Investing in an Environment Unlike Any Other

Investing in an Environment Unlike Any Other

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.

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. 

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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Transitioning to the Post-Pandemic World

“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.  

Six Critical Transformations and the Generational Opportunity to Build and Protect Capital

“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.

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.

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.

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.

Greater Uncertainties, Potentially Fewer Opportunities

“It is a paradox that in our time of drastic rapid change, when the future is in our midst devouring the present before our eyes, we have never been less certain about what is ahead of us.”

– Eric Hoffer

The world is being tested by the COVID-19 crisis in ways it has not been previously challenged and this pandemic has become a defining event in our lifetimes.  This crisis has accelerated and augmented many of the negative and positive trends which have been in place for a considerable period of time prior to the pandemic and will continue to impact many aspects of our lives well into the future.  The measures taken to counter the virus have inflicted significant damage to families as far too many lives and livelihoods have been lost.  The world is experiencing a period of heightened uncertainty which is likely to persist at least until the virus is contained and people feel confident that it is safe to return to many of the activities that are currently being prohibited, restricted, or avoided.  Given the sharp contrasts between this recession and past ones,  investors should consider viewing the current landscape through a very different lens than used during previous crises.  We are in the midst of the most unusual economic period in United States history, and one in which the stock market has seemingly disconnected from the pandemic-driven economic reality. 

It has been an extraordinary time for all given how much the world has changed in a few months.  While we do not pretend to have all the answers, there are a few critical factors that we believe are being underappreciated and/or misunderstood by market participants which have had and are having significant impacts on investment strategy.   Among the most critical factors are the differences between this pandemic recession and a typical economic recession; the impact of global policy initiatives on the markets; and the acceleration of the technology revolution.  Crises always benefit some businesses while disadvantaging others, and this virus has created an environment where investors can continue to build and protect capital by investing in the problem-solvers.  

Why is this Pandemic Recession Different from a Typical Economic Recession?

“The uniqueness of this crisis – a crisis that results from a policy to tackle a health emergency and to save lives through containment measures.  This means that in contrast to the Great Financial Crisis (GFC), this crisis is truly exogenous, not the result of the unravelling of previous financial imbalance; truly uncertain, in the specific sense that the wide range of possibilities depends on unpredictable non-economic factors; and truly global – despite how the GFC is generally portrayed, many countries did not actually experience it.”

– Claudio Borio, Head of the Monetary and Economic Department at the of the Bank of International Settlements (BIS)

Coming into the year, the United States had record low unemployment rates, historically low interest rates, muted inflation and rising corporate profits.  It was a positive backdrop for a continuation of the longest economic expansion in U.S. history.  Before COVID-19 hit,  the U.S. and global economies were gradually improving as the massive stimulus initiatives, which had been previously implemented, were supporting gradual growth.  Then came the pandemic.  What is so different about this pandemic recession? It resulted from a lockdown of economic activity which caused a sudden and severe shock to both supply and demand.  This immediately led to lower spending, forced savings, a dramatic increase in unemployment and business bankruptcies and closures.  A typical economic recession results from central bank tightening of economic conditions to combat an overheating economy.  In the months leading up to the 2001 recession,  oil prices were rising rapidly, the federal reserve was tightening interest rates and the tech bubble was about to burst.  In contrast, this pandemic recession has seen oil prices collapse, historic monetary and fiscal policy responses, technological advances and the acceleration of the prospect of scientific breakthroughs.  This is the most all-encompassing policy response by the Federal Reserve, global central bankers and fiscal policymakers that has ever occurred both in the speed and magnitude of its implementation. These policy initiatives are being implemented at a time when the developed world is facing continuing deflationary pressures that have been ongoing for many years.  The effectiveness of the policy response has been demonstrated by the sharp reversal in economic activity as seen by the rebounds in housing, employment, vehicle production, inventory rebuilds and, importantly for investors, in the stock prices in many markets.  It is also evidenced by the decline in interest rates on many securities and on mortgage rates which have hit a record low. 

A major factor in answering “where do we go from here?” lies in the ability of the medical and scientific communities to deploy proper testing, effective treatment and to discover a vaccine.  As controversial as it sounds, it also requires better behavior on the part of everyone to help contain the spread by exercising recommended precautions such as distancing and wearing masks.  Only then can we begin the process to return to a better sense of normalcy, but even then, daily life is likely to be quite different.  Until then, investors should expect the second half of the year to be volatile as the world continues to struggle with reopening the global economy. 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.  It is due to these factors, that most investors need to be grounded in their investment approach and not try to time or be swayed by short-term market swings. 

Is the Impact of the Policy Initiatives Both Misunderstood and Underestimated?

“We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.”

– Jerome Powell, Federal Reserve Board Chair, June 29, 2020

The second factor is the impact of monetary and fiscal policy on the economy and the markets.  Back in 2008, we were among the minority of investors believing that Fed policy was deflationary not inflationary.  In our December 2008 Outlook, we wrote that “the Federal Reserve will have to maintain a historically low interest rate policy for the foreseeable future. To accomplish this goal the Federal Reserve must increase the supply of dollars, which will cheapen the currency and weaken the exchange rate.”  In March of 2009, then Federal Reserve Chair Ben Bernanke announced the introduction of quantitative easing (QE) or the printing of money.  Since then, interest rates have continued to move to near zero in the United States and below zero in many European countries.  This left many market participants to believe that the central banks have exhausted most, if not all, of the tools in the monetary policy toolbox.

On March 23rd, the Fed announced QE4 and it is hard to appreciate how difficult the financial conditions were in the fixed income markets leading up to that decision. Two of the biggest sponsors of money market funds had to infuse $2.6 billion in liquidity to help meet redemptions.  This action by the Fed was underappreciated by market participants with respect to both the fragility in the system and the subsequent impact it has had on the capital markets. Consistent with its mandate of full employment and price stability, the Federal Reserve’s pandemic policies were designed to give market participants confidence that the capital markets were able to function properly and to provide liquidity to those companies that would not have needed it without the pandemic.  It also ensured that companies could continue to access the capital markets which in and of itself promotes growth.

We see something uniquely unusual that investors might be missing. In June, the Federal Reserve embarked on a program called the Secondary Market Corporate Credit Facility (Facility) to further support the capital markets as it began a program to lend, on a recourse basis, to a special purpose vehicle (SPV).  The SPV will purchase in the secondary market eligible individual corporate bonds; eligible corporate bond portfolios in the form of exchange traded funds (ETFs); and eligible corporate bond portfolios that track a broad market index.  In total, the Facility and the Primary Market Corporate Credit Facility (PMCCF) can purchase up to $750 billion of assets.  Critically, the Fed’s action to buy bonds not only supported the bond market, but it also supported the equity market.  Above is a partial list of companies whose debt the Federal Reserve is buying.  Equity owners are at the bottom of the capital structure placing them behind lenders exposing them to both credit and equity risk. The bond buying program has reduced the risk of equity ownership in so far as it has reduced the credit risk of company ownership, thereby making equity ownership potentially more valuable.  These policies have created a condition that has never existed before which requires a more tailored approach to equity valuation. The current debt cycle has been irreversibly changed, and this has enabled some companies to recapitalize using equity and others to refinance debt at lower rates, thereby buying additional time for the economy to recover.  The policy actions of the central banks have been further supported by immediate and massive fiscal responses.

Are the Markets Still Underestimating the Technology Revolution?

“As unfortunate as it has been, the virus has allowed the country to achieve the same amount of progress for digital adoption in two months as it would have in five years.”

– Mr. Vittorio Colao, head of the Italian government’s task force on reopening its economy

The third critical factor which is not fully appreciated is the acceleration of the digital transformation.  Just as the Industrial Revolution changed our way of life, we are experiencing a technology revolution that is changing how we live, learn, work and govern.  Think about how our lives have changed in just a few short months. Industry after industry is undergoing a rapid transformation.  Microsoft CEO Sayta Nadella said recently, “We’ve seen two years’ worth of digital transformation in two months. From remote teamwork and learning, to sales and customer service, to critical cloud infrastructure and security—we are working alongside customers every day to help them adapt and stay open for business in a world of remote everything.”  This digital transformation is in the early stages and has only just begun in earnest.  It will impact every aspect of our lives.  No industry can afford not to fully engage in the technology revolution as supply and demand destruction and changes in the way we live will require companies to do more with less staff and lower costs to compete in the post-COVID world. 

Key to the technology revolution is the confluence of advances in 5G, computing power, artificial intelligence, machine learning, robotics, blockchain and 3D printing. These combined with the growth of the software development industry have enabled innovation to proceed at a rate much faster than previously experienced.  One only needs to look at the healthcare sector and the efforts by pharmaceutical companies to develop, test and, bring to market a vaccine for the COVID-19 virus as an example of the ability of technology to solve complex problems in a fraction of the time it previously would have taken.  While most investors understand that these advances are occurring, they have not adjusted their portfolio exposures to acknowledge the transformation.  There will be few industries, companies or households that will not be impacted. 

The Investment Implications of the Post-COVID World

It seems like investors have been navigating uncharted waters since the Great Financial Crisis in 2008.  As we entered this year, the strength of the U.S. economy and the continued recovery of the rest of the world had investors feeling generally comfortable.  Then came the COVID-19 virus, and now we are battling an invisible enemy and a highly uncertain future.  The

current environment requires a new playbook for investors especially after the more than 40% rebound in many stock markets since March. There are several issues that make this period a particularly challenging one.  First is the belief that the policymakers have exhausted all the tools at their disposal.  This is not a point of view shared by the ARS team. Second is that the lockdown has caused permanent damage to the economy as many jobs lost in recent months will not return and too many of the unemployed and underemployed may never be able to find jobs at similar or better wages.  Again, we do not share that view as history offers many examples of technology displacement being more than offset by the creation of new jobs.  According to a report from the Boston Consulting Group,  85% of the jobs that today’s learners will be doing in 2030 have not been invented yet.  The United States and other nations have a skills gap to address to take advantage of the opportunities in new jobs that will be created in the coming months and years.  We have written in detail about our concerns about the skills gap and the need to transform our educational system to reflect the changes required.  Debt and deficits are also a concern for investors and properly so, but those are issues to address in the post-COVID period.  At the present time, policymakers should continue to focus on supporting the economy until they are confident that we are on a path to more sustainable growth.

ARS remains focused on identifying those businesses that are the problem solvers for the COVID and post-COVID world while avoiding those that are negatively impacted by this disease. To protect and build capital in this difficult climate, investors should continue to focus on the secular beneficiaries, particularly those on the cutting edge of the digital transformation across industries. Many of these companies have rebounded so strongly that their valuations have become overextended or have discounted strong earnings prospects well into the future.  We continue to own some of these in our portfolios. In those cases where the current valuation reflects growth rates beyond reasonable math, ARS is either reducing the position in case it just moved too far too fast, or liquidating the position if the price is too speculative based on reasonable standards of valuation.  We are investors, not speculators. We also continue to hold higher than normal cash levels to take advantage of the volatility in the markets.  Our primary areas of focus remain on those companies driving the digital transformation, industry leaders and innovators providing healthcare solutions and on defense companies as the geopolitical climate remains challenged, particularly considering the current state of U.S. and China relations.  During the quarter, ARS initiated a position in a gold mining company in response to growing concerns about currencies, debt and deficits.  Interesting and perhaps surprising to many since the year 2000, gold has provided similar returns to investors as U.S. equities have delivered.  

The standard of equity valuation for ARS begins with the outlook for corporate profits, interest rates and inflation rates.  While corporate profits will be lower in 2020 than 2019 and might not return to previous highs until sometime in 2022, there is wide dispersion in the outlook for earnings across sectors, industries and individual companies.  Therefore, this is an ideal environment for active strategies to outperform passive strategies.  Interest rates will likely remain low for an extended period of time as the debt levels around the world will not be able to be serviced at higher interest rate levels without weakening economic activity and thereby putting further downward pressure on deflationary forces.  While the economy has been more deflation-prone than inflation-prone for many years, it would not surprise us to see inflation pick up slightly in the coming quarters as supply chain disruptions may cause some transitory pressures.

We continue to believe that it is a time to be both cautious and opportunistic.  We would remind  investors that the sudden decline and rebound in the equity markets reflected the forces described in this Outlook.  We continue to favor individual stocks, cash and gold over bonds, and believe that policymakers must continue to provide the necessary support to manage through this COVID-19 period.  As we said at the start of the Outlook, crises always benefit some businesses while disadvantaging others, and that is certainly the case at present.  The fact is that there are far more people employed than unemployed in the United States today.  Clearly, certain industries and their workers, particularly those in the leisure, travel and hospitality, are being severely impacted but these represent a smaller part of the total employment base than those that stand to benefit from the digital transformation that is presently occurring and that lies ahead. 

This economic description does not in any way minimize the awful tragedy affecting so many individuals and their families.  It is easy and completely understandable to emphasize the challenges present in the global system, but from an investment perspective, one must balance those concerns with today’s opportunities as well as the new opportunities that are in the process of developing.  We remain vigilant in identifying those companies that are the beneficiaries while working to avoid those companies that are being negatively impacted.  In today’s rapidly changing environment, one must stand ready to seize the opportunities presented, be quick to course- correct as necessary, while remaining grounded in a proven investment process to protect and build capital in this unusual period in history.

The Restart and the Rebuild

“This crisis will test our political system, our grit, our patriotism and our willingness to sacrifice for the common good. We will emerge stronger only if we are able to reshape our policies so that, while still retaining the magic dynamism of capitalism, they are responsive to dramatically different circumstances… Our nation will never be the same, but we can emerge stronger and retain our role as a global leader – if we are smart about the rebuilding to come.”

– Henry Paulson, former U.S. Treasury Secretary, Chairman of the Paulson Institute and Co-Chairman of the Aspen Economic Strategy Group

In our January 24th Outlook, we wrote that “As a new decade dawns, the rate and magnitude of the coming changes will require investors to identify and embrace the most investable themes in a world that may at times feel un-investable.  To protect and build capital in this type of environment, investors should focus on the primary beneficiaries of a few critical secular themes in the new decade of disruption and avoid the companies that are being disrupted that are being disrupted… Successful investing in the coming year will require a high level of conviction at a time when many aspects of our lives could be experiencing significant change.”  When we wrote that Outlook, we did not anticipate the COVID-19 pandemic or the political, economic, and social challenges that the virus has presented.  Today the United States is faced with a crisis the likes of which we have not previously experienced, with historic levels of unemployment, rising debts and deficits, a record number of small businesses at risk of closures and bankruptcy which potentially adds to growing inequality.  Many are trying to envision how we can safely restart, recover, and then rebuild a better and more balanced economy, particularly considering the political dysfunction that exists today.

The COVID-19 pandemic is testing the world in ways it has not been tested previously.  This crisis has accelerated and augmented many of the positive and negative trends which were in place prior to the pandemic and that continue to impact so many aspects of our lives.  A positive resolution will require both a short-term solution to achieve a successful restart and then a longer-term one to address the problems that are either being created or worsened by the pandemic.  A successful restart will require a medical solution – testing, treatment and vaccination – to arrest the disease, a financial solution to provide a bridge from lockdown through the restart to the next normal, and an economic solution to prevent a global depression. Once a successful restart is underway, we will need a multi-pronged approach to address the three most significant longer-term issues involving debt and deficits, inequality and shifting geopolitical alliances.  For far too many, the economic and emotional damage that will result from the pandemic will be felt for decades if past pandemics can serve as a guide.  In this Outlook, we will address the most frequently asked questions we are receiving from investors and ones we are asking ourselves as an investment team.

How do you reconcile the difference between the terrible unemployment and other economic numbers with the stock market rebound?

Given the unprecedented nature of the COVID-19 virus and the resulting actions to shut down economic activity, it is no surprise that the United States and global economic activity has ground to a halt this quarter and that the stock market experienced a sudden and severe decline in March.  What has surprised many on Main Street and Wall Street has been the dramatic rebound in stocks given the uncertainty still present in the system, leaving many to wonder what to make of the disconnect.  A key element of support for the economy and the markets has been the massive monetary and fiscal response from central banks and governments in the United States and globally.  On May 25th, Japan announced an additional fiscal stimulus of over $1 trillion and is now targeting aggregate stimulus of 40% of its Gross Domestic Product (GDP).  This has had the short-term effect of replacing some lost income for workers and revenues for businesses, while offsetting some of the decline in GDP lost due to the virus.  This much global stimulus will result in further increasing asset values.  It is important for investors to bear in mind that the stock market is a discounting mechanism based on future expectations of better times. The market is anticipating the resumption of economic activity; the development of effective testing, treatment, and a vaccine; and the intermediate-term benefits of the massive monetary and fiscal policy initiatives being  introduced.  The economic effects of fiscal and monetary policy initiatives usually take between 12-24 months to work through the system, while the financial impacts are immediate.  It is also appropriate to mention that the reopening of the economy should gradually bring the unemployment numbers back down from the current 20% level.  We anticipate continued market volatility as most pandemics do not get resolved quickly.  Based on studies of past pandemics and other crises, investors should expect that the economic and social impact will be felt for years or even decades.

What are the implications of rising debt and deficits?

Rising debt and deficits matter for the economy and investors, but these need to be kept in context of the unique dynamics present in the system. Typically, rising deficits are inflationary, but conditions today clearly are without precedent.  Before the pandemic hit, for example, the United States had an economy that was ripe for inflation with full employment at 3.5%, while the U.S. was running a fiscal deficit of more than $1 trillion and growing, and yet the economy was more deflation prone than inflation prone which is why we never got the inflation that many anticipated. The present level of deficit spending has been a replacement for lost wages and revenues, while past deficit spending had been additive to economic activity. Additionally, quite a few investors also misunderstood that the pre-COVID corporate spending that was taking place was to increase productivity to gain market share and lower costs which is the antidote to inflation.

When it comes to the level of debt, what matters more than the total amount is the cost of servicing the debt which given today’s interest rate environment is near zero.  As shown in the chart, the federal debt in 2000 was $3.4 trillion with servicing costs of $223 billion. Today, we have over 7x the amount of debt but only 1.7x the interest costs. Investors should also be aware that as existing debt (carrying a higher interest rate) matures, the reissuance is being financed at significantly lower cost.  There are three major implications of the levels of debt and deficits for the United States. The first is that the Federal Reserve is able to work to keep interest rates low for a very long time as long as inflationary pressures are not an issue.  The second is that it will be very difficult to raise taxes in a meaningful way anytime soon without slowing growth and risking another downturn. The third is that if the current deflationary pressures persist, the market will not force interest rates higher, and that will keep debt servicing costs relatively low and manageable, giving government the latitude for further deficit spending including pro-growth infrastructure programs.

Given the political divide and the problems you are describing, how can we govern effectively?

“When times are tough and people are frustrated and angry and uncertain, the politics of constant conflict may be good, but what is good politics does not necessarily work in the real world. What works in the real world is cooperation.”

– William J. Clinton, 42nd President of the United States of America

The pandemic and its aftereffects will add an additional level of complexity for both the Republican and the Democratic party leaders as the traditional platforms will not work to address the multitude of long-term problems we are facing today.   Crises are the times to put partisan politics aside and focus on our nation’s most critical needs.  These include developing a plan to provide additional relief for those in need right now, creating an effective path to reopening and laying the foundation to rebuild a better, more resilient economy that is more inclusive for our entire society and essential for our future. Just as increasing productivity is the antidote to inflation, societal inclusivity is the antidote to confrontational partisan politics.  Regardless of who wins the election, the traditional approaches of either party simply won’t work given the pandemic-related economic and social damage that is being done, the growing inequality, the geopolitical instability that exists today and could grow, and the rising levels of debt and deficits.  The United States needs a long-term plan to which our nation can commit to regardless of which party is leading as policies based on two-year election cycles have contributed to putting our nation in this mess to begin with.  As Jean Claude Juncker of the European Commission once said, “We all know what to do, we don’t know how to get re-elected once we do it.” 

So, what needs to be done?  First, Congress needs to draft a bipartisan plan to provide a path to achieving a more steady and fair economy, not solely for the next election cycle but for future generations.  This plan should have mission-critical initiatives that should be implemented regardless of which party is in office.  Second,  as we suggested in a recent Outlook, the federal budget should be separated into an operating budget and an investment budget to allow for smart, strategic investments in our areas of most critical need as highlighted in the new plan.  Third, the U.S. needs to develop and fund a massive multi-year infrastructure initiative focusing on our healthcare, education, digital and physical infrastructure.  This is a need that can no longer be postponed and would go a long way to creating a more inclusive, stronger, and therefore, more resilient economy. It would accomplish two important long-term goals. It would address the inequality problem which otherwise will be intensified by the policies being implemented. The resulting growth will lay the foundation our country’s needs to eventually bring the deficits and debt down in relation to the size of the growing economy.  Fourth, we need to rework our tax system to make it fairer, and also need realize that the current backdrop makes raising taxes inappropriate at this time, beyond closing some loopholes, given the financial challenges facing so many individuals and businesses.

There is too much of a singular focus on taxes for big corporations, given that tax policies targeting one segment often have significant unintended consequences for other parts of the economy.  Fifth, we need to champion corporations that are strategically vital to our future prosperity, but to do so in a way that ensures that they are acting in an appropriate manner.  It is our businesses, both large and small, and innovation that have allowed the U.S. to prosper.  To that end, we would encourage a more collaborative and a less punitive approach from some in Washington, while encouraging more public-private partnerships to address the many complex issues facing the nation.  Finally, we need our young adults to step forward to become the next “greatest generation” and lead us with new ideas and a renewed spirit of cooperation placing practical solutions ahead of ideology.

With the current level of uncertainty, what should investors do now?

“Out of intense complexities, intense simplicities emerge.”

– Sir Winston Churchill, former Prime Minster of the United Kingdom

As a result of the extraordinary nature of the COVID-19 world, many market participants are struggling to make sense of the markets given the level of uncertainty, complexity and growing geopolitical risks, particularly with China as well as the need to better address climate change.  During times like this it helps to take a step back to assess the bigger picture and not get caught up in the news cycles about the crisis. Investors should recognize that the virus is creating a two-tiered market between those that are providing solutions during this difficult time and those that are being more negatively impacted.  Obviously some e-commerce companies are doing well right now, but in every crisis we see new businesses emerge and old ones disappear.  It has been this way throughout history and will be this time as well.

A relatively small number of companies are prospering, and many others are struggling. Why? Because these companies have embedded advantages including scale, stronger balance sheets and better access to capital enabling them to invest more heavily to increase productivity through investments in innovation and technology advances.  This, in turn, leads to higher earnings, better pay for employees, stronger market share, and ultimately greater shareholder value. Investors should focus on companies with “embedded advantages” over their peers. It is for this reason that we feel the investment environment is set to favor active investment management over passive management, and high conviction strategies over more diversified strategies. Additionally, the low-interest rate environment favors companies with strong balance sheets, good business models, and the ability to raise their dividends.

There are always risks to the economic outlook and that is certainly the case today.  Among the key risks that would change our positive views would be a sharp rise in inflation and the exchange rate for U.S. dollar.  As the world economy remains both fragile and fluid, we continue to be both opportunistic and cautious in our investment approach.  As we said at the start of this piece, the powerful shifts in the global economy are creating large 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 both absolute and relative returns over time by owning the businesses that are the beneficiaries of the secular trends.  

COVID-19 – The Problem, The Response and The Post-Pandemic World

“Leaders are dealing with the crisis on a largely national basis, but the virus’ society-dissolving effects do not recognize borders. While the assault on human health will – hopefully – be temporary in nature, the political and economic upheaval it has unleashed could last for generations. No country, not even the U.S., can in a purely national effort overcome the virus. Addressing the necessities of the moment must ultimately be coupled with a global collaborative vision and program. If we cannot do both in tandem, we will face the worst of each.

– Henry A. Kissinger, excerpts from WSJ Op-ed, April 3, 2020

The COVID-19 pandemic has presented us with an extraordinary medical, economic and social challenge the likes of which no one has previously experienced. The virus has changed almost every aspect of our lives and threatened our economic security, but it has also taken too many lives with many more to follow. There is no way to minimize the global tragedy, but we are heartened by the resolve of people all over the world, especially health care professionals and other essential workers, as we battle through this difficult period. We want to remind each of our clients that we are here to guide you through your specific challenges, and to convey our appreciation for the concerns that have been expressed for the health and safety of our team. We are fortunate to have such terrific clients and value the trust placed in us each day. While we continue to work on a remote basis, we assure everyone that we are here to assist through this difficult period. To that end, we are going to be publishing shorter, more frequent Outlooks until the spread of this disease is arrested to keep everyone informed of our latest thinking as the situation remains very fluid. This note will frame the key problems facing policymakers, the scope of the monetary and fiscal policy response, what the post-pandemic world may result in and the investment implications.

Framing the Problem

The coronavirus pandemic and mandated lockdowns imposed by governments around the world have pushed the global economy into the sharpest downturn since the Great Depression. The challenge for policymakers has been in three key areas – offering income replacement for those who lose their jobs, making available loans and grants to offset revenue loss for companies, particularly small businesses, and providing liquidity to allow the economy and capital markets to function properly. As a result of shutdowns, businesses are laying off employees at a rate and scale that is unprecedented. For the week ending March 21st, U.S. unemployment claims were 3.28 million persons which was 4.7x the highest recorded total of 695,000 back in 1982. The jobless claims then doubled for the week ending March 28th with 6.6 million reported which brought the unemployment rate over 10%. The unemployment figure may well exceed 20% if the lockdown is more prolonged. It is important to note that once the lockdown is reversed unemployment will decline rapidly. It is for this reason that St. Louis Federal Reserve Bank President James Bullard said he expected that the unemployment rate may spike up to around 30% but will decline rapidly in the subsequent quarters possibly returning to 4% levels as business activity resumes. It is clear that the combination of job losses, business shutdowns and the overall slowdown in the economy will reduce personal consumption, business investment and trade. Therefore, it has been up to the government to minimize the damage through monetary and fiscal policy.

Addressing the Policy Response

As discussed above, policymakers are working to minimize the negative effects of the COVID-19 pandemic with a focus on keeping the capital markets functioning properly, getting money into the hands of the unemployed and helping minimize small business failures. The global commitments from central banks and governments are estimated to be in excess of 13% of global GDP which is roughly $90 trillion and could exceed 20% of global GDP depending on the timing of scientific breakthroughs. The United States has initially committed over $5 trillion or more than 20% of U.S. GDP. In late March, the Federal Reserve responded to pricing issues in the fixed income markets which were functioning in a disorderly fashion. The Fed acted quickly to inject liquidity into the system with a commitment of more than $2 trillion to start and a promise to do whatever is necessary to support the economy. We would commend Fed Chair Jay Powell and the Board of Governors for their decisive and extensive response, having clearly learned from the 2008 experience. Given the limitations of interest rate policy in a near-zero-rate environment, Congress needed to act to address those who were losing their jobs or experiencing wage reductions and to try to prevent businesses from closing that would not have without the mandated lockdown. The initial commitment by the House and Senate was estimated to be between $2-2.5 trillion. It remains to be seen whether the money will get to those who need it most – the unemployed and the small businesses – in a timely fashion. Congress is already drafting additional proposals including one to extend or expand new unemployment benefits and provide additional support to protect small businesses. These programs have been defensive and reactive.

Future programs will be designed to foster growth and put the nation back on the offensive. Most importantly, we have come to the point where we can anticipate the long overdue program to address our nation’s healthcare, educational, digital and physical infrastructure. In that respect, we would propose that the United States Federal budget be split between an investment side and an expenditure side. The infrastructure budget would be in the investment category and each program would be evaluated for its expected return on investment. This would allow for future programs to be better funded and assessed on their merits.

Thoughts on the Post-Pandemic World

The pandemic has significantly changed our daily lives and could well transform the way we live, learn, govern and work after it has run its course. As long-term investors, we must make judgments as to what the post- pandemic world might look like so that we can invest not just for the next quarter or two, but for the next several years. Here are our initial thoughts on some of the changes in the behaviors of consumers, businesses and governments.

For consumers, we see a greater focus on lowering household debt, increasing savings rates, and changes in where we live and how we work. With students of all ages being forced to learn online, we see an acceleration of the changes occurring within our educational system and broadening of student internet access. We are already experiencing a necessary increase in telemedicine which we expect to accelerate as well as more personalized medical approaches that will incorporate more advanced medical technologies. We should expect to see greater use of medical rapid-testing technology to enable the public to gain access to such places as theme parks, sporting events, concerts, museums and even office buildings. From a business perspective, it is likely that more companies will support increased remote work arrangements which have important implications for the commercial real estate market and for increased use of technology as businesses look to reduce high-cost office space. Corporations will seek to create more flexible and resilient supply chains, bringing back to the United States production of some critical parts of supply chains to avoid future disruptions due to trade conflicts or shutdowns such as we are currently experiencing. We also could see the relationship between government and business altered considerably for some industries due to the bailouts and loan programs as well as for national security reasons. Furthermore, the path to growth will likely require sizable public-private partnerships, both domestic and cross-border, to address national needs such as infrastructure, cyber- defense and healthcare. As the quote from former Secretary of State Henry Kissinger points out, governments will need to be more collaborative and that begins with the U.S. and China. Depending on the behavior of global leaders, we may see closer relationships with other nations, a further fragmenting of the post-WWII global order, greater strains on the European Union project and renewed calls for modernizing the role of global institutions such as the WTO (World Trade Organization) and the United Nations. A failure to address the growing inequality issue, which is being exacerbated by the pandemic, could lead to serious social instability, and now is the time for government, business and public to act.

Investing for the Near-Term and Beyond

As we said in our March 23rd Outlook, things will get worse before they get better, but they will certainly get better once we begin to arrest the spread of the virus. In terms of sequencing, we believe that the stock market will begin the bottoming process as the trajectory of new cases begins to decline and likely well before the economy itself bottoms. The recent focus for client portfolios has been to use the market pullback to upgrade quality, fine-tune sector and industry weightings and avoid the companies that are heavily indebted. We have been initiating new positions in high-quality companies that previously were selling at considerably higher valuations, while harvesting tax losses in securities we still like but believe the risk/reward in holding them is not as favorable.

While no one can say with any precision where we go from here, there are a few questions the investment team is asking to help guide us in navigating the near term and longer term.

  • What is the length of shutdown and severity of the economic damage?
  • Will the policy response be effective and what are the possible unintended consequences?
  • How difficult will it be to restart the economy and begin to return to growth?
  • And finally, what does this mean for individual companies and industries?

Based on our preliminary views of what the post-pandemic world might look like, our portfolios will continue to reflect many of the same themes we have emphasized for the past few years. The impact of the virus has not only reinforced our convictions but has also augmented these themes. ARS portfolios will continue to emphasize healthcare companies, focusing on biotech/bioscience, pharmaceutical and high tech testing equipment among other areas; technology companies including cloud, 5G, semiconductors and capital equipment, cybersecurity, AI (Artificial Intelligence) and machine learning; companies with strong balance sheets and quality dividends; defense companies as the world is not getting any safer; and a few special situation companies that will benefit from an increase in post-crisis merger and acquisition activity. We favor the U.S. economy over the rest of the world and the U.S. stock market over other markets. There are some unique opportunities being created in the U.S. stock market, and we suggest that those waiting for an opportunity to participate should begin to incrementally build positions in world-class companies with a view to adding on future price declines. Given the nature of the world today, we favor a cautious and measured but still opportunistic approach to investing. Disciplined investors who are taking a longer-term view should be well rewarded.

From Wuhan to Wall Street to Main Street:

Think of what is happening as a huge paradigm shift for economies, institutions and social norms and practices that, critically, are not wired for such a phenomenon. It requires us to understand the dynamics, not only to navigate them well but also to avoid behaviors that make the situation a lot worse.”

– Mohamed El Erian


In just two short months, the world as we knew it has changed as a result of the worst global pandemic since the Spanish Flu in 1918.  Coming into the year, we were positive on the outlook for the U.S. economy and the secular themes we have defined in previous Outlooks, a view that was confirmed by the positive economic numbers and the stock market returns through mid-February.  However, we did not anticipate the outbreak of the  Coronavirus (COVID-19) which started in Wuhan, China and subsequently has morphed into a global pandemic.  This has turned the longest bull market in U.S. history into a bear market in just about one month.  The pandemic has served as a painful reminder of the interconnections and interdependencies of the world, and has exposed many of the economic, political and social vulnerabilities which had been building up in the global system since the financial crisis.  We expect the economy to get worse before it gets better, but it will surely get better.  Furthermore, the uncertainty and fear many are feeling are now creating substantial opportunities in the equity markets.  The market decline has left some of America’s best and most valuable corporations selling for unusually attractive valuations today.  

It is important to understand that the actions by governments and businesses to prevent the spread of the virus are purposefully disruptive to global commerce as they are protecting the populations at the expense of short-term production, spending and growth.  The U.S. economy, which continued to be quite strong coming into the year, is now falling into a recession.  Because the impact of the coronavirus will not be shared equally as small businesses and employees in certain industries will bear the brunt of the pain, the federal government proposals are targeting these segments as many small businesses are already closing and the unemployment rate is rising rapidly.  Some businesses will only recover a portion of the lost revenue, but others like those in the entertainment, restaurant, travel and hospitality industries will take longer to recover.  That is why for some businesses the economic impact might be characterized as a slowdown, while for others a recession, and for a few a depression as more than a few industries and companies will be more permanently impacted.  

While we do not in any way minimize the severity of the coronavirus, we would underscore that its economic impact will be temporary in nature as it is the result of severe, short-term supply and demand disruptions around the world rather than a collapse of the global banking system as we experienced in 2008. The recent “whatever it takes” policy initiatives by the Federal Reserve to ensure liquidity for the system is unprecedented in scale and only strengthens our view that interest rates are likely to stay low for the foreseeable future. In spite of this and other recent monetary policy actions, central bankers now have a more limited toolkit with which to stimulate growth. Therefore, fiscal policy has to and will be playing a major role.  Many European countries are recommending fiscal responses of 1% of gross domestic product (GDP),  and we expect them to be required do more.  In the United States, Democrats and Republicans are negotiating a massive stimulus well in excess of $1.5 trillion.  Unless the U.S. can stop the contagion sooner than later, the cost to the government may be much higher, possibly in the $4-5 trillion range.  For perspective, the U.S. GDP was forecast to be just over $21 trillion for 2020.  

One solution we would propose requires a two-pronged approach.  First would be an immediate one-month shutdown in the U.S. of non-essential services to stop the contagion in its tracks, similar to what has been done in China.  This would allow the government to arrest the spread of the virus sooner and to get the proper testing and health support services in place, while allowing our world-class pharmaceutical  companies and universities’ research laboratories to buy some more time to develop a treatment and eventually a vaccine to counter the virus.  Next, the government could focus on getting businesses and industries crippled by the crisis as well as those who become unemployed back on the road to recovery.  Congress could grant the Treasury the ability to borrow from the Federal Reserve whatever amounts would be required to support and heal the economy. The financial resources that the government has are almost unlimited as long as the Treasury is given the powers to borrow directly from the Federal Reserve rather than in the open market which would tend to have the effect of pushing interest rates higher.  The Federal Reserve Bank, which has a balance sheet already in excess of $4 trillion, is more than capable of providing additional large sums of money. We believe these steps would stop a pandemic recession from triggering a financial recession and support a more rapid economic recovery.  

We expect the equity markets to bottom concurrent with the spread of the disease abating but before we see the economy improving.  At the same time, investors will likely be feeling maximum discomfort with the economic outlook.  Therefore, we would caution investors against overreacting to such conditions.  We hold  above-average cash balances to take advantage, in a measured way, of the values being presented over the coming period.  Importantly, we are confident that the secular themes defined in recent? Outlooks – technology disruption, improvements in healthcare, defense to protect against global instability, quality growth in a low-growth economy, those with strong balance sheets and companies with safe dividends in a low-interest-rate world – not only remain intact but are being reinforced and even augmented by the conditions of the global economy.  While we are not by any means calling a market bottom, we have come so far so fast that we expect that investors who are patient, disciplined and opportunistic with owning and buying quality growth companies and those with safe dividends will be rewarded.  Going forward, we believe that this crisis will change many of the aspects of the way we live, learn and work. 

During this once-in-a-100-year event, we want to remind our clients that in times like these it is paramount not to let fear and panic drive investment behavior. Market declines are always difficult to experience but keeping perspective and focusing on goals are critical to successful investing.  This in no way minimizes the recent declines in accounts but serves as a reminder that successful investing always requires taking a longer-term view.  

“Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market.”  ?

– Benjamin Graham, legendary investor and father of Graham & Dodd value investing



The Decade of Disruption

“We live in an era of disruption in which powerful global forces are changing how we live and work. The rise of China, India, and other emerging economies; the rapid spread of digital technologies; the growing challenges to globalization; and, in some countries, the splintering of long-held social contracts are all roiling business, the economy, and society. These and other global trends offer considerable new opportunities to companies, sectors, countries, and individuals that embrace them successfully—but the downside for those who cannot keep up has also grown disproportionately.”

– McKinsey Global Institute Report, January 2019

As a new decade dawns, the rate and magnitude of the coming changes will require investors to identify and embrace the most investable themes in a world that may at times feel un-investable. To protect and build capital in this type of environment, investors should focus on the primary beneficiaries of a few critical secular themes in the new decade of disruption and avoid the companies that are being disrupted. These secular themes are continuing technological advances and the powerful demographic shifts involving aging, automation and inequality. Climate change is becoming a more actionable investment theme across all equity strategies, and investment professionals may have to play catch up. These three themes will have profound implications for investment strategy and are closely linked to other important factors including the adjustments in monetary policy, fiscal policy, debt burdens, political disequilibrium, geopolitical conflicts and deflationary global forces. Successful investing in the coming year will require a high level of conviction at a time when many aspects of our lives could be experiencing significant change.

While impeachment proceedings, the Phase I deal with China, and the Iran situation have dominated the news flow so far this year, the market has instead continued to react favorably to the outlook for improving corporate earnings and lower-for-longer low interest rates. Notwithstanding negative headlines, we continue to view the United States as the standout economy due to the underlying strength of consumer spending, the efforts of state and local governments to invest in infrastructure and other critical programs, and the potential for corporations to significantly increase capital spending. Consequently, we continue to view the U.S. equity market as superior to foreign markets on a risk/reward basis. In the current environment, client portfolios should continue to emphasize many of the leading companies including healthcare companies, large cloud-service providers, display, telecommunications, mobile communications companies, semiconductor

capital equipment companies and chip manufacturers, as well as cyber, software, and defense companies. In this Outlook, we will discuss the investment implications of three of the most powerful forces that are reshaping our world. We believe the rate of change is in an accelerating state, and that this will force investors, policymakers and business leaders to come to grips with the implications of these changes so that they will not be left behind. Legacy companies must transition to adjust to the changing environment, and their success or failure will result in a revaluation of the businesses, which sets the stage for potential shifts in market leadership. To the degree that this environment fosters original thinking, active management should become more important than passive management.

The Third Wave of Technology: The Start of the Transformational Phase

“Technological change is not additive; it is ecological. A new technology does not merely add something; it changes everything.”

– Neil Postman, American educator

In the past, we have written extensively about the Third Wave (see Chart 1) and the coming transformative opportunity that 5G would deliver for consumers and businesses. 5G is moving from pilot programs to becoming a reality as it moves to full deployment over time. This is a game changer in our view as the way we live and work is about to undergo unprecedented change. By solving complex data and storage problems and the latency issue, 5G facilitates breakthrough technologies and their applications that were once unimaginable. Many of the benefits of this transformation will be less transparent than the obvious download speeds of data and videos on our devices. But no less important, it will help drive down production costs for the products and services in daily use. This in turn fosters more innovation.

To help our readers understand the power of 5G and the related technological advances we focus on the healthcare industry which will be one of the biggest and most immediate beneficiaries. As many are aware, the $3.3 trillion of annual healthcare costs in the United States represent an estimated 16% of GDP, which is double most other developed nations. Technological advances should enable the U.S. to reduce costs and improve the delivery of health services, while extending average life expectancy. There are three major benefits that technology brings to the industry—more accessible and better treatment, improved care and efficiency, and software-specific programs to improve overall care and disease control. In the coming years, we will see new applications of predictive healthcare and the introduction of more personalized prevention and treatments to ensure better outcomes for individual patients.

Big Data Capabilities and Storage: One of the key inefficiencies in the healthcare system is the management, access and retrieval of medical records. Moving to an electronic health record system will address some inefficiencies as data entry into a computerized system is much less time-consuming than are paper-based systems. One study from the University of Michigan estimates that this switch alone could reduce the cost of outpatient care by 3%. Cloud storage of data helps improve efficiency and accessibility while reducing wastage. This also facilitates the research and development of new treatment protocols and lifesaving pharmaceutical formulations. As patient data is highly valuable, the critical weaknesses of electronic health record systems are being addressed such as security and data protection. According to some estimates, stolen health credentials have 10–20 times the value of credit card data.

Artificial Intelligence: A recent study published in Nature Medicine highlighted how doctors are using artificial intelligence (AI) during brain surgery to diagnose tumors with slightly greater accuracy, but in less than two and half minutes compared to 20 to 30 minutes by a pathologist. The greater speed and accuracy offered by AI means the patient will spend less time under anesthesia, while allowing surgeons to detect and remove otherwise undetectable tumor tissue according to the study.

Genomic Research and Personalized Services: According to the National Human Genome Research Institute, technological advances are lowering the cost of sequencing a human genome which fell from $14 million in 2006 to about $1000 in 2016, and costs continue to decline. Genomics is the study of a person’s genes (the genome) including interactions of those genes with each other and with the person’s environment. A genome is an organism’s complete set of DNA. As the costs of genomic sequencing continue to decline, it opens the way for personalized treatment and medical programs designed for an individual’s specific genetic makeup. While there are many ethical issues surrounding genetic research, the potential to lower costs, improve outcomes and extend lives is significant.

Wearable Technology: Continued advances in wearable technology will help transform healthcare by allowing doctors to more quickly and accurately diagnose, treat, and prevent debilitating health conditions, while increasing patients’ access to care. Healthcare is a major point of emphasis for research by Apple and Alphabet (Google) among others, and wearable devices are a significant potential revenue opportunity for many companies. Wearable devices are being designed to target the most common chronic diseases including heart disease, diabetes, hypertension, and respiratory diseases. Other types of wearable technology being introduced include: wireless headsets for EEG (electroencephalogram) tests which are less invasive; eye lens implants to help restore or improve eyesight; bionic suits to help workers lifting heavy weights in repetitive movements or the elderly being more ambulatory; and for robotics to assist doctors and nurses treat life-threatening health issues. Also being tested are smart scanners that can check someone’s vital signs with a simple touch of the forehead, and at some point in this decade, ingestible nanochips could help doctors monitor the body’s internal systems.

These are just a few of the many ways the healthcare industry will be reinvented in the future, and there will be many more advances involving the use of artificial intelligence, machine learning and blockchain technologies that will improve and extend our lives.

How Demographic Shifts Are Reshaping Our World

“Demographics, automation and inequality have the potential to dramatically reshape our world in the 2020s and beyond… In the next decade, they will combine to create an economic climate of increasing extremes but may also trigger a decade-plus investment boom. In the U.S., a new wave of investment in automation could stimulate as much as $8 trillion in incremental investments.”

– Excerpt from the Bain Consulting report, “Labor 2030: The Collison of Demographics, Automation and Inequality”

The unusual combination of rapidly aging populations, increasing workplace automation, and worsening income inequality will provide complex and interconnected challenges for policymakers for years to come. Changes in the demographic characteristics of a society have important implications for the structure of the workforce, government policy, and the overall economic outlook as most of the world’s leading economies are facing major headwinds from the demographic decline. According to data from World Population Prospects: the 2019 Revision, “by 2050, one in six people in the world will be over age 65 (16%), up from one in 11 in 2019 (9%)… In 2018, for the first time in history, persons aged 65 or above outnumbered children under five years of age globally. The number of persons aged 80 years or over is projected to triple, from 143 million in 2019 to 426 million in 2050.” This is the result of three factors – increases in life expectancy, declining fertility rates and unusual emigration patterns. Chart 2 highlights the projected trends toward an aging society as published in the United Nations report, World Population Prospects 2019.

As the world population ages, the Potential Support Ratio (PSR), or the ratio of the working-age population, 15 to 64, per one person 65 and older will become more important for investors. In 1950, the global PSR was 10.1 and it has dropped to 6.3 in 2019. By 2050 the PSRs are projected to be substantially lower at 3.5. The problem is most acute in Eastern and South-Eastern Asia with 261 million people aged 65 and over in 2019, Europe and North America (200 million), and Central and Southern Asia (119 million). By 2050, the United Nations forecasts the number of older persons doubling from 703 million to 1.5 billion. Concurrently, the birth rates in most developed nations are declining. According to a recent United Nations report, “The unprecedented shift towards a larger proportion of older persons and concomitant declines in workers is gradually and inexorably necessitating redesign of national economies.”

As a result of the demographic shifts, we anticipate greater social strains as governments are forced to address rising and, in many cases, unsustainable pension and healthcare obligations. As the yellow vest demonstrations in France have shown, the demonstrators do not want any adverse changes to their pension benefits, and one proposed change that was heavily criticized was raising the retirement age by only 2 years. The fact is that many of the future pension and healthcare obligations will not be able to be met without either lowering future benefits and/or raising taxes considerably due to fiscal constraints on governments in most developed nations. In addition, the aging issue will require a massive adjustment in the labor force that will necessitate greater use of automation, artificial intelligence solutions, and robotics in a variety of job functions in both the manufacturing and service sectors. New jobs will be created, jobs will be lost, and industries transformed in the process. This adjustment will create supply and demand imbalances in the work force for specific jobs, sometimes creating wage inflation for jobs in tight labor markets and sometimes leading to significant job elimination. There will be both inflationary and deflationary aspects of this shift that will pose additional challenges for monetary and fiscal policy.

Ironically, many nations may need to attract immigrants in order to have enough labor and consumption to drive economic growth and help meet future obligations, which for some countries would require a reversal of recent anti-immigration policies. Initially income inequality will likely be exacerbated as a result of the shift in the workplace as low-skilled, less-educated workers as well as older workers may not be as able to develop the skills required to compete for the better paying jobs. This low-interest rate environment enables businesses to be able to continue to invest in automation and lower labor costs through additional headcount reductions. This may push governments to consider skills-retraining and apprentice programs in conjunction with the private sector, a revamp of the educational system and ultimately to consider implementing some type of universal guaranteed income program.

Climate Change – We’re on the Eve of Destruction

“Climate crises in the next 30 years might resemble financial crises of recent decades: potentially quite destructive, largely unpredictable, and given the powerful underlying causes, inevitable.”

– Greg Ip, Wall Street Journal, January 17, 2020

From shifting weather patterns that threaten food production, to the terrible fires in Australia, to rising sea levels that increase the risk of flooding, among other problems, the impacts of climate change are being felt on every continent on an unprecedented scale. The problem is both man-made and due to natural causes and will require a multi-decade transition to address it. Attempts by governments to moderate the effects of climate change by controlling human activity are being undercut by the melting of the Arctic ice shield—250 billion tons of ice in 2019 alone—and the melting of the permafrost which is adding carbon dioxide and methane back into the atmosphere. There was a record melting of the permafrost in 2019, and this is critical as the melting causes erosion, the disappearance of lakes, landslides and ground subsidence. Whether you agree with the scientists or not, what is clear to the investment community is that changes in climate are having an immediate impact on supply chains, industries, living standards, water systems, food sourcing, global finance, and where people will live.

From an investment perspective, climate change is forcing immediate planning and spending that had previously been postponed. Capital spending related to climate change is going to be a much more important factor in economic activity this decade and beyond. This is forcing state, local, and federal governments as well as the private sector to respond with smart investment strategies. In many cases, it will require the continuation of low interest rates for an even longer period and greater investment spending which has repercussions for monetary and fiscal policy in a world already heavily indebted. Critically, the spending will be coming at a time when the global interest rate structure (the cost of capital) has never been lower, providing governments an ideal borrowing opportunity.

Our research efforts are focusing on the United States electrical grid and infrastructure systems as one of the most critical and immediate areas of need. The Fourth National Climate Assessment, released in 2018, noted, “Infrastructure currently designed for historical climate conditions is more vulnerable to future weather extremes and climate change.” Failure to address the nation’s grid will result in more problems like those experienced in California in the past year with rolling blackouts and wildfires. The current grid system in the U.S. is made up of three grids that are not well integrated. And one of the key issues will be transmitting energy between regions efficiently, particularly from the Southwest to the Northeast as well as from sparsely populated areas with energy supply surplus to more densely populated areas in supply deficit. The aging electrical grid system requires downtime to cool its transformers, and the shift to electric vehicles combined with rapid growth of the cloud and 5G would overwhelm the system as it stands today. The utilities are aware of the need to upgrade the electrical grid system, and four of them have announced capital expenditure plans in aggregate of more than $100 billion over the next three years. Our research continues to identify the companies benefiting from climate-related expenditures, especially those companies providing infrastructure solutions for the utility, pipeline, energy and communications industries.

As government and business leaders gather at the World Economic Forum Annual Meeting in Davos, the calls for action on climate are growing as evidenced by the theme for the event which is Stakeholders for a Cohesive and Sustainable World. Business leaders are paying attention as demonstrated by the recent pledge by Microsoft to become carbon negative in its emissions by 2030 and remove the amount of carbon it has emitted over the decades by 2050. This is a recognition of its role as a corporate leader in addressing the problem. Importantly for investors, the steps taken to address climate change will factor heavily into the valuations of companies going forward with some being helped and others being negatively impacted.

Investment Implications – Be Cautious and Opportunistic

The future depends on what you do today.”

– Mahatma Gandhi

On the surface, the conditions described above might lead investors to be pessimistic about the prospects for the U.S. and global economies, and therefore the markets. However, it is these conditions that may very well set the stage for an extension of the current economic expansion, and perhaps an even longer run for this bull market notwithstanding the possibility of a near-term pullback. The reason for the more positive view is a continuation of the present low-growth, low-interest rate and deflation-prone environment which will enable the Federal Reserve and other central banks to continue their accommodative interest rate policies and avoid impeding capital flows. Barring a significant shift in the outlook for inflation, which we do not anticipate at this time, the Federal Reserve must work to keep interest rates low for the foreseeable future, and that would continue to provide a favorable backdrop for equity investing.

While much has been made of the income and wealth inequality experienced around the world, there is a similar dynamic playing out with corporations. The leading companies are prospering, and the rest are less so. Why? Because these companies are more productive, and the resulting productivity leads to higher earnings and better pay for employees. These companies tend to have better balance sheets and access to capital, enabling them to invest more heavily, and therefore enhance their productivity, grow market share, and ultimately increase shareholder value. Investors should focus on companies with “embedded advantages” over their peers. The leading technology companies offer excellent examples of businesses with embedded advantages. Alphabet, the parent of Google, dominates the worldwide search market ex-China. While there is talk of increased regulatory scrutiny and higher taxes for companies like Google, this would likely reduce the ability of others to compete by raising the cost of doing business and increasing the barriers to entry. There are companies with these embedded advantages in several industries that are benefiting from the secular themes described in this Outlook, and that is where investors should focus their dollars. It is for this reason that we feel the investment environment is set to favor active management over passive management, and high conviction strategies over more diversified strategies. Additionally, the low-interest rate environment favors companies with strong balance sheets, good business models, and the ability to raise their dividends. Companies with solid, above-market dividend yields should continue to be rewarded under these conditions.

There are always risks to the economic outlook and that is certainly the case today. Aside from the ever-present geopolitical risks, the risk of a massive cyber-attack on the U.S. infrastructure, government institutions or the financial system, or the risk of policy missteps, among the key risks that would change our positive views would be a sharp rise in inflation and in the U.S. dollar. As the world economy remains both fragile and fluid as highlighted by the coronavirus epidemic, we continue to be opportunistic and cautious in our investment approach. Climate change has now come to the fore as a secular trend. It now represents an immediate, multi-year investment opportunity. As we said at the start of this piece, the powerful shifts in the global economy are creating large 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 both absolute and relative returns over time by owning the businesses that are the beneficiaries of the secular trends.


Can Investors Adapt to the New Investment Paradigm?

Today’s investors must adjust to a global economy unlike any previously experienced. There is no historical precedent for the post-financial crisis economy, and one need look no further than the more than $12 trillion of government bonds currently carrying negative yields. The convergence of these unprecedented economic conditions with unconventional monetary policy, insufficient fiscal policy responses, and a changing market structure are challenging many investment strategies dependent on historical precedent. Volatility and uncertainty are two defining characteristics of a deflation-prone global economy marked by low growth and low interest rates. At the same time, growing economic divergences, populist politics and changing terms of global trade are contributing to significant shifts in investor sentiment, which in turn impact short-term security valuations. Bear in mind, the more negative the sentiment, the better the value for the buyer. Conversely, more positive sentiment can lead to greater overvaluation in individual stocks or the overall market. This is important because securities trade in an auction market that has inherent inefficiencies which lead to the mispricing of securities. These mispricings create opportunities for investors who have the ability to correctly define the macroeconomic conditions and the willingness to go against popular sentiment. The distinct economic, political and social dynamics of the current environment leads us to question whether investors can adapt to this new investment paradigm.

To remind our readers, the purpose of the ARS Outlooks is to define the forces affecting the global economy and to identify the beneficiaries of the key secular trends. The Outlook is the foundation of our investment philosophy and process. We employ a long-term, investment-oriented approach, and avoid short-term speculation. We do not attempt to make predictions with unwarranted precision, but rather work to determine those outcomes that should have the highest probability of success. Our focus is to define the secular beneficiaries of the global environment and then the outlook for the three fundamental elements of securities valuation — corporate earnings, interest rates and inflation rates. Once we determine the sectors and industries that should most benefit, our team conducts fundamental research to determine which U.S.-publicly listed companies represent the best values for client portfolios. We are seeking to buy the most assets, earnings and cash flows in the beneficiaries of the global economy. Our research focuses on those businesses that generate significant free cash flow as it represents what companies actually have left at the end of the day. Cash flow is what drives a business and its ability to invest in the future and to reward investors through dividends and share buybacks. We are less concerned about reported earnings which are a creation of accounting rules. The job of investment professionals is to make their best judgment on the future earnings power of the businesses they own.

In this piece, we will describe why investors cannot compare the current expansion to past cycles, why governments must become the spenders of last resort, the implications of changes to the structure of the market and where capital is likely to flow in the new investment paradigm. While the current environment is likely to remain volatile and uncertain, we expect the U.S. and global economies to improve in the coming quarters. Efforts by central banks to stimulate growth, including the recent rate cuts by the Federal Reserve and others, typically take 2-3 quarters to work through the system. Additionally, we remain positive on the secular trends that we have identified and highlighted in recent Outlooks. While policy missteps always remain a risk for the global system, we believe that the secular trends we have identified will continue to be the principle drivers of economic activity for the foreseeable future.

Why You Cannot Compare the Current Expansion to Past Cycles?

The current economic expansion, which is the longest in U.S. history, has many distinct characteristics when compared to past cycles. The post-WWII global economic system was defined by monetary controls, administered prices, fixed exchange rates, and cost-of-living wage adjustments in labor contracts with inflationary tendencies, among other forces. In 1973, President Nixon introduced floating exchange rates where currency rates are determined by the markets. Subsequently, governments moved to managed exchange rates, also called “dirty floats”, whereby a country’s central bank intervened to raise or lower the value of its currency. From a geopolitical perspective, two important multilateral governing institutions introduced between 1948 and 1949 were the North Atlantic Treaty Organization (NATO) for defense purposes and the General Agreement on Tariffs and Trade (GATT) which was introduced to help guide international trade in the post-war period. GATT was the predecessor to the World Trade Organization (WTO) which was officially launched in 1995. In the 1970s, cost-of-living wage adjustments combined with higher oil prices stemming from the 1973 oil embargo created extensive inflationary conditions. This led then Federal Reserve Chair Paul Volcker to use monetary policy to dramatically raise interest rates to curb the inflation which peaked at 14.8% in March of 1980.

The fed funds rate peaked at 20% in June of that year. In general, economic expansions end because the economy becomes overheated causing central banks to raise interest rates in response. At the same time, spikes in oil prices often accompanied rising economic activity which put even greater strains on the system.

Current conditions are very different from past expansions especially at this late stage of a business cycle because we are running a massive federal government deficit at the wrong time. Moreover, much has changed in the past decade to challenge the post-WWII norms that make comparisons with previous cycles questionable. In response to the 2008 global financial crisis, the world’s leading central banks embarked on accommodative monetary policy programs unlike any previously conducted. These actions have resulted in the lowest level of interest rates in most investors’ lifetimes. At no time in history has the Federal Reserve lowered interest rates at this late stage in an expansion with the economy at full employment, interest rates already near record lows and deficits legislated to exceed $1 trillion for many years. This move is without precedent. In the past, an attack on the Saudi oil fields, like the one experienced recently, would have led to a sharp increase in oil prices and created a significant strain on importing nations and consumers. However, this time prices rose for about two weeks before declining as U.S. oil production continues at record levels of over 12 million barrels a day. Perhaps the two most important differences in the economic and political conditions today are that the global economy is more deflation-prone than in past periods and that the United States has pulled back from its global leadership role. The latter policy change has important geopolitical implications as it has undermined a critical decades-old system. In addition, the Administration’s policies are leading to fundamental changes in global supply chains for corporations and strategic alliances among nations.

There are four secular deflationary forces present that have not been as characteristic in past expansions as they are today. These are technology-driven disruption, debt, demographics and deficits. The worst thing that can happen to an economy is a deflationary spiral, to which the aforementioned deflationary forces contribute, as those conditions are hard to reverse. Inflationary cycles are easier to manage since the central bank can raise interest rates as Mr. Volcker did in the 1980s. Most economists and quantitative investors use statistics of past cycles to compare to this one, but the past statistics are of little practical use because the same conditions are not present today. Decades ago, interest rates were 14-15%, now the 10-year treasury is yielding 1.9%. When yields are high, capitalization rates tend to be low, when yields are low, the reverse is true. A capitalization rate is the rate at which the market calculates the value of current earnings of a company. This has important implications for securities valuation and is a key reason why the stock markets are flirting with record highs even in the face of political and economic uncertainty.

Why Do Governments Need to Become the Spenders of Last Resort?

“We all know what to do, we just don’t know how to get reelected after we do it.”

– Jean-Claude Juncker, the outgoing president of the European Commission

Why are most advanced economies growing at near stall speeds despite central banks pulling all the levers at their disposal? The answer is that the current problems cannot be solved by monetary policy alone, and that the fiscal policy responses of advanced nations has been woefully inadequate. As Mr. Juncker states clearly, politics are holding back the economy. Additionally, the trade war is retarding capital expenditures, debt and uncertainty are weighing on consumer spending, and monetary accommodation is showing diminishing effectiveness in generating economic activity. The post-crisis goal of monetary policy was to increase asset values to stimulate economic growth and make the debt problems more manageable. However, there were unintended consequences including growing income inequality that resulted from the failure of politicians to introduce the fiscal stimulus required to address the many needs of a rapidly changing world. The growing frustration with governments is evidenced by the street protests in Hong Kong, Chile, Spain, Lebanon, Bolivia, Iraq, and Russia to name just a few. This failure of elected officials to act responsibility is also a major reason for the political divisiveness in the U.S., U.K. and Europe. The outgoing European Central Bank President Mario Draghi summed up the problem succinctly with his recent comment, “If fiscal policy had been in place, or would be put in place, the side-effects of our monetary policy would be much less, the actions of our decisions today would be much faster and therefore the need to keep in place some of these measures would be much less.”

What should happen now? There are three sources of spending in an economy – consumers, corporations and governments. Today, governments need to act to become the spender of last resort in order to counter the deflationary pressures and stimulate growth. The good news is that there are several important initiatives that could be implemented immediately, and these are in areas of greatest need in most advanced nations. To start, governments should make significant investments in our physical, digital and educational infrastructures. As the former head of the International Monetary Fund and incoming ECB President Christine LaGarde said recently, “Those that have the room to maneuver, that’s to say Germany, the Netherlands, why not use that budget surplus and invest in infrastructure? Why not invest in education? Why not invest in innovation, to allow for a better rebalancing?” Advanced nations share the same challenges, but few politicians have the courage to risk reelection in order to do the right thing. France’s President Macron is one who has gone against the grain by attempting significant reforms, and his efforts are starting to bear fruit. Maybe this will encourage others to follow suit.

In the United States, there are an estimated 7.1 million job openings which highlights the significant mismatch between available workers and the skills required for the jobs of the new economy. A recent survey from the National Federation of Independent Businesses reveals that 88% of small business owners hiring, or trying to hire, reported few or no “qualified” applicants. In response, the U.S. government should partner with leading businesses to create apprenticeship programs to help address the skills gap. Governments should work with our public universities to revamp the curriculums to better prepare graduates for the jobs of the future and not those of the past. Free tuition, as it has been proposed by some Presidential candidates, will not be useful without some changes as many recent graduates feel they are not properly prepared to enter the workforce and are saddled with an average of $28,000 or more in debt. In our May 6, 2019 Outlook, we discussed in some detail initiatives that should be considered by our elected officials to foster a higher and more sustainable rate of growth.

How Do the Changes in the Structure of the Markets Impact Investment Thinking?

In our September 18, 2018 Outlook, we addressed the key changes that are impacting the structure of the equity market in the United States. The most significant changes include the significant drop in the number of publicly traded companies, the concentration of power of leading corporations, the explosive growth in the number of investment vehicles available, the growing influence of private equity and the technological advances such as artificial intelligence, machine learning and high speed trading that are redefining the market’s mechanics and investment approaches. Many businesses which would have become public in the past now have much greater access to private capital from either venture capital or private equity investors. This means that a business can remain private and avoid the regulatory burdens of being a publicly listed company. Bear in mind that private equity firms are sitting with an estimated $1.7 trillion of uninvested capital and continue to raise record amounts of cash. Another factor impacting the structure of the market is the growing influence of passive investments in index funds and exchange traded funds (ETFs).

Passive investment strategies influence sentiment and encourage a “follow the herd mentality.” This is evidenced by the significant movement of capital out of equities (even as the indices have reached record levels) and into bonds which currently offer only modest yields at best. Investors seem
to have forgotten that the bull market in bonds has been going on since 1981, while the bull market in stocks has been going on since 2009. This would indicate to us that the risks of bonds may be underestimated by market participants while the risks of equity investing may be overestimated. In a recent survey of Barron’s Big Money poll of institutional investors, bullish sentiment was at or near a record low. If this sentiment changes and there is a reversal in flows back into equities, then the market in 2020 may provide even higher returns than anticipated for those who act ahead of the crowd. The prevalence of short-term thinking is another factor that investors must consider as capital is built over time through the ownership of businesses, not through quick return schemes. While more and more market participants are making decisions based primarily on price and popularity, our decisions continue to be business-driven, based on our judgment of the outlook for cash flow and earnings growth. While our core principles for investing will not change, the application of those principles must always take into account changes in the environment. We believe it is prudent to assess the current environment with a clear eye and without preconceived notions about the present based on past experiences. As Warren Buffet once said, “The stock market is a device for transferring money from the impatient to the patient.”

Where is Capital Likely to Flow in this New Paradigm?

“It is impossible to produce superior performance unless you do something different from the majority.”

– John Templeton

Capital will flow to the problem solvers of a low-growth and low-interest-rate world. The social, economic and political forces shaping the new investment paradigm described in this Outlook will require investors to adjust in at least three ways – asset allocation, return expectations across asset classes, and their views of liquidity. Asset allocation is determined by the relative risk/reward of cash, bonds and stocks. Low interest rates have been punishing savers and pension funds encouraging each to assume higher risk to achieve required rates of return. Pension plan managers, especially of public funds, have been forced to lower their return expectations, and the plans will require greater annual contributions going forward. This comes at a time when U.S. public pension funds are already facing an estimated $4.4 trillion funding shortfall. In our view, the search for higher yields has pushed investors to assume higher risks than may be suitable for many. When interest rates were higher, pension plan sponsors could achieve a significant portion of the required returns from bond yields that are no longer available. This makes quality dividend growers an attractive alternative.

Given the growth in private equity assets to over $4 trillion, it seems appropriate to share some thoughts in this area. Private equity plays an important role in the markets as it provides capital to businesses that might not be developed sufficiently for the public markets. When less capital was available for private equity deals, there were better opportunities to achieve outsized returns. However, several major public pension funds recently lowered their excess return expectations for private equity over public equities from 3% down to 1.5%. For those focused on private equity, this year’s failed IPOs and the Softbank investment in WeWork provided an excellent reminder that private valuations are also driven by sentiment. Softbank saw the value of its investment go from $47 billion a few months ago down to $7 billion. Many investors consider private equity to be a less volatile investment, but this false sense of security is due to the lack of daily pricing. Investors in WeWork might not agree given the swift change in valuation. Finally, we would remind investors that liquidity matters most when it is needed, and it is often needed when least expected. Private equity can play an important role in investors’ portfolios, but one should make sure the characteristics of the investment match the investor’s risk appetite and liquidity needs.

The three primary beneficiaries of the Outlook are companies with above-average revenue growth in a low-growth world, companies with stable, above-market dividend yields in a low-interest-rate environment and special situation companies including publicly traded small capitalization companies. While the economic outlook remains both volatile and uncertain, the secular drivers about which we have written for several quarters remain intact with the beneficiaries continuing to attract capital. The major areas of emphasis for portfolio holdings include:

Quality dividend growers – We have identified a portfolio of high-quality companies with strong balance sheets, good growth and which pay dividends at above market rates. The dividend yields are nearly 1% higher than the 1.95% yield of S&P 500 and the 1.9% yield on the 10-year U.S. treasury bond.

Quality growth companies – One of the key implications for investors is that companies with above average revenue growth can command premium valuations as they are less reliant on a strong economy. This opportunity includes technology companies that are benefiting from unprecedented innovation which we see accelerating in the next 36 months. ARS is focused on cloud, 5G, cyber security, software services, semiconductors and capital equipment, display, telecommunications, mobile communications, network infrastructure, connectivity solutions providers, and beneficiaries of autonomous driving. We also favor select defense and materials companies as well as specially defined healthcare investments due to favorable demographic trends and technological advances.

Company-specific stories – (including some smaller capitalization investments) with compelling valuations and strong company-specific catalysts or growth drivers. Furthermore, in this environment, companies with strong balance sheets should continue to prosper as cash allows these businesses to invest in increased productivity, new growth initiatives as well as to return capital to shareholders. Please refer to our recent Outlooks for more specifics on these themes.

Our Outlook describes an environment unlike any investors have ever experienced. The U.S. and global economies should experience higher growth into 2020 and the expansion should continue for some time. Any tariff relief will release the pressure on the global economy allowing capital expenditures to increase and the outlook for corporate profit growth to improve. In turn, this could result in interest rates rising somewhat as many investors shift from bonds back into equities at a seasonally strong time for equity investing. Those equity investors who have been on the sidelines will be under pressure to invest cash. This could result in stronger equity returns than many currently anticipate in coming quarters. One can be 100 percent invested in any environment if one can correctly define it. However, the dynamics present today are very fluid and volatile, making being fully invested somewhat less appropriate in our view. Today, it pays to have some cash reserves, not as a market call, but to take advantage of the opportunities presented by market volatility. We remain optimistic about the prospects of building capital in the coming quarters but believe investors should focus on striking the appropriate balance between risk, reward, and liquidity. As legendary investor, Seth Klarman reminds us, “Investors should always keep in mind that the most important metric is not the returns achieved but the returns weighed against the risks incurred. Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.”



What Should I Do Now?

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

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

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

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

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

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

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

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

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

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

Why a Strong Fiscal Policy Response Is Even More Necessary Today

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

Jens Weidmann, head of Germany’s Bundesbank

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

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

What Are the Investment Implications of This Outlook?

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

Rana Foroohar, Financial Times, 8/19/19

Based on the economic considerations expressed in this Outlook, there is increased clarity as to where capital will likely flow. The three primary beneficiaries are companies with above-average revenue growth in a low-growth world, companies with stable, above-market dividend yields in a low-interest-rate environment and special situation companies including publicly traded small capitalization companies. While the economic outlook remains both volatile and uncertain, the secular drivers we have written about for several quarters remain intact with the beneficiaries continuing to attract capital. The major areas of emphasis for portfolio holdings include:

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

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

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

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

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

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

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

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

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

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

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

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