencies with respect to one another and the U.S dollar which has negative implications for U.S. dollar-denominated debt and demand for goods and services traded in U.S. dollars. These dollar-related stresses are especially acute in emerging market economies such as we have just seen in Argentina. [Editor’s Note: For purposes of this Outlook, we are focusing on a high-level discussion of the issues and we acknowledge that there are many nuances that we are not addressing here.]

Because of these factors, money continues to flow into the U.S. markets and with respect to fixed income is driving U.S. interest rates down. This has set the stage for the potential for the significant refinancing of U.S. government, corporate and household debt which would be highly positive for the United States economy. Current conditions remain relatively favorable for U.S. equity valuations as corporate profits are grinding higher, inflation remains muted, and central banks are reconfirming their commitments to keeping interest rates near historic lows. Norway has the world’s largest sovereign wealth fund which owns an estimated 1.5% of every listed company globally. The fund recently announced its plans to shift its equity allocation by reducing its European equity weighting by around 15% and increasing its North American weighting by almost 17%. This change reinforces our view that the U.S. will continue to be the beneficiary of capital flows.

Why a Strong Fiscal Policy Response Is Even More Necessary Today

“Ever since the onset of the crisis, central banks have been widely regarded as the only institutions capable of taking action. I think
that’s wrong.”

Jens Weidmann, head of Germany’s Bundesbank

In a world full of uncertainties, there are a few facts that are important for investors to consider. First, economic growth is decelerating around the world driven in large part by restrictive terms of trade, disruptions to global supply chains, worsening demographic trends in the developed world, and too much debt in the global system. Second, the global fiscal policy responses, which have generally been insufficient and not well targeted, need to be more forceful to stimulate growth by addressing the specific needs, including infrastructure expansions and upgrades, that have developed and have been unmet for many years. As Jean-Claude Junker, the outgoing President of the European Commission once said about the political willingness to approve a strong fiscal policy response, “We all know what to do, we just don’t know how to get re-elected after we’ve done it.” However, one major benefit of a strong fiscal response would be the reduction of income inequality by raising living standards, stimulating wage growth and closing the skills gap. Third, monetary accommodation by central banks as an exclusive tool has reached the limits of its ability to meaningfully stimulate growth. However, that does not mean that central banks won’t continue to push interest rates even lower, as evidenced by the nearly $17 trillion of government debt around the globe now carrying negative yields. As shown in Chart 2, the yields in major advanced nations are quite low already. The European Central Bank (ECB) recently announced yet another interest rate cut, and it is likely that the Federal Reserve will lower interest rates again at its upcoming meeting. Fourth, central bankers’ efforts to manage inflation rates have failed as developed economies continue to be more deflation prone than anticipated, and inflation remains stubbornly low in those countries. In fact, it can be argued that the monetary policies intended to push inflation rates closer to desired levels have had the opposite effect, as the subsequent investments in technology have increased productivity and lowered input costs. In recent months, despite more than 30 central banks having announced interest rate cuts including the Federal Reserve’s recent “mid-cycle adjustment,” the world is still experiencing slower growth. We believe that governments must now take the baton from the central banks to stimulate growth. We see that many governments are now considering new fiscal stimulus programs, which should not be lost on investors, as it has a positive impact on the outlook for corporate earnings. However, policymakers need to act now as the impact of stimulus initiatives is typically felt two or three quarters after being introduced.

As we have written frequently over the past decade, the United States and other nations must not waste the opportunity afforded by the current low-interest-rate environment to implement productive fiscal policies. So, while sentiment is fairly negative at present, the implementation of new stimulus initiatives should result in a better economic outlook and could counter some of the social and political divisiveness that exists today.

What Are the Investment Implications of This Outlook?

“As the markets finally come to terms with increased political risk, currency risk, credit risk, and the growing likelihood of left-wing governments, it’s clear that the shifts and the shocks are coming fast and furious. No wonder that everyone is now asking, “What comes next?’”

Rana Foroohar, Financial Times, 8/19/19

Based on the economic considerations expressed in this Outlook, there is increased clarity as to where capital will likely flow. The three primary beneficiaries 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 we have written about for several quarters remain intact with the beneficiaries continuing to attract capital. The major areas of emphasis for portfolio holdings include:

Dividend growers with strong balance sheets and the ability to increase their dividends. With central banks aggressively lowering interest rates, companies that are increasing their dividends and offering above-market dividend yields will become increasingly coveted.

• It is worth noting that at the time of this writing, investors have a choice between buying 10-year treasury securities yielding 1.84%, an S&P 500 Index fund with a yield of 1.85% or a portfolio of leading U.S. businesses with dividend yields of over 2.6% that has historically provided 70% of the volatility of the S&P 500 for the past eight years and has outperformed in down markets.

Technology companies that are benefiting from unprecedented innovation, including those that are integral to the introduction of 5G wireless networks and its primary beneficiaries. ARS is also focused on cloud, software services, semiconductor and equipment, display, telecommunications, mobile communications, network infrastructure, connectivity solutions providers, and autonomous driving companies. One particular area of opportunity is in cybersecurity as highlighted by the following:

• There has been a significant increase in cyberattacks on state and local governments in the United States. This past June, the cities of Riviera Beach and Lake Worth in Florida paid to cyber criminals a combined $1.1 million in bitcoin to recover encrypted files from two separate ransomware attacks. Beginning on August 16th, 23 Texas towns were struck by a coordinated ransomware attack according to the state’s Department of Information Resources. These attacks followed others in New York, Louisiana and Maryland.
• 5G will help change the world, and the United States should do everything it can to ensure that it sets the global standard. For all its benefits, 5G will provide significant opportunities for cyberattacks as the platform is being designed in a piece-meal fashion creating multiple points of vulnerability.

Industrial and materials investments in areas of need such as defense companies that are benefiting from increases in global spending, and infrastructure companies that are benefiting from programs supported by state and local governments as well as the impact of climate change on the rebuilding damaged areas.

• In the U.S. and Europe, the federal governments should take advantage of low interest rates to invest in their digital, educational and physical infrastructure.

Healthcare investments remain a strong secular theme due to breakthroughs in technology and favorable demographic trends, although the sector has been under considerable political pressure due to pricing concerns. The tension between the secular opportunity and near-term political pressures are creating strong buying opportunities, especially for those companies with critical technology-enabled breakthroughs in biotechnology and genomics as well as those with strong product pipelines. Climate change is having an increasing impact on global health as cases of some diseases are rising and the potential for epidemics to spread quickly is much greater.

• July was the hottest month on record according to the National Oceanic and Atmospheric Organization with temperatures 1.71 degrees Fahrenheit higher than the 20th-century average. Brazil recently reported almost 1.2 million dengue fever cases in the first half of the year, which represents a jump of almost 600% as extreme weather is contributing to the spread of this disease.

Consumer companies with pricing power that can increase profit margins, improve overall profitability and benefit from lower input costs and stronger consumer spending; and

Company-specific stories (including some smaller capitalization names) with compelling valuations and strong company-specific catalysts or growth drivers. With nearly $2 trillion in uninvested private equity capital seeking deals, many private equity transactions are being valued at 13–14 times cash flow compared to 7–9 times that private equity firms and their investors would typically expect. There are currently many compelling valuations in select publicly traded smaller capitalization companies that offer attractive return potential and better liquidity than typically offered by private equity.

In the current environment, there are corporations in most industries with strong balance sheets, revenue growth and future capital expenditure plans that are positioning themselves to gain market share in an increasingly competitive global economy. Those that are not will likely fall by the wayside. For example, JPMorgan Chase will spend approximately $11.5 billion on technology this year and will likely spend at comparable or higher levels in the future. Most of its competitors cannot come close to that amount of spending, so how will they compete going forward? Consequently, we would expect continued consolidation within that industry as well as in other industries, giving investors another opportunity to benefit from today’s environment. That is one of the reasons this is not an environment where all businesses perform equally. So, as we stated at the start of this Outlook, our answer to the “What should I do now?” question is that while this is a time to be appropriately cautious, it is also important to recognize and take advantage of the investment opportunities being presented. Therefore, to have higher cash balances is not intended as a market call, but rather the means to be able to take advantage of the opportunities presented. Clients should not let headline issues distract them from the opportunities being presented by the dynamics in the world today.

June 17 2019

Nobody wins a long trade war, particularly when it involves the world’s two leading economies, and it appears we may be moving towards a prolonged trade problem with China. After a positive start to the year which saw the markets rebound off the fourth quarter lows to rally back to near-record levels, the U.S. equity markets took a turn for the worse in early May as trade discussions between the United States and China suffered a major setback. On May 9th, President Trump accused China of reneging on previously agreed to settlement terms. Not surprisingly, the Chinese government subsequently denied those claims saying that is “common practice” to make adjustments and new proposals as talks progress. It is possible that both sides are using harsh rhetoric as a negotiating tactic, but it is also possible that both sides are positioning for a more drawn out negotiation that would have significant implications for the global economy and for investing. The importance of the U.S. and China trade negotiations should not be underestimated as the recent events are having a negative impact on the markets as well as business and investor sentiment. In addition, the delay in a resolution limits the ability of corporations to adjust their global supply chains to reflect new terms of trade, and that could cause a slowing of the global economy. As if the problems with China were not enough, President Trump subsequently announced his decision to remove India’s favored-nation trade status and his intention to impose tariffs on Mexico to pressure that nation to more pro-actively address the immigration issue. Subsequently, the U.S. and Mexico have reached an agreement to address the border issues and avoid the tariffs for now.

In anticipation of a more prolonged trade dispute, we had embarked on a policy to be appropriately cautious, which also would give us the opportunity to take advantage of the mispricings of quality businesses that naturally occur in periods of heightened uncertainty. At the same time, there are two factors working in favor of an eventual resolution. President Trump wants to be re-elected and President Xi has near-term social and economic challenges to consider. As a result, we anticipate a deal will eventually be reached, but the timing remains uncertain. Since the beginning of the year, we made a decision to de-risk portfolios by selectively raising cash levels as the market recovered from the fourth quarter downturn. Based on the changes we have been making, we are in a position to take advantage of opportunities in the beneficiaries of the secular trends due to the higher than normal levels of cash in client accounts. Notwithstanding the messy global economic and political situation, we remain focused on identifying those leading businesses that stand to benefit from the dramatic technological advances coming in the next 24 – 36 months, and we believe that many of the leading companies may be available for purchase at lower prices. While we cannot ignore the importance of concerns driving the uncertainty, we believe that “select” U.S. corporations with above-market revenue growth, strong balance sheets and rising dividends as well as special situation investments will provide positive returns for investors over the coming quarters.

What Some of America’s Leading CEOs are Saying About the Major Technology Opportunities

In this Outlook, we offer some insights shared by corporate executives who are members of the Business Roundtable as it relates to the critical technological challenges facing the United States. The stated objective of the Business Roundtable, an association of chief executive officers of America’s leading companies, is “to promote a thriving U.S. economy and expanded opportunity for all Americans through sound public policy.” On May 6th, the group released a report entitled “Innovation Nation: An American Innovation Agenda for 2020” in which it provided its recommendations to bolster American leadership in key technologies. The report focuses on six policy proposals addressing cybersecurity, 5G, space, artificial intelligence, autonomous vehicles and quantum computing to ensure future American leadership in these key technologies. Importantly, the areas of focus are aligned with key secular themes we have highlighted in recent Outlooks. Industries and companies are being transformed and redefined, and what the Roundtable CEOs are saying about technology is particularly noteworthy as they employ more than 15 million people and invest nearly $147 billion annually in research and development. We believe the technological advances coming in the next few years will be unlike anything we have previously experienced, and that the U.S. is in a battle for technological supremacy with China that will have critical implications for our nation and its businesses. We remain convinced that market participants continue to underestimate the pace and magnitude of the changes that lie ahead in the coming years as things that were once unimaginable become reality. While these companies may or may not be currently owned in client accounts, we have chosen these quotes from the Business Roundtable press release as they highlight some of the key secular themes that will impact business, consumers and investors in the coming years.

Cybersecurity

“Strong cybersecurity is vital to protect U.S. national and economic security and promote U.S. innovation.  Securing a prosperous future in the United States depends on business and government working together to protect networks, safeguard data and matching the sophistication and relentlessness of our adversaries.”
– Jamie Dimon, CEO of JPMorgan Chase and Chairman of the Business Roundtable

5G

 “Within 5 years, 5G will change our world and society in ways we can’t imagine now. 5G isn’t just “the next G,” it’s truly a new generation. 5G will be up to 10 times faster than 4G, operating in near-real time, with a nearly imperceptible lag between action and response.  But beyond its faster speeds and quicker response times, 5G will connect and control vast amounts of infrastructure?—?defense, transportation, manufacturing, utilities, healthcare, banking, autonomous cars … you name it.  5G enables a world of hyper-connectivity. Wi-Fi allows hundreds of devices to be connected, 4G allows thousands of devices, 5G will connect millions of devices and sensors per square mile. And it will enable you to isolate and locate a device on a 5G network within centimeters.”
– Randall Stephenson, AT&T Chairman and CEO

Space

“Continued U.S. leadership in space will require two things: robust investment in civil and national security space technologies and a commitment to developing and maintaining a best-in-class workforce. The criticality that space plays in maintaining our military and commercial technologies advantage is clear and our leadership is being challenged. We are at a very important moment in our history, and it is critical that we focus on inspiring the next generation to join us in pushing the bounds of human discovery in space. Space technologies and capabilities have transformed the way we live and work. A clear example is the GPS service we use from our vehicle or mobile device daily. GPS was a technology developed for national security applications and then was expanded to commercial use. Much of our day-to-day lives are impacted by the technology we have deployed into space and this is yet another reason why we must maintain our technological leadership.”
– Kathy Warden, CEO and President of Northrop Grumman

Artificial Intelligence

“The United States needs a coordinated national effort on AI that combines greater funding from the federal government, involvement from the business community and collaboration with leading research universities. If we are to shape how these emerging technologies impact our country and people, we must be leaders in their development and ethical introduction.”
– Stephen A. Schwarzman, Chairman, Chief Executive Officer and Co-Founder of Blackstone

Autonomous Vehicles

“Delivering safe, autonomous technology at scale is the greatest engineering challenge of our lifetime. Solving this will unlock profound societal benefits and a multi-trillion-dollar market potential – and I wouldn’t trade our position with anyone… many of the building blocks of the autonomous future are already in today’s cars and help to keep families safe, but there’s enormous opportunity to eliminate the human error that causes more than 90% of all fatalities in the U.S. We’ve laid out a vision of a world with zero crashes, zero emissions and zero congestion?—?and autonomous technology will be key to delivering that future.”
– Mary T. Barra, Chairman and Chief Executive Officer of General Motors Company

Quantum Computing

“Quantum computing will allow us to answer questions and tackle challenges that are beyond the reach of today’s classical computers.  Investing now in systems and research and building a quantum-ready workforce will help ensure the United States leads on this pivotal technology and enjoys its economic benefits for years to come.”
– IBM CEO Ginni Rometty, Chair of the Business Roundtable Education and Workforce Committee.

Why We Remain Positive on the Leading U.S. Corporations for the Longer-term

 “America is still the most prosperous nation the world has ever seen. We are blessed with the natural gifts of land; all the food, water and energy we need; the Atlantic and Pacific oceans as natural borders; and wonderful neighbors in Canada and Mexico. And we are blessed with the extraordinary gifts from our Founding Fathers, which are still unequaled: freedom of speech, freedom of religion, freedom of enterprise, and the promise of equality and opportunity. These gifts have led to the most dynamic economy the world has ever seen, nurturing vibrant businesses large and small, exceptional universities, and a welcoming environment for innovation, science and technology. America was an idea borne on principles, not based upon historical relationships and tribal politics. It has and will continue to be a beacon of hope for the world and a magnet for the world’s best and brightest.”
– Jamie Dimon, CEO of JPMorgan Chase, in a recent annual shareholder letter

For some time, we have written that the United States has been and remains the standout global economy because of its many strategic competitive advantages over all other major economies, as Mr. Dimon points out above. While not without its flaws, the United States is both a remarkable country and economy because of its resilience, adaptability and its system of government. We have the deepest and most mature capital markets system in the world, and our financial institutions rank among the strongest and best capitalized. The strength of an economy is reflected in its currency, and the U.S. dollar’s position as the world’s leading reserve currency has been highlighted recently as a result of the flaws of the other reserve currencies, the Euro and the Yen. At the same time, China’s aspirations for the Renminbi need to be tempered as the government’s attempts at currency management or manipulation have raised questions about whether the rest of the world is ready to accept it as a reserve currency. Additionally, the world will not accept a currency as a reserve currency as long as that nation is run as a dictatorship.

Another significant competitive advantage is that our system of capitalism has fostered the creation of some of the world’s most dynamic and innovative businesses. The U.S. has developed a culture that encourages those willing to take risks and work hard to innovate and change the way we live. This has enabled companies such as Apple, Google and Amazon to rank among the largest companies in the world. The current system of capitalism and the role of big corporations in society is now being questioned. Some politicians are proposing more government involvement in how businesses are managed which is ironic given the respective track records of business and government leaders. Although we know that there are some companies that have not always served the public’s best interests, overall corporate America has done an outstanding job, which is why so many U.S. companies are among the world’s most valuable and respected.  However, it is not just big corporations that set the United States apart from other countries, the U.S. is home to approximately 30 million small businesses. As a nation, we should be proud of these successes and encourage them.

Why Taking a Longer-term View Matters for Investors

“Successful investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time.”
– Warren Buffett

The U.S. stock markets have rebounded strongly this year before giving back some returns in May, leaving many investors wondering what to do now, so we thought a little perspective would be helpful. Recently, money market balances have been moving back to post-financial crisis highs and some investors have been pulling money out of U.S. equities. No one can know what the markets will do from one day to the next, but the numbers here speak for themselves. As the chart going back to 1928 indicates, the stock market has risen between 52.2%-65.6% of the time depending on whether one is measuring days, months, quarters or years. That is statistically significant. Therefore, we would suggest that investors continue to take a longer-term view and to use volatility to their advantage by holding somewhat higher levels of cash to buy shares of attractive businesses when they go on sale.

At ARS, we view the stock market as a medium of exchange, trading dollars for ownership of shares of businesses. Too much attention is being paid to news headlines and short-term price movements which do not typically reflect the earnings, cash flows and assets of listed businesses. Securities trade in an auction market that has inherent inefficiencies, and there is often an inverse relationship between the popularity of a security and its intrinsic value. However, investors often get caught up in the emotion of the moment and allow their emotions to get the best of them which then leads to bad decisions. As legendary investor Benjamin Graham reminds us, “Investing isn’t about beating others at their game. It’s about controlling yourself at your own game”.

What Should Investors Do Now?

Conventional thinking is that the economic cycle must end soon; however, the current backdrop has the ingredients for an extended economic expansion. The current slow-growth, deflation-prone environment will have the effect of elongating the economic cycle rather than shortening it, and therefore we do not see a recession coming anytime soon. The United States should continue to attract money flows to our capital markets.  Federal Reserve policy has helped fuel the rebound in equities in 2019 and barring a policy misstep should continue to be supportive of equity investing.

Furthermore, over 70% of corporations reporting earnings this quarter have beaten estimates. This combined with little to no inflation and our view that interest rates will continue to be well below historical levels are all highly constructive for equity investing. On June 4th, Federal Reserve Chair Powell in response to trade concerns said in a speech, “We do not know how or when these issues will be resolved. We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2 percent objective.” The equity and bond markets rallied as investors interpreted these comments as a willingness of the Federal Reserve to act to support the economy, even if it means reversing itself and cutting interest rates to offset the challenges of a prolonged trade war. If the Fed cuts rates at some point, we believe it will not likely be a preemptive move, but rather a reactive one based on evidence of a slowdown in economic activity.

While the economic outlook has become more uncertain, the secular drivers remain intact and should continue to attract capital. The major areas of emphasis for portfolio holdings include:

–Technology companies that are benefiting from unprecedented innovation and especially those that are integral to the introduction of 5G.  The evolution of 5G technology borders on revolutionary change. ARS is focused on the beneficiaries including telecommunications, cloud, semiconductor and equipment, mobile communication, network infrastructure, software services, cyber, connectivity solutions providers, autonomous driving and display companies;

Update on the 5G rollout – Jon Swartz, a writer at Barron’s, was recently given an exclusive to test AT&T’s new 5G network in Dallas. The test was not run on a “fully mobile 5G” but the results were still impressive. In one test using an older iPhone 6, he experienced “speeds of 128 megabits per second, up from 23 megabits on his 4G connection.” In another test at the Dallas Cowboys stadium, a “laptop using a 5G antenna reached speeds of 923 megabits per second to 1.114 gigabits per second.”  While this was only a test, it indicates the potential for 5G to change the way we live and businesses to operate over the next few years. Additionally, President Trump and the head of the Federal Communications Commission (FCC) recently announced a plan to support U.S. companies in the development of 5G by making available additional wireless spectrum and allowing companies to have access to some of the spectrum used by the Department of Defense.

–Industrial and material investments in areas of need such as defense companies that are benefiting from increases in global spending and infrastructure companies that are benefiting from programs supported by state and local governments;

Thoughts on changing U.S. weather patterns – flooding and severe weather throughout the United States have created the immediate need to spend billions of dollars on infrastructure and housing as many Midwestern towns will need to be completely rebuilt, and in some cases, relocated entirely. Higher than normal rainfall in the United States is creating a significant dilemma for farmers as the overly saturated farmland makes the decision to plant crops this year a difficult one.

–Healthcare investment remains a strong secular theme due to the favorable demographic trends, but the sector has been under considerable political pressure recently and could very well remain that way until there is greater clarity. At some point the tension between the secular opportunity and near-term political pressures could create a strong buying opportunity, especially for those companies with critical technology-enabled breakthroughs as well as those with strong product pipelines;

Dividend growers with strong balance sheets that will continue to attract capital in a low-interest rate world;

Consumer companies with pricing power that can increase profit margins, improve overall profitability and benefit from lower input costs and stronger consumer spending; and

Company-specific stories (including some smaller capitalization names) with compelling valuations and strong company-specific catalysts or growth drivers.

We continue to identify many above-average revenue-growth opportunities, including several smaller capitalization companies that have market-leading positions in the themes listed above. Investors should stay committed to their long-term plans to build capital through the ownership of the world’s most dynamic growth businesses. Under current conditions, one should expect to see continued price volatility including some of the biggest beneficiaries of this outlook. Successful investing during this period will require the patience and discipline to profit from market volatility. This is the time to be appropriately cautious but also opportunistic.

“As long as inequality and other social problems plague us, populists will try to exploit them.”

–Kofi Annan, Statesman

At a time when the United States economy is experiencing the second longest expansion in history, our nation is facing a most politically-divisive period as the benefits of the post-crisis recovery have not been shared equally. America is not alone in this situation as concerns about inequality and other issues have led to increased frustration and anger with government leaders in many developed nations which makes this environment ripe for populist exploitation. The global economy is suffering from too much debt and too little growth, while the policies employed to combat the financial crisis have contributed to rising income inequality both in the U.S. and other developed nations. For too long, our government has placed too much responsibility for economic growth on the Federal Reserve, and productive fiscal policy initiatives have not been created to break out of the current slow-growth cycle. While the battle lines are being drawn for the 2020 presidential election, this is an appropriate time to provide some perspective with respect to what is missing in the political debate and what can be done to address our country’s most pressing issues.

Notwithstanding the political climate in our country, current economic conditions of slow growth, muted inflation, and low interest rates are fostering a positive environment for the continuation of this economic expansion and for equity investing. Investors should be aware that economic expansions have no set expiration date, and the current expansion can continue for some time as evidenced by Australia’s expansion which is heading into its 28th year. By the same logic, the stock market can continue its upward trajectory given current favorable conditions for corporate earnings. The more positive view of U.S. equities is further supported by the Federal Reserve’s current accommodative monetary policy, significant efforts by the Chinese government to stimulate its economy and the increasing likelihood that the U.S. and China will reach some resolution of their trade dispute. In this slow-growth and deflation-prone environment, investors should expect continued market volatility with possibly fewer companies benefiting than in recent years. Importantly, these conditions continue to create excellent buying opportunities for investors to be able to take advantage of the mispricing of leading companies benefiting from the secular trends.

What is Missing in the Political Debate?

“Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies.”

–Groucho Marx

Many observing the political dysfunction in Washington DC would agree with the spirit of Groucho’s statement. Politicians have been too busy running for office and blaming others to acknowledge their own responsibilities for the nation’s problems and their inabilities to implement appropriate policies. Compounding the problem is the fact that they are unable or unwilling to grasp the linkages between education, immigration, infrastructure spending, health care costs, debt and deficits on the prosperity of the nation. For example, changes to our education system would allow for more equality of opportunity for high school students and prepare our future labor force to adapt to rapid changes in their job requirements as automation replaces current work functions. Revamping our immigration policies would allow the U.S. to more immediately address the current skills deficiency as we would be able to retain foreign students who are educated here rather than have them return home to compete against us. Long overdue improvements in infrastructure would make the U.S. more productive and competitive. Additionally, increased spending would also support our digital and educational needs. The aging of our existing work force puts even greater strains on our ability to address these issues. Without an understanding of the immediacy of the need to fix these problems, the world’s leading economy will continue to produce subpar growth, fail to reduce inequality, and squander the opportunity to use this low-interest-rate environment to invest for the future. Not addressing these needs will promote even greater economic disparity.

The fundamental requirement rests with our elected officials to set aside partisan ideology and agree on policies to generate more equitable growth. Policies can be constructed to reduce income inequality, increase disposable income for lower and middle-income earners, and drive new business investment. The combination of these factors would result in a larger economy with greater tax receipts for federal, state and local governments. Before leaving office, President Obama said, “Without a faster-growing economy, we will not be able to generate the wage gains people want, regardless of how we divide up the pie.”   His assertion is that the solutions to income equality cannot be achieved by redistribution alone. The debate between growth and redistribution will be one that continues through the 2020 election.

What Can be Done to Address Inequality?

“‘Inequality’ has become the political theme/slogan of our time in both Europe and the U.S., yet political leaders do not even bother to consider that their own policies, which put the entire burden on central bankers to print money and drive up stock, bond and other asset prices, are actually exacerbating income and wealth disparity.”

–Paul Singer, noted investor

The solution begins with politicians recognizing that they are the major part of the problem. Congress needs to end the “winner-take-all” politics that currently prevail, and once again, work together to make the country richer, both economically and socially. Given the unfortunate likelihood that the Federal Reserve will have fewer tools available to address the next recession, politicians will need to act together as the U.S. may require significant fiscal policy initiatives to forestall a prolonged recession. Politicians need to set aside their ideological differences and focus on bi-partisan solutions working closely with, not against, our best business leaders. At the same time, our business leaders need to act in a responsible manner as well, and some have failed in this respect. We need to develop policies that promote the best use of tax receipts and the right system to generate more receipts for all levels of government.   Education including skills training and apprenticeship programs, infrastructure, and immigration are all linked to economic growth, and effective policies are required to arrest the challenges of growing inequality and a declining middle class. Our federal government struggles to approve an annual budget, while China, our biggest competitor, has a written 5-year plan with specific programs and measurable goals. Congress must create and enact a bi-partisan, multi-year plan to address the critical and growing needs of the U.S. Such a plan must be designed to survive the bi-annual campaign cycle and deliver on our nation’s longer-term needs. The following are a few suggestions for politicians to consider that reflect some of the things they are missing today. It is neither exhaustive nor original, and that is what makes the current state of politics even more frustrating.

• Infrastructure – Why hasn’t Congress approved a major program to address our physical, digital and educational infrastructure needs, despite it being the one thing upon which both parties can agree? According to a 2018 Pew Research Center survey, 1 in 5 teenage students can’t always finish their homework due to the lack of access to technology. The digital divide in teens exacerbates inequality and must be addressed. Historically, discussions regarding infrastructure focused on the physical element, but digital and educational infrastructure have certainly increased in importance.
• Skills Gap – Why do we have 7.1 million job openings and only 6 million people unemployed? The U.S. needs programs designed to address the skills gap as well as retraining programs for jobs that are replaced by automation. Congress should also be partnering with business leaders to develop apprenticeship programs for high school students to learn trades that require skills not taught in college. A recent report by the OECD suggested that “one in six middle-income workers are in jobs that are at high risk of automation.”
• Student Debt – With $1.5 trillion of growing student debt in the U.S., why does the government need to charge students more than 5% interest on loans? One alternative is that the government could offer interest free loans tied to contracts with student borrowers to receive a percentage of future earnings for a set period depending on the wage levels of each job. High student debt loads work against growth and promote inequality.
• Immigration Reform and Skilled Labor – Why does Canada with population of roughly 38 million target a significant number of highly skilled persons out of the nearly 300,000 immigrants accepted annually, while the U.S with a population of 317 million accepts only 85,000 H-1B visas out of the more than 200,000 applications received each year? The US H-1B visa is a non-immigrant visa that allows US companies to employ foreign workers in specialty occupations that require theoretical or technical expertise in specialized fields such as in architecture, engineering, mathematics, science, and medicine. The Wall Street Journal recently reported that there are currently 732,000 unfilled information technology jobs in the U.S. Raising the quota would be an easy way to fix part of the problem. The article further stated that “in 2019, immigrants will account for one in every 3.5 patents granted.”
• Addressing Health Care Costs – How can the world’s most prosperous country have health care costs estimated to be more than 16% of GDP or $3 trillion annually, while the rest of the developed world averages about half of that? We have great health care for those that can afford it, but it is not great enough to warrant what it costs us relative to the spend differential with other countries. Congress needs to work with the insurers, pharma companies and businesses to develop a system that works without escalating costs. Grandstanding won’t fix the problem that has been building for years, and maybe if those in Congress used the system that the typical American does, things would be very different. JPMorgan, Berkshire Hathaway and Amazon have decided not to wait for the federal government to figure it out and are jointly developing their own health care program for their over 1 million employees.
• Fixing the Tax System – Why is “carried interest” for real estate and private equity owners taxed at 15% when ordinary workers are taxed at higher rates? This loophole and others like it should be closed as they are unfair and lead to misallocation of capital. The Administration got corporate taxes partially right by bringing these taxes down to the average of other advanced countries, but many small businesses are still taxed at the individual rate. Small business is a key driver of the economy and should be better supported. Additionally, some of the proposals for raising taxes on the ultra-wealthy should be considered but getting the definition of ultra-wealthy right is also important.
• Extending Retirement Age and Benefits Eligibility – Why have ages for retirement plans and benefits eligibility for Social Security and Medicare programs not been adjusted to reflect increased life expectancy? The NY Times recently reported that the trust funds for Social Security and Medicare both will be depleted by 2035. According the Social Security Administration website, “a man reaching age 65 today can expect to live to 84 and a woman to 86.5 years old. While about one of our every three 65-year-olds today will live past age 90, and about one out of seven will live past age 95.” In 1930, the life expectancy at birth was only 58 for men and 62 for women, and the retirement age was 65. When the social security system was created in 1935, the government did not anticipate paying out much, and now we are heading towards a deficit in the program and an even larger fiscal deficit. Government pension plans are facing similar demographic and funding problems on the federal, state and local levels. There are many possible ways to address the funding issue and adjusting the age for eligibility is one that needs serious consideration.   What is Congress doing to address this worsening issue?

These are just a few of the things that should be on the to-do list of the President and Congress, and while we do not pretend to think that the solutions to our nation’s problems are easy, taking this type of approach would be far better than our current path. Our politicians must not squander the country’s unique opportunity presented by the historically low-interest-rate environment to address these pressing needs. Not acting now would represent a major failure by our elected officials. While some of the populist proposals being discussed may make for good campaign slogans, they do not address the causes or reflect the economic realities of the U.S. We are reminded of the words of economist Thomas Sowell who said, “the first lesson of economics is scarcity: there is never enough of anything to fully satisfy all those who want it. The first lesson of politics is to disregard the first lesson of economics.”

In a February 22nd speech at the U.S. Monetary Policy Forum, Federal Reserve Vice Chair Richard Clarida said “the economy is constantly evolving, bringing with it new policy challenges. So it makes sense for us to remain open minded as we assess current practices and consider ideas that could potentially enhance our ability to deliver on the goals the Congress has assigned us.” The speech was timely as we were approaching the ten year anniversary of the start of one of the longest economic expansions in history. In March 2009, a group of global central bankers, led by the Federal Reserve, unleashed the most aggressive and coordinated monetary policy initiatives in history to set in motion the global recovery. At that time, many believed that these initiatives would result in a surge in inflation, but our readers know we did not share that point of view. Even the inflation models used by the Federal Reserve would have forecast a surge in inflation by now, but inflation has been running well below expectations. The assumption that monetary policy would promote inflation was not unreasonable based on historical precedent, but the unusual nature of the post-crisis global economy has confounded many of the so-called market experts.   The presumption that the economy is more inflation prone ignores the powerful cyclical and secular deflationary forces present today. As our world continues to undergo rapid changes, we believe this time continues to be different, and reliance on past experience and historical precedent can lead to the wrong conclusions.

Most investment professionals have been in the business during the more recent decades in which they experienced only declining inflation coming off the high inflation years of the 1970s as seen in the chart on the previous page. Today the traditional playbook for forecasting inflation expectations is being called into question as the existing models employed by investors and central bankers appear to be out of sync with current economic conditions.   In recent years, the terms ‘unprecedented’, ‘unconventional’ and ‘uncharted waters’ have been used to describe the economic conditions and policies adopted during the last ten years.   Rarely do investment professionals or the media use the term ‘typical’ to describe the current investment environment. In times of rapidly changing social, political and economic conditions such as we have been experiencing since 2009, it is not surprising that the actual outcomes deviate from past experience. The difference between being in a deflation-prone versus an inflation-prone environment has important implications for investment portfolios because the winners will have different characteristics than those of past cycles. As John Maynard Keynes, influential economist, said, “When my facts change, I change my mind. What do you do, sir?”

What Might the Models be Missing?

“Going forward, we need, I believe, to be cognizant of the balance we must strike between (1) being forward looking and (2) maximizing the odds of being right given the reality that the models that we consult are not infallible.”

– Fed Vice Chair Richard Clarida, February 28, 2019

The recent speeches by Mr. Clarida and other Federal Reserve voting members reflect their awareness of the need to question the accuracy of the Federal Reserve’s forecasting models. This may be the first time that the voting members of the Fed have publicly questioned the accuracy of their forecasting models. One of the problems is that the historic models have been based on an inflation-prone system as the concept of deflation has not been embodied in investment thinking. The models were typically based on previous depressions, post-inflation periods and times of administered prices, where companies cut production instead of lowering prices. The post-financial crisis economy has different characteristics than previous periods, and adjustments to models need be made to reflect those differences. Of the developed economies, only Japan has recently experienced a prolonged period of continuing deflationary pressures, although its economy differs significantly from that of the United States. As market participants struggled to explain the lack of inflationary pressures in recent years, the view was that the factors suppressing inflation were transitory, and that inflation would accelerate in the nearer term. Yet for years inflation has remained below expectations, challenging that view.   In 2017, Federal Reserve Chair Janet Yellen reminded the markets that the Fed, and several other central banks, had yet to solve the “mystery” of low inflation, despite healthy employment growth that was not accompanied by expected growth in wages.

There are several significant forces at work in the global economy which contribute to a more deflation prone environment. Ironically, the deflationary pressures present in the system today can, in part, be attributed to the same monetary policies that many thought would feed inflation. This is due to the fact that the additional liquidity in the system was invested in areas that increased productivity resulting in lower production costs and prices. These deflationary pressures have been and continue to be fostered by the following:

• Technological advances are lowering costs, increasing productivity and suppressing wage growth
• Globalization continues to lower input costs. China, once the lowest-cost producer, now has wages that are estimated to be 6x higher than those for the same jobs in Cambodia
• Competitive pressures are forcing some businesses to absorb price increases in many items rather than passing them on to customers for fear of driving business to new, lower-cost competitors
• Debt levels are high and rising with $11 trillion in government debt carrying negative yields. Debt servicing diverts capital away from capital expenditures and consumer spending, and high debt levels make the economy more sensitive to changes in interest rates
• Demographic trends of an aging society are another factor as in most major economies those 60 and older represent the fastest growing age group. This trend tends to greatly reduce spending of the wealthiest demographic until their final years
• Mergers & Acquisitions are on the rise and generally lead to cost cutting, job losses and downward pressure on wages

As a result of these factors, investors should not anticipate dramatic changes in the trajectory of inflation. Globalization and technological advances are secular in nature and should continue to weigh on inflation expectations. Despite the desire of central banks to “normalize” policy, the current accommodative approach is required to offset the deflationary tendencies of the global economy. Given these factors one can see why this period is different from past periods, and why the economy could remain deflation prone for an extended period.

What are the Investment Implications of the Deflationary Forces on Securities Valuation and Portfolio Strategy?

Contrary to conventional thinking, the current economic backdrop has the ingredients for an extended economic expansion, namely deflationary tendencies and slow growth. Historically, economic expansions come to an end when the economy begins to “overheat” and the Fed is required to raise interest rates to control inflation. A positive side effect of deflationary forces is that the economy has been able to expand for a longer period of time without driving up prices. This has had the effect of elongating the economic cycle. However, not every type of business is equally suited for thriving in an environment of slow growth.

One of the key implications for investors is that companies with above-average revenue growth will command premium valuations as they are less reliant on a strong economy. At the start of the year, we felt that the U.S. equity markets were undervalued and there was a high probability of a recovery of stock prices from the fourth quarter lows. Our view was supported by the five-year low valuation placed on the market while the outlook for corporate earnings continued to be positive, inflation subdued, and interest rates stable. The U.S. stock markets have rebounded strongly since then supported by better communication from Fed Chair Powell who lowered interest rate expectations. In addition, the avoidance of a second government shutdown and greater optimism for a positive resolution of the trade negotiations with China further improved investor sentiment. Because the basis for securities valuation begins with the outlook for corporate profits, inflation and interest rates, inflation expectations have important implications for investment strategy and portfolio positioning. Against this unusual setting, the separation between the winners and losers in each industry becomes more exaggerated making security selection even more important. In a more volatile and deflation-prone environment, investment strategy should focus on high-quality growth, high-quality balance sheets, strong dividend payers and special situation investments. The companies that should command higher valuations will be those that deliver above-market revenue growth through consistent execution.

Our research has identified select opportunities for above-market revenue growth. There are four major areas of particular emphasis – technology involving 5G (the new fifth-generation cellular networks), robotics and related beneficiaries; healthcare; defense; and special situations – on which we remain focused as their growth characteristics make them among the most attractive areas in this environment. Importantly we are witnessing a significant technological inflection point whereby new technologies are upgrading existing technologies and accelerating the rate of change.   This inflection point has been brought about by advances in three key areas: the introduction of 5G wireless technology, major advances in semiconductor development, and lastly, emerging innovations in the world of display. The result of these advances is that existing systems used by governments, businesses and consumers, some of which are already outdated, are falling by the wayside and require a dramatic upgrade cycle.

While 5G is just being introduced in select markets across the U.S., it will allow for the better integration of technology into everyday job functions across a range of industries including banking, healthcare, defense, and manufacturing. 5G combines a revolutionary speed change with better network responsiveness and will be the enabling technology for future applications. As we wrote in our January Outlook, Cisco Systems, Inc., projects the number of connected devices to grow by 10.5 billion between 2017 and 2022, while internet traffic will grow 3-fold during that period. The faster download speeds and reduced latency will make the next generation of chips more important. At the same time, we are seeing continued improvements in the semiconductor chips with the introduction of 7 nanometer chips coming this year. This will lead to increased processing power, higher data traffic, longer battery life and the need for more storage. This will also lead to the obsolescence of many devices in the market today as well as to the introduction of billions of new devices.

Accompanying the major innovations and advances in technology is the need for governments, businesses and individuals to increase investments in cybersecurity. The Internet of Things, self-driving cars, military equipment, drones, medical devices and critical infrastructure such as the electrical grid, water supply, public transportation are all vulnerable and in need of greater cybersecurity. As technology gets even more integrated into our society, governments, businesses and consumers need to upgrade their defenses against cyber-attacks. In the United States, the Department of Defense has been a leader in the development of new technology and many of the largest defense companies are at the forefront of cybersecurity. In addition, the big tech companies and cloud providers are also leading the way in developing the services to protect customers against attacks. This is an area in which we have invested for clients for some time. As governments, businesses and consumers spend more to protect themselves, related cyber companies with strong growth profiles will continue to be the beneficiaries.

In the coming quarters, investors should also focus on high-quality companies that pay dividends at levels above market as investors will continue to be attracted to higher rates of return. We anticipate a continuation of the low interest rate environment for some time. In addition, we would caution bond investors to make sure their portfolios have a bias towards strong balance sheet companies as we expect a large number of issues to be downgraded in the coming quarters.

In summary, we believe that there will be significant differentiation between the winners and losers in this deflation-prone economy. Under these conditions, it would not be surprising to see continued market volatility including in some of biggest beneficiaries of this outlook. Successful investing during this period will require the discipline to profit from the volatility in these same strong-revenue growth companies. Furthermore, we believe that investors should not be fixated on historical thinking to drive decisions in the coming period as the dynamics of a changing world will require adjustments to investing thinking.

“Wisdom is not a product of schooling but of the lifelong attempt to acquire it.”

–Albert Einstein, physicist