Category: The Outlook

“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.

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 with 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.

“Russia’s invasion of Ukraine has dealt a blow to the global economy – weakening the post-pandemic recovery and aggravating already high inflation. Even if the worst fears of rising geopolitical tensions and larger economic disruptions do not materialize, private forecasters anticipate an inflationary slump for the world economy… The war’s economic damage will partly depend on the persistence of high inflation and economic “scarring” over the medium to long term.”

– Excerpt from Dallas Federal Reserve Bank, May 17, 2022

The global economy is facing a series of destabilizing shocks intensified by the Russian invasion of Ukraine. In addition to creating a tragic humanitarian crisis, the war is disrupting global supply chains, food, energy, trade, and geopolitics.  While the current environment bears some resemblance to past periods such as the 1970s, it also has several distinctive characteristics. As we said in our last Outlook, the world has changed as the global economy and markets are undergoing a series of critical transformations.  Prior to the Russian invasion of Ukraine, some countries were returning to pre-pandemic economic activity, but many other countries were facing severe economic, social, and political challenges which the war has only exacerbated. As the duration and severity of the war in Ukraine remains highly uncertain, the potential risks to the downside have market participants and policymakers worrying about an inflationary slump and possibly a deep recession for the world economy. While a deep recession is not our base case, investors should proceed with caution given the variability of outcomes and the possibility of a major policy miscalculation. At the same time, the recent market pullback now has any number of the highest-quality businesses selling at valuations typically available only during periods of severe economic stress. 

For much of the past decade investors across asset classes have benefited from the most aggressive monetary and fiscal policy regimes in history that had been appropriate for the circumstances at that time, but no longer exist today. Presently, central banks around the world have been forced to shift from a highly accommodative policy to a restrictive policy to counter a rapid increase in inflationary pressures much of which began on February 24^th with the invasion of Ukraine.  Concurrently, governments are facing several significant budgetary constraints in the face of many necessary big-dollar investment programs including the green energy transition, strengthening and reorienting supply chains, fixing aging infrastructure, and enhancing national security, among others.  After kicking the can down the road for decades on many critical investments which can no longer be postponed, the bill has now come due, and it could not have happened at a worse time for many politicians.  The combination of the lingering effects of the pandemic and the invasion of Ukraine by Russia is undoing much of the work done by policymakers since 2008 as rising inflation and slowing growth are damaging consumer and business confidence. For politicians, it will be exceedingly difficult to do the right (and likely unpopular) thing to address the multitude of problems and still get re-elected. Meanwhile, there is growing dissatisfaction among voters around the world which is forcing politicians to be even more short-term oriented which will make enacting effective legislation even more difficult.

One key to a solid investment strategy is to invest in the beneficiaries of the problems. The secular trends we have identified in recent Outlooks will continue to be fundamental to improving the economy One key to a solid investment strategy is to invest in the beneficiaries of the problems. The secular trends we have identified in recent Outlooks will continue to be fundamental to improving the economy and living standards, but there will be a time lag between the future benefits and current conditions as reflected in the stock prices of the beneficiaries.  Just to remind our readers, the trends are in digitalization, electrification, lowering healthcare costs, productivity improvements and the need to enhance national security. The equity markets, both public and private, are dealing with an unknown outcome of the war and COVID related disruptions and cannot value with any certainty these circumstances. This uncertainty, combined with tightening of financial conditions, suggests further contraction in price/earnings multiples followed by earnings declines which are likely to persist until inflation levels off and interest rates stabilize or decline.  Those investors with the knowledge, experience, and conviction to look beyond the immediate period will be able to recognize rare buying opportunities.  Accordingly, we have been taking advantage of the choices available to initiate positions in some of these companies or to add to existing positions in client portfolios

From QE to QT

“The Committee is acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials. The Committee’s commitment to restoring price stability— which is necessary for sustaining a strong labor market—is unconditional.”

– Federal Reserve Monetary Policy Report, June 17, 2022

The above statement from the Federal Reserve’s Monetary Policy Report highlights one of the major transformations occurring today as the Fed transitions from trying to stimulate the economy to trying to manage a tightening of conditions to bring inflation back down and avoid a recession. In addition to the Fed, most major central banks, with the exception of the Bank of Japan and the Peoples Bank of China, are tightening financial conditions aggressively to counter inflationary pressures. The Federal Reserve Bank of Dallas recently produced a paper which illustrates how the outlook for growth and inflation has shifted since the start of the war. In the Dallas Fed’s report, global growth projections (Chart 1) declined by 1% for 2022 and 0.3% for 2023 since February 18th, while the CPI inflation forecast for 2022 increased by 2.3% and by 1% for 2023. What a difference a few months made in the forecast.

Chart 1. Weakening Global Growth, Higher Inflation

Source: Consensus, Economics: authors’ calculations.

Among the biggest challenges for the Fed and other central banks are the high degree of uncertainty which must be factored into their decisions and the limitations for future policy maneuvers. The outlook for inflation will depend on several factors including the COVID-19 lockdowns in China, how and when the invasion of Ukraine ends, potential strikes this summer of workers at the Ports of L.A. and Long Beach as well as railroad workers, and labor costs where worker shortages will command higher wages to compensate. These factors could lead to more persistent inflation for certain parts of the economy leaving the Fed in the position of raising rates beyond market expectations. Again, this is not our base case as we expect the Fed to respond to slowing growth by backing off on the number of expected rate hikes as inflationary pressures ease.  Regardless of when inflation peaks, the result for consumers and corporations will be higher prices than before the pandemic and the war. 

Chart 2. Signs Wage Pressures May Be Easing

Source: Piper Sandler, Marco Economic Research, July 2, 2022

We have already seen a pickup in layoff announcements (Chart 2) as well as hiring freezes which should ease wage pressures in some industries and slow growth, reducing the need for central banks to tighten as aggressively as currently expected and may even require a policy reversal later in 2022 or 2023.  However, as we have seen in many industries, there are still shortages of skilled labor which will take time and policy changes to moderate.  As we mentioned in our April Outlook, “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.”  For example, a strong dollar will slow U.S. export activity which will slow global growth even further.  As business and consumer confidence declines, behavioral changes in the form of reduced spending typically follows, which should support an easing of inflationary pressures.

Risks and Global Economic Prospects

“The outlook is subject to various downside risks, including intensifying geopolitical tensions, growing stagflationary headwinds, rising financial instability, continuing supply strains, and worsening food insecurity. These risks underscore the importance of a forceful policy response. The global community needs to ramp up efforts to mitigate humanitarian crises caused by the war in Ukraine and conflict elsewhere, alleviate food insecurity, and expand vaccine access to ensure a durable end of the pandemic.”

– Excerpt from the World Bank Global Economic Prospects Report, June 2022

Chart 3. Rising Risks to Global Systems

Source: World Bank, Global Economic Prospects, June 2022

In its most recent Global Economics Prospects Report, the World Bank highlighted several risks facing the world today and these risks are highlighted in Chart 3. The world is facing rising risks of an increase in geopolitical tensions as the U.S. Department of Defense recently identified Russia and China as the primary threats with North Korea, Iran and terrorist states representing other main concerns.  The war has layered on additional problems for the global supply chain system as nations are scrambling to ensure that they can access dependable and secure supplies of materials necessary for national security (including food, energy, cyber and military) through re-shoring (bringing manufacturing back home), onshoring (bringing in new production capabilities) or “friend shoring” (running supply chains only through countries that are close political partners) which Treasury Secretary Janet Yellen has discussed recently.  The world continues to work to arrest the COVID-19 pandemic, but much more needs to be done there even before we start to address potential future pandemics. Higher inflation coupled with weaker long-term growth prospects will create added stress on societies and greater demands for government support at a time where government finances are stressed.

Concurrently, climate-related disasters are increasing in both frequency and severity, while the clean energy transformation is not progressing as hoped and will require far greater reliance on fossil fuels to power the world for longer than originally planned to effect the transition. The problems are many, but innovation is one of the keys and the reason the battle for technological supremacy between the United States and China has grown so intense. Perhaps the greatest area of concern is the intensification of geopolitical tensions which could further disrupt economic activity, increase policy uncertainty, and potentially lead to a significant fragmentation as nations form blocs with like-minded nations for economic and security purposes.

Opportunities – Quality and Innovation on Sale

“For long-term investors, it will prove beneficial over time that markets are exiting an artificial regime that was maintained for far too long by the Fed and that resulted in frothy valuations, relative price distortions, resource misallocations and investors losing sight of corporate and sovereign fundamentals. The promise now is one of a more sustainable destination. Unfortunately, it comes with an uncomfortably bumpy and unsettling journey.”

– Mohamad El-Erian, Bloomberg, July 5, 2022

Notwithstanding relief rallies due to periodically oversold conditions, markets will likely continue to struggle to find firmer footing until inflation and Treasury yields begin to peak.  For investors, the current conditions are resulting in a significant reset of valuations across asset classes to reflect a vastly different monetary and fiscal policy regime from that of just a few quarters ago. The reset has been painful as the NASDAQ has lost over 30% from its recent high, cryptocurrency Bitcoin is down from a high of over $66,000 to around $20,000, the big mega cap tech stocks are down anywhere from 25-75%, mortgage rates have spiked up from 3.25% to almost 6%, and the S&P 500 has fallen into bear market territory.  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. We remain focused on the beneficiaries of the trends in electrification, digitalization, lowering healthcare costs, and those delivering on the need to enhance national security (food, energy, cyber, and military) at home and abroad. 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 overall.

Excessive focus on near-term concerns distracts from the subset of companies that stand to benefit from the current environment, especially those experiencing pricing power and inelasticity of demand for their products. An important fundamental concept for investors to understand at this time is that price inelasticity reflects goods and services that typically tend to have few substitutes, few competitors and are considered necessities by users. Given the ongoing supply-chain woes, inflationary pressures and a strong dollar, the ability of companies to offset any increase in production costs will enable them to increase earnings and cash flow from operations and should be worth more over time. Among the areas of investment opportunity are semiconductor chips and equipment, cloud providers, select commodities producers including steel, rare earth materials, chemicals, copper and even some fossil fuel producers as each should continue to see strong pricing power, demand, and earnings growth.  In addition, our research has identified a number of public companies which have announced significant, multi-year stock buyback programs of 15-20% of their outstanding shares annually with an eye toward potentially taking their companies private over time. These companies have the financial strength to thrive against their competitors in this particularly challenging environment.

There is a growing separation between the corporate haves and have-nots making security selection the most important it has been in a long time.  The shift from near-zero interest rates will require portfolio managers to be much more selective to invest in those companies that benefit from this policy regime change.  The winners will be those companies whose product demand is inelastic as those will continue to have better pricing power – an important theme that we touched on in prior Outlooks – as well as those with strong balance sheets which allow for continued investment, merger and acquisition activity, increased buybacks, and – importantly – growing dividend payments.  Due to surging inflation, higher input costs, and a strong dollar, market participants should expect analyst estimates to be reduced when companies report second quarter earnings as more corporate executives are likely to announce lower guidance, and in some cases, withhold guidance completely.

At some point, inflation will ease.  The result will be a higher level of interest rates than before the war and aAt some point, inflation will ease.  The result will be a higher level of interest rates than before the war and a higher cost of living.  Considering that the dollar has lost around 83% of its purchasing power since 1974, asset class and security selection need to protect purchasing power even more effectively than at any time in the last 50 years.  While the natural tendency during times of economic stress is to shift to a more conservative approach such as increasing fixed income exposure, we believe that this will only work as a short-term decision as well-selected equities will be the only way to offset higher living costs over time.  In addition, the current conditions suggest that market winners will be a narrow subset of the overall market whereas for much of the past decade it was more beneficial to own the entire market.  In the current economic environment, indexing will capture both the winners and the losers, something we and most investors will find unsatisfactory.  This is a time for focused and targeted security selection regardless of whether you are in the public or private markets.  Many companies are on the lookout to purchase undervalued companies to enhance their competitive positions and business prospects.  Given the amount of liquidity still present in the global system and the excess cash flow being generated by many corporations, the window of opportunity for investors in these mispriced companies may not be available for long.  As great investors know, the best investments are presented when the markets are under extreme pressure and most market participants are not emotionally able to act to take advantage of exceptional circumstances.   

Published by the ARS Investment Policy Committee: Stephen Burke, Sean Lawless, Nitin Sacheti, 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.

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 prospects for common stock investing are more positive than the headlines would lead market participants to believe because the investment opportunities are broadening.  The strong equity returns of the past few years should continue in 2022 for investors able to identify strong revenue and earnings growth in a slower growth environment and those undervalued companies that have been previously overlooked due to extreme concentration of investment in a relatively small number of pandemic beneficiaries.  Additionally, investment success will require navigating some subtle and some not-so-subtle shifts that are occurring in market leadership as the pandemic wanes.  Leading ARS to this more positive view is that the determinants of security valuation, namely the outlook for corporate profits, interest rates and inflation rates remain positive even with the elevated inflationary levels and higher cost of living experienced in the second half of 2021.  The world continues to undergo the transformations that ARS introduced to readers in our October 31, 2020 Outlook that define many of the most important investment opportunities.  These transformations will continue to shape the future of the global economy.

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In addition to the impact these six transformations will have on the global economy, the United States’ post-pandemic economy will be shaped by the handoff from government spending to corporate and consumer spending as the primary drivers of growth in 2022 and beyond. Against the current economic backdrop, the areas that will attract capital in the new year will continue to be the beneficiaries of these transformations, particularly companies focused on cloud/data management and storage, semiconductor and capital equipment, broadband providers, select commodity producers, defense, biotech, cybersecurity, autonomous vehicles, gaming, and both renewable energy and fossil fuels.  ARS also continues to favor those companies with strong managements, steady earnings growth, and strong dividend policies as we project interest rates to remain range-bound near historically low levels for the foreseeable future.   Furthermore, investors should be focused on U.S. small cap companies which are selling at strikingly attractive valuations relative to larger capitalization companies in the S&P 500.

This Outlook will address the forces that are creating this favorable environment for equities, the risks that investors should consider for the coming period, and the investment implications with examples of businesses that our research has identified as particularly attractive on an absolute and relative basis.  Current conditions suggest that investors must look past the headlines and seek to identify those select companies that are particularly well-positioned to benefit from the secular trends that will drive global growth in a world economy that is undergoing a massive transformation, and one that has little or no historical precedent.   

Why is the ARS view more positive than the headlines are leading investors to believe?

Due to the highly unusual political, economic, and social dynamics present in the world today, the markets have been experiencing elevated levels of volatility.  However, the recent market pullback has created interesting opportunities in companies that are selling for highly attractive valuations. A recent report from JPMorgan highlighted the divergences between and within the indices, particularly the Russell 3000 and the NASDAQ.  The report stated “that outside of the Big 10 stocks in the US, equity drawdowns and multiple de-ratings have been severe. Russell 3000 was down only -4% and Nasdaq Composite -7% from 12-month highs, however, the average drawdown for constituents in these indices was -28% and -38%, respectively.”  A drawdown is the decline in a stock’s price from its recent highs.  In addition to the wide spread of returns within the indices, what some investors seem to be missing is how the sequencing of policy action is impacting the economy and markets.  For example, the Federal Reserve and other central banks acted in March 2020 to lower interest rates and re-instituted their quantitative easing programs (which increased the money supply) adding massive liquidity into the global system.  This in turn fueled the rise in valuations across a variety of assets including stocks, real estate, collectibles, and cryptocurrency. As consumer net worth has increased, this has led to improved consumer confidence which fueled consumer spending. For corporations, the effects of the pandemic and the rise in corporate earnings and cash flows are now fueling the ability to increase capital expenditures to improve productivity. The strength of the economy during the pandemic period has resulted in record profits for many companies which will help drive continued earnings and dividend growth and investments in people and productivity. 

First, the massive monetary and fiscal stimulus that has been implemented in the past 18 months will continue to provide favorable conditions for the next 18-24 months even after the Federal Reserve completes its tapering and begins to raise short-term interest rates. 

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Second, the U.S. has experienced rapid growth in its money supply since March of 2020, and this has helped foster a surge in consumer net worth which, when combined with higher wages, supports and augments consumer spending and investment.   For perspective, the Federal Reserve’s balance sheet prior to the 2008 recession was around $975 billion and today is approximately $9 trillion, and other leading central banks also experienced similar increases in their balance sheets.  It is completely impractical for market participants to expect a dramatic reduction in central bank balance sheets anytime soon without engendering a huge global shock. 

Third, corporate profits will continue to hit record levels which will allow many to pay higher wages while investing in the productivity improvements necessary to increase earnings and remain competitive over the long term as they move to replace human labor with technology. 

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Fourth, ARS believes that supply chain problems will continue to ease in 2022 which should reduce inflationary pressures, while onshoring and reshoring will further bolster domestic economic growth.

Finally, the global economy will continue to adjust to the issues related to COVID and should begin to return to more normal pre-pandemic levels as vaccination rates/herd immunity allow for reopening to take hold, barring the development of additional variants.  It is the cumulative effect of all these forces that will drive positive returns for equity investors.  In 2022, investors should focus on those companies with the ability to increase revenues, those with pricing power, with the ability to invest in improving productivity, and who can effectively manage their overall wage costs.  Market participants should be careful about their country exposures as debt, currency and health issues are exacerbating the divergences between the handful of advanced nations that are growing in a more sustainable fashion than the rest of the world.  In 2022, the United States should continue to be the primary driver of global economic growth.

What are the risks in the system?

With the rapid spread of the Omicron variant and vaccination challenges in much of the world, the most obvious risks are geopolitical, inflation, debt levels and pandemic-related disruptions including global supply chains.  The Scowcroft Center for Strategy and Security recently released a report entitled “The Top 12 Risks and Opportunities for 2022”.  The areas highlighted in the report are as follows:

1. The lack of effective COVID-19 vaccination in developing countries triggers new variants that are potentially more contagious and lethal. The report states that African nations have vaccinated only about 12% of the population as developed nations have not stepped up to provide sufficient supplies of vaccines.

2. Russia attacks Ukraine. This represents one of the biggest threats to global stability next year as Russian President Putin has poked and prodded the European nations over Ukraine and energy security. Mr. Putin has stated that “Russia and Ukraine are one people – a single whole.” 

3. As China peaks, its economy sputters – sparking global disruptions. The Chinese economy hit several speed bumps last year.  President Xi is positioning for a third term and as the leader for life, but the Chinese economy is experiencing some growth pains as evidenced by the debt problems of Evergrande and other companies in the real estate sector which represents 29% of the Chinese economy.  The government made examples of several companies including Alibaba, Tencent, Didi, and many in the for-profit education sector under its “common prosperity” initiative to address inequality and reinforce the party’s control of the nation.

4. Afghanistan collapses and the U.S. cannot escape the consequences. This nation faces a humanitarian crisis as the U.N. projects over 23 million Afghans faced imminent starvation and its banking system is in an uncertain state as the international community struggles to navigate prohibitions on aiding the Taliban. 

5. Developing countries suffer more severe economic troubles and a rash of political instability. The pandemic has carved out large numbers of the global middle class with more than 131 million more people in poverty.  Adding to the problems are widening inequality which fosters more political instability, potentially more civil strife and forced migration.  The strength of the U.S. dollar places further strains on developing economies to service high U.S. dollar debts. 

6. Oil tops $100 a barrel. The clean energy transition is proving more difficult to effect, and fossil fuels will remain a larger portion of global energy supply for longer than hoped after a period of underinvestment.  The supply issues combined with stronger than anticipated demand pushes prices higher.  The U.S. and other developed nations are in the hands of OPEC and Russia’s willingness to accommodate growing demand for fossil fuels.

7. The world fails to meet its climate goals from the inconclusive Glasgow summit. Global carbon emissions have grown 60% since the 1997 Kyoto Protocol was signed.  The Glasgow summit did little to inspire confidence that the world will achieve the necessary levels of carbon emissions in timely fashion.

8. A bifurcated world emerges, but it’s not a repeat of the cold war with Russia. The report highlights the differences in China’s political and economic strengths relative to where Russia was in the cold war.  China’s global aspirations, importance as a growing consumer market, its long-term planning, overall economic strength, and position in the high-tech world are    just a few of the differences that need to be considered.

9. Food security worsens, propelled by COVID-19, climate change and conflict. The World Food Program estimates that 45 million people are on the brink of famine with higher food and transportation costs creating problems for families and organizations that provide support.

10. More countries slip from their current state into failure. While countries such as Syria, Yemen and Somalia are regularly at the top of the list of “very high risk” nations, these and other nations are moving closer to failed state status, if not there already, as drought, water scarcity, food crises, rising inequality, the pandemic and other healthcare issues are pushing nations to the brink.  Two major concerns stemming from this issue are the negative effects on others in the region and migration issues, which pose social, economic, and political issues for other nations, especially European ones.

11. Western efforts to revive the Iran Nuclear Deal fail. Iran is demanding that sanctions be lifted even as it continues to develop its nuclear program.  As involved nations continue to fight proxy wars and engage in cyber-attacks and other provocations, the probability for political missteps increases as does the potential for armed conflict.

12. U.S. democracy further decays. The report suggests that democracy will erode significantly next year in the U.S. which continues a trend that started a decade ago but was made crystal clear during the January 6^th attack on Congress, something most Americans never thought they would see in their nation.    

In addition to the 12 risks listed above, inflation has become a concern for U.S. policymakers for the first time in decades.  In addition to supply chain issues pushing costs up, wages have been rising in the past few quarters with some unions, including workers at Deere and Kellogg, having negotiated big wage gains with cost-of-living adjustments (COLA) being included.  These cost-of-living adjustments bear watching as ARS has previously written that our team was more concerned about the wage bill (the total compensation costs for the company) as opposed to wage rate (how much individual workers are paid per hour).  Our view was based on the belief that productivity improvements would more than offset the higher hourly wages for many firms, however, the recent union wins on COLA will require investors to be more company-specific about its impact.

These risks are, for the most part, well known and well understood.  However, that does not mean that investors should not take note and invest accordingly as these factors and new ones will determine the appropriate positioning for portfolios. Interestingly, the authors did not list inflation as a top twelve risk.  ARS believes that after a period of elevated inflationary pressures, the deflationary tendencies that existed prior to the pandemic will re-emerge in the second half of 2022.  The four deflationary forces are globalization, which has been more inflation-prone since the onset of the pandemic, technological advances, which accelerated during the pandemic, debt, which continues to rise globally, and demographics, which continue to worsen.  

What are the investment implications of the Outlook?

For all the risks described above and other uncertainties, there are exciting opportunities as the global economy is undergoing a long-term revolution of digitalization and electrification.  Technology has been advancing at such a rapid pace that we are witnessing a massive reorientation of economic activity which is being further augmented by the necessity to address climate change with advanced technology that did not exist only a few years ago.  The conditions heading into 2022 are positive for equity markets as we expect strong earnings next year and the highly accommodative monetary environment to continue at least through next year.  However, investors must be selective as the potential for equity returns will be driven by absolute earnings and revenue growth rather than expectations of future growth, as it has been since the onset of the pandemic.  Taken in the aggregate, stronger corporate earnings, low interest rates and the gradual easing of inflationary pressures should continue to create favorable conditions for equity returns in 2022. 

The recently passed infrastructure bill in conjunction with increases in consumer and corporate spending are creating positive longer-term investment opportunities in a number of areas.  The following are quotes from an industry leader describing the sector dynamics and an example of an unnamed company in that industry that highlights the unique combination of a high-growth company selling at an attractive valuation. 

Semiconductors and Capital Equipment

What the leaders are saying – “The secular tailwinds around semis, everybody knows what it is. We all get excited about 5G, AI, automotive, all of the things you’ve heard everybody talk about for the last, I don’t know, 6, 9 months, are growing. Semi content is growing on top of that. Capital intensity is growing… And when you look at that, it just sets up to be what I think is a great industry.”

Stock Opportunity – One leading semiconductor company has revenues of $27.7 billion, holds more than 48,000 patents, does business in 17 countries, and has 11 manufacturing sites. It will invest more than $150 billion in leading edge memory manufacturing and research and development over the next decade. Total revenues have risen more than 33% year over year.  Data center revenues were up more than 70% year over year. The company projects “that automotive and industrial will be the fastest growing memory and storage markets over the next 10 years. New EVs are becoming like a data center on wheels, and we are already seeing examples of 2022 model year EVs supporting Level 3 autonomous capability with over 140 gigabytes of DRAM and also examples with over 1 terabyte of NAND.”  This company currently sells for less than 9x earnings and generates free cash flow to raise dividends and buy back stock.  This is an unusual opportunity when companies with much less growth sell for much higher valuations.

Commodity Companies

What the leaders are saying – “Underlying all of this is the fundamental outlook for copper is incredibly favorable. Copper’s role in the economy and as the economy changes with global investments in infrastructure – I know we have a controversy here – but countries around the world are going to build infrastructure. Less developed countries are going to develop. The world is getting increasingly focused on electrification with modern technology, 5G, and artificial intelligence. And then a new major element that people are talking about and recognizing now, for demand that’s coming, it’s not here in real significance now, is all the investments that people are going to be making to reduce carbon. And across the board, those investments are – result in significant demands for copper. And then you’ve got – and we’ll talk about this more, the commodity really supported by supply factors.”

Stock Opportunity – One leading company is selling for 10x earnings, an estimated 7.5x cash flow from operations with 27% return on capital and 42% return on equity.  The company has operating margins of 44% and a net profit margin of 25% with strong cash flows.  The company’s earnings and dividends are expected to grow double digits over the next few years.

Broadband Industry

What the leaders are saying – “As expected, we continue to see very high demand for data by our customers. During the quarter, non-video Internet customers used over 600 gigabytes per month, stable as of late, but more than 30% higher than pre-pandemic levels.  And today, close to 20% of our nonvideo Internet customers use a terabyte or more of data per month.”

Stock Opportunity – One leading company is selling for 12x forward cash earnings while growing earnings at 15% per year and spending all of free cash flow to buy back stock.  If the stock price were not to rise between now and 2025, the company could buy back 35% of shares outstanding and generate $110 in cash earnings per share on a $650 stock or 6x cash EPS. More realistically, should the multiple stay constant, the stock price should increase by 25-30%/year, in line with the free cash flow per share growth.

In a world that is rapidly changing, investors must recognize and appreciate the magnitude of the changes that will impact companies for many years.  It is easy to get thrown off course from a long-term investment plan by short-term factors, so be careful not to confuse speculation with investing.  Businesses that are proactively investing to redefine themselves will have a chance to compete,while those that do not will be left behind. To protect and build capital in this environment, investors should focus on the primary beneficiaries of critical secular themes in this period of significant disruption and avoid the companies that are being disrupted.  These secular themes include the continuation of technological advances and the powerful demographic shifts involving aging, automation, and inequality. Climate change has become a more actionable investment theme across all equity strategies. These themes will have profound implications for investment strategy.  Successful investing in the coming year will require a high level of conviction and insight at a time when many aspects of our lives could be experiencing significant change. 

We wish our clients and readers a happy, healthy and fulfilling New Year.

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.

While short-term investors are concerned about the political dysfunction in Washington D.C., the Delta variant slowing Gross Domestic Product (GDP) growth, the dramatic remake of the Chinese economy, ongoing supply chain disruptions, rising debt levels, and inflationary pressures, we believe they have been somewhat discounted by the markets, and there is a much bigger story to be told.  The American economy is using innovation, entrepreneurialism, and some thoughtful pro-growth government initiatives to position itself for the post-pandemic world.  Last month some of our team visited six Midwest cities and met with entrepreneurs, government officials, business, and community leaders as well as university students.  We walked away feeling excited about the potential for the United States in the post-pandemic period from both a market and economic perspective. ARS believes that investors should take advantage of the aforementioned fears to position their portfolios for the opportunities that lie ahead.

Excessive focus on near-term concerns often distracts from the sub-set of companies that stand to benefit from the current environment, especially those experiencing price inelasticity of demand for their products.  An important fundamental concept for investors to understand in the coming period, price inelasticity reflects goods that typically tend to have few substitutes, few competitors and are considered necessities by users.  Given the current supply-chain woes and inflationary pressures, the ability of companies to offset any increase in production costs will enable them to increase earnings and cash flow from operations and should be worth more over time.  Among the areas of investment opportunity where there is inelastic demand are semiconductor chips and equipment, cloud providers, select commodities producers including steel, rare earth materials, copper and even some fossil fuel producers as each should continue to see strong pricing power, demand, and earnings growth.  This point cannot be over-emphasized.    

We continue to view the United States as the best market on a risk/reward basis due in large part to our nation’s innovative and entrepreneurial spirit despite recent hang-ups in D.C. Larger amounts of money than ever before are being invested in the transformation of the economy.  This will continue to generate greater productivity, record earning power and greater tax revenues for the United States over time and will also reduce inflationary pressures which have developed as a consequence of the pandemic.  Because the profound transformations occurring will continue to be the defining themes for the markets and the economy, positive investment returns should be a consequence of the focus on the digital, monetary, fiscal, healthcare and climate transformations that support productivity improvements and rising living standards which will offset the potential for long-term inflation from taking hold.  Under present conditions, we define the companies for our research focus that will be among the specific beneficiaries of the forces we describe below. 

In a world awash in liquidity, asset values will continue to benefit from accommodative monetary policy initiatives and an interest rate structure that has never been so low. Corporations have unit labor costs rising at the same time the marginal cost of capital is at such low rates allowing for technology substitutions to be executed to lower costs over time.  We are investing in greater efficiencies in the economy.  The initial pandemic lockdowns and the subsequent challenges in reopening the global economy have led to significant pricing pressures in the near term, but we anticipate that the logistics logjam will clear suddenly and that these short-term pricing pressures will evaporate.  While we are experiencing short-term inflationary pressures, investors should not assume that these pressures must lead to a longer-term inflation problem.  Our research continues to identify companies with the potential to increase earnings, assets, and cash flows against this backdrop.  There must be a particular emphasis on those companies driving the digital transformation as technology producers or users require these productivity improvements to thrive in the post-pandemic world.

Remembering What Makes the United States Special

Americans live in an amazing country, one that is flawed as our elected officials in Washington continue to remind us, but also one where people can accomplish things through innovation and hard work that were once unimaginable as demonstrated by the creation of two highly effective vaccines in less than 18 months.  As the chart below from Zbigniew Brzezinski’s 2003 book Strategic Vision highlights, the United States has its share of short comings, but it is a highly resilient and adaptable nation with some unique strengths that we need to continue to build on.  We have a system based on the rule of law with the deepest and most mature capital markets system in the world.  It is this capital market system that funds the growth and innovation that continues to raise living standards for so many.  While we share similar demographic challenges with many other leading nations, the United States remains an attractive destination for many immigrants looking to better their lives.  If we do not squander the opportunity to attract and retain highly skilled talent from around the world, then we will continue to be one of, if not the leading economic powers for many years to come.

Table 1. America’s Balance Sheet

To accomplish this, the United States must remain competitive from a tax, infrastructure, immigration, and business-friendly perspective as well as maintain the dollar’s reserve currency status.  Yes, we must address inequality, climate change, and other key issues, but we need smart policies that bring people together rather than divide them.  Our nation is at its best when we come together to help each other as we did after the 9/11 attacks and not when we are divided as we are today.  We need true leaders and principled officials focused on the best outcome for our nation, rather than ideologues.  The strength of the United States going forward will be determined in large part by our overall economic strength, our ability to remain technology and innovation leaders, to use our democratic appeal and practical immigration policies to offset our demographic challenges, and by our ability to put partisanship aside for the greater good as the challenges are significant, but so is our ability to solve them.    

Exciting Stories from the American Midwest

As mentioned above, we visited Chicago, Detroit, Ann Arbor, Cincinnati, Columbus, and Cleveland in September and met with senior government officials, business leaders, entrepreneurs, students, and other investors.   The trip served as an important reminder of what is really going on in our states and cities and told a story of innovation, entrepreneurial spirit and how government can plan beyond an election cycle to put a state or city on track for sustainable growth.   There are great success stories in each city: however, for the purpose of this Outlook, we will focus on an organization called JobsOhio, and how two Ohio-based companies are driving innovation – Cintrifuse in Cincinnati and Nottingham Spirk in Cleveland.   Anyone meeting leaders at JobsOhio, Cintrifuse and Nottingham Spirk could not help but come away with a completely different perspective on the state of our nation than one would get from the daily news headlines.  These leaders see problems as opportunities waiting for a solution.

JobsOhio

In the aftermath of the Great Financial Crisis, Ohio was faced with double-digit unemployment and had lost 400,000 jobs.  Leaders knew something had to be done as businesses were leaving the state which then ranked 48^th in its prospects for growth and job creation.  Then in 2011, leadership decided to launch JobsOhio, a private nonprofit corporation designed to drive job creation and new capital investment in Ohio through business attraction, retention, and expansion efforts.  Unlike other economic development organizations, JobsOhio has a unique funding model in that it uses no tax dollars or other public dollars to support it.  Rather it uses revenues from the JobsOhio Beverage System (JOBS) to which it leased the rights for 25 years.  The organization’s design enables it to make the kind of long-term investments needed to solve complex challenges such as supporting the development of new cutting-edge industries and businesses to serve new large total addressable markets.  JobsOhio focuses on supporting high- value industries including advanced manufacturing, aerospace and aviation, automotive, autonomous mobility, energy and chemicals, financial services, food and agribusiness, healthcare, logistics and distribution, military, and technology.   Ironically, this list of industries closely matches the “strategically vital” industries the Chinese government highlighted in its “Made in China 2025” 5-year plan.  Because of the funding source, industry focus and thoughtful design, JobsOhio should be closely looked at by other states as a model to attract and retain businesses and keep young talent at home.  Corporate America is taking notice as companies including Amgen, AWS, First Solar, Google, Peloton, Sarepta Therapeutics, Ultium Cells, and Upstart, among others, have all made recent major investments in Ohio.

Nottingham Spirk and Cintrifuse

In Cleveland, a visit to the beautiful 60,000 square foot facility of the Nottingham Spirk Innovation Center In Cleveland, a visit to the beautiful 60,000 square foot facility of the Nottingham Spirk Innovation Center highlighted a firm at the cutting edge of disruptive innovation and one that is inventing and improving many of the healthcare and consumer products we use every day.  Nottingham Spirk is an open innovation and product development firm that was established in 1972.  It uses the latest technologies such as 3D printing to design, test and develop its products, and its approach has significantly reduced the time and cost to bring new products to market.  Nottingham Spirk uses vertical integration in its facility where the entire product development cycle – from focus group facilitation to product design and mechanical engineering – is executed. Cincinnati-based Cintrifuse has one goal which is “to make Greater Cincinnati the number one tech start-up hub in the Midwest and among the most attractive innovation hubs in our nation.” Cintrifuse’s approach leverages its venture fund to access cutting edge technologies, generate strong financial returns and create investment pools for entrepreneurs; to connect the region’s largest corporations with the innovations and innovators they need to stay ahead of their peers; and they work with entrepreneurs to start new businesses and connect them with leading corporations in the area.  According to its website, Cintrifuse has over 600 startups in the pipeline half of which are attracting seed and later stage investments. 

By partnering with firms like JobsOhio, Nottingham Spirk and Cintrifuse, companies have access to unique industry insights, design, and manufacturing expertise as well as marketing and branding support.  While we are highlighting just these initiatives in Ohio, there are many other organizations like these around the country including Ben Franklin Technologies of NE Pennsylvania which has helped launch many companies, create new products and markets, and to develop cutting-edge innovations and create jobs.  Finally, we would recommend spending some time listening to college students discuss their hopes, dreams, and concerns if you want an optimistic view of the future as our nation turns out some of the world’s finest students.  When we combine strong leadership and innovation with talent and supportive government programs and policies, then there is virtually nothing that the American economic engine cannot achieBy partnering with firms like JobsOhio, Nottingham Spirk and Cintrifuse, companies have access to unique industry insights, design, and manufacturing expertise as well as marketing and branding support.  While we are highlighting just these initiatives in Ohio, there are many other organizations like these around the country including Ben Franklin Technologies of NE Pennsylvania which has helped launch many companies, create new products and markets, and to develop cutting-edge innovations and create jobs.  Finally, we would recommend spending some time listening to college students discuss their hopes, dreams, and concerns if you want an optimistic view of the future as our nation turns out some of the world’s finest students.  When we combine strong leadership and innovation with talent and supportive government programs and policies, then there is virtually nothing that the American economic engine cannot achieve.  

The Climate Transformation and the Challenge of Getting There

“The climate crisis is real, and energy transition is a necessity, and we must accelerate it — but it’s not a flick of a switch.  If we want to solve climate change, we need to do so while at the same time insulating the global economy from extreme energy shocks.”

– Amos Hochstein, U.S.’s top energy diplomat

It is easy to get broad support for reducing the world’s dependence on fossil fuels but wanting to effect a transition and actually doing so are two very different things.  This is especially true when we are still in the early stages of developing the green energy industry.  Cost and infrastructure remain significant hurdles.  It has been estimated that even if all the Paris Accord pledges were met, oil and gas would still be 46% of the world’s energy supply in 2040.  It seems that climate activists wanted to address years of neglect in a shorter period than is feasible, and we are currently experiencing energy issues in the United Kingdom, Europe, China, and India just to name a few countries.  For the United States, the green transition comes just a few years after the U.S. achieved energy independence once again.  As opposed to China which relies on imports of oil and natural gas for much of its energy needs and will be slower than other leading nations to make the transition; and the Chinese are also increasing their coal production this year as they are experiencing severe power outages.  As shown in Chart 1, fossil fuels will be key components of the energy supply for the foreseeable future.  Rather than vilify the industry, green energy proponents should be focusing on working to ensure an effective transition.  In fact, the major oil companies are diverting tens of billions of dollars of their excess cash flows from high-cost exploration and development to research into cleaner energy technologies.  From a geopolitical perspective, the rush to make the climate transition has empowered Russia and OPEC to be the price setters as the U.S. producers will not invest in high-cost exploration and development.  This has been the single most important determinant of the share prices of U.S. energy producers this year in the S&P 500.

Chart 1. Projected Growth in Energy Demand by Fuel Type – 2020-2045

In our view, there are three key considerations regarding the energy transition.  The first is that the power grid systems will need to be upgraded, hardened, and modernized to deal with the increased demand, extreme climate events, and new energy use patterns.  The second is that oil companies, in response to public pressure and shareholder activists, have been reducing their capital expenditure programs and drilling rig counts which are exacerbating a supply/demand imbalance that has led to higher-than-expected oil and gas prices.  The third consideration is that success in expanding the use of green energy, especially for electric vehicles, will increase electricity consumption and timing of its usage.  This begs the question as to how we produce that electricity and store and transport new renewable energy?  Perhaps the most important question is how do we affect the transition without damaging growth prospects and fueling inflationary pressures?  And how do we do it with an aging and antiquated grid system in the United States?  Climate activists will need to embrace one challenging concept: the green energy transition will be powered in large part by fossil fuels which are experiencing reduced investment spending and lack of support from equity and bond investors.  At a less than 3% weight in the S&P 500, the energy sector is one that will likely see its weighting increase in the coming period as it did back in the late 1970’s and the early 2000’s when each time its weighting more than doubled. One must wonder if the power problems being experienced around the world today are a precursor to our future energy transition challenges.  After the pandemic, the climate transformation may be the most important scientific and political challenge for the rest of the century.

Investment Implications

Since the onset of the pandemic, market participants have been faced with an investing environment that is simply unlike any other mainly due to the unique character of the health situation, inflationary/deflationary forces, and technological advances.  This is not an economy we’ve ever seen.  While rising costs have led many investors to have a stronger inflationary bias, the view that more inflation is here to stay is not supported by investment activities occurring to substitute capital for labor (robotics and artificial intelligence), advances in manufacturing efficiency, and mergers and acquisition transactions to promote greater business activity and lower production costs. Infrastructure spending raises productivity and saves costs that would otherwise occur by avoiding needed repairs, restoration, and damage from climate change.  Additionally, modernization of old infrastructure which yields better employment outcomes and higher living standards, by definition, is needed by the United States to better compete globally.  Many of the inflationary concerns seem to ignore secular deflationary pressures that are a characteristic of the hidden forces at work.  These include the demographic pressures from an ageing work force, overall debt levels in the system, lower costs thru technology improvements and breakthroughs, and communication advances.  Solving the short-term supply chain and logistic bottlenecks will rapidly lower inflation expectations.

With respect to manufacturing, just-in-time inventory management had been considered to be an ideal way to manage manufacturing processes for many years.  However, the recent experience of U.S. businesses running with low inventory levels has come to damage the economy, and therefore has been an impediment to lowering costs.  Present economic conditions are accelerating the reshoring and onshoring of critical manufacturing capabilities drawing capital back from overseas as well as utilizing excess liquidity in the United States.  Because the economy is awash in liquidity, there is no shortage of investment capital to fund critical initiatives.  In the 3rd quarter alone, corporations completed a record $1.6 trillion in mergers and acquisitions transactions globally.  Industries are rapidly being digitized.  This yields higher living standards, new products, large new total addressable markets, and ways of doing business that had never existed before.  We expect this economy to continue to produce outsized breakthroughs in products and services.  Irrespective of the timing and amount of proposed fiscal policy initiatives, monetary policy must remain accommodative with interest rates needing to be kept low for longer even after the tapering of quantitative easing begins later this year or early next year.

In addition to the above, there are several key investment considerations which investors should incorporate into their investment strategy that we address below:

Price inelasticity – In the current environment, market participants should focus on those companies that are well-positioned to benefit from price inelasticity. These include companies involved with the infrastructure buildout; producers of copper, iron ore, steel, and rare earths; technology companies including cloud service providers; businesses involved in the green energy transition; and certain defense companies to name a few. Importantly, these companies should be strong market performers in the coming quarters irrespective of the economic cycle.  

The Character of the Inflation Cycle – Perhaps the most widely debated topic at present is the state of inflation around the world as to whether or not it will be persistent or transitory.  Our expectation is a little of both with inflation more persistent for longer than we originally anticipated and then transitory with the surprise being a possible faster easing of supply chain problems than the market currently anticipates which would ease inflationary pressures quickly in certain areas.  While we see this as positive for the U.S., many emerging market economies are experiencing greater inflation pressures and their currencies will be more negatively impacted as will those nations dependent on imports of high-cost fossil fuels during the green transition.

Opportunity to Improve the State of Health Care – Unlike past business cycles, the United States needs a remake of its healthcare system, and we need to use technology to make healthcare more accessible, affordable, and adaptable to changing conditions such as future pandemics. The use of telemedicine, artificial intelligence, and data management to make our healthcare system more productive and efficient will help change economic output for the better, improve workforce demographics allowing workers to work more productively and potentially have longer careers as life expectancies continue to rise; and the combination of these should lead to increased future earnings for workers.  We also need to recognize that the pandemic requires a global solution as one recent report indicated that 96% of people in low-income countries are still unvaccinated which will lead to highly divergent economic outcomes with potentially large geopolitical considerations.  This is important because many leading scientists expect that pandemics may be more frequent in the future, so having a plan that would deliver better outcomes will benefit all. We continue to participate or take investment advantages of the convergence of technology with legacy industries through our cloud and software exposures.

Record Levels of Excess Cash Flows – The private sector has never had such high levels of cash flows available for investment and distribution to shareholders.  This will allow companies to raise wages, invest to improve productivity, to reshape their businesses to focus on high-return, high-growth business lines through mergers and acquisitions, but also allow for greater returns to shareholders in the form of dividends and buybacks.

Disintermediation of Businesses – Another characteristic of this environment is the disintermediation of businesses by new non-traditional competitors much of which is being driven by new technologies which companies are adapting at a much faster rate than in the pre-pandemic period. In fact, McKinsey recently reported that in 2020 “half of the North American and European businesses surveyed had increased their investments in new technologies and 75% planned to accelerate these investments between 2020-2024.”  Another interesting note from this report was that “companies digitized activities 20-25 times faster than they had previously thought possible.”  Technologies have the ability to disintermediate many businesses in the banking, insurance, and housing industries to name a few, and much of this disruption will be highly damaging to incumbents.  By following the capital expenditure plans of companies, investors can gain some insight into the future risks and opportunities of businesses.

Politics and Investing – Some politicians are viewing the pandemic as a chance to fix all historic ills and inequities which is admirable but needs to be matched with realistic and sound policies backed by good economic thinking.  From antitrust cases to tax and vaccination policies, there are major issues that require strong, thoughtful leadership focused on the best outcomes and not the most short-term politically expedient ones.  Another political problem is that the approach of governments to address climate change is actually helping the fossil fuel industry, but more concerning is that it is helping bad-actor, fossil fuel producing states such as Russia and Iran to benefit from higher prices and demand for oil and natural gas, including those products sold on the black market.    

The diverse needs of the nations and economies will favor those companies that (i) can lower costs and increase productivity, (ii) have strong global franchises with meaningful barriers to entry, (iii) benefit from resource scarcity, and (iv) have rising demand.  In our view, the best investment approach will be to focus on the intermediate beneficiaries of the conditions described in this outlook.  When the pandemic first started, we wrote that generally things would get worse before they would get better, and they did. Then conditions worsened again with each new wave of the virus.  This volatility has created negativity in the markets with many investors fearing a major pullback.  While that is always a consideration, we believe that investors will be well rewarded by taking a longer-term view, balancing return expectations with realistic risk assessments and taking a somewhat contrarian view to find uncommon values in a market with big divergences between the corporate haves and have-nots.  Fortunately, the next two decades should bring about more technology disruption than even occurred during the past two decades creating dramatic and timely improvements in productivity, health outcomes, economic growth, and accordingly improved living standards.  The journey is always a little bumpy, but patient and opportunistic investors will be well rewarded.

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. 

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 economic environment of the United States has never existed before.  Current conditions are a manifestation of the distortions in the economy and the markets brought about by the pandemic and subsequent policy responses.  Today’s challenge in building and protecting capital requires investors to view the world differently than in past cycles because current investment conditions are truly unique.  The transformation of the economy is being reflected in the equity market’s shift to the industries and companies benefiting from a broad reopening and expansion of economic activity and away from the beneficiaries of the pandemic. The former concentration of capital came at the expense of a broad number of companies and industries which could not do well during a stay-at-home lifestyle and a remote-work environment.  Subsequently, many previously neglected areas have taken on a new investment life, some of which we see as cyclical winners and some as secular winners.  We continue to believe that many are underappreciating the magnitude of the rapid digitalization of the $22 trillion U.S. economy which will continue to occur over many years and have material societal benefits.  

While there are critical social, political, and economic challenges that global leaders continue to struggle to address, the near-term headlines often serve as a distraction from what matters most from an investment perspective which is the outlook for corporate earnings, inflation, and interest rates that serve as the basis for equity valuations.  Even with temporary, near-term inflationary pressures building, corporate earnings should continue to rise as the economy recovers, and interest rates and inflation rates remain historically low.  These conditions are favorable for the companies that can raise prices to increase earnings as opposed to those companies whose earnings will be negatively impacted by their inability to absorb higher costs and pass on price increases.  Some argue that innovation and productivity will continue to improve overall economic activity and suppress inflation pressures, while others argue that proposed tax increases, growing deficits, and rising inflationary pressures will slow economic activity and depress stock market valuations.  From our perspective, the inflationary surge is a function of a short-term mismatch between consumer demand and production levels.  The unprecedented monetary and fiscal policy responses to the virus are increasing the debate about how governments and markets should think about debt, deficits, and inflation.  Lost in the debates is the fact that the U.S. economy and corporate earnings should remain strong for the next few years, notwithstanding episodes of volatility along the way.

Given this unique nature of the post-pandemic period, investors should remain focused on the businesses that are the primary beneficiaries of the secular transformations we have written about in recent Outlooks, especially those benefiting from the ongoing digital transformation which is still in the early innings.  As this transformation further develops, it should drive the innovation and productivity growth needed to foster a more sustainable and balanced economy.  Further augmenting these trends is the real concern to re-shore and rebalance supply chains away from geographic and politically challenged regions.  As the cyclical inflationary pressures are absorbed by the global system, long-term inflation should remain muted allowing central banks to keep rates lower for longer, but not likely as low as currently projected by the Fed.  This, in turn, should support some of the expansive fiscal policy initiatives needed to address climate, equality, health, and other long-term issues that are priorities for governments.  In contrast to the post-WWII boom which was also characterized by pent-up demand and savings for products that had existed, the post-pandemic boom will also be characterized by products and services that had never existed and are creating new, large total addressable markets.  This Outlook will lay out the case for near-term inflation rising and then moderating, will focus on the growth of the digital economy and how innovation and productivity will impact the overall economic prospects for the U.S. and global economies, and then focus on the investment opportunities that will be at the forefront for investors over the next 12 months and beyond. 

Understanding the Short-Term and Longer-Term Outlook for Inflation

One of the most widely debated topics among investors involves the outlook for inflation as the battle lines are being drawn between a growing number of market participants and the Federal Reserve on whether the recent rise in inflation is becoming more permanently embedded in the system or is transitory in nature.  As shown in Chart 1, inflation has averaged 3.10% from 1913 to 2020, but has been in a downward trend since the 1970s and was crushed by then Fed Chair Paul Volker beginning in 1981.  For some time, the ARS team has held the view that four secular forces – technology advances, globalization, debt levels, and demographics – were creating a more deflation-prone economy.  Three of the four forces are still intact with trade tensions and the resulting supply-chain disruptions having reversed some of the positive, deflationary tendencies stemming from globalization.  However, as indicated in Chart 2, the market expects inflation to rise from last year’s depressed levels, but forecasts inflation rates rising to around 2.4% in five years.  We continue to side with Treasury Secretary Janet Yellen and Federal Reserve Chair Jay Powell in their beliefs that recent upward pressure on inflation rates will be transitory in nature.  The basis for our view is that pent-up consumer demand and severely drawn down inventories, which are causing price hikes, will be satisfied and short-term production shortfalls due to the pandemic are in the process of being corrected.   Because the substantial level of shortfalls is so large, it could take longer to be corrected but nevertheless equilibrium will be restored, and inflationary pressures will abate.

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The cyclical forces pushing up inflation involve supply-chain disruptions, labor shortages, skills mismatches between job openings and available talent, commodity price pressures, and pent-up demand alongside monetary and fiscal stimulus.  Unlike the 1970s inflationary period where cost-of-living wage increases were contractual and administered prices were more the norm, the current period is very different as companies can more easily substitute capital for labor to manage the rise in compensation costs, while new and non-traditional competitors make passing on price increases far more difficult for many companies.  One of the key factors that will determine whether wage inflation will be more permanent or transitory is the wage bill.  The wage bill is the total amount of wage a company or industry pays annually while the wage rate is the unit cost of an hour of work.  There has been a great deal of debate on raising the minimum wage rate, but wage rates matter less to companies than their total costs of labor which is their wage bill.   If wage rates rise, but the wage bill does not rise proportionately then the inflation concerns will prove to be misplaced.  The companies that thrive in the upcoming period will be the ones that are able to grow their revenues and earnings using innovation and productivity improvements to keep the wage bill from impacting profitability.   

Investors should keep in mind that the Federal Reserve has been trying to stimulate the economy since the Great Financial Crisis in 2008 using quantitative easing (QE or the printing of money) and low interest rates to support its dual mandate of price stability and maximum employment levels. To date, the economy has struggled to reach the 2% inflation target set out by the Fed but was on track for its maximum employment goals prior to the pandemic which has introduced renewed concerns about the impact of longer-term economic scarring for segments of the economy. Chart 2 presents two measures of expected inflation followed by the Federal Reserve which are 10-year breakeven inflation rate and the 5-year, 5-year forward inflation expectation rate.  While each indicates that inflation pressures are on the rise, they are not inconsistent with the Federal Reserve’s stated goal of letting inflation run higher to allow the economy to return to more appropriate levels of price stability and employment.  It is understandable for market participants to react to headlines about inflation pressures rising as the cost for items like lumber, homes, used cars, and commodities rise sharply on the re-opening of the economy.  However, investors should expect some of these pressures to dissipate after the initial wave of pent-up demand is met.  Importantly from a market perspective, the digital transformation should re-emerge as the more dominant theme after the economy adjusts to the distortions in inflation measures stemming from the collapse in prices experienced in the early stages of the pandemic in the second quarter of 2020. 

The Growth of the Digital Economy – Innovation and Productivity

If the politicians in Washington are to effectively manage the nation through its social, economic, and political challenges, they will need to combine smart bi-partisan leadership and clear priorities with a commitment to supporting the continued growth of the digital economy.  Since the Great Financial Crisis, the U.S. digital economy’s share of gross domestic product (GDP) has been on the rise and is reshaping business and daily lives in America as shown Chart 3. The COVID-19 pandemic has accelerated the digital economy’s growth rates and increased its share of GDP.  From 2006-2018, the overall economy grew 1.7% annually, while the digital economy grew 6.8% annually as shown in Chart 4. The digital economy grew at an average annual rate of more than 3 times that of the overall economy.  For that same period, business-to-consumer e-commerce grew over 12% a year on average and cloud services also grew very strongly at 8.5%.  Bear in mind that these were pre-pandemic figures, and these growth rates have been exceeded in the past twelve months. 

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As Microsoft’s CEO Satya Nadella recently stated, “The next decade of economic performance for every business will be defined by the speed of their digital transformation.”  This means that a greater share of capital expenditures will be dedicated to the rapid advancement of technological breakthroughs to create new products, new markets, new ways of solving health issues, lower costs, increase competitiveness, and gain market share.  But not all companies and industries will benefit equally.  The healthcare, manufacturing, and financial services sectors stand to be among the primary beneficiaries.  The enormity of this century’s transformation is exemplified by the rapidity of the COVID-19 vaccine development which took a matter of days to analyze the code necessary to create the vaccines.  The use of A.I. (artificial intelligence) to successfully handle the exponential growth of data generation has led to a digital transformation to create value from the enormous volumes of data.  This is leading to an explosion of new drugs, therapies, and the prospect of revolutionizing medicine.  In turn, the prospect of improving healthcare outcomes enabling longer and better lives leading to greater productivity and cost savings with big implications for government finance as healthcare cost represents approximately 17% of GDP.  As the digital economy continues to become a larger part of the overall economy, it will bring with it both significant opportunities and challenges for policymakers, populations, business leaders, and investors.

The Power of the Digital Economy to Increase Output and Lower Costs

The expansion of the digital economy comes at a perfect time for the United States and other nations that are struggling to deal with the aftermath of two of the most disruptive economic events in recent history – the Great Financial Crisis and the COVID-19 pandemic, which occurred less than 15 years apart.  Economies around the world are battling a lack of sustainable growth, rising deficits, high debt levels, growing frustration, and a lack of trust between populations and their governments. Technological advances will allow economies to be more efficient by increasing productive capacity.  As shown in Charts 5 and 6, the digital economy has grown at a much higher rate than the overall economy, while at the same time technology is lowering prices. Chart 5 compares real gross output, which is the annual measure of total economic activity in the production of goods and services between the digital and overall economy.  Chart 6 compares the real gross price index of the digital to the overall economy.  Real gross price index measures inflation in the prices of goods and services in the U.S.  In summary, these two charts show that the digital economy is becoming a larger percent of the economy and lowering prices in the process.  As stated in past Outlooks, productivity is the antidote to inflation, and these charts illustrate this concept clearly.

For the United States’ economy to realize its potential, the government and corporations must commit to investing in the digital transformation at higher levels than ever before as aggressive global competition for technology leadership grows in importance. In 2020, China’s digital economy was estimated to be 7.8% of its GDP with a target of reaching 10% of GDP by 2025.  China is also becoming a leader in patents issued across the key areas of technology including artificial intelligence, drones, cybersecurity, and quantum computing.   For the United States to continue to be a technology leader, it needs to invest in infrastructure for 5G, research and development for innovation, up-skilling and re-skilling existing workers, and better educating our youth for the digital age.  As many leading nations are experiencing record low fertility rates and rapidly aging populations, the digital transformation can partially offset the demographic challenges these countries are facing.    

Investment Implications

It is in a time like this that the best investment opportunities are often missed because of excessive focus on the heightened uncertainty stemming from the multitude of problems present in the system, and the fact that there is no historical precedent for the world we are living in today.  The global system is undergoing massive transformations due the unusual political, social, economic and climate conditions, and the magnitude of the problems has required the use of unconventional monetary and fiscal policies by governments.  The fallout from global trade tensions, population displacements from failed states, and the COVID-19 pandemic has forced governments and businesses to adapt to changing conditions and societal tensions.  For the United States government, it forces the need to promote changes in infrastructure, immigration, and education policies.  It is also forcing businesses to come to grips with conditions that they have not previously had to prioritize or even consider including equality, diversity, and opportunity.  At the same time, it is requiring all businesses to accelerate the pace of innovation to improve their productivity to protect and grow market share and transition to this new post-pandemic world.  Fortunately, from a purely financial point of view, the wherewithal to deal with the many needs and opportunities is available. As one need leads to another, and to keep up with the emerging requirements, significant structural changes to the educational system and immigration policies are required to produce the necessary labor force to deal with the 21st century needs.  New and dangerous competitive challenges for democratic states from autocracies, which also possess advanced technologies, is now manifest in the area of cybersecurity.   When one connects the dots, new investment opportunities present themselves to reveal the potential for large addressable markets.

Cybersecurity/space – This area has come to the forefront of concerns as the recent Colonial Pipeline ransomware attack has now raised additional national security concerns across the entire United States infrastructure.  To protect the United States, national security has become the principal concern as ransomware is exacting an intolerable and dangerous toll on the national well-being.  Correcting this problem will also require major upgrades and overhauls of both the national grid and our communications networks including GPS systems – long a need and now no longer postponable.  Microsoft also recently announced that the Russian hacking group behind last year’s SolarWinds cyber-attack is at it again as it is targeting government agencies, think tanks, consultants, and non-governmental organizations.  This also involves a shift and an increase in our national defense budget and goes beyond political posturing.

Essential Materials for Infrastructure and Climate – A new level of increased demand for essential and basic raw materials has emerged.  Many materials are critical for addressing the United States’ and the world’s climate transformation, particularly for wind, solar, and the efficient transition from fossil fuels. And because we are competing with Europe and other regions for these resources, this creates even greater demand which will require additional investment spending to bring supply into better balance.  Steel, copper, and rare earth materials are among the areas on which we are focusing. The trade tensions between the United States and China are forcing companies to consider reshoring and onshoring to ensure dependable supplies of the inputs needed to compete, particularly in areas where future demand is certain to outstrip the previous supply capabilities of the global system.

Semiconductor technology – Semiconductor technology is the lifeblood of technological advancement for everything from smartphones, electric vehicles, robotics, medical research, wireless spectrum, and broadband to datacenters and gaming.  However, the combination of the pandemic and trade tensions has created supply shortages that will persist for some time.  Few countries will be able to compete effectively on the world stage without a dependable and resilient domestic supply of the chips to support their digital transformations. It is important to note that bringing supply and demand into balance can take 2-3 years to build additional manufacturing capacity.  To that end, the Senate is considering a bi-partisan bill that would authorize over $500 billion to compete with China in the race for technology supremacy. The bill includes over $50 billion for domestic semiconductor production and $100 billion for research into artificial intelligence and machine learning, robotics, high-performance computing, and other advanced technologies.  This follows previous announcements by Taiwan Semiconductor and Samsung to build facilities to produce state-of-the-art facilities in Texas and Arizona with each facility costing upwards of $10-15 billion dollars.  China is a formidable competitor in this area as it has become the leading nation in terms of patents in the most important areas supporting advanced technologies.

Healthcare – The use of A.I. to successfully handle the exponential growth of data generation has led to a digital transformation to create value from enormous volumes of data. This is leading to an explosion of new drugs, therapies, and the prospect of revolutionizing medicine. The benefits of digitalization are being realized in healthcare, and the pandemic illustrated this in two key areas – the dramatic growth of telemedicine and the research and development of new vaccines and medicines.  Similar to the ability of companies to transition their employees to remote work, doctors were able to transition many patients to telemedicine visits instead of office visits.  In the pre-pandemic period, it took approximately 10 years to bring a new drug to market, and the industry was able to bring 2-4 vaccines to the market in less than 1 year.  These are just two examples of opportunities to improve the quality of healthcare and to lower costs which will be even more important given the demographic challenges associated with the longer lifespans of a rapidly aging global population. The prospect of better healthcare enabling longer and better lives should lead to greater productivity with big implications for U.S. government finance.

High Quality Dividend Payers – High quality companies with defined dividend policies represent superior opportunities for investors who focus on income. For investors, the bond market will represent a poor asset class in a rising rate environment.  Investors holding U.S. Treasury bonds with a 10-year maturity yielding 1.6% could lose nearly 8% of their principal value in the event of a 1% increase in rates.   Conversely, equity investors can find many high-quality companies with dividend yields well in excess of Treasury rates and with both the reality and the prospect of increasing dividends.

The conditions for capital appreciation are noteworthy in stocks of all market capitalizations and in particular in smaller capitalization companies. We continue to focus on the investment opportunities which grow out these and our other observations of what changes and opportunities are presenting themselves in the markets. We anticipate companies will redefine themselves 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 two years, periods of market volatility should be viewed both as the pause that refreshes and an opportunity to add to investments at more attractive prices. This is particularly true for companies which have significantly increased their revenues and earnings and continue to have bright prospects for significant growth over the intermediate term.  Because the economy is progressing so rapidly, the companies with embedded advantages will continue to fetch the best market valuations as a result of great investor interest.  To do so, they must innovate and embrace the latest technologies, while assuring themselves of the needed elements to remain at the forefront of competition. 

Published by the ARS Investment Policy Committee:
Brian Barry, 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. 

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“The COVID-19 pandemic has demonstrated that no institution or individual alone can address the economic, environment, social and technological challenges of our complex, interdependent world.  The pandemic itself will not transform the world, but it has accelerated systemic changes that were apparent before its inception.  The fault lines that have emerged in 2020 now appear as critical crossroads in 2021.”

– Excerpt from World Economic Forum website on the Davos 2021 agenda

Last year presented challenges that no one anticipated.  While the battle against the COVID-19 virus is far from over, the rollout of vaccines has provided a light at the end of the tunnel.  This is a welcome relief for consumers, businesses and governments after one of the most difficult and uncertain periods in history.  Last year could not end quickly enough for most, and it will appropriately be remembered more for the devastation to lives and livelihoods stemming from the COVID-19 pandemic than the returns of the market or any individual stock.  As policymakers continue to work to arrest this terrible virus and to heal the global system, there are five critical forces that should drive the recovery and, importantly for investors, help to determine those industries and companies that will be the primary beneficiaries of the resulting capital flows.  The five forces involve pent-up demand, vaccine distribution, massive liquidity, low interest rates, and productivity improvements.  The combined effect of these forces will lead to both strong economic growth and healthy returns for investors in well-selected equities. 

To be sure, there are fundamental issues such as tackling a decaying infrastructure system, income inequality, civil unrest, fixing the education system, enhancing cyber security, and reducing the political divisiveness that need to be addressed immediately so that the country can then move onto important longer-term concerns such as deficits, debt levels, tax policy, entitlements, and demographic challenges.  Under these circumstances, market participants should emphasize actively managing their portfolios as a narrow range of securities should benefit disproportionately from the complex dynamics of the global economy. That said, the acceleration of the systemic changes described by the World Economic Forum will create a relatively small number of well-defined opportunities for market participants.  A January 4th article from McKinsey stated, “2021 will be the year of transition. Barring any unexpected catastrophes, individuals, businesses, and society can start to look forward to shaping their futures rather than just grinding through the present. The next normal is going to be different. It will not mean going back to the conditions that prevailed in 2019.”  Given the many challenges facing the world, these times suggest investors should continue to be both cautious and opportunistic in 2021. However, better times are ahead for the economy, and market participants have already started to look past many of the near-term concerns and are focusing on opportunities developing for the post-COVID economy.

Pent-up Demand – Consumers, Corporations and Governments

“The great comeback of 2021 is surely coming, at least according to the new picture I have in my head, and it will be led and fed by the idea of pent-upness. There’s so much pent-up desire for joy out there. Surely it will begin to explode in late spring, with vaccines more available and a spreading sense that things are easing off and be fully anarchic by summer.  Growth will come back, people will burst out, it’s going to be exciting.”

– Peggy Noonan, The Wall Street Journal, December 31, 2020

After being locked down and unable to take part in what were our normal activities prior to the pandemic, most people are eager to return to living without restrictions.  As Peggy Noonan sums up quite well, there is so much pent-up demand not only from consumers, but also from governments and corporations that the effect may be similar to that of a coiled spring.  As shown in the chart, the lockdowns forced savings rates to extreme levels and consumers have spending power that will be unleashed once economies reopen likely in the second half of the year.  We have not seen this type of pent-up demand since the post-WWII period.   Back then it was ending the war that ignited the resumption of spending, this year it will be the distribution of vaccines that will get things started. 

The consumer is just one part of the pent-up demand; governments and corporations will also be increasing spending this year.  President Biden has proposed a $1.9 trillion stimulus plan, and this would be in addition to the $3 trillion fiscal stimulus in 2020.  For corporations, there is little choice but to increase capital spending in 2021 to acquire the most advanced technologies in order to effectively compete.  Investors should anticipate that much of corporate spending in the manufacturing sector will be directed to increasing capacity and upgrading plants and equipment with the newest technologies to lower costs and meet increasing demand. While many market prognosticators are forecasting a rapid increase in inflation, that is not the base case for ARS.  Our team believes that we might experience a modest rise in inflation this year but expect it to be transitory.  

Vaccine Distribution

“In the aftermath of the presidential election, the US has its last best chance to reset the fight against the coronavirus. Such a reset will require restoring the working relationship between the national government and the states. And the first true test of this strengthened relationship will be the distribution of vaccines.”

– Boston Consulting Group, November 30, 2020, “Only a Reset Can Defeat the Virus”

The COVID-19 pandemic has been a human and economic catastrophe, and the battle is far from over as new mutations are creating additional concerns.  But with the vaccine roll out underway, it’s possible to be cautiously optimistic that we will be shifting away from the lockdowns and restrictions so prevalent today to the next normal which should begin in earnest later this year.  The Biden Administration has taken a fresh approach to fight the virus and it started with designing a strategy that plays to the distinct strengths of the federal and state/local governments.  As the BCG highlights, “Federal and state governments have different strengths. By virtue of its borrowing and purchasing power, the federal government excels at funding and procurement. Its expertise and broad perspective also position the federal government to establish evidence-based national standards and offer tailored regulatory relief. The states’ strength derives from local knowledge and service delivery. They clearly see the reality in the field that can be fuzzy to federal officials.”  It is safe to say that the lack of proper coordination and communication between federal and state officials as well as with the drug manufacturers had prevented a more effective response to the distribution process. 

The ability of biotechnology and pharmaceutical companies to produce not one, but several effective vaccines in just a few months has put the United States and global economies on track for potentially a strong recovery in the second half of the year.  However, there are many manufacturing and logistical problems to be addressed which would suggest that not only does the United States need better coordination on all levels of government, but that corporations need to pitch in to assist in helping solve these complex challenges. This would not only provide a public service but also accelerate the time to get their businesses closer to the post-COVID environment.  The world continues to experience episodes of heightened uncertainty which are likely to persist at least until the virus is contained and people feel more confident that it is safe to return to many of the activities that are currently being prohibited, restricted, or avoided.  As we said in our August Outlook, “While we believe that innovation and science will win in the end, the road to recovery will be bumpy with unsettling news headlines adding to the already high level of uncertainty and unease.”  That has been the case the past few months and may continue to be until the current supply and logistical difficulties are resolved and herd immunity is achieved.  

Liquidity

One of the most fascinating aspects of 2020 was the speed and magnitude of the policy response from governments around the world, not just in lowering benchmark interest rates, but also by pumping an unprecedented amount of liquidity into the global system.  Nowhere was this more evident than in the U.S. as shown in the following chart.  As one can see, the United States’ combined monetary and fiscal policy responses last year was equivalent to over 48% of gross domestic product (GDP).  And that does not take into account this year’s initial stimulus proposal which would bring total stimulus in the U.S. to over 50% of gross domestic product.  Globally, governments and central banks have provided stimulus equal to more than 33% of global GDP and this figure continues to rise. 

Why is this important? The liquidity injected into the system has allowed the global economy to absorb the shock of the pandemic and rebound from the brink of a severe recession, if not, a depression. It also allowed employment, consumer net worth, and corporate profits to rebound strongly since the March lows. All this liquidity sloshing around the global system has forced investors to seek opportunities to get a higher return on their money and has encouraged added risk-taking.  This was clearly evidenced in the markets the last week in January as retail investors, using social media, turned the tables on a few hedge funds by executing a coordinated attack on the extreme short positions in GameStop shares which led to a “short-squeeze” that drove up the price of the company’s shares beyond reason.  The implications of this and the unusual trading activity of other stocks have yet to be determined, but it is safe to say that we have not heard the last of this yet as investors can expect regulatory and other changes in the not-too-distant future.

Interest Rates

“When the time comes to raise interest rates, we’ll certainly do that, and that time, by the way, is no time soon,”

– Jay Powell, Federal Reserve Chair, in comments on January 14, 2021

For investors, the outlook for interest rates, inflation rates and corporate profits are the critical determinants of equity valuations.  Low interest rates are to the economy what blood is to the body as it promotes the flow of capital throughout the economy.  Interest rate levels either retard or augment capital flows, and today’s historically low rates maximize the ability of capital to be deployed.  Low interest rates allow for economies to heal and to grow by promoting consumption and capital expenditures by businesses.  High interest rates slow economic activity by restricting investment, borrowing and risk taking.  As Chair Powell and the rest of the Federal Reserve officials regularly remind us, they do not intend to raise rates any time soon.  As shown in the following chart, Fed officials do not forecast federal funds rate increases before 2023.  By anchoring rates near zero, the Federal Reserve is attempting to bring down other rates such as those for corporate debt as BAA yields have fallen to record low levels and mortgage rates have also come down to near-record low levels of 2.86% as of the time of this writing.  The Federal Reserve is maintaining its laser-like focus on returning the economy to full employment even if inflation runs above its target in the near term.  With the recent confirmation of Janet Yellen as Treasury Secretary, Chair Powell has a close ally to coordinate policy between the Federal Reserve and the Treasury Department.  Secretary Yellen’s knowledge of the challenges of U.S. economy and the Federal Reserve’s policy intentions are unique. For market participants, the Yellen-Powell combination should provide a supportive backdrop for equity valuations.

Productivity

“What we are witnessing is the dawn of a second wave of digital transformation sweeping every company and every industry. Digital capability is key to both resilience and growth.  It’s no longer enough to adopt technology to compete and grow.”

– Satyta Nardella, Chief Executive Officer, Microsoft Corporation

Productivity reflects the efficiency of an economy as well as serving as the determinant of the foreign exchange value of its currency.  Productivity growth has been lackluster in the United States over the past few decades.  The productivity improvements from technological advances have been most evident in the ability of the pharmaceutical industry to develop and bring to market multiple vaccines for COVID in record time.  In addition, U.S. manufacturers have made their production lines so much more efficient that they can run shifts with a fraction of the workers required 20 years ago.  This enables companies to bring back jobs and more effectively compete with foreign workers who are earning a fraction of the wages of U.S. workers.  Furthermore, the scale of the shift to remote work due to the pandemic would not have been possible without advances in cloud computing, artificial intelligence, software and 5G.  Productivity improvements are creating new large addressable markets in several areas such as green energy by lowering costs for electric vehicles, solar and wind power. 

The digitalization of the economy is enabling companies, large and small, to do more with less time and expense.  The growth of the digital economy is important for society as it aids nations in closing the gap between the actual and potential GDP of their economies by driving productivity growth, keeping inflation low and raising living standards.  While much has been written about the loss of jobs due to technology, many studies have shown the longer-term benefits offset the negatives. However, in the nearer term it does put a greater burden on governments and companies to help those workers impacted to learn new skills to compete in the new workplace.  Additionally, technological advances help create new industries, jobs and functions which can result in new and more efficient markets.  The productive capacity of a nation is closely connected with its education system as it needs to prepare workers for multiple careers they will likely experience.  Investors should anticipate that the expected increases in capital expenditures will lead to significant improvements in productivity while resulting in a strong growth, low inflation environment.  The rapid adoption of new technologies creates a positive feedback loop with future technologies being brought to market at an accelerated pace.  While certain types of jobs will disappear or see significant reductions in demand, the technological advances we see occurring at this time will create many new jobs which could well be better paying such as those being created in emerging industries like clean energy.

Investment Implications

As the economic recovery remains both fragile and fluid, we continue to be both opportunistic and cautious in our investment approach.  As we have written throughout this piece, the powerful shifts in the global economy are creating large investment opportunities, and well-selected equities should reward investors over the next several years.  There are investable ideas present in virtually all market environments, and investors should be able to achieve attractive absolute and relative returns over time by owning the businesses that are the beneficiaries of the secular trends. One issue that has been hard for many investors to grasp is the fact that a relatively small number of companies are prospering, while many others are struggling.  Why has this been occurring?  Because these successful companies have significant embedded advantages including scale, stronger balance sheets and better access to talent and capital. This enables them to commit more funds to increasing productivity by investing in innovation and technology advances.  Last year, Amazon, Apple, Alphabet and Microsoft together increased their capital expenditures at a nearly 25% rate.  This, in turn, led to higher earnings, better pay for employees, stronger market share, and ultimately greater shareholder value, while at the same time increasing their competitive positions.  Investors should focus on companies with “embedded advantages” over their peers.  It is for this reason that we feel the investment environment should favor active investment management over passive management and high conviction strategies over more diversified strategies.  Additionally, this low-interest-rate environment favors companies with strong balance sheets, resilient business models, and the ability to raise their dividends. These conditions have led to a broadening of the market to include small capitalization companies that are drivers of some of the most important new innovations.  We continue to identify a number of companies that are uniquely positioned to benefit and are strategically vital to enable the ongoing global transformation.

There are always risks to the economic outlook and that is certainly the case today.  Among the key risks that would shift our positive views from our current position would be a sharp rise in inflation and the exchange rate for the U.S. dollar. Other risks include how we manage the expanding federal deficits, asset valuations, tax and regulatory increases, extreme weather, geopolitical uncertainties and, of course, the resolution to the current health crisis.  The focus for client portfolios remains consistent with our recent Outlooks as we continue to favor the beneficiaries of the digital transformation involving cloud, cybersecurity, 5G and semiconductor chips as well as healthcare companies helping to lower healthcare costs in the U.S.  In the past quarter, we have increased our emphasis on the clean energy transition and climate change but continue to be vigilant to avoid over-hyped areas of the market.  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 in the post-pandemic world.  

“The global COVID-19 pandemic shows few signs of relenting – in fact, in addition to its dual burden on lives and livelihoods, it is triggering civil unrest, new concerns about economic inequality, geopolitical tensions, and many other effects.  The pandemic is more than an epidemiological event; it is a complex of profound disruptions.”

– McKinsey Global Institute

This rapidly changing world is presenting both interesting existing and new investment opportunities in the beneficiaries and profound challenges.  In just a few months, the world has undergone critical transformations and, as highlighted in the McKinsey reference above, “a complex of profound disruptions”.  Our lives continue to be reshaped in ways that were predictable prior to the COVID-19 virus and in ways that were not predictable.  Many investors we speak with these days tend to be less aware of the dynamic opportunities available and more focused on the many uncertainties stemming from the resurgence of COVID-19 cases globally, rising geopolitical tensions, and the potential consequences of the upcoming U.S. election.  It is important that serious, long-term investors not get sidetracked by the near-term uncertainties as we believe the six transformations described in this Outlook will provide a generational opportunity to protect and build capital in the beneficiaries even if future investment returns across the broad range of asset classes are lower than previously experienced. 

As hopes for a 2020 resolution to the pandemic have faded, the economic consequences of business closures, high unemployment, lost incomes, and lower economic activity have become clearer.  Investors should expect business closures and bankruptcies to continue or even accelerate in the coming months.  The dramatic improvement in the unemployment rate experienced from May through August has begun to stall as companies announce new layoffs and furlough programs.  Additionally, state and local government finances in the United States are being severely strained due to the virus, and this is accompanied by an increase in Federal spending needs placing even further pressures on the financial system.  These developments have raised concerns with respect to the longer-term economic scarring that can occur whereby many of the long-term unemployed experience long-lasting damage to their individual economic situations as well as segments of the economy that may have become semi-permanently impacted. 

It is important to note that the United States has long been the most resilient, innovative and adaptive economy in the world.  As seen in Chart 1, new business formations are up significantly this year over last year, one sign of entrepreneurs adapting to the evolving circumstances.

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Despite the efforts by central banks and governments around the world to provide support to the global economy, more needs to be done.  The next round(s) of fiscal initiatives should be structured to provide some immediate support and stimulus targeting productive investments to create sustainable, long-term growth.  Smart support and stimulus can help the U.S. and other nations not only recover from the pandemic but also raise living standards.  However, the pandemic recovery requires not just additional spending, but also a healthcare solution in the form of better testing, approved vaccines and treatments that are made widely available to allow a return to more normal activities on a global basis.  This Outlook will frame the six critical transformations that are changing our world and their investment implications.

The Six Critical Transformations

“When we emerge from this corona crisis, we’re going to be greeted with one of the most profound eras of Schumpeterian creative destruction ever — which this pandemic is both accelerating and disguising… The reason the post-pandemic era will be so destructive, and creative is that never have more people had access to so many cheap tools of innovation, never have more people had access to high-powered, inexpensive computing, never have more people had access to such cheap credit — virtually free money — to invent new products and services, all as so many big health, social, environmental and economic problems need solving.”

– Thomas Friedman, NY Times, October 20, 2020

Since the financial crisis in 2008, societies have seemed to be struggling to accept, absorb and adapt to the pace and magnitude of the constant changes occurring all around.  As Thomas Friedman points out, the COVID-19 pandemic has acted as another accelerant for change bringing forward by years the adoption of new ways of doing things, while affecting all aspects of our lives.  Importantly, the transformations are also accelerating the greater adoption of technology which in turn drives the adoption of future innovations.  The virus is forcing consumers, businesses and governments to embrace change as there is simply no other choice.  There are six critical transformations occurring that are changing our world and will have an outsized impact on achieving more sustainable economic growth, increasing corporate profits and raising living standards.  These transformations are the monetary and fiscal, the geopolitical and political, the digital, the social and societal, the climate and the educational.  These transformations are highly interdependent, and therefore their proper management by policymakers as well as the private sector is essential to a successful transition.  If done correctly, this would lead to a profoundly positive outcome for the United States as a country.

The Monetary and Fiscal Transformation

The global central banks have been working overtime this year in response to COVID-19.  When the Federal Reserve announced new interest rate cuts and monetary easing in March as the virus was accelerating, investors initially viewed it as a temporary stimulus move.  The Federal Reserve and other central banks have taken monetary accommodation to levels that were once unimaginable.  With the Fed’s recent forecast that rates will remain low at least until 2023, more market participants are starting to believe we are in a period of semi-permanent near-zero interest rates perhaps like Japan has experienced since the 1990s.  Most advanced economies cannot tolerate a return to a normal interest rate policy due to the current political and social dynamics, deflationary forces, debt levels, government spending needs and lack of sustainable growth.  A premature return to a normal interest rate policy would immediately weaken economic activity and promote an unwanted downturn, a lesson learned by central bankers from the aftermath of the Great Depression.  Therefore investors should anticipate that monetary policy will remain highly accommodative and understand that central banks have more tools, such as interest-rate caps, to bring to bear if necessary.

One of the most essential transformations involves the shift in attitude toward fiscal policy.  During the period following the financial crisis, the prevailing view was to lean toward austerity rather than deficit spending as an answer to the debt and deficit problems present in the system.  This was particularly true in Europe.  Central banks have set the stage for a new era of fiscal policy by giving policymakers the ability to finance deficit spending with historically low interest rates.  Governments have abandoned the policies of austerity and are replacing them with spending programs to address major needs such as infrastructure, clean energy, education, skills re-training programs, and healthcare.  In the United States, the pandemic crisis has also led to a change in attitude among politicians in both parties with Republicans now supporting even greater deficit spending as our federal deficit as has reached $3.1 trillion and appears likely to increase further regardless of who wins the upcoming election.  Investors should expect higher deficits in most advanced economies, new spending programs and possibly more public-private partnerships to address the most pressing social and economic issues.

What has been noteworthy in recent weeks have been the numerous calls for increased fiscal spending from Christine LaGarde, President of the European Central Bank, Federal Reserve Chair Jay Powell and several Federal Reserve Bank members including Lael Brainard, Neel Kashkari, and Charles Evans.  One of the strongest messages about providing more fiscal stimulus came from IMF Managing Director Kristalina Georgieva, who said recently, “Public investment—especially in green projects and digital infrastructure—can be a game-changer. It has the potential to create millions of new jobs, while boosting productivity and incomes.” In a recent release, the IMF also stated that “policymakers have to address complex challenges to place economies on a path of higher productivity growth while ensuring that gains are shared evenly, and debt remains sustainable.  Many countries already face difficult trade-offs between implementing measures to support near-term growth and avoiding a further buildup of debt that will be hard to service down the road.”   The challenges are complex, and the problems can no longer be postponed, but the opportunity remains the best one to reverse the damage done by the pandemic and flawed policy responses of the past. 

To meet the challenge from the IMF to invest, policymakers should consider splitting government spending plans into two categories – an operating budget and an investment budget. For the operating budget, the recommendation would be that all existing programs be reviewed to ensure that each expense is still necessary, the spend is being done effectively, and whether there are any opportunities to combine some operating expenses with investment expenses to maximize spending.  For the investment budget, the recommendation would be evaluated in a manner similar to corporate capital programs with a return-on-investment approach over multiple years.  This approach would avoid some of the waste that exists in government programs and allow for more efficient capital allocation.

The Geopolitical and Political Transformation

There has been a significant geopolitical transformation occurring for some time driven primarily by a few key factors – the pandemic, the shifting geopolitical landscape and each nation’s specific internal challenges.  The COVID crisis restart has provided governments with a complex set of challenges as each works to protect the public, to manage the economic and social consequences of the pandemic, and to put the global economy on a sustainable growth trajectory.  Top of mind is how to create a framework to think about managing the new stages of the pandemic and still address the ongoing and future needs of each nation.  A recent report from the Boston Consulting Group discussed a framework employed by one government to make decisions to assess the varied interests that needed to be balanced.  The report discussed an Australian state government that is “assessing each step in its reopening process against three dimensions: its potential economic benefits in terms of jobs and economic value creation, its potential social benefits in terms of improved mental health and social equity, and the degree of increased health risk from the kind of social interactions that are likely to occur.”  

Other major factors to be considered are the implications of the apparent withdrawal of the U.S. as the global leader and the aspirations of China to play a leading role in the world. This is resulting in perhaps the most significant shift since the end of the Cold War with the former USSR and will have important implications for the global order for decades.  We are moving to a bifurcated world with nations being forced to choose sides.  This is evidenced by the measures taken by the United States to redefine its trade relationship with China, the actions surrounding technology leadership and the rising tensions in multiple parts of the globe.  The changing geopolitical dynamics are forcing some nations to choose sides and allowing autocratic leaders like those in Russia and Turkey to take advantage of the global leadership void.

In addition to the geopolitical challenges, politicians are fighting battles on multiple fronts as they attempt to arrest the pandemic and manage the disruptions while attempting to navigate these six transformations.  Countries are experiencing swings in national politics between the far left and the far right, and as with most things the pendulum tends to swing back from one extreme to the other after a period as the majority is typically underserved by the politics of either the far right or left.  These swings are not ideal from an economic perspective as they lead to waste and suboptimal outcomes.  At the same time, politicians in the U.S. and in other nations are dealing with near-term issues such as social unrest, weak national, state and local finances, significant spending requirements to address near and long-term issues, and highly divisive politics.

The Digital Transformation

Technology allows us to accomplish some of the most complicated and challenging endeavors faster, more effectively and less expensively. However, creative destruction comes at a cost with some old industries being carved out and those jobs lost, while new industries, companies and jobs are created. Some industries will see even more jobs created than are lost by obsolescence.  Today technology adoption is occurring faster than ever due to ongoing innovation and the willingness and/or needs of governments, businesses and consumers to change. Corporations are embracing productivity-improvement technologies in response to the economic realities of the new business environment. With an estimated near $1 trillion investment for global deployment, 5G is a key enabler of the new technologies being pioneered including AI (artificial intelligence), cybersecurity, blockchain/bitcoin, advanced robotics, autonomous vehicles and drone delivery systems to name just a few.  While much has been written about the pull forward of future demand due to the pandemic, one major aspect of the shift underway is accelerating the adoption of the next generation of technologies across a broad array of applications.  In the United States, the government should play a critical role in ensuring that the right balance is struck between public and private sector roles in championing infrastructure and the US role as the global tech leader.  Technology is so important to economic, political and military leadership that it is the focal point of continuing tensions between the U.S. and China. (Note: We invite readers to visit our website to hear our recent conference call on 5G). 

The Social and Societal Transformation

While the economic and political changes tend to be the focus of our Outlooks, the social and societal ones are equally important for investors, and the pandemic has brought about some of the more critical forces for investors to consider.  The COVID-19 virus has changed many aspects of how we live, learn, work and govern.  All around the world, people’s daily lives have been changed in ways many could not have contemplated prior to the virus.  This is evidenced by the shift from cities to the suburbs, from work in the office to working remotely, from in-person meeting to Zoom meetings and from mass transit to driving oneself.  Some changes will be temporary, but others will be semi-permanent and still others permanent.  This is impacting commercial and residential real estate values surrounding major cities, where, when and how we work, and how we educate our children.  The virus has also forced companies to adopt technology more quickly to replace jobs completely or reduce tasks of workers.

The pandemic has also highlighted the need for societies to address essential services in which most developed nations have underinvested due to either the austerity bias discussed above or the lack of political will.  In the United States, it has led to a shift in attitudes toward healthcare, educational costs and inequality, but it has also led to increased social unrest as evidenced by violent demonstrations in many cities.  Governments’ roles in all aspects of our lives has increased because of the pandemic along with the many underlying problems that were below the surface and had been bubbling up for years.

The Climate Transformation

“The 21st-century energy system promises to be better than the oil age—better for human health, more politically stable and less economically volatile. The shift involves big risks. If disorderly, it could add to political and economic instability in petrostates and concentrate control of the green-supply chain in China. Even more dangerous, it could happen too slowly.”

– The Economist, September 17, 2020

One of the most controversial transformations involves climate change.  From the melting of the permafrost to the wildfires in California to the rising water temperatures, climate transformation is clearly underway.  The world has also seen rising air temperatures, changes in migration patterns and more violent storms.  With the onset of the COVID-19 virus, oil demand dropped by 20% and prices collapsed.  This has placed strains on oil-producing nations and the oil sector.  Unlike past periods of oil price declines, this one has opened the door for clean energy transformation as governments, businesses and the public are now more focused on climate change than ever before.  Supported by the current zero-interest-rate policies of central banks in the developed markets, governments are more aggressively pursuing green-infrastructure plans with the EU committing nearly $880 billion for clean energy initiatives and American Presidential candidate Joe Biden proposing a $2 trillion program to decarbonize the U.S. economy.  China is also shifting to cleaner energy as its moves to reduce its carbon footprint and reliance on oil imports, while strengthening its global economic, military and political position. It is also about China playing to its other strengths.  China has a dominant position in several aspects of the clean energy supply chain as it produces an estimated 72% of the world’s solar modules, 69% of its lithium-ion batteries and 45% of its wind turbines. The fact that it also has the leading position in the rare-earth materials necessary for the production and distribution of clean energy is another reason for its interest in green initiatives.  China is positioned to be as dominant a player in clean energy as the Saudi’s have been in oil for decades.

The Economist also points out that “Today fossil fuels are the ultimate source of 85% of energy … A picture of the new energy system is emerging. With bold action, renewable electricity such as solar and wind power could rise from 5% of supply today to 25% in 2035, and nearly 50% by 2050.”  For the transformation to take place, it will likely take a higher commitment from governments including changes to regulations, continued advances in technology to lower the costs of the transition, public-private partnerships to finance and support the required infrastructure spending, and a higher commitment from the public to support the transformation with their actions.  There are potential negatives for investors as the transition may increase costs in the nearer term and lower earnings for some companies, but those companies with the balance sheets and foresight to embrace the transformation should separate themselves from their competition and increase their valuations.

The Educational Transformation

“The main hope of a nation lies in the proper education of its youth.”

– Erasmus

For all the progress made in society in the last hundred years, one area that has been slower to advance has been the nurturing of its most important asset – its children. Too many students today learn in a similar fashion as their parents and grandparents, and yet math and reading scores continue to decline. This is true in too many countries.  As Alibaba founder Jack Ma has said, “If we do not change the way we teach, 30 years from now, we’re going to be in trouble.”  If for no other reason, the rapid changes in technology require a new approach to education to provide the skills that are necessary for individuals to reach their potentials with the alternative of falling by the wayside.  As shown in Chart 3, educational attainment plays a significant role in unemployment.  The educational system needs to shift the focus from standard test scores as the basis for evaluating success to preparing students for a life of continuous learning.  A recent World Economic Forum piece titled the Future of Jobs 2020 reported that the top 5 skills for 2025 are active learning and learning strategies, complex problem solving, critical thinking and analysis, creativity, originality and initiative, and analytical thinking and innovation as well as core social skills and emotional capabilities.

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The educational system needs an immediate overhaul as it is at the core of many of societies’ challenges such as inequality, economic scarring and political divisiveness.  Education is about much more than getting a good job.  Without fixing the problems, the status quo opens the door for more populist politics as populations react aggressively to failed institutions, a lesson learned by several nations in the last decade.  However, if done right, it can break cycles of poverty and oppression while lifting nations up.  The stakes are high as democracies require a strong and growing middle class which results from an effective educational system.

Investment Implications – Looking Past the Near-Term Uncertainties

The global pandemic is now entering its next critical stage as the seasons change, new cases surge in parts of Europe, the United States, and the rest of the world.  Meanwhile, the prospects for quality vaccines and therapeutics to be available in the quantity required for broad distribution to arrest the disease to allow for a return to normal activity remain, conservatively speaking, quarters away.  As fall turns to winter in the northern hemisphere, we are beginning to see some troubling signs as recent announcements of severe new restrictions emerge.  Politicians around the world are struggling to balance the health considerations with the social, political, and economic ones as a pandemic of this magnitude was something that few have ever experienced and something, we all hope we will not experience soon again. 

Given the unique issues associated with a major pandemic, many policymakers, central bankers and professional investors were forced to research past pandemics to better understand both nearer-term and longer-term implications.  Our research has led us to an April 2020 working paper  released by the San Francisco Federal Reserve Bank that studied the 15 largest pandemics with at least 100,000 deaths to determine the longer-term consequences (see Chart 4 for 20th Century pandemics).  The Fed working paper concluded that past pandemics generally result in lower returns on assets and in lower interest rates. Additionally, labor shortages also developed due to the higher mortality rates at the time and therefore relatively better wage growth in the following decades.  As it relates to the COVID-19 pandemic, we anticipate that the longer-term consequences can be similar to the findings of the San Francisco Fed working paper with one key exception: that we could anticipate better wages with the absence of inflationary wage pressures due to the use of technological advances, including robotics.  The Spanish Flu, which lasted from February 1918 to April 1920, had four waves infecting about one-third of the world’s 1.5 billion people and killed an estimated 100 million as shown in the chart below, although some estimates of the number of deaths ranged from 40-75 million.  The highest number of cases occurred in the second and third waves of the pandemic with the second wave starting in September 1918 and the third wave in early 1919 with the fourth wave ending in early 1920.  We conclude that the economic effects of this pandemic will be felt for some time to come.

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Periods of broad transformations are characterized by the elimination and creation of particular industries, companies and jobs.  This process of creative destruction is one that the world has experienced many times in the past, is occurring now and will again in the future.  Obviously for example, the leisure and travel industries, brick and mortar retail, specific areas of commercial real estate, restaurants and parts of the sharing economy have been severely damaged.  If the 2008 financial crisis is any guide, then it could be 3-5 years before some of these businesses recover.  On the other hand, the housing industry, the remote work beneficiaries, education and entertainment content providers, the auto market, and the technology enablers that allow companies and consumers to transition during this virus have been and are likely to continue to be among the primary beneficiaries. From a market perspective, the sudden decline in February and March as well as the subsequent rebound in the markets has been astounding to say  the least, but the popularity and the success of the winners has had the effect of distorting company valuations just as the valuations of some of the 2020 laggards have as well. The valuation gaps and the uncertainties about the possible post-election policy changes are leaving investors wondering, “Where do we go from here?”

After lowering interest rates to near zero, the Federal Reserve has indicated that rates are likely to remain at or near zero until at least 2023.   It is also our view that the world remains more deflation prone, and that any inflationary pressures are likely to be transitory in nature.  Overall corporate earnings should continue to rebound off the lows and are likely return to 2019 levels sometime in 2021. The earning power of the winners will continue to distinguish and separate themselves from the broader market.  Many of the 2020 COVID winners should continue to attract capital as their earning power expands giving these companies the resources to finance further innovation and expansion. With respect to 2020 laggards, some can reverse their performance in 2021 given that corporate earnings are poised to rebound.   Mergers, acquisitions and restructurings are also playing an important role in redefining the business models for many companies. Therefore, we would caution investors not to follow the much-discussed rotation from so called “growth to value” as any market shifts can be more subtle.  The one area where investors may realize better returns in 2021 is with companies that have solid balance sheets, reasonable growth and quality dividends.  These companies have been underperformers this year as the market lost confidence in their ability to maintain dividend payments due to revenue disruptions, and now there is better clarity around their prospects.

The uncertainty of the impact of the upcoming election on markets has weighed on investors’ minds for several weeks. Interestingly for investors, there have been 6 Democratic administrations for a total of 48 years and 7 Republican administrations for a total of 39 years.  The common perception is that Republican administrations would be more favorable for the markets, but the reality is that the average annual returns for Democratic administrations is 10.50% and for Republican ones is 6.90%. Regardless, we would advise market participants to look past the nearer-term issues and focus on the beneficiaries of the six critical transformations and the generational opportunity to build and protect capital.