Author: Rachel Shulman

“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.

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.

The decade-long party involving ultra-easy fiscal and monetary policies has come to an end as concurrent food, energy, security, and cost of living crises are reshaping our world. The days of the Fed rescuing markets are over and have been replaced by policymakers working to rapidly tighten economic conditions to bring down inflation. As a result, the world and the U.S. monetary regimes are returning to a more normalized interest rate environment after an extended period of negative and zero interest rates.  Valuations are undergoing the most meaningful re-adjustment process since the Great Financial Crisis to reflect current interest rates and inflation rates. Under present conditions, the global economy will likely experience a recession in the coming quarters with Europe and China among the greatest areas of financial stress. The U.S. remains the most attractive developed market economy and a magnet for capital flows from the rest of the world, but its economy will be challenged as well. The pandemic, its accompanying supply chain problems, and Russia’s attack on Ukraine continues to remake our world and accelerate the rate of change for so many aspects of society. It remains unclear just how much things will change as we still do not know how everything sorts out. Nevertheless, what is clear is that the global economy is experiencing more persistent cost pressures and reduced economic activity while policymakers have less bandwidth to support their economies than they have had in the past. Therefore, the adjustment process will be painful for the most vulnerable governments, companies, and individuals.

Chart 1. When the Fed Tightens, Financial Cries Usually Follows

Sources: Federal Reserve Board, Yardeni Research, Inc

In our April Outlook titled “Everything’s Changed,” we wrote that the global economy would experience trade shocks, financial turbulence, flows of capital, and the flight of refugees. At that time, we felt that the global economy would experience higher levels of inflation which would lead to slower global growth. Unfortunately, all these concerns have come to pass which has raised the probability of a global recession. Historically, when the Federal Reserve begins a cycle of interest rate increases, it causes financial stress in other parts of the world as seen in Chart 1 and investors should anticipate that this tightening cycle will probably cause a problem in one or more economies.  Since March of 2009 when then Federal Reserve Chair Ben Bernanke announced the initial quantitative easing program, investors have relied on central banks and fiscal initiatives to provide support to the economy, equity, and bond markets. As a result, investors were able to be much more aggressive and much less disciplined, while seeing equity and bond markets rally significantly as the policy support provided was massive and unprecedented. Today, market participants are facing a market environment characterized by increased uncertainty and volatility as the previously favorable conditions driving returns have been and continue to be in the process of being reversed. To bring inflation down, the Fed is targeting both the real economy and as a result the asset markets which means slower growth, higher unemployment, and lower asset values. Market participants who have grown accustomed to strong returns across asset classes must now recognize that we have entered a new economic period where assets are being revalued and different investment opportunities are presented. Notwithstanding the obvious challenges in the world today, the pullback in the global equity markets has created an attractive opportunity to selectively purchase some of the world’s leading businesses at much more favorable valuations than just a few quarters ago.

The End of the Easy Money Era and the Strengths of the U.S. Dollar

Since the start of the pandemic, central banks and fiscal authorities have committed more than 35% of global GDP or over $30 trillion in stimulus to combat the virus. That along with the food and energy inflation stemming from the Russian invasion of Ukraine has forced monetary and fiscal authorities to reverse course shifting from easy money policies to restrictive policy to bring inflation under control. Gone are the easy-money days of zero and negative interest rates, and these have been replaced by a rapid tightening of global financial conditions. The Federal Reserve has raised the fed funds rate from 0.0-0.25% to 3.25% within the last seven months with plans to move to an estimated 4-5% level. In the U.S., mortgage rates have risen from around 3.5% to 7% creating a material change in housing market dynamics. Global short-term interest rates have risen from near 0.5% to over 3.5% as there have been more than 180 rate increases by central banks over the last 18 months. After having pumped $120 billion per month into the system, the Fed has started to reduce its balance sheet by $95 billion per month. The combination of these actions has tightened financial conditions with the outcome theoretical as we have never had a reversal of quantitative easing of this magnitude, so no one really knows how this will end as it is all based on monetary modeling.

Chart 2. The U.S. Dollar Strength

Source: Refinitiv

One area where we are seeing the financial dislocations is in currency markets as the multi-decade strength of the U.S. dollar is wreaking havoc on other nations and their respective currencies (see chart 2). Importantly, the strength of the U.S. dollar means that the United States is now importing deflation and exporting inflation as commodities and other products are priced and traded in U.S. dollars (as shown in Chart 3). This is important in bringing down inflation in the United States as the U.S. currently imports $4.065 trillion per year and exports $2.98 trillion per year. The strong dollar also raises the debt servicing cost for foreign countries holding dollar-denominated debt and is placing further strains on the most vulnerable nations in the emerging markets.

Chart 3. The U.S. Dollar’s Importance

Sources: The Global Dollar Cycle, Obstfeld and Zhou, Aug 2022

There are three key implications of the end of the easy-money era. First, many governments now find themselves facing rising deficits, higher debt servicing costs, and growing social strains. When the history of this period is written, many governments will be criticized for wasting a significant opportunity to use zero-interest rates to invest in the structural changes needed to put their economies on a path to sustainable growth. Instead, governments focused on short-term benefits and are now left with big spending needs, but without the resources to stimulate economic activity with a global recession looming. Second, the aggressive moves by the fed to hike interest rates are causing disruptions in the currency markets as the U.S. dollar plays an outsized role in the global economy impacting commodities, global trade, global payments, foreign exchange transactions, foreign dollar-denominated debts, and reserves. This is leading to “reverse currency wars” whereby countries are trying to strengthen their respective currencies to offset inflationary pressures brought about by the strong U.S. dollar as most commodities trade in dollars. Third, the sudden shift from easy-money policies to tightening policies means that valuations are being reset to reflect a return to classic levels of inflation rates, interest rates and equity valuations.

Investing in Secular Themes

Notwithstanding the pressures described, there are five secular themes which should attract capital in the coming period. These themes are the electrification of the world, digitalization to improve productivity and offset demographic challenges, national security around food, energy, cyber and military security, biotechnology that will lower the cost of healthcare in the U.S., and special situation opportunities. Many of these are identified by governments and businesses as areas of mandatory future spending.

ELECTRIFICATION – ARS is investing in this theme in three ways. First, through old energy companies by owning independent oil and gas exploration and production/marketing companies which are typically selling at significant discounts to the market P/E multiples, but their renewed financial discipline and reduction of trusted energy sources for the world’s needs will make these companies even more valuable. Many are allocating more than 50% of free cash flow to be paid out to shareholders through dividends. Second, we are investing in industrial solar plays including one company that is a global provider of utility-scale solar installations and another that is a key global supply chain and manufacturing solutions provider. Finally, we are investing in the shift to EVs (electric vehicles) from ICEs (internal combustion engines). We are investing in two industrial companies that provide the rare earth materials and copper which are essential in EV production, and American multinational car manufacturers committed to expanding their EV fleets.

DIGITALIZATION – The world is facing major challenges of rising inflation and worsening demographics. Technology holds one of the keys to combating these two issues, and it still has a long runway for investors. ARS is investing in the major players in cloud computing, semiconductor chips, cyber security, and companies that improve power and efficiency. In addition, labor supply and costs are pushing more companies to use robotics and automation to improve efficiency, offset wage pressures, and as a substitute in jobs lacking qualified candidates.

NATIONAL SECURITY – In response to recent setbacks on the battlefield in Ukraine, Mr. Putin has doubled down on his aggressive behavior by attacking civilian targets and critical infrastructure while threatening the use of tactical nuclear weapons. The war in Europe was a wake-up call for government leaders, especially those of NATO members, to properly supply their armed forces with state-of-the-art equipment. We expect military spending to increase among NATO members and their adversaries in the coming decade.

LOWER HEALTHCARE COSTS – The use of artificial intelligence to analyze data has led to exciting developments in healthcare. This is leading to an accelerating pipeline and the introduction of new drugs, therapies, and breakthrough medical technology. The benefits of digitalization are being realized in healthcare, and the pandemic illustrated this with the research and development of new vaccines and medicines in record time. The prospect of better healthcare enabling longer lives leads to greater productivity.  

SPECIAL SITUATION OPPORTUNITIES – There are three types of companies that fall into this category. The first is companies with strong and growing free cash flows (FCF) which enable them to invest in future growth ahead of their peers. The second is businesses whose financial positions are so strong that they can use their free cash flows to buy back significant amounts of their outstanding stock over multiple years as well as increasing dividends; ARS currently owns at least four companies with announced plans to buy back 15-25% of their outstanding stock annually. The third is companies that will use mergers, acquisitions and divestitures to enhance shareholder value.

Investment Considerations

Conducting securities research and determining individual security selection is a fascinating, challenging and intellectually stimulating profession. Ferreting out opportunities is like solving a complex puzzle. Some economic conditions are easier to describe, and some have more moving parts which reflect different levels of complexity with the final conclusion always being a probability rather than a certainty.  It is in times like these that managers should balance protecting the downside while taking advantage of opportunities being presented. As the U.S. and global economy are experiencing the most significant inflationary pressure in over 40 years, it is something most investors today have not experienced. The ARS 8-person investment policy committee averages over 30 years in the industry which gives us perspectives and experience in various markets that many firms simply do not have. That experience combined with our investment process discipline which marries our macro-economic analysis (top-down) and fundamental company research (bottom-up) have allowed us to deliver distinct portfolios for clients. Investment process discipline means we know what we own in client portfolios, why we own each business and what our future expectations are for the business as we have done for over 50 years. This process gives us an advantage in being able to invest in the secular themes to position ahead of shifts in capital flows as we have in recent years. While our strategies may be out of step with the market for brief periods as we were last quarter, we remain confident that the beneficiaries of the secular themes we have identified will generate attractive returns over time. The shift from near-zero interest rates will require market participants to be much more selective among companies that will benefit from these changing conditions. Due to surging inflation, higher input costs, and a strong dollar, market participants should expect analyst estimates to be reduced when companies report third quarter earnings as more corporate executives are likely to announce lower earnings guidance, and in some cases, withhold guidance completely.

For ARS clients, it is important to keep in mind that the secular trends we have identified in recent Outlooks will continue to be fundamental to an improving economy, but there will be a time lag between the future benefit as reflected in the stock prices of the beneficiaries and the present economic pressures weighing on the markets. In our view, the best investment approach continues to be a focus on the beneficiaries of the conditions described in this Outlook rather than to try to time the market before committing capital. The fallout from global trade tensions, population displacements, the COVID-19 pandemic, and the war in Ukraine has forced governments and businesses to adapt to changing economic conditions and societal tensions. The global system is undergoing massive transformations due to the current political, social, economic, and climate conditions. Past experience has shown that it is in a time like this that the best investment opportunities are often missed because of excessive focus on heightened uncertainty.  Uncertainty creates opportunity.  

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

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.

We are heartbroken to see what the people of Ukraine are experiencing. The extraordinary leadership of President Zelensky and the bravery of the Ukrainian people in defending their homeland and families is inspiring people around the world. The defense of Ukraine is a vivid reminder of the high cost of freedom that many people enjoy but often take for granted.

“The war in Ukraine could not have come at a worse time for the global economy—when the recovery from the pandemic-induced contraction had begun to falter, inflation was surging, central banks in the world’s largest economies were gearing up to hike interest rates, and financial markets were gyrating over a formidable constellation of uncertainties.  The war has aggravated those uncertainties in ways that will reverberate across the world, harming the most vulnerable people in the most fragile places. It’s too soon to tell the degree to which the conflict will alter the global economic outlook… Much will depend on what happens next.” 

– Indermit Gill, Non-resident Senior Fellow at the World Bank excerpt from Brookings Institute, March 8, 2022

Everything changed on February 24th as war is being waged on European soil for the first time in decades. There will be no winners from this war as the damage already done has been far too great in terms of loss of life and destruction of a nation.  Unfortunately, the steepest economic price will be paid by the people of Ukraine and Russia followed by the world’s poorest nations and households that spend the highest share of their incomes on food and energy.  Besides higher prices, the fallout is likely to arrive through several other vectors: trade shocks, financial turbulence, flows of capital, and the flight of refugees.  The global economy will experience higher levels of inflation leading to slower global growth.

After being supported by historically low interest rates and highly accommodative policies, market participants who have grown accustomed to strong returns across asset classes must now recognize we have entered a new economic period where different investment opportunities are presented and invest accordingly.  With additional supply chain disruptions to food and energy being layered on top of the pandemic-related issues, the global economy is experiencing reduced monetary and fiscal policy support, higher levels of inflation and lower global growth.

The world is entering a period of massive geopolitical, economic, and societal shifts.  Russia’s attack on Ukraine will remake the world, but it is unclear at the present time just how much things will change as we do not know when or how the war will end.  What is clear, however, is that the global economy is facing another significant economic shock; the Ukrainian and Russian economies will likely be severely damaged for an extended period; Europeans will be facing significantly higher energy prices and greater prospects for a recession; the world food supply will be disrupted; global trade will undergo a significant makeover; national security has become a much bigger priority; and international alliances will be reconfigured.  Countries closest to the conflict—by virtue of their strong trade, financial, and migration links to Russia and Ukraine—are likely to suffer the greatest immediate harm. But the effects will be felt worldwide.

It is worth noting that since ARS Investment Partners was established in 1971, we have successfully navigated previous inflationary periods for our clients as well as several geopolitical conflicts during that time.  Our investment process, which combines both proprietary macro-economic analysis (top-down) and fundamental company research (bottom up), gives us an advantage in being able to invest in the secular themes to position ahead of shifts in capital flows as we have in recent years.  We began overweighting semiconductor and capital equipment companies, defense companies, Electric Vehicle  manufacturers and commodity producers essential for the clean-energy transition often well in advance of major market shifts.  We have employed the same investment philosophy and approach since our inception, and that approach has allowed us to successfully build and protect capital in challenging environments.  The most important consequence of the war in Ukraine is the lives lost and the humanitarian crisis associated with the huge numbers of besieged and displaced people.  This war represents a human tragedy of epic proportions with significant business, economic and geopolitical considerations as we describe in this Outlook.

Forces Driving Shifts in Capital Flows

“Sweeping and indiscriminate sanctions would only make people suffer. If further escalated, they could trigger serious crises in the global economy and trade, finance, energy, food, and industrial supply chains, crippling the already languishing world economy and causing irrevocable losses.”

-Excerpts from China’s Ministry of Foreign Affairs statement following the President’s Xi-Biden March 18^th video conference call

As if fighting a global pandemic for the past two years was not enough, the world is now dealing with a ground war in Europe that has the potential to undo much of the progress made since the Berlin Wall came down in 1989.  In recent years, China and Russia have been seeking a rebalancing of the global order with the desire to reduce the military and economic influence of the United States and its allies. Autocratic nations have been spending heavily on developing their military capabilities.  The sanctions recently imposed on Russia were among the most severe issued in history and have already had a devastating effect on the Russian economy as shown in Chart 1.  As a result, our adversaries are considering new ways to mitigate the costs of future sanctions on their economies by establishing alternatives to existing Western-controlled systems such as SWIFT (Society for Worldwide Interbank Financial Telecommunication) banking system.  The sanctions are also causing nations and companies to reorient their supply chains and currency reserves to protect their economic interests against future actions by rival nations or blocs.  The remaking of the world order and the global economy is underway, and this may be the most meaningful change the world has experienced since WWII.

Chart 1. The Impact of Sanctions on the Russian Economy

Several forces are redefining the global economy.  First, global growth will be lower than previously projected.  Second, headline inflation will remain elevated as labor costs rise and energy and food supplies are being disrupted.  Third, the supply chain issues, which the world has been battling since the start of the pandemic and which had been starting to ease, are now being exacerbated by the war and the sanctions imposed on Russia by allied nations.  The combination of energy and food inflation combined with supply shortages and stockpiling will impact the most vulnerable countries, companies, and individuals.  Fourth, policymakers will increase or shift spending to improve national defense, space, cyber, food and energy security.  One additional issue that investors should consider is the intended and unintended consequences of the sanctions imposed by the West, particularly if the U.S. follows through on threats to add sanctions to China in the event that the Chinese help Russia.  The Russian economy is feeling the full effects of the initial sanctions as it has been forced to raise its benchmark policy rate to 20%, while its stock market and currency have been severely damaged.

Lower Global Growth

Gross Domestic Product for many countries was on pace to return to pre-COVID levels by the end of this year or next, but the war makes those projections unlikely to be achieved.  Prior to the invasion, global real gross domestic product was projected to grow around 3.4% due to the impact of inflation, reduced government stimulus, tighter monetary policies and ongoing supply chain issues which were only starting to be resolved.  The OECD recently released an update which projected world GDP to drop by 1.09% (see Chart 2).  Unfortunately, many emerging economies will be severely impacted by the combination of the lingering healthcare issues from the pandemic, high U.S. dollar-denominated debts, volatile commodity prices and availability, and erratic economic policies.  For the global economy, slower growth will mitigate some of the current inflationary pressures as demand declines.

Chart 2. The War’s Impact on Global Growth

Higher Inflation

Coming into the year, ARS believed that the economy would see its deflationary tendencies return in the second half of 2022 following the supply-driven inflation experienced due to the pandemic.  However, the war has added a new layer of complexity on to the inflation dynamics as Russia and Ukraine account for only 2% of GDP combined but have an outsized impact on the world’s energy and food supplies.  Russia, the 11^th largest economy in the world, is one of the world’s leading exporters of oil, natural gas, nickel, aluminum, semi-finished iron, and wheat.  Europe, in particular Germany, is highly dependent on Russia for its energy needs.  Europe had been aggressively shifting away from fossil fuels to renewable energy but was still early in the transition when the war broke out.  The subsequent spike in oil and natural gas prices, as well as concerns about sanctions cutting off supplies to Europe, has governments scrambling to figure out ways to reduce the impact in the form of fuel subsidies, gas tax holidays, and fast-tracking permit approvals for energy companies to bring on additional production sooner.  The food problem may prove to be even more difficult to address as the world may lose a substantial portion of crops if Ukrainian farmers cannot meet this season’s planting deadlines.  Food inflation was one of the key issues leading to the Arab Spring over a decade ago.  Regardless of the actions taken by policymakers, the OECD projects that the war’s impact on inflation will range from increases of 1.36% for the U.S. to 2.47% for the world (see Chart 3).  While it is exceedingly difficult to make projections when the war’s duration and outcome is unknown, the world has clearly entered a period of higher prices.

Chart 3. The War’s Impact on Inflation

Interest Rates to Rise, But Must Remain Historically Low

The interest rate outlook calls for higher rates for the coming period as the Fed grapples with higher inflation arising from energy and food supply shortages as well as higher labor costs.  Since 2009, central bank policy has played an outsized role in supporting the markets and global economy as both struggled to recover first from the great financial crisis, then from the pandemic and now from the war.  Last year, central banks began tightening policy by raising benchmark policy rates, reducing quantitative easing, and signaling the end of the most extraordinary period in monetary policy history.  Central bankers are trying to balance curbing inflation by increasing rates just enough, while avoiding tipping the economy into recession. One of the challenges is that there is little central banks can do to offset inflationary pressures caused by supply disruptions beyond simply trying to reduce the level of aggregate demand, as their tools are designed to address inflation that results from excess demand.

Given the current state of the world’s economy, this interest rate hiking cycle may be quite different than previous ones as much of the world’s economy was still struggling to recover from the two previous crises.  Based on current conditions, it is likely that many countries will experience a recession sometime over the next 24 months.  We believe the Fed will prefer to continue to let inflation run higher than normal rather than cause a recession by hiking too aggressively.  Furthermore, the Fed will likely raise rates fewer times and to levels below what the Fed and market participants currently project, as the slowing global economy will naturally reduce demand and dampen inflationary pressures.  It is too soon to determine the full impact of the war on growth and inflation given the broad range of possible outcomes, and therefore, investors should expect the Fed and other central banks to be flexible in setting the course for policy actions.

Geopolitical and Political Forces

“It now seems likely that the world economy really will split into blocs, each attempting to insulate itself from and then diminish the influence of the other. With less economic interconnectedness, the world will see lower trend growth and less innovation. Domestic incumbent companies and industries will have more power to demand special protections. Altogether, the real returns on investments made by households and corporations will go down.”

-Economist Adam Posen, President of the Peterson Institute

For decades, globalization has brought the world closer together and raised living standards for billions of people, but it also created vulnerabilities for many domestic economies which have been brought to light in the past two years.  First the pandemic and then the war provided a painful reminder just how interconnected and interdependent the global economy had become.  The pandemic and the war in Ukraine underscored the over-reliance on autocratic nations in the global system for necessary resources including food, energy, commodities, and other basic materials.  The war in Europe is remaking the world order and alliances, and it is forcing world leaders to reassess their foreign and domestic policy priorities and dependencies in several key areas including national security (military, food, cyber and energy), the role of intergovernmental agencies such as NATO, WTO, and the UN, and how to properly affect the climate transition.  It is also forcing policymakers to reconsider budget priorities.  The severity of the sanctions placed on Russia by western governments has countries, including China, exploring ways to insulate their economies from future sanctions and to form new economic and defense alliances.  The United States and virtually every nation will now be focused on building up strategic reserves in a variety of essential materials required for the advancement of alternative energy sources, and critical defense needs and technologies.  The buildup of strategic reserves can increase the prices of these materials and keep them elevated for an extended period of time.

being forced to adjust spending priorities and policy around national security.  Given the need to increase spending in certain areas, President Biden’s Build Back Better agenda will likely be greatly reduced or not implemented at all.  Congress will likely be forced to rethink our energy policy, defense spending, and social spending priorities to deal with the new political and economic realities.  For China, the war has put the nation in a difficult position as it has close political ties to Russia, but much greater economic dependency on western nations.  As the world’s second largest economy and largest exporter, China will play an outsized role in how the political and economic issues get resolved. Europe will be facing several new challenges involving energy, defense, immigration, and resources while working to avoid a severe recession.  Some experts are suggesting that globalization has ended, but it will more likely shift to blocs whereby like-minded nations work to protect people and grow their economies in a changing world order.

Investment Opportunities for a Changing World

“The availability of ever-cheaper goods like cars, appliances and furniture produced abroad was a major contributor to the benign U.S. inflation picture in this quarter-century. On the other hand, offshoring also led to the elimination of millions of U.S. jobs, the hollowing out of the manufacturing regions and middle class of our country, and most likely the weakening of private-sector labor unions. The recognition of these negative aspects of globalization has now caused the pendulum to swing back toward local sourcing. Rather than the cheapest, easiest and greenest sources, there’ll probably be more of a premium put on the safest and surest.”

-Howard Marks, Oaktree Capital

Portfolio management is both an art and a science. It is a decision-making process that requires sifting through enormous amounts of incomplete information and making a judgment as to what is really important.  This is particularly true not only in a period of heightened uncertainty, conflict, and volatility such as we are in now, but also when the world is undergoing a fundamental change that is impacting virtually every industry.  Policymakers must address the growing cost of security due to the significant damage from climate change and the effects of war.  For much of the past decade, market participants had the wind at their backs and were able to be more aggressive than in normal times.  This was due to historically low interest and inflation rates which supported higher price-earnings multiples for companies with the promise of strong future growth, but the reality of little or no current earnings.  In a rising interest rate environment such as we are in today, price-earnings multiples have been and are contracting, and valuations are coming down.  While we did not anticipate rates to rise as much as they have this year, we were, for some time, of the belief that multiples would contract for those companies with elevated valuations and little if any current earnings.  As a consequence, in late 2020, we began to reduce positions and completely eliminate those companies whose valuations we felt were not sustainable.  We did this because the preservation of capital in pursuit of investment returns is both an offensive and a defensive process.

The dramatic shifts now taking place in the global economy will have profound implications for every country, company, and household, and these shifts are creating new investment opportunities, while reinforcing some previous ones.  There are two important factors to consider for portfolio positioning: first, the need for nations to reshore and expand onshore manufacturing capabilities critical to ensuring economic and national security, and second, the need to build up strategic reserves to protect future supplies of required resources.  Whereas just in-time inventory management had been considered an ideal way to manage manufacturing processes in the past, the pandemic and war have made “safe and sure” supplies in needed materials the priority over cost savings.  Advanced technologies will also allow companies to offset the former attraction of lower foreign manufacturing costs thereby creating many new jobs at home.

Aside from the opportunities described above, the focus for client portfolios remains consistent with our recent Outlooks as we continue to favor the beneficiaries of the digitalization and electrification involving cloud, cyber security, communications, semiconductor technology, industrials, healthcare, energy companies including wind and power, and commodity and materials producers.  Investors should continue to avoid over-hyped areas of the market, but also to be opportunistic to take advantage of the mispricing of quality companies that inevitably occur in volatile markets and uncertain periods.

We focus on the investment opportunities which meet our standards of valuation under these changed conditions.  We anticipate that companies will move more aggressively to improve productivity and better compete in the coming period through merger and acquisition activity and spinoffs.  Notwithstanding the significant advancements of many of the leading beneficiaries of this Outlook over the past few years, periods of market volatility should be viewed both as the pause that refreshes and an opportunity to add to quality companies with particularly attractive valuations which have significantly increased their revenues and earnings and continue to have bright prospects for strong growth.  Because the economy is undergoing a reorientation, the companies with embedded advantages will continue to fetch the best market valuations over time.  Security of critical raw materials is fundamental to successful investment outcomes. Continuing innovation and embracing the latest technologies will be fundamental for companies to remain at the forefront of competition.

Regardless, a number of leading companies, large and small, will continue to innovate, disrupt, and evolve their business models to thrive in the coming years.  As such, investors should be focused on benefiting from the powerful secular trends and not on speculating in shares of companies whose futures are behind them as they have either lost their way or will be unable to transition in their current forms to benefit going forward.

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

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

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