Author: Rachel Shulman

“The greatest danger in times of turbulence is not the turbulence — it is to act with yesterday’s logic.”

– Peter Drucker

These are turbulent times as evidenced by significant bank failures, an attempted coup in Russia, ongoing tensions over Taiwan and trade, and the debt ceiling debacle in Washington, DC. The combination of the COVID-19 pandemic, the war in Ukraine and the resulting geopolitical, social, and economic problems along with the challenges posed by climate change and the introduction of generative artificial intelligence (AI) has created one of the most interesting and complex investment landscapes we have witnessed.

These circumstances are disrupting global commerce, and the policy responses have led to distortions in economic activity. As we wrote in our January 12th Outlook, there are three major changes occurring simultaneously. These changes involve a meaningful increase in the cost of living, a realignment of the world order, and the reindustrialization of the global economy. These changes are defining the most critical investment opportunities for the next decade, creating additional revenues and profits
for those who benefit.

The investment opportunities in the real economy, encompassing goods and services, rather than just the financial side of economic activity, are particularly noteworthy. It’s crucial for investors to avoid assuming that this period resembles past ones, as our world has significantly changed in just a few years. Efforts focused on decarbonization, deglobalization, and remilitarization are shaping a new economic and geopolitical era with lasting implications. Therefore, careful consideration and adaptation to these emerging trends will be essential.

The multi-decade neglect by governments in required areas of investment is being reversed by new and targeted fiscal policies. At the same time, we never had the degree of monetary resources in the system that we have today. One notable difference is that, unlike previous periods, this time the Chinese government cannot be counted on to drive global growth as it had in the past. We believe that investors should focus on the strategically vital economic segments that governments are targeting for required spending. The areas of investment opportunity encompass national security (military, food, energy, and cyber), the maintenance of technological and industrial leadership, the clean energy transition, and companies benefiting from technological advances in healthcare.

The U.S. has been, and remains, a magnet for attracting foreign capital. Although we have written about these shifts since November of 2020, they have become the reality as money from all levels of government enters the economy, and corporations react to new legislation. Following the government’s lead, the private sector has jumped on the opportunities created by the Inflation Reduction Act (IRA) and the CHIPS and Science Act with an estimated $470 billion of recently announced capital expenditure programs as shown in Chart 1.

Chart 1. The Beneficiaries of Private Spending

Virtually every industry will be affected, and competitive advantages will accrue to those countries and companies offering leading-edge capabilities. The recognition of this has pushed China and the U.S. to enact major fiscal stimulus initiatives to support the transition and their battle for technological supremacy. The CHIPS Act will revolutionize technology for devices and software applications as we continue to develop far greater efficiencies than have ever been created. As technology evolves, our
existing devices will need to be upgraded as evidenced by the more than
250 million iPhones which are currently viewed to be obsolete. The greater sophistication of innovative technologies will accelerate the replacement cycles for many devices and their related software. Elsewhere, the implications for medical breakthroughs are clearly in evidence which should result in better productivity and living standards. The response from the pharmaceutical industry to develop vaccines for COVID-19 in a few short months was incredible, but we believe the medical advances coming will
be equally amazing.

Today’s uncertainty is creating some of the most exciting investment opportunities in the past 40 years as the advent of generative AI, the reshoring of manufacturing to the U.S., and the introduction of trillions of dollars of fiscal stimulus are redirecting capital flows away from leading producers including China and Germany, while creating massive revenue opportunities for others.

The Reindustrialization of the Global Economy

The secular decline in manufacturing in many economies is being reversed. U.S. manufacturing peaked in the 1950s at about 28% of the economy only to decline to about 10%. Manufacturing shifted to China and had a big influence on trade liberalization and resulted in globalization of supply chains to lower cost producers. For the past few decades, China and Germany have stood out as the world’s premier manufacturers, and now both are facing difficult challenges with North America and a handful of nations in Asia and Latin America standing to benefit. The implication of this shift of production is a fundamental change to the economic outlook.

Chart 2 illustrates just how powerful the U.S. government incentives have been as evidenced by the dramatic increase in total non-residential construction spending in the U.S. in the past two years with new announcements being made each month. Demand for manufacturing construction will remain strong for many years to put in place the needed elements to rebuild, modernize, and expand the industrial base of the U.S. 

Chart 2. Construction Spending for U.S. Manufacturing Sector on the Rise

It is not just U.S. corporations that are responding as a recent European Business Roundtable survey of CEOs stated that 57% plan to shift investments or operations to North America over the next two years. As shown in Chart 3, 84% of CEOs responding stated that Europe’s competitive position in industry is weakening or weakening significantly. The reasons for concern cited by CEOs include geopolitical tensions, deglobalization, still elevated inflation, potentially higher energy prices, and labor issues. The introduction of the IRA and CHIPS acts highlight the lack of comparable incentive programs for European nations. The free world has come to realize that autocratic regimes cannot be relied on to be dependable and secure trading partners.

Chart 3. The Weakening of Europe’s Industrial Base

With the CHIPS & Science Act and the Inflation Reduction Act, there are now at least 35,000 projects underway in the United States. This has major implications for demand for critical inputs and skilled labor, while also requiring large investments in the nation’s electrical grid, which is wholly inadequate, to support the energy transition and prevent massive damage from climate change. Not only is manufacturing making a comeback but so too is the nation’s defense industry as the U.S. and Europeans’ needed increases in defense spending are making themselves felt. In 2021, total global defense spending was $2.1 trillion. But after Russia invaded Ukraine, European defense outlays rose 14% to $480 billion versus global growth of 4%, according to the Stockholm International Peace Research Institute. After the annexation of Crimea, EU nations agreed to allocate a minimum 2% of their GDP on defense. However, they have only achieved half of that commitment and will need to increase their spending further to meet the goal. Bear in mind, the U.S. defense industry provides a significant portion of our allies’ security needs, and filling these needs will result in growing backlogs, earnings, and cash flows for those companies benefiting. 

Capital is flowing to the United States in areas such as semiconductors and electronics, clean energy, electric vehicles and batteries, biomanufacturing, and heavy industry as shown in Chart 4. Regionally, the South has received 42% of new private investment dollars followed by the West at 25% and the Midwest at 19%.

Chart 4. Construction Spending for U.S. Manufacturing Sector on the Rise

What Are Leaders Saying About the Global Economy?

Below, we present some thoughts shared by political and corporate leaders on the state of the world, global trade, and how they are adjusting to the current situation. Countries, industries, and companies are being transformed and redefined, and the winners are proactively driving the changes and adapting, while the losers are not, due to a lack of vision or financial wherewithal to change. The comments reflect leaders’ concerns about the political and economic fragmentation occurring in the world today. Their remarks also speak to the challenges of competing for business in China due to its nationalistic industrial policies, conflicts regarding the climate transition, labor costs/availability/skills against a slow growth, and highly indebted economy.

On the Remaking of the World Order

“On the current trajectory of relations, some military conflict is probable. But
I also think the current trajectory of relations must be altered…. It’s a unique situation in the sense that the biggest threat of each country is the other — that is, the biggest threat to China is America, in their perception, and the same is
true here.”

– Henry Kissinger, former Secretary of State and National Security Advisor, Bloomberg, June 15, 2023

“The United States must also respect China and not harm China’s legitimate rights and interests. Neither party can shape the other according to its own wishes, let alone deprive the other of its legitimate right to development.”

– President Xi Jinping, Financial Times, June 2023

The Reindustrialization of the Global Economy

Roland Busch, Chief Executive of Siemens, a German Industrial Conglomerate

On June 15th, Mr. Busch announced significant investments in China and Singapore as the company is doubling down on China due to its position as a driver of technological innovation, but also to hedge against overreliance on a country where U.S. restrictions are making it more difficult to operate.

“I avoid the word decoupling, because decoupling means deciding either/or
and nobody wants to do that… the difference is diversification, which is looking at how you can serve more markets… which makes you at the same time
more resilient.”

Sanjay Mehrotra, President and CEO of Micron, a worldwide leader in innovative memory and storage solutions

Micron is making a $600-million investment in China and a $825-million investment in India following China’s announcement that it had banned the company from key infrastructure projects noting national security concerns.

“This investment project underscores Micron’s unwavering commitment to our China business and our China team members. The investment is in line with Micron’s global packaging and testing concept and would give the company the flexibility to manufacture a wide portfolio of products in Xi’an.”

James Litinsky, Chairman and CEO of MP Materials

Mr. Litinsky discussed MP’s initiative to shift rare earth mining and refining from China to the U.S., crucial for an independent U.S. supply chain for the ongoing decarbonization initiative and a key partner of General Motors in electric vehicles.

“What’s important about this supply chain is that if you can mine the material and refine it, but we’re still sending it all to China to be made into magnets. So, the material gets mined-refined, but then 90%+ of the magnetics are made in China. We produce that content today and we send it to China, but we are in the process of moving downstream, what we call our Stage 3, where we’re building a magnetics facility in Fort Worth, Texas. We have a foundational deal with General Motors, where we will take our mine-refined material from Mountain Pass, and we will send it to Fort Worth and make it into a magnet for the GM Ultium platform and then other industry use cases.”

Commercial Metals Corporation, a leading U.S. steel producer

Commercial Metals Corporation described the key trends driving strong quarterly earnings.

“During Q3, North American segment volumes were supported by significant structural trends, including the re-shoring of manufacturing and logistical supply chains, and increasing investment to improve the condition and functionality of our nation’s core infrastructure and energy markets. We expect increased activity in these rebar-intensive construction sectors will continue to drive demand in the quarters and years ahead.”

Gridlock on the Electrical Grid

From wildfires in Canada, to water temperatures spiking 4 degrees in the waters around the UK, to the melting of the permafrost, the climate transition has been difficult, costly, and inflationary. In China, floods and extreme heat are putting pressure on food costs, exports, and imports. Rebuilding from climate damage will be costly as we’ve mentioned in the past with implications for insurance coverage and costs. The rush to develop alternative energy sources and storage (solar, wind, and battery) has laid bare the inadequacy of the planning process for the transition and the vulnerabilities of the U.S. power grid. The grid will require exceptionally large capital commitments over a longer period than anticipated, and projects are already facing delays of 5–15 years to connect to the grid. The Department of Energy has committed to spend $400 billion for alternative energy projects over the next two years as part of the Inflation Reduction Act.

The growth of electric vehicles (EVs) and alternative energy sources is outpacing both the capacity and upgrading of the electric grid. Importantly, this results in a mismatch between the ability to produce alternative energy and integrating it into the outdated grid. This fundamental imbalance will take considerable time and investment to bring into equilibrium resulting in increased demand and higher prices for companies focusing on strengthening and expanding the grid’s capacity.

According to the International Renewable Energy Agency (IRENA), meeting the target of limiting the planet’s temperature increase to no more than 1.5 degrees Celsius will require more than tripling today’s energy production of 3,000GW to more than 10,000GW by 2030. However, many companies may have to wait 5, 10, or even 15 years for a physical grid connection which varies by country whether the grid is government or privately run. This is one reason it is likely that fossil fuels will remain a necessary part of the energy solution for some time, and the transition will be significantly more expensive than originally planned.

Investment Implications

This Outlook’s primary focus is on the reindustrialization process and issues involving global fragmentation, but that does not make the cost-of-living increases any less important. Inflation has become more imbedded into the world economy, and it is likely to settle above the 2% inflation target held by many central banks. Generally, headline inflation around the world is coming down as energy prices have declined sharply, goods inflation has come down rapidly, while core inflation is coming down gradually but nevertheless remains persistently higher than desired. That said, inflation trends may reverse for Europe as fears of more difficult weather in the second half of the year would push headline inflation back up. From an investment perspective, market participants need to balance the immediate geopolitical, climate, and economic risks against the opportunities coming from government policies targeting essential needs that can no longer be postponed. Market participants should closely follow the private sector spending in which CEOs are adjusting plans to take advantage of both government support and rapid advances in technology.

The ARS investment focus has always been on owning businesses and not trying to forecast the unpredictability of the stock market. Some of our favorite investments such as semiconductor chips and commodities (including copper, rare earths, steel, and energy) have experienced mixed results this year. This is indicative of the short-term focus of so many market participants, and not reflective of the opportunities for investors looking out over time with the philosophy that they are buying businesses and not trading the stock market. The supply and demand dynamics combined with the national security concerns make these areas clear opportunities to build capital and income to counter inflationary pressures and the higher cost of living. Many of our industrial investments are selling for quite attractive valuations (with many selling for single-digital multiples of earnings and cash flow) with the ability to raise prices as evidenced by Cleveland-Cliffs increasing prices on 7 occasions this year on some of its products. This pricing power is in stark contrast to what we are seeing from many companies that cannot maintain the price increases introduced during the pandemic.

As we wrote in our April Outlook, the United States is attracting capital in the form of foreign direct investments and reshoring. As capital flows into the U.S., jobs follow. Given that the U.S. unemployment rate is virtually at historically low levels, Congress needs to immediately address our immigration policy, as one of the next big competitions will be a battle for skilled and unskilled labor. Despite the tremendous advances occurring in technology, productivity has declined in recent years, and the hope is for generative AI to aid in reversing this poor productivity trend. We believe generative AI is a game-changer but will take time to see the productivity benefits become absorbed into the system.

In our January Outlook, we wrote that “After a difficult year in the markets, it is easy to dismiss the public markets as an attractive area to find opportunities in 2023, and that would be a big mistake.” While there are always things to worry about for investors, we believed that the setup for 2023 was positive for equity investors as governments and corporations were focusing their spending on well-defined segments of the economy and therefore defining the investment opportunity for investors. That view has been proven correct by the returns in the U.S. stock market this year. What we did not appreciate was the reopening of China having a different focus than in the past which has weighed on some of our holdings in the first half but has set them up as even more attractive investments going forward. Our focus continues to be on the areas we have discussed in recent Outlooks, particularly those companies driving the clean energy transition, digitalization, and national security as well as those focused on improving healthcare costs
and outcomes.

We believe that there will be significant differentiation between the winners and losers due to the forces described. Under these conditions, it would not be surprising to see further market volatility in the second half as the market adjusts to changes in interest rates, inflation rates, and corporate profits. Furthermore, we believe that investors should not be fixated on historical thinking to drive decisions in the coming period as the dynamics of a changing world requires a fresh and open-eyed approach.

Published by the ARS Investment Policy Committee:

Stephen Burke, Sean Lawless, Nitin Sacheti, Greg Kops, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor, Tom Winnick.

The information and opinions in this report were prepared by ARS Investment Partners, LLC (“ARS”).  Information, opinions and estimates contained in this report reflect a judgment at its original date and are subject to change. This report may contain forward-looking statements and projections that are based on our current beliefs and assumptions and on information currently available that we believe to be reasonable. However, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements.

ARS and its employees shall have no obligation to update or amend any information contained herein. The contents of this report do not constitute an offer or solicitation of any transaction in any securities referred to herein or investment advice to any person and ARS will not treat recipients as its customers by virtue of their receiving this report. ARS or its employees have or may have a long or short position or holding in the securities, options on securities, or other related investments mentioned herein. 

This publication is being furnished to you for informational purposes and only on condition that it will not form a primary basis for any investment decision. These materials are based upon information generally available to the public from sources believed to be reliable. No representation is given with respect to their accuracy or completeness, and they may change without notice. ARS on its own behalf disclaims any and all liability relating to these materials, including, without limitation, any express or implied recommendations or warranties for statements or errors contained in, or omission from, these materials. The information and analyses contained herein are not intended as tax, legal or investment advice and may not be suitable for your specific circumstances. This report may not be sold or redistributed in whole or part without the prior written consent of ARS Investment Partners, LLC. 

“Uncertainties are exceptionally high, including because of risks of geo-economic fragmentation which could mean a world split into rival economic blocs — a ‘dangerous division’ that would leave everyone poorer and less secure. At a time of higher debt levels, the rapid transition from a prolonged period of low interest rates to much higher rates — necessary to fight inflation — inevitably generates stresses and vulnerabilities, as evidenced by recent developments in the banking sector in some advanced economies.”

-IMF Managing Director Kristalina Georgieva, March 25, 2023

The economic outlook has changed.  As a result of the recent collapse of three regional banks, the Federal Reserve’s policy of rapid interest rate increases and quantitative tightening have been importantly affected. The recent issues in the banking system have the effect of tightening credit, slowing the economy, and therefore reducing inflation – accomplishing what the Fed has been trying to do with its rapid increases in interest rates. The troubles in the banking system now have the Federal Reserve facing three issues – fulfilling its mandate to maximize employment, maintaining price stability, and now protecting the soundness of the financial system. This last point has added a new element to the Fed’s decision-making process and future policy actions.  On March 12th, the Fed created the Bank Term Funding Program (BTFP) to support American businesses and households by making additional funding available to eligible banks to ensure their ability to meet the needs of all their depositors.  Additionally, the US and other nations set up currency swap lines to ensure that the global system had ample availability of dollars.  Both these initiatives, while not well publicized, may prove to be key to providing ample liquidity and restoring confidence in the financial system.

While the current market backdrop remains challenging, the investment opportunities presented by the real economy (goods and services) rather than just the financial side of economic activity now stand out. Given our expectations that banks will tighten lending standards, the US consumer will not likely be spending at the same level as in the past and thus will not be the same driver for growth in the near-term. Rather, investors should now focus on the areas where recent legislation is promoting rising spending by Federal, state, and local governments, and corporations. This legislation is assuring rising demand and production now and for the rest of the decade.  In our January 12th Outlook ARS introduced three critical, multi-year transitions – the cost-of-living increase, the realignment of the global geopolitical order, and the re-industrialization of the global economy – that are occurring today and have major implications for investment strategy. These and other factors help explain why there is no historical precedent for the current economic environment, and why so many investors struggle to make sense of the conflicting messages of economic strength and weakness in the economy.

We continue to favor those companies supporting the clean energy transition, improving productivity, lowering healthcare costs, and ensuring national security. Our team has identified high-quality companies with strong balance sheets and solid dividend growth benefitting from the current economic outlook.  We have been underweight in financial and consumer-oriented stocks, businesses with weak balance sheets (especially those with elevated levels of short-term debt), and those whose unsustainable demand has begun to have a negative impact on their outlooks for earnings and cash flow.

The Accelerator and Brake Economy

Market participants have struggled to make sense of the equity and bond markets this year as policymakers are driving the economy with one foot on the accelerator, stemming from Congress’ accommodative fiscal policies (Inflation Reduction Act, Chips & Science Act, National Defense Authorization Act).  The other foot is on the brake as the Fed had abruptly shifted from its ultra-easy monetary policy to significantly tighter conditions (higher interest rates) over a particularly short period of time.  One of the biggest challenges for effective implementation of monetary and fiscal policy is the fact that the economic impact can take up to 18 months to be fully felt, and consequently the effectiveness of the Fed’s policy and legislative acts will not be completely manifested until some future date.  In response to the pandemic and war in Ukraine, the world has experienced the most aggressive monetary and fiscal policy initiatives in history. Policymakers felt the need to provide a forceful response to prevent the global economy from hurtling towards a depression.

The playbook from the Great Financial Crisis (GFC) led markets to first look toward central banks to provide immediate support to the global economy by lowering interest rates and enacting a new QE program (quantitative easing or the printing of money). Governments also implemented fiscal policy initiatives aimed at providing support to workers and businesses impacted by the crisis.  As shown in Chart 1, the combination of monetary and fiscal stimulus from February 2020 to May 2021 totaled $30.95 trillion on a $100 trillion world economy. In the United States, policymakers’ responses totaled $12.3 trillion or 57.4% of US GDP. The level of response was unprecedented, and this was before Congress enacted the Inflation Reduction Act, the CHIPS and Science Act of 2022, and the National Defense Authorization Act in the past year.

Chart 1. Unprecedented Policy Response to Unprecedented Problems Globally

After a decade of central banks’ attempts to lift inflation above 2%, it appears that a higher level of inflation now is embedded in the world economy.  With the United States and global economies returning to more traditional interest rate structures, investors need to assess whether their current portfolios still have the same or better risk characteristics than they had a few months ago. The March inflation reading for Europe remained stubbornly high leading to the most recent 0.50% benchmark rate hike by the European Central Bank (ECB). The challenge for policymakers in the United States is further compounded by the need to address the debt ceiling and restore trust in the banking system, while battling inflation and a slowing economy with a critical election next year.

Thoughts on the Troubles in the Banking System

“Banking is a business that can be a very good business, when run right. There’s no magic to it. You just have to stay away from doing something foolish. It’s a little like investing. You don’t have to do anything very smart. You just have to avoid doing things that are ungodly dumb.”

– Warren Buffett

Chart 2. A Crisis Waiting to Happen

The German economist Rudi Dornbusch once said, “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”  The failure of Silicon Valley Bank (SVB) and others in the system was slow to develop and then happened with a speed that surprised even veteran investors. During periods of easy monetary conditions (ultra-low interest rates) such as we have experienced since 2009, investors typically take on risk which does not appear to be excessive at the time but is obvious in hindsight. This was the case when, after a decade of near zero interest rates, rates spiked up, access to capital slowed quickly, and importantly, confidence in the safety of the system was questioned.

The early assessment of the current banking crisis suggests that many factors contributed to the problem of Silicon Valley Bank with some being external and some being bank-specific errors.  These include:

1. Uninsured Deposits – As shown in Chart 2, this vulnerability was building in the US banking system since 2013. Over 90% of the deposits at SVB and Signature Bank were uninsured at the time of the failures, and uninsured deposits are much more vulnerable to runs.

2. Lengthened Maturities – Many banks extended the bond maturities in their balance sheet holdings prior to the Fed starting its dramatic interest rate policy reversal to counter inflationary pressures which increased the banks’ risk profiles. This shift occurred late in the economic cycle and made the banks more vulnerable to interest rate increases.

3. Monetary Policy Changes – The actual reversal of low interest rate policies (in reaction to inflation), was done so quickly that a problem was inevitable in hindsight.  Since monetary conditions were easy for nearly a decade, it would have been ideal for the Fed to take longer to tighten conditions.  However, the pandemic, the war in Ukraine, and supply chain problems created a spike in inflation that forced the Fed to raise rates much faster than ideal. Chart 3 illustrates the speed and magnitude of this tightening cycle compared to previous ones.  It was totally unrealistic for a financial system that was a decade in the making to adjust in just 10 months.

Chart 3. Comparing Federal Funds Tightening Cycles

Source: Evercore ISI

4. Regulatory Changes – The Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) was introduced to overhaul financial regulation following the Great Financial Crisis. According to the Senate brief on the law, the aim of the act was “to create a sound economic foundation to grow jobs, protect consumers, rein in Wall Street and big bonuses, end bailouts and too big to fail, prevent another financial crisis.” Dodd-Frank was followed by The Economic Growth, Regulatory Relief and Consumer Protection Act (2018) which rolled back some aspects of Dodd-Frank. One change was that it raised the threshold from $50 billion to $250 billion under which banks are deemed too big to fail. While reasonable people might disagree, this change was likely a factor in the SVB failure and was lobbied for by many mid-sized banks, including SVB CEO Doug Becker. It is notable that Mr. Becker also served as a Director of the Federal Reserve Bank of San Francisco up until March 10th, the day the bank was closed by regulators.

5. Mistakes by Management – In the process of reducing risk for the banks, the 2010 Act also changed the revenue opportunity for some, while the low interest rate environment hurt the ability to earn fees on deposits. While there is still much we do not know about what exactly occurred at SVB, the failure is likely the result of problems involving concentration risk of its business, weak risk management, and greed.

A. Concentration Risk – First, the bank had tremendous success over the past decade as it became perhaps the most important banker to the startup community. It provided startup businesses with corporate loans and cash management services, personal loans for the founders of those businesses, investment and deposit services, and similar services to the employees of these startups. In short, its success in the hottest sector in the US lead to an unanticipated concentration risk in a highly volatile industry.

B. Risk Management – When interest rates rose at a much faster rate than its risk models might have projected, securities that were meant to be held to maturity, and therefore valued at full maturity value on SVB’s books, were required to be revalued to the current lower values (marked-to-market) when too many deposits were withdrawn in a run. Additionally, it has been reported that SVB was without its Chief Risk Officer for 8 months at the time of its collapse.

C. Greed – Finally, the bank increased the risk on its balance sheet by extending the maturity of its bond portfolio to increase its revenues (net interest margins). This in turn made it more susceptible to a rapid increase in interest rates and a run on its deposits.  When investors stretch for yield late in an expansion, the additional income is usually not worth the associated risk. The Fed was clear in its communication regarding the path of interest rates, but SVB and others with large levels of uninsured deposits seem to have chosen to ignore the interest rate risk that each was accepting to boost earnings and its share price.

Investing for a Non-Traditional Investment Cycle

Our investment process is focused on identifying the beneficiaries of the current economic environment and avoiding those areas of the market that are negatively impacted by the problems in the global economy. Based on our assessment of the United States economy, investors should focus on investing in areas where governments and corporations are spending and investing rather than relying on the consumer as the driver for growth as inflation is limiting consumer spending, and confidence is shaken by recent bank failures. The economic slowdown resulting from now tighter lending standards will likely achieve what the Fed was embarking on to slow inflation in the first place.  Volatility and market declines are now yielding better investment opportunities among the beneficiaries of the Infrastructure Act, the Chips Act, and the Defense Authorization Bill. 

Recent interest rate declines are likely to stimulate home buying as mortgage rates have fallen and housing permits, a leading economic indicator, have risen. Currently, there is a housing deficit of three to six million homes while some 75 million millennials are entering their home buying years. Because investing in much of the financial sector has become more difficult, investment choices have narrowed resulting in capital flows and investment interest that is more focused toward companies that benefit from strong and rising demand, have strong balance sheets, are not difficult to analyze, and are in secular uptrends. In addition, national security remains one of the most critical areas that will continue to attract capital as tensions between democratic and autocratic nations remain elevated with no resolution expected in the near-term.

There is a continuing gap between US job openings and the smaller number of available workers due to a labor pool that is unlike the prior periods. In particular, there is a shortage of skilled workers that includes teachers, assembly line workers, electricians, health care professionals, construction workers, engineers, and workers for most economic activity.  In January, there were more than 5 million more positions than people to fill them. Demographic trends play a leading role. The US working-age population shrank in 2018 – the first time since 1960. Baby boomer retirements picked up and fewer young people entered the labor force. From 2017 to 2022 the working-age population grew by 1.7 million people while between 2000 and 2005 working-age population growth was 11.9 million people. Challenges from this issue can be dealt with by raising the social security age (which also helps the funding problem), accelerating the use of advanced technology to substitute for labor, increasing productivity through medical breakthroughs, releasing infrastructure spending (which has begun), improving childcare policy (the Chips Act requires companies receiving $150 million or more to make childcare available to employees), and passing an effective immigration policy that the country needs.

Overall, the cost of labor has been rising and the Federal Reserve monetary policy of slowing economic activity and trying to create unemployment would only have the effect of slowing supply when increases in supply lowers inflation.  At the same time the infrastructure spending legislated along with the Chips Act serves as a stimulant to economic activity while the Fed is trying to slow activity. One foot is on the brake, the other on the accelerator.

While there are considerable stresses in the global economy, it is in times of economic stress and dislocation that some of the best investment opportunities are presented, and yet many investors are more concerned about risk avoidance than seeking opportunity. However, the two do not need to be mutually exclusive. The stresses in one part of the economy often create opportunities for other parts of the economy. ARS client portfolios are currently positioned to benefit from the clean energy transition by owning both fossil fuel and renewable energy companies, defense companies, industrial commodity and materials companies (steel, copper, and rare earths), and biotech, with characteristics that include strong balance sheets and quality dividends. Our financial sector exposure has been minimal and our fixed income portfolios have been invested to balance yield with preservation of capital, rather than stretching for income.

As we are approaching the end of the rate-hiking cycle in the United States, we believe that equity valuations will begin to find firmer footing. While there are several longer-term issues which may keep inflationary pressures elevated including labor shortages, the clean energy transition, and changes in terms of global trade, innovation remains key to addressing many of the world’s most pressing problems. Critically, the reindustrialization of the global economy that is occurring is creating a generational opportunity for the manufacturing sector and the United States economy overall. In closing, we are reminded of another quote from Mr. Buffett that we feel is an appropriate reminder for investors as he once said, “Bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.” 

Published by the ARS Investment Policy Committee: Stephen Burke, Sean Lawless, Nitin Sacheti, Greg Kops, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor, Tom Winnick.

The information and opinions in this report were prepared by ARS Investment Partners, LLC (“ARS”). Information, opinions and estimates contained in this report reflect a judgment at its original date and are subject to change. This report may contain forward-looking statements and projections that are based on our current beliefs and assumptions and on information currently available that we believe to be reasonable. However, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements.

ARS and its employees shall have no obligation to update or amend any information contained herein. The contents of this report do not constitute an offer or solicitation of any transaction in any securities referred to herein or investment advice to any person and ARS will not treat recipients as its customers by virtue of their receiving this report. ARS or its employees have or may have a long or short position or holding in the securities, options on securities, or other related investments mentioned herein.

This publication is being furnished to you for informational purposes and only on condition that it will not form a primary basis for any investment decision. These materials are based upon information generally available to the public from sources believed to be reliable. No representation is given with respect to their accuracy or completeness, and they may change without notice. ARS on its own behalf disclaims any and all liability relating to these materials, including, without limitation, any express or implied recommendations or warranties for statements or errors contained in, or omission from, these materials. The information and analyses contained herein are not intended as tax, legal or investment advice and may not be suitable for your specific circumstances. This report may not be sold or redistributed in whole or part without the prior written consent of ARS Investment Partners, LLC.

“This battle cannot be frozen or postponed. It cannot be ignored.  This struggle will define in what world our children and grandchildren will live.”
-Ukraine President Volodymyr Zelensky in 12/20/22 speech to U.S. Congress

For more than 5 decades we have written our Outlooks to serve two purposes: (1) to represent our roadmap for our investment security selections and (2) to inform our clients and prospects of our thinking. Our Outlooks reflect our view of the world and our investment approach to manage risk, capitalize on opportunities, and generate strong returns for our clients.  Economic conditions determine interest rates, inflation rates, and corporate profits which in turn determine the valuations of common stocks. Therefore, a key focus of ours is to identify companies that are well-positioned to capitalize on and benefit from major forces and disruptions in the system.  The world is at an historic inflection point with broad economic, geopolitical, and social implications as President Zelensky’s quote describes. Global economic activity is experiencing a sharper-than-expected slowdown with inflation at levels we have not seen in decades, and this is occurring at a time when governments are facing shared challenges with other nations including national security, food and energy crises, and climate change, to name a few. 

We see three key changes occurring and they will require investors to re-assess their investment strategies.  The three key shifts are the cost-of-living increase, the realignment of the global geopolitical order, and the re-industrialization of the global economy.  The magnitude and suddenness of these changes has led to a re-rating of valuations across asset classes for most of this past year. For market participants, the biggest adjustment for investors in the coming quarters will be adapting to a less stable geopolitical environment with higher living costs and the possibility of a global recession.  At the same time, the re-orientation of global supply chains and the advent of digital process automation are promoting a shift in manufacturing and production closer to home. This is a fundamental change for the global economy and a major boost for the United States.  While the challenges are great, innovation continues to accelerate and will change virtually every sector and industry.  Major economic shifts, such as the one occurring today, typically create new market leadership as shown in Chart 1.

The United States stands as the strongest and best-positioned economy, and it’s reasonable to expect a significant increase in capital flows to the U.S.  While it is easy to see a recession hitting the United States, any recession experienced at home will have a very different character than previous ones due to the enactment of several recent major legislative changes and the shifting of industrial activity to North America. Regardless of the degree of any recession the U.S. may experience, our team continues to identify businesses selling at attractive valuations with strong balance sheets and above-market growth rates which, in our opinion, are not yet being properly recognized. 

The recent zero-interest rate environment favored passive and index investing which led the market to overvalue growth companies with little to no earnings.  The increase in interest rates has continued to force a reset of valuations.  As a result, 2023 will continue to be a stock-picker’s market where the most likely beneficiaries will be companies whose fortunes are augmented by recently passed major legislation for the broad infrastructure needs of the U.S., reshoring of manufacturing and leading-edge semiconductor technologies, and national defense.  In addition, the worsening demographics of the world population are putting greater stress on governments to reduce healthcare costs and improve outcomes particularly through the application of advanced biotechnologies.  We are particularly positive on the beneficiaries of this outlook despite the overall negative sentiment which is so pervasive today.

Cost-of-Living Increase

“Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures… The war and related events are contributing to upward pressure on inflation and are weighing on global economic activity.”
-Federal Reserve FOMC Statement, December 14, 2022

With the dramatic increase in the cost of living, the Fed is committed to bringing inflation down to the 2% goal it continues to articulate. The last inflation statistic was 7.1%. We continue to see wages rise through legislated minimum wage increases, an 8.7% social security adjustment, labor contracts  that compensate for inflation, a shortage of skilled labor and now the reshoring and investment costs of the American manufacturing supply chain.  The Fed will likely, over time, move away from it’s 2% inflation goal. The  increase in both buying power and U.S. economic activity now being firmly established suggests that the Fed will have to raise its 2% target. Therefore, the purchasing power of the U.S. dollar will erode more rapidly, and investors should be careful shifting to fixed income securities with longer-term maturities and  should instead focus on the highest quality equities, and those that pay strong and growing dividends to protect their purchasing power.

Global Fragmentation: The World at an Inflection Point

“The international community is facing changes defining an era. We are reminded once again that globalization and interdependence alone cannot serve as a guarantor for peace and development across the globe. The free, open, and stable international order, which expanded worldwide in the post-Cold War era, is now at stake with serious challenges amidst historical changes in power balances and intensifying geopolitical competitions. Today we are in an era where confrontation and cooperation are intricately intertwined in international relations.”
-Japan’s Ministry of Defense National Security Strategy, December 2022                                                          

The existing world order is being redefined due to the unusual events of the past few years, intensifying geopolitical competition in the international community. As a result, leaders of each country are being forced to rethink existing trade and security relationships.  NATO nations have a target of 2% of Gross Domestic Product (GDP) for defense spending, but many members are now only starting to fund to that level. In October, the U.S. issued its updated National Security Strategy, followed by Japan issuing its report in December.  Both are calling for significant increases in spending for defense with Japan targeting to double its spending.  Japan is particularly interesting since it has had a more pacifist approach since WWII, but it is one of a handful of critical partners to help challenge China’s ambitions in the Asia-Pacific region.

Japan maintains its policy of “Proactive Contribution to Peace” but the report highlights its concern that some nations are unilaterally trying to upset the status quo, and they have accelerated actions to achieve these goals. Germany announced a significant increase in its spending earlier this year to be in line with NATO’s 2% of GDP target but has since backed off that goal as the demands on the government are only increasing with food and energy costs on the rise, its economy weakening, and social stresses increasing as evidenced by the recently failed coup attempt.  Leaders around the world are being forced to make difficult choices as the demands on governments far exceed the fiscal wherewithal to fund all the needs.  Furthermore, the scope of national security has expanded to include those fields previously considered non-military such as economic, technological, and others, and thus the boundary between military and nonmilitary fields is no longer clear-cut.

In its recently released National Security Strategy report, the U.S. addressed what it considers the twin challenges facing our nation – out-competing our rivals to shape world order and tackling shared challenges including climate, food and energy security, and the pandemic. The leaders of China and Russia, among others, have very different visions of the future. Each would like to see the United States’ role on the global stage diminished, but what is really at stake is a contest of ideologies between democracy and autocracy/dictatorship.  China is the one nation with both the desire and capability to challenge the U.S. and reshape the international order in a way that favors China and hurts the United States and its allies. 

Re-industrialization of the Global Economy

The manufacturing sector of the United States has struggled for decades to compete with lower-cost labor around the world. Companies were under enormous pressure to outsource production to low-cost countries or risk losing competitiveness. That process is reversing as the world’s problems converge with the considerable competitive advantages that the U.S. enjoys, particularly its supply of energy resources, rule of law, and a culture of innovation.  Beginning with the previous administration’s focus on China’s anticompetitive practices and intellectual property theft which was followed by supply chain disruptions due to the pandemic and the war in Ukraine, the United States now stands to become a premier global manufacturing region.  In support of this, the U.S. government is beginning to provide incentives, such as tax breaks, to encourage businesses to locate factories in the U.S. and to invest in research development. As shown in Chart 2, there were nearly 350,000 manufacturing jobs that came to the U.S. last year versus only 6,000 jobs in 2010.  The rise in the number of jobs created by the return of manufacturing from China and elsewhere to the U.S. is the result of companies bringing jobs back and foreign companies seeking a more stable production environment.  Europe is losing some of its competitive advantage due to the war and rising energy prices.  A core element of the shift is the need to secure stable and trusted supply chains. We cannot stress enough the importance of this shift and its longer-term implications.

With all these jobs coming to the U.S., unemployment down to 3.5%, and over 10.5 million job openings in the United States, Congress needs to address our flawed immigration system and adapt a policy that will address the current and future labor shortages and skills gaps.  Like most leading economies, the U.S. has a rapidly aging workforce with declining birth rates making a proper immigration policy an even bigger priority. Given current conditions, securing our border and developing a policy targeted at filling critical shortages across industries would be in the best interest of the country and must be a top priority for Congress. 

Investment Opportunities in Three Acts

For many years we have deplored the deterioration of our infrastructure but finally legislation has been passed to spend $1.2 trillion to rebuild roads, bridges, create high-speed internet access for those who don’t have it, improve our ports, airports, clean water, electric vehicle chargers, upgrade and strengthen our electrical grid, as well as a focus on climate change mitigation. Because the transportation sector is the largest single source of greenhouse gas emissions, $39 billion of new investment is committed to modernize public transit as well as $90 billion in guaranteed funding for public transit over the next 5 years. Including additional targeted areas for this legislation, it is estimated that the U.S. could  add 1.5 million jobs per year for the next 10 years. Just with respect to railroads, $66 billion is allocated for additional rail funding to modernize the Northeast corridor and bring first rate service to areas outside the northeast and mid-Atlantic. Further, the global shifts described in this Outlook spell increasing demand for the components and materials required for wind power, solar power, conversion of the vehicle fleet to electric propulsion, and the expansion of the electrical grid. In short, the resulting productivity improvement will be a powerful antidote to inflation over time as the benefits to higher living standards become clear. 

Two more pieces of legislation, the CHIPS and Science Act of 2022 (“Act”), and the $858 billion Defense Authorization Bill, will also result in a significant expansion of the U.S industrial base. In 1990, the U.S. manufactured 37% of the world’s semiconductor chips and today we produce only 10%, but that is  about to change.  With the introduction of the $280 billion CHIPS and Science Act in August of last year, Congress took an important step toward ensuring that the United States will remain a leader in the production of advanced technologies. The national security aspect of the Act recognizes that Taiwan-based companies account for about 73% of global market share for semiconductor production today. Therefore, it is vital for the U.S. to dramatically reduce its dependence on Taiwan which is being targeted by China.  The CHIPS Act includes an estimated $39 billion worth of investment tax credits over the decade. The Act also calls for $13.2 billion in workforce development which is particularly significant as the Department of Commerce estimates that an additional 90,000 workers will be needed by 2025. There is $2 billion allocated to focus solely on legacy chip production for the auto industry, national defense, and other critical infrastructure, including charging stations.  It is worth noting that companies receiving federal incentive funds under the Act are prohibited from expanding or building manufacturing capacity for advanced semiconductors in countries considered to be a national security threat.

Since the introduction of the Act, the private sector has announced dozens of projects to increase manufacturing capacity in the U.S. including over 40 new projects involving the construction of new facilities and enhancement of existing sites as well as the facilities that supply the industry, nearly $200 billion of private investments announced across 16 states to increase domestic manufacturing capabilities, and 40,000 new high-quality jobs have been announced for the industry. Both domestic and foreign companies such as Global Foundries, Intel, Samsung, TSMC, Texas Instruments, and Micron are planning to build or have under construction at least 9 new fabrication facilities. It takes about 3 years and some 6,000 workers to build one facility at a cost of at least $10 billion.  Taiwan-based TSMC alone plans to spend $40 billion in the U.S. Estimates of expenditures total several hundred billion dollars. Manufacturing equipment can cost as much as $250 million per machine and each plant can require at least 35,000 tons of steel to construct.  When taken all together, the numbers are considerably larger than the total manufacturing investment announced by the Administration. Bear in mind that manufacturing jobs have a high multiplier effect adding an estimated 3-4 jobs to the economy for each manufacturing job created, making a tight market for skilled labor even tighter.

These conditions should also push companies to incorporate more robotics and automation into the U.S. manufacturing system. The Act is designed to allow the U.S. to control access to advanced technologies for economic competitiveness and national security reasons.

The war in Ukraine has forced global leaders to refocus on the importance of strong military capabilities as a form of deterrence.  The heroic and innovative defense by the Ukrainians is also redefining the future of war as we have seen drones, cyberattacks, and other non-traditional forms of warfare used effectively against what should be a superior military. In response, NATO nations are stepping up their spending, and the United States is as well. The Defense Authorization Act calls for a 4.6% pay increase for both troops and the civil employees of the U.S. Department of Defense.  In its new National Security Strategy, the U.S. identifies China as the biggest concern with Russia and other terrorist state actors also a key part of the strategy.

The Defense Bill will increase the munitions stocks if China were to act against Taiwan.  This will involve the largest number of multi-year procurement contracts that has been authorized in recent history. To make sure the industrial base and those allied nations can meet the demand required for Ukraine, bureaucratic red tape will need to be reduced. While the Act runs 4,400 pages, we note that 11 battle force ships are authorized for procurement and the early retirement of 12 ships has been reversed. The Navy’s budget had been to build 8 ships and decommission 24. The bill also advances air power, land warfare capabilities, advanced munitions, sea power, undersea warfare, aircraft procurement, and weapons procurement with production increases. In addition, $1 billion is allocated for the National Defense Stockpile to acquire strategic and critical industrial materials.

After a difficult year in the markets, it is easy to dismiss the public markets as an attractive area to find opportunities in 2023, and that would be a big mistake. Unlike the past decade, financial market returns could struggle with weak economic growth with the key difference this time being materially higher interest rates, a higher cost of living, and much more limited bandwidth for governments to provide fiscal and monetary support.  While there are major differences between then and now, the bursting of the tech bubble in 2001 led to a major shift in market leadership, and ARS was able to identify areas to protect and build capital in the subsequent years by investing in previously underfollowed and underappreciated parts of the economy.  Today, we recognize that there are defense, steel, industrial companies, and commodity producers selling at particularly attractive valuations with strong balance sheets and relatively strong growth rates that we believe will be among the market leaders in the coming period.  Moreover, many stocks have declined from their highs by anywhere from 20-70% in the past year.  While many stocks deserve to be down that much as their businesses never justified their lofty valuations, there are others that are now selling at highly attractive valuations.  Lastly, the increase in global interest rates has provided investors with more attractive bond yields, however, equity investors should be better able to offset the inflationary impact on the purchasing power of the dollar over time than fixed income investors. As market participants adjust to the changes highlighted in this Outlook, new leadership is likely to emerge and investors with the vision to look beyond the next quarter or two should be well rewarded.

Wishing our clients and friends a happy, healthy and peaceful New Year.

Published by the ARS Investment Policy Committee: Stephen Burke, Sean Lawless, Nitin Sacheti, Greg Kops, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor.

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