Author: Kristen Niebuhr

As the fourth quarter began, we noted a few troubling signs for the U.S. economy, but we didn’t expect that these would contribute to one of the worst quarters for equity investors in history and the worst December since 1931. While it would be easy to try to point to one thing that was the cause of the pullback, this would be understating the complexity of the relationship between today’s chaotic political environment, conflicting monetary and fiscal policy, the slowing global economy, a strong U.S. dollar, plunging oil prices and the markets. We believe that a healthy amount of concern moving forward is certainly appropriate, but it is important that investors do not lose sight of the attractive valuations being created in some the world’s finest businesses as a result of the recent market retracement. Looking at 2019, we see many challenges for the United States and global economies, but believe there are three key factors that investors should strongly consider. First, it is in everyone’s best interest that we avoid a recession; this is especially true for governments and central banks in the developed world and China. Today’s high levels of global debt, trade frictions and slowing global growth make extending the business cycle the top priority for world leaders. Second, the S&P 500 is currently valued at just 14x earnings according to consensus earnings estimates and earnings are still expected to grow in 2019. This is the lowest valuation level in more than five years.  Third, greater volatility will be a fundamental characteristic of the markets for the foreseeable future. As the market digests economic and political headwinds, we believe the market has already fallen to attractive levels for investors.  We have been taking advantage of this recent weakness to selectively add to favorite positions, or to swap into high-quality investments that are better positioned for a slowing growth environment.

What’s behind the market correction?

Coming into 2018, the United States was the standout economy. U.S. growth was strong with corporate earnings growing at 24% helping to drive positive U.S. equity returns through September. Even though the headline numbers for the United States were positive, the economy was beginning to show signs of deceleration, monetary policy was less accommodative, oil prices were plunging and price to earnings (P/E) multiples were contracting. The indexation of the market and high frequency trading may have further added to the severity of the decline in stock prices. While global economic activity was fairly resilient, it was becoming more uneven and global growth was decelerating as China was attempting a controlled slowing to better manage its economic risks. As the European Central Bank highlighted in its December 13th Bulletin, “the maturing global economic cycle, waning policy support across advanced economies and the impact of tariffs between the United States and China are weighing on global activity.” In addition to slower growth and trade concerns, arguably the biggest concerns for the U.S. equity markets stem from the economic and trade outlook for China, the uncertainty and instability in the Trump Administration, and the inconsistent and confusing messaging from the Federal Reserve regarding future monetary policy.

China – Slowing and stimulating

“The practices of reform and opening up in the past 40 years have shown us that the Chinese Communist Party leadership is the fundamental character of socialism with Chinese characteristics … east, west, south, north, and the middle, the party leads everything. Every step in reform and opening up will not be easy, and we will face all kinds of risks and challenges in the future and we may even encounter unimaginable terrifying tidal waves and horrifying storms.”

– Chinese President Xi

China has grown gross domestic product (GDP) from $306 billion in 1980 to over $12.2 trillion in 2017 becoming the world’s second leading economy during that time. Its economic growth has been remarkable, and China has offered its economic model to other developing nations as an alternative to the economic model of the U.S. However, China’s growth has not been without risks as the drivers of its growth – ultra-high infrastructure investment and rapid debt accumulation – now make its economy more fragile and prone to deceleration. As China was attempting a controlled slowdown, which was in and of itself a challenge, the subsequent trade war with the United States made a difficult economic situation even worse. The Chinese stock market lost $2.3 trillion in value this year further adding to China’s woes. The combination of a slowing Chinese economy, a trade war and the rout in its stock market are causing significant political, economic and social issues for the government. So much so that several Chinese economists are publicly questioning the country’s economic model, and students are protesting more frequently.

[Update January 8, 2019: China announced two moves to support the economy. It added liquidity into its system to stimulate lending activity  by lowering the rate for reserve requirements for banks by 1%, and also announced a $125 billion infrastructure initiative for the buildout of its railway system. Both moves are supportive of China’s attempt to prop up its economy to address the economic slowdown and prepare for a difficult outcome of its trade negotiations.]

Uncertainty and instability in the Trump Administration

The “unconventional” approach of the current administration towards governing has created a great deal of uncertainty at home and abroad. One of the key goals of the Trump Administration was a reduction of the United States’ role as a global leader. Recent actions, such as the announced troop withdrawal from Syria, are changing the geopolitical dynamics in many regions. For market participants there were two major issues this quarter which have added to market volatility. The first issue relates to the high rate of turnover of key members of the administration. With the departures of Chief-of-Staff John Kelly and the resignation (and subsequent firing) of Secretary of Defense James Mattis, the Administration is losing two highly respected and experienced leaders who were regarded as important voices of reason. The second major issue was President Trump publicly questioning the policy decisions of the Federal Reserve. This was followed by rumors that Fed Chair Powell might be fired. This was disquieting for the markets as independence and stability at the Fed are paramount to the effective functioning of this agency. As we head into 2019, President Trump will be faced with an unfriendly, Democrat-led House of Representatives whose agenda is at odds with his, waning support from within his own party, and the partial government shutdown. This is likely to be just the beginning of two challenging years. The House Oversight and Governmental Committee and the Mueller investigation will further complicate matters and serve as a distraction from needed initiatives such as immigration reform and increased infrastructure spending.

Communication gaffes by Fed Chair Powell and Secretary of Treasury Mnuchin

“The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore. Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.”

– Federal Reserve Chairman Jay Powell, October 3, 2018

In a late September speech, Fed Chair Jay Powell signaled a much more aggressive approach to tightening monetary policy than the markets expected when he indicated that the then current Fed Funds interest rate was below the desired neutral rate (the rate that neither stimulates nor contracts the economy) and that the Federal Open Market Committee (FOMC) believed it appropriate to raise rates beyond neutral. At the December meeting, the Federal Reserve announced it would raise interest rates by a quarter of a point but would likely raise interest rates twice next year and that the process of shrinking its balance sheet was on “auto-pilot”. Immediately following this statement, the market began a sharp decline. The FOMC felt the strength of the economy was such that it could be more aggressive with its normalization of monetary policy in order to provide it with the tools to address the next recession whenever that might be. This was despite the fact that the economy was already showing signs of deceleration. In light of that we feel it would have been prudent for the Fed to take more time to observe how the economy is digesting the previous hikes of the past few years before hiking further. In our view, the messaging by Chair Powell missed the mark. We believe it was a mistake for the Fed to telegraph its future policy with such a degree of certainty and inflexibility when the data supporting those decisions did not exist.

[Update January 8, 2019: Chairman Powell, on January 4th spoke to economists at the American Economics Association’s annual meeting with two former Fed Chairs, Ben Bernanke and Janet Yellen.  In a wide-ranging discussion, Mr. Powell went a long way to calm the primary concern of market participants regarding monetary policy, namely, that the fed would not tighten monetary policy too much if economic conditions are not supportive of such actions.  Mr. Powell said, “we will be prepared to adjust policy quickly and flexibly, and to use all of our tools to support the economy should that be appropriate to keep the expansion on track, to keep the labor market strong, and to keep inflation near 2 percent… So if we ever came to the conclusion that any aspect of our normalization plans was somehow interfering with our achievement of our statutory goals we wouldn’t hesitate to change it, and that would include the balance sheet, certainly.”]

Shortly after the FOMC press conference, Secretary of the Treasury Steven Mnuchin held a conference call with top bankers to make sure the financial system had proper liquidity which is part of the Treasury department’s role to ensure orderly functioning of the capital markets. The problem was not that he spoke to the bankers who assured him that there was ample liquidity and everything was fine, but rather that in an effort to reassure the markets Mr. Mnuchin announced to the world that the call was held. Since most already presumed that there was ample liquidity in the system, the announcement only served to frighten the markets and led to renewed selling pressures. While demonstrating their inexperience in their roles, Chair Powell and Secretary Mnuchin hopefully were reminded that what they say matters and every statement must be carefully worded.

Where do we go from here?

As we described above, it is our view that key stakeholders in the global economy, namely Presidents Trump and Xi, European leaders and central bankers around the world, will view avoiding a recession and extending the business cycle to be the top priorities for 2019. Given the challenges facing President Trump, he will likely be looking for wins in the next few months which will mean taking steps to help the economy. Mr. Xi and the Chinese government have already been implementing aggressive fiscal and monetary policy initiatives to stimulate the economy. While China has a more long-term orientation than most developed nations, its concern with the short-term is evident in its willingness to repeatedly use stimulus initiatives to manage its economy. These factors are raising the probability that both presidents will reach a resolution of the trade conflict between the U.S. and China even if it falls short of the Administration’s stated objectives. A failure to reach an agreement would place strains on each nation and the global economy as well. At the same time, Europe is wrestling with at least three major issues – uncertainty surrounding Brexit negotiations, its most prominent leaders (Germany’s Merkel and France’s Macron) losing support at home and the ongoing fallout from the rise in populism. As a result, the European Central Bank will likely be forced to continue its accommodative monetary policy for some time. Either continued slowing global growth or the lack of a resolution to the U.S.-China trade negotiations, should force the Federal Reserve to moderate its interest rate policy and modify or delay its current plans for reducing its balance sheet. Furthermore, the FOMC may even deem it appropriate to ease monetary policy at some point in the next 6-12 months.

What are the investment implications?

“I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.”

-Warren Buffett

When markets decline with the rapidity we witnessed in December, it is easy to fear the worst. In addition to the political and economic factors driving the market pullback in December, significant selling was occurring as a result of hedge fund liquidations and investors harvesting tax-losses. These factors placed added pressure on prices as buyers were reluctant to step into the market in the face of heavy selling which created significant buying opportunities that we have been selectively taking advantage of in client accounts. No one knows exactly what 2019 will bring for equity investors, and it is impossible to predict exactly when markets will bottom. However, it is clear that as a result of the pullback many leading businesses are now selling at compelling valuations, which should provide for attractive returns from these levels. Those companies that are benefitting from the secular trends driving economic activity, which we have identified for several years, should continue to generate higher cash flows and earnings allowing them to continue to increase their competitive positions. Our research efforts are concentrated on companies with strong balance sheets, growing market share, increasing dividends, and repurchasing shares.

Frequent readers of the Outlook know that technology has been an area of focus for client portfolios for several years with our emphasis on mobility, cloud, storage, the Internet of Things (IoT) and autonomous vehicles. Companies in the technology sector, including some of our favorite names, saw prices decline even more than the market during the pullback. These companies are at the forefront of the technology revolution which continues to change the way we live and businesses operate. There are four major areas of emphasis – technology involving 5G (the new fifth-generation cellular networks) and the related beneficiaries; health care; defense; and special situations – on which we remained focused as the values created by the retracement helped make several leading businesses compelling investment opportunities.

Technology – 5G and related beneficiaries

“A quick explainer: 5G combines fast speeds with low “latency” or network responsiveness, which will be critical to the technology’s long-time impact on everything from self-driving cars to remote surgery.”

– USA Today, December 12, 2018

In 2019, the much-awaited commercial rollout of 5G wireless technology will begin in earnest in the U.S., China and Europe. We will not experience the full benefits of 5G for some time, but global investment in 5G is estimated by Morgan Stanley to be in excess of $850 billion, with China’s capital expenditures of over $420 billion and the United States’ capital spending estimated to be $265 billion. These investments will be made over the next decade, and will include investments in spectrum, cell towers, small cells, fiber, datacenters, and other companies involved in the build-out of the 5G infrastructure. The leading telecom companies, Verizon, AT&T and T-Mobile, will be at the forefront of the build out in the U.S., and are investing heavily in this area. 5G is important as it will enable greatly improved efficiencies for businesses, governments and consumers and help to realize the full benefits of the internet of things, artificial intelligence and autonomous vehicles.

The evolution of the science of computing power has been quite spectacular as shown in the chart on the Evolution of Computing Power and continues unabated. Cisco recently projected that worldwide there will be 28.5 billion networked devices by 2022, up from 18.0 billion in 2017. Cisco also estimates that internet traffic will grow 3-fold from 2017 to 2022, and will reach 396.0 exabytes per month by 2022, up from 122.4 per month in 2017.   For perspective, one exabyte is equivalent to 250 million DVDs of data. In 2019, 7 nanometer chips are being introduced, a significant change in computing power from the 10 nanometer shown above. The faster download speeds and reduced latency will make the next generation of chips more important. 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. As 5G is rolled out and computing power continues to evolve, investors should not underestimate the impact of the powerful technological advances coming over the next 18-36 months which will affect every industry. These are revolutionary changes.

Health Care

“According to the United Nations, the number of those over 60 worldwide is expected to double by 2050 to 2.1 billion. In the 1950’s, that segment of the world’s population was around 205 million.”

– Excerpt from the New York Times, December 30, 2018

The health care sector also aligns closely with our Outlook as an aging global population provides a strong secular tailwind for healthcare demand.

According to the World Health Organization (WHO), in most countries the proportion of people age 60 or older is growing faster than any other age group due to longer life expectancy and declining fertility rates. This is expected to drive demand for healthcare services, including medicines and medical devices as well as the companies that provide these services. An aging population will also drive healthcare demand in large developing countries such as China and India. Moreover, demand in these markets will also benefit from increased per capita spending as their populations insist on better quality care. Greater spending suggests greater volumes of healthcare consumption, but there will also be a “trade up” from medicines and devices that are locally-sourced or generic to best-in-class patented drugs and devices sold by the leading global pharmaceutical and device companies. We expect a select group of pharmaceutical, biotech and medical device companies to be beneficiaries of these spending trends. We are focusing on those health care companies whose relatively strong balance sheets and diverse product portfolios offer the ability to use divestitures and mergers/acquisitions to increase the value of their companies. These companies are also supported by powerful demographic trends which make them less economically sensitive as many treatments cannot be postponed.

Defense

One of the few certainties in the world today is that the geopolitical environment remains decidedly unstable as the United States’ withdrawal from global leadership is causing a shift in regional alliances and calls into question the multi-lateral arrangements that helped govern the world following WWII. At the same time, there has been a troubling rise in the number of autocratic regimes which is adding to geopolitical instability. In addition to the changes brought about in the United States, China continues to exert its economic and military influence globally, and in particular, in the South China Sea. The Middle East is seeing progressively more complex dynamics as OPEC’s influence is waning, traditional relationships are becoming increasingly strained, and many historic conflicts show no signs of positive resolution. In short, the global geopolitical situation has grown increasingly more unsettled at this time.

In recent years, the United States had slowed defense spending as a result of the financial crisis and the federal budget sequestration. That trend is in the process of being reversed, not only in the U.S. but also globally. In 2019, U.S. military spending is projected to be between 4% and 5% of GDP or nearly $890 billion. China is projected to spend between 3% and 4% of GDP or between $240 billion and $360 billion although that figure may be even higher. Saudi Arabia and Russia are projected to spend between $50 billion and $90 billion. Furthermore, NATO nations are under pressure from the United States to increase spending to the agreed target of 2% of GDP. Technological advances in drones, advanced weapons systems, cyber-security and space are now bigger drivers of spending. With market capitalizations of roughly $350 billion, the top U.S. defense companies represent a relatively small percentage weighting of the S&P 500, so most institutional portfolios have a representation to defense of approximately 2% or less. In our view, these businesses represent strong investment opportunities and should continue to generate significant cash, have robust orders, maintain high and/or growing backlogs, raise their dividends, and maintain share repurchase programs. Therefore defense companies should have a more meaningful representation in client portfolios than their representation in the S&P 500.

Special Situations

As industry after industry is being disrupted, CEOs are being faced with difficult choices in order to be competitive and, in some cases, just survive. This will lead to companies making interesting strategic decisions that may, in the case of divestitures, create values either for the seller or the buyer of assets. With private equity firms holding over $1.7 trillion in cash still to be invested, investors should expect an increase in merger and acquisition activity as businesses seek to divest underperforming assets to compete more effectively. We have identified a few companies that are executing strategies to unlock hidden value by selling low-growth businesses and taking the proceeds from the sales to pay down debt, re-invest in higher-growth opportunities, increase dividends or repurchase shares. Companies have many tools to unlock value, and those with strong balance sheets are using this opportunity to take advantage of the attractive valuations.

After a market retracement, clients often ask “should I be invested in stocks or should I reduce my exposure”, so we thought it would be helpful to offer some perspective. The U.S. stock market generated positive returns in 71.5% of the past 193 years according to Carter Worth of Cornerstone Macro. History has demonstrated that the ownership of businesses is the best way to build capital and protect purchasing power. Market declines are never fun to experience, but keeping perspective and focusing on goals are critical to successful investing. This in no way minimizes the declines in account balances resulting from the recent pullback, but serves as a reminder that successful investing requires taking a longer-term view and the courage to use volatility to one’s advantage.

“Those who keep their heads while others are panicking do well.”

–David Tepper, legendary hedge fund investor

Wishing our clients and friends a happy, healthy and prosperous New Year,

– ARS Investment Partners, LLC

At a time when political dysfunction is virtually at an all-time high, Republicans and Democrats on federal, state and local levels all seem to agree on one thing: the urgent need to invest in physical, educational and digital infrastructures in the United States. Following the mid-term elections, President Trump and leaders from both parties said the right things about working together on such a program. However, the question remains: Will they be able to stop talking and reach an agreement?

Funding this critical need cannot be postponed. Since the 1990’s, we have woefully underinvested in our nation’s infrastructure, and neglect by our government continues to hurt the well-being of the United States. According to the American Society of Civil Engineers (ASCE), the 2017 report entitled “Failure to Act: Closing the Infrastructure Investment Gap for America’s Economic Future”, we need to invest approximately $4 trillion in our infrastructure between now and 2025, and the ASCE report projects a funding shortfall of $2 trillion of that total. By 2025, this underinvestment is projected to cost the U.S. $3.9 trillion in lost GDP (economic activity), $7 trillion in lost sales for our businesses and 2.5 million jobs at a cost to families of $3,400 annually.

We suggest the following framework to finance a meaningful portion of the estimated $2 trillion gap with a different approach for the use of a gasoline tax. Assuming the average miles driven per vehicle is 14,000 per year with each averaging 20 miles per gallon, the average vehicle consumes 700 gallons a year. In 2017, Americans consumed an estimated 143 billion gallons of gasoline. We propose that the U.S. government issue a $600 billion special-purpose bond offering with a yield as high as 5% (or tax-free equivalent) and a 40-year maturity as a dedicated fund for the most urgent and high-impact projects as outlined in the ASCE report. The interest payments would be financed by a special gasoline tax of 25 cents per gallon (possibly indexed for inflation) and an equivalent registration tax on the growing fleet of electric vehicles. This would equate to an estimated tax of $175 annually on all vehicles. To ensure fairness between traditional vehicles and the nearly 1 million electric vehicles on the roads, the government should impose an additional vehicle registration tax for a 2-year registration. These combined taxes would generate revenues of approximately $36 billion annually and would more than offset the bond interest payments of $30 billion, while providing a significant boost to the economy.

By issuing this special-purpose bond to reduce the projected $2 trillion funding gap, the projected benefit to GDP would be over $1 trillion due to the multiplier effect of infrastructure spending on the broader economy. The program would also have the benefit of extending the business cycle and acting as a buffer against a future recession. Furthermore, it would provide a multi-year stimulus to economic activity by increasing employment, consumer spending, business earnings, corporate spending, and tax revenues for federal, state and local governments, while reducing the costs for families.

It is important to note that in the past when the United States was much more dependent on imported oil whose price was determined by OPEC (with the swing producer being Saudi Arabia), the use of a gasoline tax was less feasible. Today, for the first time since the 1960’s, the United States is again the world’s leading oil producer (with October’s production exceeding 11 million barrels a day and growing). Our current oil production levels combined with the growing use of electric and hybrid vehicles has reduced the pricing power of OPEC and helped drive gasoline prices lower. Furthermore, the United States is continuing to build its facilities for exporting increasing volumes of oil thereby putting downward pressure on the international price – a situation that has not occurred in over 50 years. These factors are giving the United States greater control over future gasoline prices.

Every member of Congress should study the ASCE reports to better grasp how their political posturing along with their lack of action negatively impacts businesses and households every single day. The ASCE 2017 report uses the traditional A – F report-card system to grade our infrastructure and it gives ours a D+. Although our railroad system is in relatively better shape, our bridges, tunnels, airports and water systems are, to varying degrees, in disrepair. Yet action by our leaders is tepid and too often incompetent, even cynical. In the U.S., there are over 600,000 bridges and 40% are 50 years or older with many approaching the end of their design lives and more becoming structurally deficient. There are also our roads and highways with traffic delays estimated to cost over $150 billion annually in wasted time and fuel. As anyone on the East Coast knows well given the power outages caused by recent hurricanes, our electric grid is also aging and vulnerable. And our digital infrastructure is at a critical juncture as well. According to one survey from late last year, it was reported that the U.S. ranked 44th in mobile download speeds, surely unacceptable to Americans who, after all, created the internet. Lack of easy availability as well as slow download speeds compromise our educational system.

While no one enjoys paying taxes, the tangible benefits far outweigh the costs especially for something that would benefit everyone and reduce some of the inequality that is at the forefront of politics today. Our deteriorating infrastructure continues to affect business productivity in every sector and region, and the right investments would reverse this trend. With the growing challenges stemming from climate change and more violent weather patterns, the cost of repairs will only escalate.   While the World Economic Forum recently ranked the United States as the most globally competitive nation in the world, we cannot and should not expect this condition to continue under present circumstances. Congress needs to act quickly and boldly to preserve our prosperity.

If you have any thoughts or questions about our views or your portfolio, please feel free to call us.

Published by the ARS Investment Policy Committee:

Brian Barry, Stephen Burke, Sean Lawless, Jared Levin, Michael Schaenen, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor.

The sharp pullback in U.S. equity prices has created many compelling opportunities for companies we currently own and companies we are considering for inclusion in client portfolios. As our regular readers are aware, historically the months prior to a mid-term election have tended to be volatile and generally negative for stock markets, and the current correction was no exception. However, the period following an election has typically provided strong returns into the end of the year for investors. As we wrote in our September Outlook, stocks trade in an auction market where buyers exchange dollars for shares of businesses. In the recent market pullback, there has been a temporary absence of buyers that has created significant opportunity for long-term investors. Following such periods, premier companies can provide significant returns for investors when buyers return to the market. Given the sudden and sharp move in stock prices, we felt it appropriate to share with you our thoughts on three key questions:

– What drove the market pullback?

– What are we doing as a result?

– What are our highest conviction opportunities going forward?

What drove the market pullback?

As we wrote in our last Outlook, today’s stock market is more short-term oriented than ever before as ETF, algorithmic and high-frequency trading have come to dominate daily trade volumes. The structure of the market has changed with more short-term trading done by computers and algorithms focused primarily on price movements, and not fundamentals. The computer-driven trading trends that drive prices up or down are leading other market participants to react to the price movements exacerbating the price action. Recently, headlines highlighted that the global economy has been slowing somewhat and conditions have become somewhat less favorable due to concerns about companies lowering guidance, trade conflicts, geopolitics (Saudi Arabia, Brazil and Germany), recent comments by Federal Reserve Chairman Powell on future rate hikes, debt, deficits and the China economic slowdown. What is lost in the frenzy of the recent trading activity is the fact that fundamentals remain relatively strong for the U.S. economy and for the businesses at the core of our secular trends – tech, defense, healthcare and select consumer companies as well as small capitalization companies.

Strong balance sheets and free cash flows should matter more than in recent years. It is worth noting that we are experiencing a transition from a liquidity-driven market to a more fundamentally-driven one, which is positive for active management and the many companies we favor whose earnings and free cash flows are expected to grow again in 2019.

What are we doing as a result?

We are making some adjustments to the portfolios, looking for opportunities to reduce taxes by realizing capital losses, and by taking advantage of the opportunities created by the recent pullback by adding to selected positions. Importantly, our secular views remain intact and we are putting cash to work in a measured way. We are focused on positive fundamentals of the businesses we own and other companies whose valuations have become particularly compelling. While the economic headwinds have increased, we maintain our strong conviction in the secular forces that we have identified and the fundamental value of the companies in our portfolios. Howard Marks, a legendary investor, has said that, “Investment success requires sticking with positions made uncomfortable by their variance from popular opinion.” We share his viewpoint, and believe that the short-term price movements do not reflect either the business realities or the fundamental valuations that are inherent in our portfolio holdings, despite the recent sharp declines in stock prices. Doing right in investing often involves doing what is initially unpopular. 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 flows and earnings growth. In the past two years, we have generally held higher cash levels to take advantage of price dislocations due to the realities of today’s market structure. We are currently redeploying some of that cash by buying companies we believe are on sale.

What are our highest conviction opportunities going forward?

Those companies that are benefitting from the secular trends we have identified for several years should continue to generate higher cash flows and earnings allowing them to continue to invest to increase their competitive positions, raise dividends and repurchase shares. To this end, we continue to focus on the secular trends favoring technology (including cloud, memory, storage, the internet of things), health care, energy, and defense companies among others. Smaller capitalization companies should continue to be attractive given their more domestically-oriented businesses in light of the growing challenges of investing in foreign markets. We believe that many positive factors for U.S. corporations and the U.S. economy continue to be underestimated. By implementing the tax cuts and increased deficit spending in advance of the introduction of tariffs, the Administration has, at least in the near term, offset some of the negative consequences of the changing terms of trade. Moreover the devaluations that are occurring in the emerging market economies have the effect of augmenting the attractiveness of the United States economy and its markets. Notwithstanding the changes to the structure of the market, investors should not underestimate the impact of the powerful technological advances coming over the next 36-48 months that will affect every industry.

If you have any thoughts or questions about our views or your portfolio, please feel free to call us.

“The underlying principles of sound investment should not alter from decade to decade, but the application of these principles must be adapted to significant changes in the financial mechanisms and climate.”

– Benjamin Graham, investor and professor widely acknowledged as the “father of value investing”

We have always viewed the markets as a medium of exchange, swapping dollars for shares of businesses understanding that the opportunity to build long-term capital lies in the discrepancy between the real worth of a business and its stock price as determined by the auction market. Our focus is to own a relatively small number of the best-positioned, best-valued companies in the market, and not the market itself. Investments are made in client portfolios with a view to holding them for the medium to longer-term believing that these companies are the beneficiaries of the secular trends driving the global economy. Before committing capital, our research must produce a clear picture of those investments that are deemed to offer the most cash flow, assets and earnings for the fewest dollars invested. We evaluate a stock the same way we would value the purchase of an entire company. This is the approach we have successfully employed for over 45 years. As more and more market participants make investment decisions based primarily on price and popularity, our decisions continue to be business-driven, based on our judgment of the outlook for the business fundamentals.

While our core principles for investing have not and will not change, the application of those principles must be adapted to changes in the environment as the stock and bond markets today are very different from previous ones. In our April Outlook, we discussed how important convergences in monetary policy, global politics and trade were creating challenging conditions for stock and bond investors. This Outlook will more narrowly focus on some of the key changes that are impacting the structure of the equity market in the United States. These include the significant drop in number of publicly traded companies, the concentration of power of leading corporations, the explosive growth in the number of investment vehicles available and the technological advances such as artificial intelligence, machine learning and high speed trading that are redefining the market’s mechanics and investment approaches. Today’s market is more short-term oriented than ever before. Understanding these changes will enable investors to better navigate the challenges that currently exist and take advantage of opportunities to build and preserve capital. We still believe that many positive factors for U.S. corporations and the U.S. economy continue to be underestimated. In fact, the United States continues to attract significant capital as the currency devaluations that are occurring in the emerging market economies have had the effect of augmenting the attractiveness of the United States economy.

What has changed in the U.S. equity markets?

The two most significant changes in the U.S. equity markets are the dramatic drop in the number of publicly-traded companies and the growing concentration in the power of America’s leading companies. These topics were the focus of the recent Jackson Hole Symposium hosted by the Kansas City Federal Reserve. Using the Wilshire 5000 Total Market Index (Wilshire 5000) as a proxy for the U.S. equity market, there were roughly 5000 publicly traded stocks in 1974, a figure which peaked at 7562 in 1998 and has declined to about 3492 companies as of December 31, 2017. According to Wilshire, there have not been 5000 stocks in the index since December of 2005. As shown in Chart 1, a historical review of the New York Stock Exchange (NYSE) confirms a similar pattern with the number of NYSE-listed companies declining to about 2800 as of the end of 2017.

So why has the number of listed companies declined so dramatically? There are two reasons – the low number of newly listed firms and the high number of firms delisting. The lower number of new listings reflects greater opportunity for small businesses to access private capital from either venture capital or private equity investors and the desire for smaller companies to 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 in un-invested capital and continue to raise record amounts of capital. The high number of firms delisting is due, in large part, to the increase in merger and acquisition activity that has been supported by high cash balances at large. corporations, capital repatriation and private equity firm investments supported by the low interest rate policy of the last decade which has made acquisitions highly accretive.   In the U.S., there were 5,326 deals in 2017, with a combined value of $1.26 trillion according to a report by Mergermarket. In 2016, there were 5,325 deals, with a combined value of about $1.5 trillion. The United States has accounted for over 40% of global merger and acquisition activity for some time.

“In 1954, the top 60 firms accounted for less than 20% of GDP. Now, just the top 20 firms account for more than 20%.”

–Brookings Institution report by William Galston and Clara Hendrickson

As the number of companies in the public markets has declined over several decades, the concentration of industries has increased. This trend is accelerating as disruptive technologies are affecting companies in all industries. According to a JPMorgan report on global M&A, “technology is creating more differentiation between the largest, most successful firms and the rest of the market, which suggests that disruption is fueling a “winner takes all” environment.” In a working paper by Kathleen Kahle and Rene Stulz titled “Is the U.S. Public Corporation in Trouble?” produced for the National Bureau of Economic Research (NBER), the authors highlight that “In 1975, 50 percent of the total earnings of public firms was earned by the 109 top earning firms; by 2015, the top 30 firms earn 50 percent of the total earnings of the U.S. public firms. Even more striking, in untabulated results we find that the earnings of the top 200 firms by earnings exceed the earnings of all listed firms combined in 2015, which means that the combined earnings of the firms not in the top 200 are negative.”  Just look at the technology industry today, where Apple and Google operating systems run nearly 99% of all smart phones. Google and Facebook dominate the mobile advertising market, while Amazon, Microsoft and Alphabet dominate the cloud services business.   Amazon is expected to capture almost 50% of the U.S. e-commerce market by the end of 2018. While much has been made about the potential for such concentration of power in the hands of a few with respect inflationary pricing, the history of these firms has been to lower prices by disrupting industries. The dominance of these companies can more likely be attributed to their financial strength, their ability and commitment to invest in research and development, and their willingness to reinvent and reinvest for the future. The combination of their dominance and financial strength are reinforcing the competitive positions of these firms as the rich get richer in corporate America.

How is the investment landscape changing?

Concurrent with the changes in the equity markets, market participants now have more choices than ever to participate through a variety of investment vehicles and investment approaches. According to the Investment Company Institute (ICI), the mutual fund industry in 1960 consisted of 161 U.S.-registered funds totaling $17.03 billion. In 2017, there were over 7,956 U.S-registered mutual funds with 25,112 share classes totaling $18.75 trillion.

The number of Exchange Traded Funds (ETFs) has grown from around 120 in 2003 to more than 1,700 today.   While both are baskets of securities, ETFs added a new element to the equity markets in that mutual funds are only priced daily, whereas ETFs are priced and trade continuously like individual stocks. Furthermore, technology is enabling algorithmic trading that utilizes high-powered computers to buy and sell massive amounts of securities in milliseconds. Consequently, high-frequency trading (HFT) allows traders to move in and out of short-term positions at high volumes and high speeds to capture sometimes a fraction of a cent in profit on every trade. HFT is a type of algorithmic trading characterized by high speeds, high turnover rates and extremely short-term investment horizons. Computer-based trading has become a much larger part of the market’s daily activity and focuses almost exclusively on price movements rather than on business fundamentals. It is estimated that computer-driven trading accounts for 80-90% of trading volume daily.

What do these changes mean for investors?

“The single greatest edge an investor can have is a long-term orientation.”

– Seth Klarman, Founder of Baupost Group and legendary hedge fund investor

While it is difficult to ascertain the average holding period for stocks, the figure has declined considerably as shown in Chart 1. The average holding period for an NYSE stock has dropped from 8.3 years in 1960 to an estimated 1.2 years in 2000, and the number is believed to be even lower today. Holding periods for high-frequency-traded securities have been estimated by some sources to be as low as 11 to 22 seconds. Today more securities are traded based on price movements than are bought and sold based on the fundamentals of the underlying businesses. The growing disconnect between price and fundamentals is creating a greater opportunity for longer-term investors.

While these changes are occurring within the structure of the market, the global economy is in the midst of a period of unprecedented monetary and fiscal policy initiatives, growing economic divergences, challenges to the post-WWII global order, and shifting terms of trade.   With a dizzying array of investment choices combined with current global economic, social and political characteristics, people can be easily confused. Investors need to make a few fundamental choices to determine the best plan to meet their specific goals. Investors need to choose between a market approach based upon predicting price or an investment approach based upon the evaluation of business fundamentals and the real worth of each business. We believe it is difficult, if not impossible, to attempt to do both.   Business ownership has proven throughout history to be the best approach to building capital, but it requires patience and a longer-term perspective.

How is ARS addressing the changes in the structure of the market?

“Investment success requires sticking with positions made uncomfortable by their variance with popular opinion.”

– Howard Marks, co-founder of Oaktree Capital, noted institutional investor and author

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. In the past two years, we have generally held higher cash levels to take advantage of the price dislocations due to the realities of today’s market structure. In several strategies, we have reduced the number of securities held, which in part is a reflection of the concentration of power described above, as fewer businesses have been driving the returns of the broader markets. Notably, we have also taken some profits and generated capital gains for clients as the prices of some businesses had been pushed up in the short-term beyond reasonable levels of valuation. Clients should not view trims of a position as a statement on the long-term outlook for that business, but rather as a reflection of our views of over and under valuation. At the same time, businesses at the intersection of important secular trends may experience periods of underperformance and will require some patience in the face of a lack of popularity in the short term. Investors should not confuse popularity, or lack thereof, with the quality of the business or its outlook. A perfect example of this has been the recent price declines of some of our favorite technology holdings where the fundamental outlooks haven’t changed.   As a consequence of owning businesses that can fall out of favor for a period of time, client portfolios may underperform the major market indices for some period. Our concern when a business is underperforming is not its short-term popularity, but rather its ability to continue to execute its business plan, grow its cash flows and earnings effectively, and ultimately realize its value.

In addition to the adjustments we are making to our active strategies, we launched the ARS Focused ETF Strategy in March of 2017. This strategy involves our team constructing portfolios that utilize ETFs to express the views put forth in our Outlooks. The strategy is designed to concentrate our investments in ETFs that provide the greatest exposure to our highest-conviction themes, similar to the exposures that we have in our other active strategies. We are excited about this offering as it provides an efficient way to gain the desired exposures, and allows us to manage client portfolios with lower investment minimums.

Those companies that are benefitting from the secular trends we have identified for several years should continue to generate higher cash flows and earnings allowing them to continue to invest to increase their competitive positions, raise dividends and repurchase shares. To this end, we continue to focus on the secular trends favoring technology, health care, energy and defense companies. Smaller capitalization companies should continue to be attractive given their more domestically-oriented businesses in light of the growing challenges in investing in foreign markets. We continue to believe that many positive factors for U.S. corporations and the U.S. economy continue to be underestimated. By implementing the tax cuts and increased deficit spending in advance of the introduction of tariffs, the Administration has, at least in the near term, offset some of the negative consequences of the changing terms of trade. Moreover the devaluations that are occurring in the emerging market economies have the effect of augmenting the attractiveness of the United States economy and it markets. Notwithstanding the changes to the structure of the market, investors should not underestimate the impact of the powerful technological advances coming over the next 36-48 months that will affect every industry.

Published by the ARS Investment Policy Committee:

Brian Barry, Stephen Burke, Sean Lawless, Jared Levin, Michael Schaenen, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor.

The U.S. economy is in the midst of the second longest expansion in its history which is being supported by massive tax cuts, deficit spending, growing capital expenditures and some deregulation. The global economy is experiencing strains that it has not experienced in recent times making the United States economy the prime destination for capital flows resulting in a stronger U.S. dollar. This in turn is placing further strains on dollar debt held by foreigners as well as the earning power of multinational corporations. The United States’ economic advantage is such that some of Wall Street’s leading strategists are suggesting that the expansion could continue into the second half of 2021 or even beyond. At the start of the year, the world economy was experiencing synchronized growth. This is no longer the case. As trade tensions mount, investors should recognize that the United States will be less affected as it is a net importing nation. Notwithstanding today’s headlines, we remain constructive on a narrowing group of U.S. equities based on our positive outlook for their corporate profits. Those companies that are benefitting from the secular trends we have identified for several years should continue to generate higher earnings and cash flows allowing them to continue to invest to increase their competitive positions. Given the current economic outlook, investors should focus more closely on company-specific earnings and events. We expect the market to reassess company valuations, especially for those highly indebted companies that may need to issue additional debt or equity to finance their businesses.

In times of considerable uncertainty, many investors make the mistake of overreacting to short-term conditions and market movements. The growing media attention towards trade wars, political divisiveness and immigration issues have been unsettling for many and serve as a distraction from the positive secular trends driving the global economy. Since the market has not had a significant pullback in some time, it is always possible for the markets to experience one. When and if such a pullback occurs, we will use cash to add to our favorite names. The secular trends favoring technology, defense and health care companies remain intact and smaller capitalization companies should be attractive given their more domestically-oriented businesses. We continue to believe that many positive factors for U.S. corporations and U.S. economy continue to be underestimated.

In this Outlook, we discuss the three main challenges for the global economy, share some insights from some of the leading executives of various industries, address client concerns about inflation, and discuss the investment implications of the adjustments occurring in the global economy.

What’s really behind the trade war?

“The People’s Republic of China (China) has experienced rapid economic growth to become the world’s second largest economy while modernizing its industrial base and moving up the global value chain. However, much of the growth has been achieved in significant part through aggressive acts, policies, and practices that fall outside of global norms and rules (collectively, “economic aggression”). Given the size of China’s economy and the extent of its market-distorting policies, China’s economic aggression now threatens not only the U.S. economy, but also the global economy as a whole.”  

Excerpt from the White House Office of Trade and Manufacturing Policy Report, June 2018 on China policies

In our April Outlook, we wrote that President Trump was sending a strong message to the world that the U.S. was no longer willing to accept unfair trade practices from any nation. President Trump is following through on his campaign pledge to address unfair trade practices, particularly those of China, which have taken place in a global system to which the World Trade Organization, past U.S. Presidents and other nations have turned a blind eye for decades. In order to change current practices, our trading partners need to be convinced that the U.S. will go all the way in terms of enforcing fair trade. Therefore, suffice it to say that we have now entered into a trade war. The critical underlying issue regarding trade is the battle for future technology supremacy between the United States and China due to economic and security considerations. The concern of the United States is not about competing on the basis of legitimate competitive practices, but rather on China’s use of stolen intellectual property. President Trump’s comments have been directed at China’s “Made in China 2025” plan whereby the Chinese government is supporting what it deems to be strategically vital and important industries in ways that are considered outside of globally accepted practices. The chart on the top of the next page highlights the key sectors being targeted by China according to the US Chamber of Commerce. As we have written for years, data is the new global currency and those that own the intellectual property will have a significant competitive advantage.

As a net importing nation, the U.S. should be hurt less by a trade war than other nations, but there is great uncertainty about the impact of tariffs on global growth. Consumers should expect higher prices on certain goods as many companies will not be able to absorb the costs of tariffs. After a period of strong earnings growth of the S&P 500 companies, we anticipate many companies will be lowering earnings expectations until they have clarity on the impact of changes on their costs and revenues. A trade war at this stage of the global expansion will have repercussions for global growth with Europe and a number of emerging market economies likely being the hardest hit. If this ultimately results in fairer trade and better global security, then everybody wins.

What happens when fiscal and monetary policies clash?

The U.S. tax cuts and higher deficit spending initiatives are requiring the U.S. Treasury to substantially increase the issuance of Treasury securities. Concurrently, the Federal Reserve is attempting to normalize interest rates and reduce its balance sheet. The combination of the clash of the expansion of the federal debt and the contraction of the Federal Reserve’s balance sheet has led to a shortage of U.S. dollar funding which impacts sovereign debt markets and has created a reversal of capital flows. This in turn has reduced the value of emerging market bonds and currencies, and accordingly raised the cost of global commodities traded in dollars. The United States is the world’s largest economy at $19.97 trillion and largest debtor nation at $21.04 trillion with fiscal deficits to be $828 billion estimated for 2018. The U.S. has been running annual trade deficits ranging from $395 billion to $723 billion or roughly 3% of GDP. That our trade deficits are high is well known, but the fact that the trade and fiscal deficits cause the United States to be overly dependent on foreigners to finance fiscal deficits perhaps is not as well understood. The efforts to eliminate unfair trade practices would help reduce our dependence on China and other nations to purchase our Treasuries. While this would have limited impact in the short term, the longer-term benefits would be tangible.

We are monitoring the pace of the rise in U.S. interest rates relative to those of other countries to anticipate future adjustments in currencies and capital flows as well as any debt problems that might arise. We are keeping a close eye on policy changes around the globe to assess their impacts as well.   For example, China is in the process of adjusting its monetary and fiscal policies to address its growing debt problems, manage capital flows and its exchange rate, in part to respond to trade issues, and is also considering a proposal to lower taxes to stimulate domestic consumption. Reuters recently reported that the European Central Bank is considering its own version of “operation twist” whereby the ECB will be buying more long-dated bonds next year to keep Eurozone borrowing costs in check even after it stops pumping fresh money into the economy.

So even though it has been 10 years since the debt-induced financial crisis, governments still need to keep borrowing costs down because the recovery needs more time. Perhaps the biggest takeaway regarding interest rates is that investors should expect central banks to feel the need to keep interest rates historically low well into the future. As the economic expansion has progressed, it has not shown itself to be strong enough to withstand higher rates based on the debt burdens facing the global system. Importantly, central banks lack the firepower to respond to the next recession with the traditional tool of significant interest rate cuts. We anticipate this will force bankers to extend the low-interest-rate cycle even beyond current expectations, while on the margin trying to push short rates somewhat higher.

What’s changing in politics today and why does it matter?

“This is an important time in the history of China and the United States as we work our relationship forward … The China-U.S. relationship is one of the most important in the world, [and] must be treasured.”

U.S. Secretary of Defense James Mattis at a 6/26 meeting with President Xi

Three fundamental geopolitical changes we are monitoring are the rise of populism and autocratic regimes in the developed world, the massive migration problem, and the apparent reduction of the United States’ role as the global leader. The United States’ withdrawal from its global leadership role is giving China an opportunity to step up and exert greater influence from an economic and military perspective. At the same time, China’s rise is being augmented by the United States challenging traditional alliances, trading relationships and many of the international institutions that have been in place for over 70 years. China is planning to invest an estimated $1.5 trillion in 80 countries as part of its “One Belt, One Road” initiative that it is using strategically to expand its sphere of influence although the original commitments may be tempered due to concerns about overreach and risks associated with the financing of these initiatives. The geopolitical situation is resulting in an increase in military spending.

The implications of the shifting alliances and anti-immigration sentiment have important ramifications for the future of the European Union and the economic expansion in Europe both of which are quite fragile right now. On the need for European reform, Angela Merkel, Chancellor of Germany, summed up the European challenge with her statement, “if we stand still, we will be pulverized.” On June 28th, European leaders agreed to the framework for an important agreement regarding the migration crisis that has plagued incumbent political parties throughout Europe and threatened to topple Angela Merkel’s coalition government. Given that the deal was put together in an overnight session, many details need to be worked out or this issue will remain politically divisive. Europe still needs to pull together to address the structural issues of the original design of the EU as its governing institutions did not foresee many of today’s key issues. The lack of a common vision is undermining efforts from leaders like France’s Macron to not only increase competitiveness, but to create a compelling and sustainable future for the upcoming generation. Importantly, the majority of people in Europe want to remain in the European Union and we do not anticipate a break up, but the status quo is not sustainable.

What are leaders saying about the economy, trade and secular trends?

We wanted to share some insights from political, business and industry thought leaders to understand their views on the economy, and the secular drivers of growth. The unique perspectives that these leaders bring to the table is invaluable to understand where the world is headed as political and corporate leaders are making decisions for future growth.

On the Economy

Jamie Dimon, CEO of JPMorgan Chase discussing the length of the economic expansion

“I would look at it a little bit more like we’re probably in the sixth inning or something like that … Bad tax policy, bad regulatory policy, bad policies some of which are being fixed and stuff like that. So I think it’s very possible you’re going to see stronger growth in the United States of America and that is picking up a little bit. You see capital expenditures going up a little bit. Consumer and business confidence are close to all-time highs. There are no potholes. I’ve heard [some people] say, well, it’s looking like 2007, completely untrue. There’s much less leverage in the system. The banks are much better capitalized. I can go on and on about the safer system. So, yeah, I think it can easily continue.”

On Trade

U.S.-China Economic and Security Review Commission, 2017 Annual Report, 11/15/17

“The Chinese government is implementing a comprehensive, long-term industrial strategy to ensure its global dominance … Beijing’s ultimate goal is for domestic companies to replace foreign companies as designers and manufacturers of key technology and products first at home, then abroad.”

Brian Coulton, chief economist at Fitch

“A major global tariff shock would have adverse supply side impacts, raising costs for importers and disrupting supply-chains, while reducing consumers’ real wages. The global multiplier effect of lower U.S. imports could be significant. U.S. outward foreign direct investment — the largest source of FDI (foreign direct investment) globally — would probably fall. Along with weaker confidence and lower investment, a global tariff shock would also hit job creation.”

On Technology

George Schultz, a former Secretary of the Treasury, in an Op-Ed in the Wall Street Journal on 6/27/18 on politics and technology

“The world is experiencing change of unprecedented velocity and scope. Governments everywhere must develop strategies to deal with this emerging new world. They should start by studying the forces of technology and demography that are creating it.”

Sanjay Mehrota, President, CEO & Director, Micron Technology from 5/21/18 earnings transcript on the growth of the cloud, data and storage business, and why this technology cycle is different

“One point I would like to make sure that I get across to you is that the cloud, the data center and the intelligent devices on the edge are really forming a virtuous cycle. The intelligent devices rely on more data to provide useful experience but they also create more data that gets stored in the cloud, which makes the cloud bigger, more pools of data created and stored on the cloud and processed in the cloud, that enables cloud to provide even greater value to the edge devices. It unleashes even more innovation and creation of new intelligent devices, more powerful intelligent devices, which then, in turn, guess what, create more data. And so, this is a virtuous cycle between cloud and billions of edge devices really leveraging this data economy to bring great value to the consumers as well as businesses across the globe, and at the heart of this is memory and storage industry and DRAM and flash.”

On Defense

Eric DeMarco, President, Chief Executive Officer & Director, Kratos Defense & Security Solutions, Inc.

“We are seeing significant demand for Kratos‘ target drones in the United States and also globally as a recapitalization of strategic weapon systems to address nation-state adversaries underway. With not only the United States DoD, but every NATO ally increasing its defense spending this year with 15 NATO countries increasing their defense budgets as a percent of their GDP. These strategic systems being deployed need to be exercised against the highest performance and most realistic threat surrogates of the world, which are Kratos‘ targets, and where Kratos is the undisputed an industry leader.”

Should clients be concerned about inflation?

Clients have been expressing concerns about rising inflation. While we acknowledge the near-term inflationary pressures from rising oil prices and tariffs, we believe that longer-term inflation remains constrained by the highly deflationary secular forces of technology, globalization, demographics and debt present in the system. While conditions are right for a modest increase in inflation rates, we do not feel that these concerns are warranted. In fact, the Dallas and Atlanta Federal Reserve Banks held a meeting in May to address this topic and the views are summarized in the quote below from the Dallas Fed. We are focused on the rate of change and will make necessary portfolio adjustments accordingly if inflation rates diverge from our expectations.

“Technology-enabled disruption means workers are increasingly being replaced by technology. It also means that existing business models are being supplanted by new models, often technology-enabled, for more efficiently selling or distributing goods and services. In addition, consumers are increasingly able to use technology to shop for goods and services at lower prices with greater convenience—having the impact of reducing the pricing power of businesses which has, in turn, caused them to further intensify their focus on creating greater operational efficiencies. These trends appear to be accelerating… To deal with disruptive changes and lack of pricing power, many companies are seeking to achieve greater scale economies in order to maintain or improve profit margins. This may help explain the record level of merger and acquisition activity globally over the past few years.”

What are the investment implications?

In our last Outlook, we advised readers that the two quarters preceding mid-term elections have historically proven to be challenging for the markets. The changes in monetary policy, global politics and trade are creating challenging conditions for stock and bond investors. As tempting as it is for investors to be distracted by short-term considerations, we would strongly encourage investors to focus on the secular forces to drive investment decisions. We cannot overemphasize the need to take advantage of the opportunities presented by market pullbacks. The United States should continue to attract capital from the rest of the world which should strengthen the U.S. dollar and constrain interest rate increases. The economic expansion could continue for a few more years and create an opportunity for companies to see even stronger earnings. Central banks will likely conclude that while normalizing policy is a desirable goal, it is secondary to extending the economic cycle for as long as practical in order to delay the next recession for which they do not currently have the tools to effectively address. This means that global interest rates should remain lower for longer than most anticipate. U.S. companies, should continue to enjoy the benefits of massive tax cuts, deficit spending, growing capital expenditures, and some deregulation. However, fewer companies will benefit in the current environment as some could experience supply chain disruptions and higher input costs from tariffs which they may not be able to pass on to consumers. Additionally, the stronger U.S. dollar will reduce earnings for some multi-national companies. As the beneficiaries continue to narrow, the market should react to support the winners at the expense of the rest of the broader market which is highly supportive of active management. Those that benefit from the conditions highlighted above should be well rewarded.

Share prices of some of the leading companies came under pressure in June as profit taking as well as concerns about a trade war had investors selling winners to lock in profits. However, we believe that capital will again flow to companies with above average growth characteristics, strong balance sheets, and high free cash flow to drive investments in future growth. In addition to being big beneficiaries of tax reform and deregulation, small capitalization companies whose earnings are better insulated from tariffs and currency fluctuations offer investors attractive opportunities. We continue to prefer to invest in the areas that are attracting increased capital spending, and those include disruptive technology, defense, healthcare and financial companies.   We also favor energy companies in the exploration and production area that have demonstrated greater financial discipline and have become more attuned to purchasing reserves at a discount to market value by using their free cash flows to buy back shares, while benefiting from higher prices. As a result, we have increased our energy exposure this year. We continue to remain cautious on fixed income investments given the risk/reward dynamics and would suggest that investors consider reducing their allocations and shortening their maturities to reduce the risk of capital losses. We recognize that important shifts in the global economy are occurring, and therefore it is a time to be more selective and opportunistic in portfolio construction and asset allocation.

Published by the ARS Investment Policy Committee:

Brian Barry, Stephen Burke, Sean Lawless, Jared Levin, Michael Schaenen, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor.

Consistent with past actions, Congress has once again taken the easy path while leaving others the hard work of addressing our nation’s long-term fiscal problems. The passage of a bipartisan federal budget by the Senate and the House, which followed the massive tax cuts passed in 2017, represents an inflection point for U.S. fiscal policy, and one which has important implications for stock and bond market investors. The current concerns about growing deficits and national debt levels are pushing interest rates higher, yet only somewhat higher than the recent historic lows. At the same time, markets are experiencing greater volatility after an extended period of extremely low volatility. Due to the increase in the federal budget deficit, we are modestly adjusting our expectations for interest rates, inflation rates and market volatility, but we are not changing our positive views on corporate earnings and the companies benefitting from this environment. We remain focused on the secular beneficiaries we have defined previously and would remind our readers that the drivers for these businesses remain firmly in place, notwithstanding these changed fiscal and monetary conditions. Moving forward, investors should expect even greater capital flows to the beneficiaries of this Outlook, particularly leading defense, technology and healthcare companies as well as those benefitting from increases in consumer spending globally.   One important consequence of the changes in our Outlook is that we anticipate that there may be fewer winning companies in 2018.

Will Corporate Earnings Continue to Rise in 2018?

As we wrote in our January 31st Outlook, “we expect corporate profits to increase supported by a synchronized global economic expansion with subdued inflation… this market rise is being driven by rising corporate earnings rather than just an expansion of price/earnings (P/E) multiples which often is a characteristic of the later stages of a market advance.” This view remains unchanged. However, there are two key questions for investors to consider following the tax cuts and increased deficit spending, these are – will the benefits be short-lived and how broadly will they benefit companies? The recent pullback notwithstanding, we believe that 2018 and likely 2019 will see a continuation of the growth in pre-tax and after-tax profits (as highlighted in Chart 1), but that the changes in fiscal and monetary policies will create an unequal playing field for U.S. corporations and small businesses. Well-respected investment strategist Ed Yardeni, of Yardeni Research, Inc., forecasts S&P 500 earnings of $155 in 2018 and $166 in 2019. Yardeni Research projects the S&P 500 will reach 3100 by the end of the year which is up from 2726 as of the time of this writing, and that target is based on the belief that the forward P/E will be 18.7. We have followed Ed’s work for some time, and he has been very effective defining the environment for many years. We expect that those businesses with strong balance sheets, the ability to raise prices, invest aggressively to offset inflationary pressures and increase productivity will be rewarded, and those that cannot will be penalized. Ironically for businesses, the budget deal adds additional near-term fiscal stimulus, and increased deficit spending will increase demand which should further boost corporate earnings.

What are the Pros and Cons of the Recently Approved Budget?

The budget deal is one with a few near-term positives and many longer-term negatives. On the positive side, the Senate and House are significantly boosting defense spending after years of underinvestment following sequestration. This spending increase comes at a critical time as our military needs to upgrade, replace and modernize to maintain its strength. The challenges of sequestration were evident in the deadly naval accidents that have occurred in recent years. In short, the U.S. was putting the brave men and women of our armed services at greater risk than necessary. These multi-year spending increases are meaningful in a world where the geopolitical picture remains unstable with potential troubles looming with Russia, North Korea, China and the Middle East. Some needed domestic social programs also received additional funds including the Children’s Health Insurance Program. Additionally, the budget suspends the debt ceiling until March of 2019 so that neither party can hold the nation hostage for political gain until then. On the negative side, The Committee for a Responsible Federal Budget (CRFB) estimates that the budget increases will add $300-400 billion to the deficit and possibly add more than $1.5 trillion of new debt over the next decade. According to the CRFB press release, “this deal represents budgeting at its worst – each party is giving the other its wish list with all the bells and whistles included and asking future generations to pick up the tab.”   The CRFB estimates have the federal deficit rising from roughly $665 billion in 2017 to projected $1.2 trillion dollars in 2019 and over a trillion dollars for the foreseeable future as shown in the Chart 2.

One of the critical issues facing investors is the inherent conflict between this expansionary fiscal policy and the Federal Reserve’s efforts to normalize monetary policy by raising interest rates and reducing its balance sheet. This is happening while leadership of the Federal Reserve is transitioning from Janet Yellen to Jerome Powell. In response to this concern, Treasury yields (which had been gradually rising for two years) have moved up more aggressively over the past eight weeks rising nearly half of a percentage point on the 10-year Treasury bond. We will be closely monitoring the rate of change of Treasury yields, the foreign exchange value of the dollar, and the appetite of buyers to purchase the new supply of Treasuries that is required to fund the growing federal deficit. Conversely, we would not be surprised if interest rates stall or move down to the lower end of the trading range in the near term, as rapid changes are often met with counter-trend moves. With the national debt forecast to rise to $21.5 trillion this year and the economy in its best position to continue its expansion since the financial crisis, this is not an ideal time for the government to be adding more stimulus to the economy. Unfortunately, our elected officials have “kicked the can down the road” once again by not addressing entitlements in this process and by not allocating the proper spending to infrastructure needs which require over $4.6 trillion just to maintain the system in a state of good repair. We believe many of our infrastructure needs can no longer be postponed, and state finances are such that they cannot be relied on to foot a significant portion of the bill. This would argue for even higher deficits in the years to come as the inevitable infrastructure problems will need to be financed through additional deficit spending by the federal government.

Quick Thoughts on Active versus Passive Management, Leveraged Products and Derivatives

“The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.”

– Seth Klarman, founder of the Baupost Group

Many investors have moved to passive investing through mutual funds or exchange traded funds (ETFs) based on the belief that markets are efficient. We do not share that belief as our philosophy has always been that securities trade in an auction market with inherent inefficiencies. The market volatility of the past few weeks provided a reminder that passive investing assures investors that they participate fully in the markets’ returns achieving both 100% of the upside and 100% of the downside in the market moves.   Given that we are at an inflection point in policy, this sets the stage for a narrowing of opportunities and a more favorable backdrop for active management.   Therefore, we believe that investors taking a passive approach should consider increasing the actively-managed portion of their portfolios.   As a reminder to our readers of the dangers of leveraged products and the use of derivatives, we would point to the $2.2 billion Credit Suisse low-volatility product that recently lost 96% of its value overnight and is now being closed.

Investment Implications of the Outlook

“The only other thing I’d say is that too many investors look at the present. The present is already in the price. You have to think out of the box and sort of visualize eighteen to twenty four months from now what the world is going to be and what securities might trade at. What a company’s been earning doesn’t mean anything. What you have to look at is what people think it’s going to earn. If you can see something in two years is going to be entirely different than the conventional wisdom, that’s how you make money.”

– Stanley Druckenmiller, legendary investor, speaking at the USC Marshall School of Business

This is an interesting time for investors as the contemporaneous shifts in U.S. fiscal and monetary policy regimes, occurring at a later stage in the business cycle, will have important implications for investment strategy. We believe that the ability to distinguish between the companies that benefit from rising deficits, higher interest rates and modest inflationary pressures, from those that get hurt, is going to be critical for investors. Historically markets eventually come under pressure during periods of rising interest rates, but within the market not all companies are treated equally. We strongly believe that fewer companies will benefit from this environment, and that the market will react to support those companies at the expense of the rest of the broader market. Those that benefit from the conditions highlighted above will be rewarded with premium valuations. Capital is already flowing to the defense, the technology and the healthcare companies, and we expect those flows to continue and possibly accelerate. Interestingly, companies attempting to fight inflationary pressures will likely add further to their technology spend in an effort to counter those pressures. Our emphasis remains on selecting companies benefiting from disruptive technologies, rising defense spending, changes in the financial and healthcare industries, increasing U.S. consumer spending and the shift to a more service-oriented global economy led by China and India. Companies with strong balance sheets that can more aggressively invest in the future growth of their businesses should be more highly rewarded as will those with the ability to repatriate large overseas cash balances. U.S. small capitalization companies also stand to be significant beneficiaries of further improvements in the economy, tax reform, strong consumer spending and increases in capital expenditures. We continue to remain cautious on fixed income investments given the risk/reward dynamics, and would suggest that investors consider reducing their allocations and shortening their maturities to reduce the risk of capital losses.

While we remain positive on the outlook for corporate earnings to rise and the continuation of the synchronized expansion of the global economy for 2018, we must keep in mind the risks present in the system that can impact longer-term investment strategies. In the coming months, one risk we will closely monitor will be the rate and magnitude of change in interest rates. We described many of these risks in detail in our December 2017 Outlook. Businesses that are proactively investing to redefine themselves will have a chance to compete, while those that do not will be left behind.

For our regular readers, we have not changed our fundamental views on the economy but recognize that an important shift in fiscal policy has occurred, and therefore it is a time to be even more selective and opportunistic in portfolio construction and asset allocation.

The rising equity market is being met with a level of skepticism from the average investor that would normally be associated with a much less positive economic backdrop. Given the many concerns we have heard expressed about valuations and elevated market levels, we thought it would be appropriate to share a brief note to discuss why we expect the market advance to continue, notwithstanding the potential for a pullback at any time. In this Outlook, we share our thoughts on why investors are so skeptical, why the market appreciation should continue, and how investors should position themselves to benefit. For our regular readers it is worth noting that the positive views for 2018 as expressed in our 2017 Outlooks have not changed and in fact have been reinforced. We expect corporate profits to increase supported by a synchronized global economic expansion with subdued inflation. It is particularly noteworthy that this market rise is being driven by rising corporate earnings rather than just an expansion of price/earnings (P/E) multiples which often is a characteristic of the later stages of a market advance.

Why are investors so skeptical?

“In times of rapid change, experience could be your worst enemy.”

– J. Paul Getty

While a healthy dose of skepticism is always appropriate when investing, the post-financial crisis period has created an economic and market environment with little or no historical precedent and one which has been confusing for investors. Yet most investors rely on past experiences and historical references to reinforce their views, positive or negative, of the current situation as hindsight provides the highest level of clarity. While we also use our past experiences to frame our views, we believe that the distinct characteristics of the current environment make historical comparisons less relevant. At the same time, we fully appreciate the factors that have made it difficult for market participants to feel confident. Below we highlight some of the key issues weighing on investor sentiment and distracting investors from the many opportunities being presented today.

Globalization and Technological Advances – the rate and magnitude of change brought about by globalization and technological advances is so great that most market participants are challenged to adapt, and these changes are requiring more rapid adjustments in the global system. For many, keeping up with the rate of change is overwhelming.

Geopolitical Dynamics – The unconventional political setting is challenging the norms, fueling populism and nationalistic sentiment. Political dysfunction and frustration with the flawed efforts of governing institutions are all too common themes in many developed nations pressuring existing political parties to reassess their platforms. Many find this environment unsettling and some believe it has to end badly for the West, the country and the market.

Social Concerns – The uneven distribution of the benefits of the economic recovery has resulted in growing income inequality and education/skills gaps globally. This type of wealth disparity fosters growing social unrest. As technology displaces old industry jobs, older workers are being increasingly challenged to adjust. This is occurring as the United States is reaching full employment and as the developed economies are seeing unemployment rates decline as well.

Unconventional Monetary Policy – Following the most accommodative period in its history, the Federal Reserve is attempting to normalize monetary policy by gradually raising interest rates and shrinking its balance sheet. Given the historically low level of interest rates and limited room for central banks to stimulate economic activity if needed, they must put themselves in a position to effectively respond to a future recession. Therefore central bankers in working towards normalization must, at the same time, be careful to extend the business cycle. This will also buy time to reduce national debt as a percentage of GDP.

Why should the market appreciation continue?

“This game of economic miracles is in its early innings. Americans will benefit from far more and better ‘stuff’ in the future. The challenge will be to have this bounty deliver a better life to the disrupted as well as to the disrupters.”

– Warren Buffett, as reported in Newsweek, 1/5/18

The strong market appreciation in 2017 that continued in January of this year can be attributed to two main factors – accelerating corporate earnings growth and a synchronized global economic expansion that has been stronger than many anticipated. Bear in mind that an earnings-driven market typically reflects a stronger economy and therefore is on sounder footing than a P/E-driven market. The corporate earnings outlook is being further supported by repatriation of cash held overseas and in some cases lower regulatory burdens. This is occurring even before the much-needed investment in infrastructure has been made. Corporate earnings and global growth are benefiting from several factors including:

Pent-up Demand – One of the consequences of the financial crisis was that deleveraging became a priority over consumption and capital spending. We are now seeing pent-up demand translate into higher spending by both consumers and businesses thereby increasing overall economic activity.

Unprecedented Monetary Policy Support – Although monetary policy in the developed world has begun to tighten, it remains accommodative by historical standards. While gradually lessening, the accommodative monetary conditions should remain in place for an extended period.

U.S. Tax Cuts – The tax changes, with accelerated depreciation for capital spending, are positive for earnings and economic activity in the U.S. and abroad. Moreover one aspect of the new tax rules that is not getting as much attention from equity investors is that the changes to interest deductions should push companies that can to reduce debt, strengthen their balance sheets and increase equity values. Unfortunately, not all companies will have the financial wherewithal to reduce their debt burdens and will lose some of the benefits of interest deductibility. This will set up a key point of differentiation among businesses in the next 12-24 months.

Technology – Companies are taking advantage of technology to grow more efficiently. It is enabling companies to do more with less, reduce input costs and focus on productive growth.

How should investors position portfolios to benefit?

“The rate of change has never been this fast, and yet will never be this slow again.”

– Justin Trudeau, Canadian Prime Minister in his Davos speech.

The economic conditions we have written about for over a year should continue, notwithstanding an exogenous geopolitical event or a temporary pullback in the market. In our opinion, the investment outlook for 2018 remains positive for U.S. equities, especially those that are leading the aforementioned transformation. Our ongoing portfolio strategy has three areas of focus – high-quality growth, high-quality dividend payers and opportunistic investments. The emphasis remains on selecting companies benefiting from disruptive technologies, rising defense spending, changes in the financial and healthcare industries, increasing U.S. consumer spending and the shift to a more service-oriented global economy led by China and India. We believe that investors continue to underappreciate the power of this technology cycle as comparisons to the past are just not valid as it is not a PC-driven cycle anymore. Mobility, the Internet of Things, 5G, artificial intelligence, machine learning, and the dawn of quantum computing are changing the supply/demand and pricing dynamics of the industry. The advent of these technologies is also changing the way businesses operate making historical comparisons inappropriate. These advances are going to require a significant increase in capital expenditures by companies to effectively compete going forward. For instance, Verizon just announced its plans to spend $35 billion over 5 years to implement a 5G network. In the healthcare sector, the combination of technological advances in research and demographic trends remain powerful drivers making this sector among the best performers this year.

We expect to see a continuation of merger and acquisition activity, while companies continue to reengineer their balance sheets and refine their business models to compete in the new world. We continue to concentrate on companies that are gaining market share, maintaining or improving profit margins, increasing free cash flow, restructuring to gain more efficiency, increasing pricing power and/or growing dividends. Companies with strong balance sheets that can more aggressively invest in the future growth of their businesses should be more highly rewarded as will those with the ability to repatriate large overseas cash balances. U.S. small capitalization companies also stand to be significant beneficiaries of further improvements in the economy, tax reform, strong consumer spending and increases in capital expenditures.   We remain cautious on fixed income investments given the risk/reward dynamics, a less accommodative monetary policy stance by central banks, gradual rate increases from the Federal Reserve and a high and rising federal budget deficit.

Notwithstanding our constructive view of the Outlook, it is always prudent to be mindful of risks and what could go wrong, and there are several potential risks that we monitor as we wrote in our most recent Outlook.   Key economic indicators are already sitting near the high end of their traditional ranges. There are also headwinds to growth such as the Federal Reserve interest rate increases which have led to higher borrowing costs for consumers. Energy prices have also been on the rise, and consumer spending has been outpacing growth in personal income. With these and other concerns in mind, we continue to focus on those companies best positioned to benefit from the intermediate to longer-term outlook. The equity markets almost always focus on the short-term rather than the secular trends, so we would suggest clients not let headline issues distract them from the opportunities being presented by a positive outlook and economic dynamics in the world today.

Published by the ARS Investment Policy Committee:

Brian Barry, Stephen Burke, Sean Lawless, Jared Levin, Michael Schaenen, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor.