Everything’s Changed

Everything’s Changed

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

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

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

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

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

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

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

Forces Driving Shifts in Capital Flows

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

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

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

Chart 1. The Impact of Sanctions on the Russian Economy

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

Lower Global Growth

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

Chart 2. The War’s Impact on Global Growth

Higher Inflation

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

Chart 3. The War’s Impact on Inflation

Interest Rates to Rise, But Must Remain Historically Low

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

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

Geopolitical and Political Forces

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

-Economist Adam Posen, President of the Peterson Institute

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

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

Investment Opportunities for a Changing World

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

-Howard Marks, Oaktree Capital

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

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

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

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

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

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

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

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As the Pandemic Matures, Different and More Equity Opportunities Emerge

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

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

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

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

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

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

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

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

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

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

What are the risks in the system?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What are the investment implications of the Outlook?

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

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

Semiconductors and Capital Equipment

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

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

Commodity Companies

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

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

Broadband Industry

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

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

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

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

Published by the ARS Investment Policy Committee:

Stephen Burke, Sean Lawless, Nitin Sacheti, Michael Schaenen, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor.

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

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

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

Looking At the World Through a Different Lens

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

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

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

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

Remembering What Makes the United States Special

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

Table 1. America’s Balance Sheet

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

Exciting Stories from the American Midwest

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


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

Nottingham Spirk and Cintrifuse

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

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

The Climate Transformation and the Challenge of Getting There

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

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

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

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

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

Investment Implications

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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. 

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

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.  


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.


“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

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