Category: The Outlook

The sharp pullback in U.S. equity prices has created many compelling opportunities for companies we currently own and companies we are considering for inclusion in client portfolios. As our regular readers are aware, historically the months prior to a mid-term election have tended to be volatile and generally negative for stock markets, and the current correction was no exception. However, the period following an election has typically provided strong returns into the end of the year for investors. As we wrote in our September Outlook, stocks trade in an auction market where buyers exchange dollars for shares of businesses. In the recent market pullback, there has been a temporary absence of buyers that has created significant opportunity for long-term investors. Following such periods, premier companies can provide significant returns for investors when buyers return to the market. Given the sudden and sharp move in stock prices, we felt it appropriate to share with you our thoughts on three key questions:

– What drove the market pullback?

– What are we doing as a result?

– What are our highest conviction opportunities going forward?

What drove the market pullback?

As we wrote in our last Outlook, today’s stock market is more short-term oriented than ever before as ETF, algorithmic and high-frequency trading have come to dominate daily trade volumes. The structure of the market has changed with more short-term trading done by computers and algorithms focused primarily on price movements, and not fundamentals. The computer-driven trading trends that drive prices up or down are leading other market participants to react to the price movements exacerbating the price action. Recently, headlines highlighted that the global economy has been slowing somewhat and conditions have become somewhat less favorable due to concerns about companies lowering guidance, trade conflicts, geopolitics (Saudi Arabia, Brazil and Germany), recent comments by Federal Reserve Chairman Powell on future rate hikes, debt, deficits and the China economic slowdown. What is lost in the frenzy of the recent trading activity is the fact that fundamentals remain relatively strong for the U.S. economy and for the businesses at the core of our secular trends – tech, defense, healthcare and select consumer companies as well as small capitalization companies.

Strong balance sheets and free cash flows should matter more than in recent years. It is worth noting that we are experiencing a transition from a liquidity-driven market to a more fundamentally-driven one, which is positive for active management and the many companies we favor whose earnings and free cash flows are expected to grow again in 2019.

What are we doing as a result?

We are making some adjustments to the portfolios, looking for opportunities to reduce taxes by realizing capital losses, and by taking advantage of the opportunities created by the recent pullback by adding to selected positions. Importantly, our secular views remain intact and we are putting cash to work in a measured way. We are focused on positive fundamentals of the businesses we own and other companies whose valuations have become particularly compelling. While the economic headwinds have increased, we maintain our strong conviction in the secular forces that we have identified and the fundamental value of the companies in our portfolios. Howard Marks, a legendary investor, has said that, “Investment success requires sticking with positions made uncomfortable by their variance from popular opinion.” We share his viewpoint, and believe that the short-term price movements do not reflect either the business realities or the fundamental valuations that are inherent in our portfolio holdings, despite the recent sharp declines in stock prices. Doing right in investing often involves doing what is initially unpopular. While more and more market participants are making decisions based primarily on price and popularity, our decisions continue to be business-driven based on our judgment of the outlook for cash flows and earnings growth. In the past two years, we have generally held higher cash levels to take advantage of price dislocations due to the realities of today’s market structure. We are currently redeploying some of that cash by buying companies we believe are on sale.

What are our highest conviction opportunities going forward?

Those companies that are benefitting from the secular trends we have identified for several years should continue to generate higher cash flows and earnings allowing them to continue to invest to increase their competitive positions, raise dividends and repurchase shares. To this end, we continue to focus on the secular trends favoring technology (including cloud, memory, storage, the internet of things), health care, energy, and defense companies among others. Smaller capitalization companies should continue to be attractive given their more domestically-oriented businesses in light of the growing challenges of investing in foreign markets. We believe that many positive factors for U.S. corporations and the U.S. economy continue to be underestimated. By implementing the tax cuts and increased deficit spending in advance of the introduction of tariffs, the Administration has, at least in the near term, offset some of the negative consequences of the changing terms of trade. Moreover the devaluations that are occurring in the emerging market economies have the effect of augmenting the attractiveness of the United States economy and its markets. Notwithstanding the changes to the structure of the market, investors should not underestimate the impact of the powerful technological advances coming over the next 36-48 months that will affect every industry.

If you have any thoughts or questions about our views or your portfolio, please feel free to call us.

“The underlying principles of sound investment should not alter from decade to decade, but the application of these principles must be adapted to significant changes in the financial mechanisms and climate.”

– Benjamin Graham, investor and professor widely acknowledged as the “father of value investing”

We have always viewed the markets as a medium of exchange, swapping dollars for shares of businesses understanding that the opportunity to build long-term capital lies in the discrepancy between the real worth of a business and its stock price as determined by the auction market. Our focus is to own a relatively small number of the best-positioned, best-valued companies in the market, and not the market itself. Investments are made in client portfolios with a view to holding them for the medium to longer-term believing that these companies are the beneficiaries of the secular trends driving the global economy. Before committing capital, our research must produce a clear picture of those investments that are deemed to offer the most cash flow, assets and earnings for the fewest dollars invested. We evaluate a stock the same way we would value the purchase of an entire company. This is the approach we have successfully employed for over 45 years. As more and more market participants make investment decisions based primarily on price and popularity, our decisions continue to be business-driven, based on our judgment of the outlook for the business fundamentals.

While our core principles for investing have not and will not change, the application of those principles must be adapted to changes in the environment as the stock and bond markets today are very different from previous ones. In our April Outlook, we discussed how important convergences in monetary policy, global politics and trade were creating challenging conditions for stock and bond investors. This Outlook will more narrowly focus on some of the key changes that are impacting the structure of the equity market in the United States. These include the significant drop in number of publicly traded companies, the concentration of power of leading corporations, the explosive growth in the number of investment vehicles available and the technological advances such as artificial intelligence, machine learning and high speed trading that are redefining the market’s mechanics and investment approaches. Today’s market is more short-term oriented than ever before. Understanding these changes will enable investors to better navigate the challenges that currently exist and take advantage of opportunities to build and preserve capital. We still believe that many positive factors for U.S. corporations and the U.S. economy continue to be underestimated. In fact, the United States continues to attract significant capital as the currency devaluations that are occurring in the emerging market economies have had the effect of augmenting the attractiveness of the United States economy.

What has changed in the U.S. equity markets?

The two most significant changes in the U.S. equity markets are the dramatic drop in the number of publicly-traded companies and the growing concentration in the power of America’s leading companies. These topics were the focus of the recent Jackson Hole Symposium hosted by the Kansas City Federal Reserve. Using the Wilshire 5000 Total Market Index (Wilshire 5000) as a proxy for the U.S. equity market, there were roughly 5000 publicly traded stocks in 1974, a figure which peaked at 7562 in 1998 and has declined to about 3492 companies as of December 31, 2017. According to Wilshire, there have not been 5000 stocks in the index since December of 2005. As shown in Chart 1, a historical review of the New York Stock Exchange (NYSE) confirms a similar pattern with the number of NYSE-listed companies declining to about 2800 as of the end of 2017.

So why has the number of listed companies declined so dramatically? There are two reasons – the low number of newly listed firms and the high number of firms delisting. The lower number of new listings reflects greater opportunity for small businesses to access private capital from either venture capital or private equity investors and the desire for smaller companies to avoid the regulatory burdens of being a publicly-listed company. Bear in mind that private equity firms are sitting with an estimated $1.7 trillion in un-invested capital and continue to raise record amounts of capital. The high number of firms delisting is due, in large part, to the increase in merger and acquisition activity that has been supported by high cash balances at large. corporations, capital repatriation and private equity firm investments supported by the low interest rate policy of the last decade which has made acquisitions highly accretive.   In the U.S., there were 5,326 deals in 2017, with a combined value of $1.26 trillion according to a report by Mergermarket. In 2016, there were 5,325 deals, with a combined value of about $1.5 trillion. The United States has accounted for over 40% of global merger and acquisition activity for some time.

“In 1954, the top 60 firms accounted for less than 20% of GDP. Now, just the top 20 firms account for more than 20%.”

–Brookings Institution report by William Galston and Clara Hendrickson

As the number of companies in the public markets has declined over several decades, the concentration of industries has increased. This trend is accelerating as disruptive technologies are affecting companies in all industries. According to a JPMorgan report on global M&A, “technology is creating more differentiation between the largest, most successful firms and the rest of the market, which suggests that disruption is fueling a “winner takes all” environment.” In a working paper by Kathleen Kahle and Rene Stulz titled “Is the U.S. Public Corporation in Trouble?” produced for the National Bureau of Economic Research (NBER), the authors highlight that “In 1975, 50 percent of the total earnings of public firms was earned by the 109 top earning firms; by 2015, the top 30 firms earn 50 percent of the total earnings of the U.S. public firms. Even more striking, in untabulated results we find that the earnings of the top 200 firms by earnings exceed the earnings of all listed firms combined in 2015, which means that the combined earnings of the firms not in the top 200 are negative.”  Just look at the technology industry today, where Apple and Google operating systems run nearly 99% of all smart phones. Google and Facebook dominate the mobile advertising market, while Amazon, Microsoft and Alphabet dominate the cloud services business.   Amazon is expected to capture almost 50% of the U.S. e-commerce market by the end of 2018. While much has been made about the potential for such concentration of power in the hands of a few with respect inflationary pricing, the history of these firms has been to lower prices by disrupting industries. The dominance of these companies can more likely be attributed to their financial strength, their ability and commitment to invest in research and development, and their willingness to reinvent and reinvest for the future. The combination of their dominance and financial strength are reinforcing the competitive positions of these firms as the rich get richer in corporate America.

How is the investment landscape changing?

Concurrent with the changes in the equity markets, market participants now have more choices than ever to participate through a variety of investment vehicles and investment approaches. According to the Investment Company Institute (ICI), the mutual fund industry in 1960 consisted of 161 U.S.-registered funds totaling $17.03 billion. In 2017, there were over 7,956 U.S-registered mutual funds with 25,112 share classes totaling $18.75 trillion.

The number of Exchange Traded Funds (ETFs) has grown from around 120 in 2003 to more than 1,700 today.   While both are baskets of securities, ETFs added a new element to the equity markets in that mutual funds are only priced daily, whereas ETFs are priced and trade continuously like individual stocks. Furthermore, technology is enabling algorithmic trading that utilizes high-powered computers to buy and sell massive amounts of securities in milliseconds. Consequently, high-frequency trading (HFT) allows traders to move in and out of short-term positions at high volumes and high speeds to capture sometimes a fraction of a cent in profit on every trade. HFT is a type of algorithmic trading characterized by high speeds, high turnover rates and extremely short-term investment horizons. Computer-based trading has become a much larger part of the market’s daily activity and focuses almost exclusively on price movements rather than on business fundamentals. It is estimated that computer-driven trading accounts for 80-90% of trading volume daily.

What do these changes mean for investors?

“The single greatest edge an investor can have is a long-term orientation.”

– Seth Klarman, Founder of Baupost Group and legendary hedge fund investor

While it is difficult to ascertain the average holding period for stocks, the figure has declined considerably as shown in Chart 1. The average holding period for an NYSE stock has dropped from 8.3 years in 1960 to an estimated 1.2 years in 2000, and the number is believed to be even lower today. Holding periods for high-frequency-traded securities have been estimated by some sources to be as low as 11 to 22 seconds. Today more securities are traded based on price movements than are bought and sold based on the fundamentals of the underlying businesses. The growing disconnect between price and fundamentals is creating a greater opportunity for longer-term investors.

While these changes are occurring within the structure of the market, the global economy is in the midst of a period of unprecedented monetary and fiscal policy initiatives, growing economic divergences, challenges to the post-WWII global order, and shifting terms of trade.   With a dizzying array of investment choices combined with current global economic, social and political characteristics, people can be easily confused. Investors need to make a few fundamental choices to determine the best plan to meet their specific goals. Investors need to choose between a market approach based upon predicting price or an investment approach based upon the evaluation of business fundamentals and the real worth of each business. We believe it is difficult, if not impossible, to attempt to do both.   Business ownership has proven throughout history to be the best approach to building capital, but it requires patience and a longer-term perspective.

How is ARS addressing the changes in the structure of the market?

“Investment success requires sticking with positions made uncomfortable by their variance with popular opinion.”

– Howard Marks, co-founder of Oaktree Capital, noted institutional investor and author

While more and more market participants are making decisions based primarily on price and popularity, our decisions continue to be business-driven, based on our judgment of the outlook for cash flow and earnings growth. While our core principles for investing will not change, the application of those principles must always take into account changes in the environment. In the past two years, we have generally held higher cash levels to take advantage of the price dislocations due to the realities of today’s market structure. In several strategies, we have reduced the number of securities held, which in part is a reflection of the concentration of power described above, as fewer businesses have been driving the returns of the broader markets. Notably, we have also taken some profits and generated capital gains for clients as the prices of some businesses had been pushed up in the short-term beyond reasonable levels of valuation. Clients should not view trims of a position as a statement on the long-term outlook for that business, but rather as a reflection of our views of over and under valuation. At the same time, businesses at the intersection of important secular trends may experience periods of underperformance and will require some patience in the face of a lack of popularity in the short term. Investors should not confuse popularity, or lack thereof, with the quality of the business or its outlook. A perfect example of this has been the recent price declines of some of our favorite technology holdings where the fundamental outlooks haven’t changed.   As a consequence of owning businesses that can fall out of favor for a period of time, client portfolios may underperform the major market indices for some period. Our concern when a business is underperforming is not its short-term popularity, but rather its ability to continue to execute its business plan, grow its cash flows and earnings effectively, and ultimately realize its value.

In addition to the adjustments we are making to our active strategies, we launched the ARS Focused ETF Strategy in March of 2017. This strategy involves our team constructing portfolios that utilize ETFs to express the views put forth in our Outlooks. The strategy is designed to concentrate our investments in ETFs that provide the greatest exposure to our highest-conviction themes, similar to the exposures that we have in our other active strategies. We are excited about this offering as it provides an efficient way to gain the desired exposures, and allows us to manage client portfolios with lower investment minimums.

Those companies that are benefitting from the secular trends we have identified for several years should continue to generate higher cash flows and earnings allowing them to continue to invest to increase their competitive positions, raise dividends and repurchase shares. To this end, we continue to focus on the secular trends favoring technology, health care, energy and defense companies. Smaller capitalization companies should continue to be attractive given their more domestically-oriented businesses in light of the growing challenges in investing in foreign markets. We continue to believe that many positive factors for U.S. corporations and the U.S. economy continue to be underestimated. By implementing the tax cuts and increased deficit spending in advance of the introduction of tariffs, the Administration has, at least in the near term, offset some of the negative consequences of the changing terms of trade. Moreover the devaluations that are occurring in the emerging market economies have the effect of augmenting the attractiveness of the United States economy and it markets. Notwithstanding the changes to the structure of the market, investors should not underestimate the impact of the powerful technological advances coming over the next 36-48 months that will affect every industry.

Published by the ARS Investment Policy Committee:

Brian Barry, Stephen Burke, Sean Lawless, Jared Levin, Michael Schaenen, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor.

The U.S. economy is in the midst of the second longest expansion in its history which is being supported by massive tax cuts, deficit spending, growing capital expenditures and some deregulation. The global economy is experiencing strains that it has not experienced in recent times making the United States economy the prime destination for capital flows resulting in a stronger U.S. dollar. This in turn is placing further strains on dollar debt held by foreigners as well as the earning power of multinational corporations. The United States’ economic advantage is such that some of Wall Street’s leading strategists are suggesting that the expansion could continue into the second half of 2021 or even beyond. At the start of the year, the world economy was experiencing synchronized growth. This is no longer the case. As trade tensions mount, investors should recognize that the United States will be less affected as it is a net importing nation. Notwithstanding today’s headlines, we remain constructive on a narrowing group of U.S. equities based on our positive outlook for their corporate profits. Those companies that are benefitting from the secular trends we have identified for several years should continue to generate higher earnings and cash flows allowing them to continue to invest to increase their competitive positions. Given the current economic outlook, investors should focus more closely on company-specific earnings and events. We expect the market to reassess company valuations, especially for those highly indebted companies that may need to issue additional debt or equity to finance their businesses.

In times of considerable uncertainty, many investors make the mistake of overreacting to short-term conditions and market movements. The growing media attention towards trade wars, political divisiveness and immigration issues have been unsettling for many and serve as a distraction from the positive secular trends driving the global economy. Since the market has not had a significant pullback in some time, it is always possible for the markets to experience one. When and if such a pullback occurs, we will use cash to add to our favorite names. The secular trends favoring technology, defense and health care companies remain intact and smaller capitalization companies should be attractive given their more domestically-oriented businesses. We continue to believe that many positive factors for U.S. corporations and U.S. economy continue to be underestimated.

In this Outlook, we discuss the three main challenges for the global economy, share some insights from some of the leading executives of various industries, address client concerns about inflation, and discuss the investment implications of the adjustments occurring in the global economy.

What’s really behind the trade war?

“The People’s Republic of China (China) has experienced rapid economic growth to become the world’s second largest economy while modernizing its industrial base and moving up the global value chain. However, much of the growth has been achieved in significant part through aggressive acts, policies, and practices that fall outside of global norms and rules (collectively, “economic aggression”). Given the size of China’s economy and the extent of its market-distorting policies, China’s economic aggression now threatens not only the U.S. economy, but also the global economy as a whole.”  

Excerpt from the White House Office of Trade and Manufacturing Policy Report, June 2018 on China policies

In our April Outlook, we wrote that President Trump was sending a strong message to the world that the U.S. was no longer willing to accept unfair trade practices from any nation. President Trump is following through on his campaign pledge to address unfair trade practices, particularly those of China, which have taken place in a global system to which the World Trade Organization, past U.S. Presidents and other nations have turned a blind eye for decades. In order to change current practices, our trading partners need to be convinced that the U.S. will go all the way in terms of enforcing fair trade. Therefore, suffice it to say that we have now entered into a trade war. The critical underlying issue regarding trade is the battle for future technology supremacy between the United States and China due to economic and security considerations. The concern of the United States is not about competing on the basis of legitimate competitive practices, but rather on China’s use of stolen intellectual property. President Trump’s comments have been directed at China’s “Made in China 2025” plan whereby the Chinese government is supporting what it deems to be strategically vital and important industries in ways that are considered outside of globally accepted practices. The chart on the top of the next page highlights the key sectors being targeted by China according to the US Chamber of Commerce. As we have written for years, data is the new global currency and those that own the intellectual property will have a significant competitive advantage.

As a net importing nation, the U.S. should be hurt less by a trade war than other nations, but there is great uncertainty about the impact of tariffs on global growth. Consumers should expect higher prices on certain goods as many companies will not be able to absorb the costs of tariffs. After a period of strong earnings growth of the S&P 500 companies, we anticipate many companies will be lowering earnings expectations until they have clarity on the impact of changes on their costs and revenues. A trade war at this stage of the global expansion will have repercussions for global growth with Europe and a number of emerging market economies likely being the hardest hit. If this ultimately results in fairer trade and better global security, then everybody wins.

What happens when fiscal and monetary policies clash?

The U.S. tax cuts and higher deficit spending initiatives are requiring the U.S. Treasury to substantially increase the issuance of Treasury securities. Concurrently, the Federal Reserve is attempting to normalize interest rates and reduce its balance sheet. The combination of the clash of the expansion of the federal debt and the contraction of the Federal Reserve’s balance sheet has led to a shortage of U.S. dollar funding which impacts sovereign debt markets and has created a reversal of capital flows. This in turn has reduced the value of emerging market bonds and currencies, and accordingly raised the cost of global commodities traded in dollars. The United States is the world’s largest economy at $19.97 trillion and largest debtor nation at $21.04 trillion with fiscal deficits to be $828 billion estimated for 2018. The U.S. has been running annual trade deficits ranging from $395 billion to $723 billion or roughly 3% of GDP. That our trade deficits are high is well known, but the fact that the trade and fiscal deficits cause the United States to be overly dependent on foreigners to finance fiscal deficits perhaps is not as well understood. The efforts to eliminate unfair trade practices would help reduce our dependence on China and other nations to purchase our Treasuries. While this would have limited impact in the short term, the longer-term benefits would be tangible.

We are monitoring the pace of the rise in U.S. interest rates relative to those of other countries to anticipate future adjustments in currencies and capital flows as well as any debt problems that might arise. We are keeping a close eye on policy changes around the globe to assess their impacts as well.   For example, China is in the process of adjusting its monetary and fiscal policies to address its growing debt problems, manage capital flows and its exchange rate, in part to respond to trade issues, and is also considering a proposal to lower taxes to stimulate domestic consumption. Reuters recently reported that the European Central Bank is considering its own version of “operation twist” whereby the ECB will be buying more long-dated bonds next year to keep Eurozone borrowing costs in check even after it stops pumping fresh money into the economy.

So even though it has been 10 years since the debt-induced financial crisis, governments still need to keep borrowing costs down because the recovery needs more time. Perhaps the biggest takeaway regarding interest rates is that investors should expect central banks to feel the need to keep interest rates historically low well into the future. As the economic expansion has progressed, it has not shown itself to be strong enough to withstand higher rates based on the debt burdens facing the global system. Importantly, central banks lack the firepower to respond to the next recession with the traditional tool of significant interest rate cuts. We anticipate this will force bankers to extend the low-interest-rate cycle even beyond current expectations, while on the margin trying to push short rates somewhat higher.

What’s changing in politics today and why does it matter?

“This is an important time in the history of China and the United States as we work our relationship forward … The China-U.S. relationship is one of the most important in the world, [and] must be treasured.”

U.S. Secretary of Defense James Mattis at a 6/26 meeting with President Xi

Three fundamental geopolitical changes we are monitoring are the rise of populism and autocratic regimes in the developed world, the massive migration problem, and the apparent reduction of the United States’ role as the global leader. The United States’ withdrawal from its global leadership role is giving China an opportunity to step up and exert greater influence from an economic and military perspective. At the same time, China’s rise is being augmented by the United States challenging traditional alliances, trading relationships and many of the international institutions that have been in place for over 70 years. China is planning to invest an estimated $1.5 trillion in 80 countries as part of its “One Belt, One Road” initiative that it is using strategically to expand its sphere of influence although the original commitments may be tempered due to concerns about overreach and risks associated with the financing of these initiatives. The geopolitical situation is resulting in an increase in military spending.

The implications of the shifting alliances and anti-immigration sentiment have important ramifications for the future of the European Union and the economic expansion in Europe both of which are quite fragile right now. On the need for European reform, Angela Merkel, Chancellor of Germany, summed up the European challenge with her statement, “if we stand still, we will be pulverized.” On June 28th, European leaders agreed to the framework for an important agreement regarding the migration crisis that has plagued incumbent political parties throughout Europe and threatened to topple Angela Merkel’s coalition government. Given that the deal was put together in an overnight session, many details need to be worked out or this issue will remain politically divisive. Europe still needs to pull together to address the structural issues of the original design of the EU as its governing institutions did not foresee many of today’s key issues. The lack of a common vision is undermining efforts from leaders like France’s Macron to not only increase competitiveness, but to create a compelling and sustainable future for the upcoming generation. Importantly, the majority of people in Europe want to remain in the European Union and we do not anticipate a break up, but the status quo is not sustainable.

What are leaders saying about the economy, trade and secular trends?

We wanted to share some insights from political, business and industry thought leaders to understand their views on the economy, and the secular drivers of growth. The unique perspectives that these leaders bring to the table is invaluable to understand where the world is headed as political and corporate leaders are making decisions for future growth.

On the Economy

Jamie Dimon, CEO of JPMorgan Chase discussing the length of the economic expansion

“I would look at it a little bit more like we’re probably in the sixth inning or something like that … Bad tax policy, bad regulatory policy, bad policies some of which are being fixed and stuff like that. So I think it’s very possible you’re going to see stronger growth in the United States of America and that is picking up a little bit. You see capital expenditures going up a little bit. Consumer and business confidence are close to all-time highs. There are no potholes. I’ve heard [some people] say, well, it’s looking like 2007, completely untrue. There’s much less leverage in the system. The banks are much better capitalized. I can go on and on about the safer system. So, yeah, I think it can easily continue.”

On Trade

U.S.-China Economic and Security Review Commission, 2017 Annual Report, 11/15/17

“The Chinese government is implementing a comprehensive, long-term industrial strategy to ensure its global dominance … Beijing’s ultimate goal is for domestic companies to replace foreign companies as designers and manufacturers of key technology and products first at home, then abroad.”

Brian Coulton, chief economist at Fitch

“A major global tariff shock would have adverse supply side impacts, raising costs for importers and disrupting supply-chains, while reducing consumers’ real wages. The global multiplier effect of lower U.S. imports could be significant. U.S. outward foreign direct investment — the largest source of FDI (foreign direct investment) globally — would probably fall. Along with weaker confidence and lower investment, a global tariff shock would also hit job creation.”

On Technology

George Schultz, a former Secretary of the Treasury, in an Op-Ed in the Wall Street Journal on 6/27/18 on politics and technology

“The world is experiencing change of unprecedented velocity and scope. Governments everywhere must develop strategies to deal with this emerging new world. They should start by studying the forces of technology and demography that are creating it.”

Sanjay Mehrota, President, CEO & Director, Micron Technology from 5/21/18 earnings transcript on the growth of the cloud, data and storage business, and why this technology cycle is different

“One point I would like to make sure that I get across to you is that the cloud, the data center and the intelligent devices on the edge are really forming a virtuous cycle. The intelligent devices rely on more data to provide useful experience but they also create more data that gets stored in the cloud, which makes the cloud bigger, more pools of data created and stored on the cloud and processed in the cloud, that enables cloud to provide even greater value to the edge devices. It unleashes even more innovation and creation of new intelligent devices, more powerful intelligent devices, which then, in turn, guess what, create more data. And so, this is a virtuous cycle between cloud and billions of edge devices really leveraging this data economy to bring great value to the consumers as well as businesses across the globe, and at the heart of this is memory and storage industry and DRAM and flash.”

On Defense

Eric DeMarco, President, Chief Executive Officer & Director, Kratos Defense & Security Solutions, Inc.

“We are seeing significant demand for Kratos‘ target drones in the United States and also globally as a recapitalization of strategic weapon systems to address nation-state adversaries underway. With not only the United States DoD, but every NATO ally increasing its defense spending this year with 15 NATO countries increasing their defense budgets as a percent of their GDP. These strategic systems being deployed need to be exercised against the highest performance and most realistic threat surrogates of the world, which are Kratos‘ targets, and where Kratos is the undisputed an industry leader.”

Should clients be concerned about inflation?

Clients have been expressing concerns about rising inflation. While we acknowledge the near-term inflationary pressures from rising oil prices and tariffs, we believe that longer-term inflation remains constrained by the highly deflationary secular forces of technology, globalization, demographics and debt present in the system. While conditions are right for a modest increase in inflation rates, we do not feel that these concerns are warranted. In fact, the Dallas and Atlanta Federal Reserve Banks held a meeting in May to address this topic and the views are summarized in the quote below from the Dallas Fed. We are focused on the rate of change and will make necessary portfolio adjustments accordingly if inflation rates diverge from our expectations.

“Technology-enabled disruption means workers are increasingly being replaced by technology. It also means that existing business models are being supplanted by new models, often technology-enabled, for more efficiently selling or distributing goods and services. In addition, consumers are increasingly able to use technology to shop for goods and services at lower prices with greater convenience—having the impact of reducing the pricing power of businesses which has, in turn, caused them to further intensify their focus on creating greater operational efficiencies. These trends appear to be accelerating… To deal with disruptive changes and lack of pricing power, many companies are seeking to achieve greater scale economies in order to maintain or improve profit margins. This may help explain the record level of merger and acquisition activity globally over the past few years.”

What are the investment implications?

In our last Outlook, we advised readers that the two quarters preceding mid-term elections have historically proven to be challenging for the markets. The changes in monetary policy, global politics and trade are creating challenging conditions for stock and bond investors. As tempting as it is for investors to be distracted by short-term considerations, we would strongly encourage investors to focus on the secular forces to drive investment decisions. We cannot overemphasize the need to take advantage of the opportunities presented by market pullbacks. The United States should continue to attract capital from the rest of the world which should strengthen the U.S. dollar and constrain interest rate increases. The economic expansion could continue for a few more years and create an opportunity for companies to see even stronger earnings. Central banks will likely conclude that while normalizing policy is a desirable goal, it is secondary to extending the economic cycle for as long as practical in order to delay the next recession for which they do not currently have the tools to effectively address. This means that global interest rates should remain lower for longer than most anticipate. U.S. companies, should continue to enjoy the benefits of massive tax cuts, deficit spending, growing capital expenditures, and some deregulation. However, fewer companies will benefit in the current environment as some could experience supply chain disruptions and higher input costs from tariffs which they may not be able to pass on to consumers. Additionally, the stronger U.S. dollar will reduce earnings for some multi-national companies. As the beneficiaries continue to narrow, the market should react to support the winners at the expense of the rest of the broader market which is highly supportive of active management. Those that benefit from the conditions highlighted above should be well rewarded.

Share prices of some of the leading companies came under pressure in June as profit taking as well as concerns about a trade war had investors selling winners to lock in profits. However, we believe that capital will again flow to companies with above average growth characteristics, strong balance sheets, and high free cash flow to drive investments in future growth. In addition to being big beneficiaries of tax reform and deregulation, small capitalization companies whose earnings are better insulated from tariffs and currency fluctuations offer investors attractive opportunities. We continue to prefer to invest in the areas that are attracting increased capital spending, and those include disruptive technology, defense, healthcare and financial companies.   We also favor energy companies in the exploration and production area that have demonstrated greater financial discipline and have become more attuned to purchasing reserves at a discount to market value by using their free cash flows to buy back shares, while benefiting from higher prices. As a result, we have increased our energy exposure this year. We continue to remain cautious on fixed income investments given the risk/reward dynamics and would suggest that investors consider reducing their allocations and shortening their maturities to reduce the risk of capital losses. We recognize that important shifts in the global economy are occurring, and therefore it is a time to be more selective and opportunistic in portfolio construction and asset allocation.

Published by the ARS Investment Policy Committee:

Brian Barry, Stephen Burke, Sean Lawless, Jared Levin, Michael Schaenen, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor.

Consistent with past actions, Congress has once again taken the easy path while leaving others the hard work of addressing our nation’s long-term fiscal problems. The passage of a bipartisan federal budget by the Senate and the House, which followed the massive tax cuts passed in 2017, represents an inflection point for U.S. fiscal policy, and one which has important implications for stock and bond market investors. The current concerns about growing deficits and national debt levels are pushing interest rates higher, yet only somewhat higher than the recent historic lows. At the same time, markets are experiencing greater volatility after an extended period of extremely low volatility. Due to the increase in the federal budget deficit, we are modestly adjusting our expectations for interest rates, inflation rates and market volatility, but we are not changing our positive views on corporate earnings and the companies benefitting from this environment. We remain focused on the secular beneficiaries we have defined previously and would remind our readers that the drivers for these businesses remain firmly in place, notwithstanding these changed fiscal and monetary conditions. Moving forward, investors should expect even greater capital flows to the beneficiaries of this Outlook, particularly leading defense, technology and healthcare companies as well as those benefitting from increases in consumer spending globally.   One important consequence of the changes in our Outlook is that we anticipate that there may be fewer winning companies in 2018.

Will Corporate Earnings Continue to Rise in 2018?

As we wrote in our January 31st Outlook, “we expect corporate profits to increase supported by a synchronized global economic expansion with subdued inflation… this market rise is being driven by rising corporate earnings rather than just an expansion of price/earnings (P/E) multiples which often is a characteristic of the later stages of a market advance.” This view remains unchanged. However, there are two key questions for investors to consider following the tax cuts and increased deficit spending, these are – will the benefits be short-lived and how broadly will they benefit companies? The recent pullback notwithstanding, we believe that 2018 and likely 2019 will see a continuation of the growth in pre-tax and after-tax profits (as highlighted in Chart 1), but that the changes in fiscal and monetary policies will create an unequal playing field for U.S. corporations and small businesses. Well-respected investment strategist Ed Yardeni, of Yardeni Research, Inc., forecasts S&P 500 earnings of $155 in 2018 and $166 in 2019. Yardeni Research projects the S&P 500 will reach 3100 by the end of the year which is up from 2726 as of the time of this writing, and that target is based on the belief that the forward P/E will be 18.7. We have followed Ed’s work for some time, and he has been very effective defining the environment for many years. We expect that those businesses with strong balance sheets, the ability to raise prices, invest aggressively to offset inflationary pressures and increase productivity will be rewarded, and those that cannot will be penalized. Ironically for businesses, the budget deal adds additional near-term fiscal stimulus, and increased deficit spending will increase demand which should further boost corporate earnings.

What are the Pros and Cons of the Recently Approved Budget?

The budget deal is one with a few near-term positives and many longer-term negatives. On the positive side, the Senate and House are significantly boosting defense spending after years of underinvestment following sequestration. This spending increase comes at a critical time as our military needs to upgrade, replace and modernize to maintain its strength. The challenges of sequestration were evident in the deadly naval accidents that have occurred in recent years. In short, the U.S. was putting the brave men and women of our armed services at greater risk than necessary. These multi-year spending increases are meaningful in a world where the geopolitical picture remains unstable with potential troubles looming with Russia, North Korea, China and the Middle East. Some needed domestic social programs also received additional funds including the Children’s Health Insurance Program. Additionally, the budget suspends the debt ceiling until March of 2019 so that neither party can hold the nation hostage for political gain until then. On the negative side, The Committee for a Responsible Federal Budget (CRFB) estimates that the budget increases will add $300-400 billion to the deficit and possibly add more than $1.5 trillion of new debt over the next decade. According to the CRFB press release, “this deal represents budgeting at its worst – each party is giving the other its wish list with all the bells and whistles included and asking future generations to pick up the tab.”   The CRFB estimates have the federal deficit rising from roughly $665 billion in 2017 to projected $1.2 trillion dollars in 2019 and over a trillion dollars for the foreseeable future as shown in the Chart 2.

One of the critical issues facing investors is the inherent conflict between this expansionary fiscal policy and the Federal Reserve’s efforts to normalize monetary policy by raising interest rates and reducing its balance sheet. This is happening while leadership of the Federal Reserve is transitioning from Janet Yellen to Jerome Powell. In response to this concern, Treasury yields (which had been gradually rising for two years) have moved up more aggressively over the past eight weeks rising nearly half of a percentage point on the 10-year Treasury bond. We will be closely monitoring the rate of change of Treasury yields, the foreign exchange value of the dollar, and the appetite of buyers to purchase the new supply of Treasuries that is required to fund the growing federal deficit. Conversely, we would not be surprised if interest rates stall or move down to the lower end of the trading range in the near term, as rapid changes are often met with counter-trend moves. With the national debt forecast to rise to $21.5 trillion this year and the economy in its best position to continue its expansion since the financial crisis, this is not an ideal time for the government to be adding more stimulus to the economy. Unfortunately, our elected officials have “kicked the can down the road” once again by not addressing entitlements in this process and by not allocating the proper spending to infrastructure needs which require over $4.6 trillion just to maintain the system in a state of good repair. We believe many of our infrastructure needs can no longer be postponed, and state finances are such that they cannot be relied on to foot a significant portion of the bill. This would argue for even higher deficits in the years to come as the inevitable infrastructure problems will need to be financed through additional deficit spending by the federal government.

Quick Thoughts on Active versus Passive Management, Leveraged Products and Derivatives

“The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.”

– Seth Klarman, founder of the Baupost Group

Many investors have moved to passive investing through mutual funds or exchange traded funds (ETFs) based on the belief that markets are efficient. We do not share that belief as our philosophy has always been that securities trade in an auction market with inherent inefficiencies. The market volatility of the past few weeks provided a reminder that passive investing assures investors that they participate fully in the markets’ returns achieving both 100% of the upside and 100% of the downside in the market moves.   Given that we are at an inflection point in policy, this sets the stage for a narrowing of opportunities and a more favorable backdrop for active management.   Therefore, we believe that investors taking a passive approach should consider increasing the actively-managed portion of their portfolios.   As a reminder to our readers of the dangers of leveraged products and the use of derivatives, we would point to the $2.2 billion Credit Suisse low-volatility product that recently lost 96% of its value overnight and is now being closed.

Investment Implications of the Outlook

“The only other thing I’d say is that too many investors look at the present. The present is already in the price. You have to think out of the box and sort of visualize eighteen to twenty four months from now what the world is going to be and what securities might trade at. What a company’s been earning doesn’t mean anything. What you have to look at is what people think it’s going to earn. If you can see something in two years is going to be entirely different than the conventional wisdom, that’s how you make money.”

– Stanley Druckenmiller, legendary investor, speaking at the USC Marshall School of Business

This is an interesting time for investors as the contemporaneous shifts in U.S. fiscal and monetary policy regimes, occurring at a later stage in the business cycle, will have important implications for investment strategy. We believe that the ability to distinguish between the companies that benefit from rising deficits, higher interest rates and modest inflationary pressures, from those that get hurt, is going to be critical for investors. Historically markets eventually come under pressure during periods of rising interest rates, but within the market not all companies are treated equally. We strongly believe that fewer companies will benefit from this environment, and that the market will react to support those companies at the expense of the rest of the broader market. Those that benefit from the conditions highlighted above will be rewarded with premium valuations. Capital is already flowing to the defense, the technology and the healthcare companies, and we expect those flows to continue and possibly accelerate. Interestingly, companies attempting to fight inflationary pressures will likely add further to their technology spend in an effort to counter those pressures. Our emphasis remains on selecting companies benefiting from disruptive technologies, rising defense spending, changes in the financial and healthcare industries, increasing U.S. consumer spending and the shift to a more service-oriented global economy led by China and India. Companies with strong balance sheets that can more aggressively invest in the future growth of their businesses should be more highly rewarded as will those with the ability to repatriate large overseas cash balances. U.S. small capitalization companies also stand to be significant beneficiaries of further improvements in the economy, tax reform, strong consumer spending and increases in capital expenditures. We continue to remain cautious on fixed income investments given the risk/reward dynamics, and would suggest that investors consider reducing their allocations and shortening their maturities to reduce the risk of capital losses.

While we remain positive on the outlook for corporate earnings to rise and the continuation of the synchronized expansion of the global economy for 2018, we must keep in mind the risks present in the system that can impact longer-term investment strategies. In the coming months, one risk we will closely monitor will be the rate and magnitude of change in interest rates. We described many of these risks in detail in our December 2017 Outlook. Businesses that are proactively investing to redefine themselves will have a chance to compete, while those that do not will be left behind.

For our regular readers, we have not changed our fundamental views on the economy but recognize that an important shift in fiscal policy has occurred, and therefore it is a time to be even more selective and opportunistic in portfolio construction and asset allocation.

The rising equity market is being met with a level of skepticism from the average investor that would normally be associated with a much less positive economic backdrop. Given the many concerns we have heard expressed about valuations and elevated market levels, we thought it would be appropriate to share a brief note to discuss why we expect the market advance to continue, notwithstanding the potential for a pullback at any time. In this Outlook, we share our thoughts on why investors are so skeptical, why the market appreciation should continue, and how investors should position themselves to benefit. For our regular readers it is worth noting that the positive views for 2018 as expressed in our 2017 Outlooks have not changed and in fact have been reinforced. We expect corporate profits to increase supported by a synchronized global economic expansion with subdued inflation. It is particularly noteworthy that this market rise is being driven by rising corporate earnings rather than just an expansion of price/earnings (P/E) multiples which often is a characteristic of the later stages of a market advance.

Why are investors so skeptical?

“In times of rapid change, experience could be your worst enemy.”

– J. Paul Getty

While a healthy dose of skepticism is always appropriate when investing, the post-financial crisis period has created an economic and market environment with little or no historical precedent and one which has been confusing for investors. Yet most investors rely on past experiences and historical references to reinforce their views, positive or negative, of the current situation as hindsight provides the highest level of clarity. While we also use our past experiences to frame our views, we believe that the distinct characteristics of the current environment make historical comparisons less relevant. At the same time, we fully appreciate the factors that have made it difficult for market participants to feel confident. Below we highlight some of the key issues weighing on investor sentiment and distracting investors from the many opportunities being presented today.

Globalization and Technological Advances – the rate and magnitude of change brought about by globalization and technological advances is so great that most market participants are challenged to adapt, and these changes are requiring more rapid adjustments in the global system. For many, keeping up with the rate of change is overwhelming.

Geopolitical Dynamics – The unconventional political setting is challenging the norms, fueling populism and nationalistic sentiment. Political dysfunction and frustration with the flawed efforts of governing institutions are all too common themes in many developed nations pressuring existing political parties to reassess their platforms. Many find this environment unsettling and some believe it has to end badly for the West, the country and the market.

Social Concerns – The uneven distribution of the benefits of the economic recovery has resulted in growing income inequality and education/skills gaps globally. This type of wealth disparity fosters growing social unrest. As technology displaces old industry jobs, older workers are being increasingly challenged to adjust. This is occurring as the United States is reaching full employment and as the developed economies are seeing unemployment rates decline as well.

Unconventional Monetary Policy – Following the most accommodative period in its history, the Federal Reserve is attempting to normalize monetary policy by gradually raising interest rates and shrinking its balance sheet. Given the historically low level of interest rates and limited room for central banks to stimulate economic activity if needed, they must put themselves in a position to effectively respond to a future recession. Therefore central bankers in working towards normalization must, at the same time, be careful to extend the business cycle. This will also buy time to reduce national debt as a percentage of GDP.

Why should the market appreciation continue?

“This game of economic miracles is in its early innings. Americans will benefit from far more and better ‘stuff’ in the future. The challenge will be to have this bounty deliver a better life to the disrupted as well as to the disrupters.”

– Warren Buffett, as reported in Newsweek, 1/5/18

The strong market appreciation in 2017 that continued in January of this year can be attributed to two main factors – accelerating corporate earnings growth and a synchronized global economic expansion that has been stronger than many anticipated. Bear in mind that an earnings-driven market typically reflects a stronger economy and therefore is on sounder footing than a P/E-driven market. The corporate earnings outlook is being further supported by repatriation of cash held overseas and in some cases lower regulatory burdens. This is occurring even before the much-needed investment in infrastructure has been made. Corporate earnings and global growth are benefiting from several factors including:

Pent-up Demand – One of the consequences of the financial crisis was that deleveraging became a priority over consumption and capital spending. We are now seeing pent-up demand translate into higher spending by both consumers and businesses thereby increasing overall economic activity.

Unprecedented Monetary Policy Support – Although monetary policy in the developed world has begun to tighten, it remains accommodative by historical standards. While gradually lessening, the accommodative monetary conditions should remain in place for an extended period.

U.S. Tax Cuts – The tax changes, with accelerated depreciation for capital spending, are positive for earnings and economic activity in the U.S. and abroad. Moreover one aspect of the new tax rules that is not getting as much attention from equity investors is that the changes to interest deductions should push companies that can to reduce debt, strengthen their balance sheets and increase equity values. Unfortunately, not all companies will have the financial wherewithal to reduce their debt burdens and will lose some of the benefits of interest deductibility. This will set up a key point of differentiation among businesses in the next 12-24 months.

Technology – Companies are taking advantage of technology to grow more efficiently. It is enabling companies to do more with less, reduce input costs and focus on productive growth.

How should investors position portfolios to benefit?

“The rate of change has never been this fast, and yet will never be this slow again.”

– Justin Trudeau, Canadian Prime Minister in his Davos speech.

The economic conditions we have written about for over a year should continue, notwithstanding an exogenous geopolitical event or a temporary pullback in the market. In our opinion, the investment outlook for 2018 remains positive for U.S. equities, especially those that are leading the aforementioned transformation. Our ongoing portfolio strategy has three areas of focus – high-quality growth, high-quality dividend payers and opportunistic investments. The emphasis remains on selecting companies benefiting from disruptive technologies, rising defense spending, changes in the financial and healthcare industries, increasing U.S. consumer spending and the shift to a more service-oriented global economy led by China and India. We believe that investors continue to underappreciate the power of this technology cycle as comparisons to the past are just not valid as it is not a PC-driven cycle anymore. Mobility, the Internet of Things, 5G, artificial intelligence, machine learning, and the dawn of quantum computing are changing the supply/demand and pricing dynamics of the industry. The advent of these technologies is also changing the way businesses operate making historical comparisons inappropriate. These advances are going to require a significant increase in capital expenditures by companies to effectively compete going forward. For instance, Verizon just announced its plans to spend $35 billion over 5 years to implement a 5G network. In the healthcare sector, the combination of technological advances in research and demographic trends remain powerful drivers making this sector among the best performers this year.

We expect to see a continuation of merger and acquisition activity, while companies continue to reengineer their balance sheets and refine their business models to compete in the new world. We continue to concentrate on companies that are gaining market share, maintaining or improving profit margins, increasing free cash flow, restructuring to gain more efficiency, increasing pricing power and/or growing dividends. Companies with strong balance sheets that can more aggressively invest in the future growth of their businesses should be more highly rewarded as will those with the ability to repatriate large overseas cash balances. U.S. small capitalization companies also stand to be significant beneficiaries of further improvements in the economy, tax reform, strong consumer spending and increases in capital expenditures.   We remain cautious on fixed income investments given the risk/reward dynamics, a less accommodative monetary policy stance by central banks, gradual rate increases from the Federal Reserve and a high and rising federal budget deficit.

Notwithstanding our constructive view of the Outlook, it is always prudent to be mindful of risks and what could go wrong, and there are several potential risks that we monitor as we wrote in our most recent Outlook.   Key economic indicators are already sitting near the high end of their traditional ranges. There are also headwinds to growth such as the Federal Reserve interest rate increases which have led to higher borrowing costs for consumers. Energy prices have also been on the rise, and consumer spending has been outpacing growth in personal income. With these and other concerns in mind, we continue to focus on those companies best positioned to benefit from the intermediate to longer-term outlook. The equity markets almost always focus on the short-term rather than the secular trends, so we would suggest clients not let headline issues distract them from the opportunities being presented by a positive outlook and economic dynamics in the world today.

Published by the ARS Investment Policy Committee:

Brian Barry, Stephen Burke, Sean Lawless, Jared Levin, Michael Schaenen, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor.

As an exceptional year in the equity markets draws to a close, many investors have been caught either underweight the primary beneficiaries or out of the U.S. stock market altogether even as the major stock indices regularly reached new highs. The strong equity market returns are a consequence of stronger than expected corporate earnings and a synchronized global expansion that had begun some years ago and which should continue into 2018. At the same time, we are witnessing growing divergences between the haves and the have-nots as well as an extreme degree of political partisanship in the U.S. that has affected the ability of Congress to address the needs of the people. The world is undergoing a rapid transformation that continues to redefine lives faster than most people are able to absorb. There are several powerful forces impacting the global economy – namely, technological advances, accommodative central bank policies, debt burdens, cybersecurity, globalization and demographic trends among others. It is in this setting that many market participants are particularly uncomfortable because there is no playbook for investors as we are in an economic, geopolitical and social environment with little historical comparison.

As it stands today, the tax reform plan out of Washington D.C. should have the effect of increasing capital spending which in turn will improve productivity, keep a lid on interest rates and inflation, and continue the favorable backdrop for equity investing. Importantly, rapid and ongoing technological advances are being introduced to every industry which should continue to promote productivity improvements. Further productivity improvements would suggest that the U.S. unemployment rate could fall below 4% without triggering a significant inflation response; this arguably runs counter to prevailing opinion.   This Outlook will address the reasons why inflation has been subdued relative to expectations, the growing disparity between those benefiting and those not from today’s financial conditions, risks to consider in the system and our investment strategy heading into next year. We have included a new section to this Outlook to share the views of some corporate executives from their recent earnings reports regarding important changes impacting their industries. While many challenges remain for the United States and the world overall, global growth is on the rise and leading U.S. companies should continue to have growing earnings and cash flows. At a time when many have suggested that the multi-year economic expansion would start to fade, it has begun to accelerate with strong results from the United States, China and Europe which further supports our constructive outlook for 2018.

The Inflation Paradox

“It is also possible that this year’s low inflation could reflect something more persistent. Indeed, inflation has been below the Committee’s objective for most of the past five years… To generate a sustained boost in economic growth without causing inflation that is too high, we need to address these underlying causes. In this regard, Congress might consider policies that encourage business investment and capital formation, improve the nation’s infrastructure, raise the quality of our educational system, and support innovation and the adoption of new technologies.”

– Janet Yellen, Federal Reserve Chair, remarks before the Joint Economic Committee November 19, 2017

• The difficulty of getting inflation to the 2% level has confounded central bankers in spite of the fact that we have experienced the most highly accommodative and unconventional policies in history which were designed to stimulate economies through increased lending. Through a combination of zero interest rate policies and quantitative easing (QE or printing of money) initiatives, global central banks’ balance sheets increased by approximately $15 trillion, but much of this did not work its way into the system as planned. When the Federal Reserve announced its initial QE program, several politicians, Wall Street executives and professional investors were highly critical of what they thought was such an inflationary policy. As it turned out, several factors have worked against plans for fostering a healthy level of inflation. These included the lack of appropriate fiscal stimulus to support the monetary policies and, importantly, the fact that the money simply did not get lent out as intended. In past recessions, consumers would have had pent up demand to borrow and spend, but this time consumers focused on paying down debt. For businesses, capital spending was directed toward increasing efficiency and making sure that they had the most competitive pricing structure for their products.

While we expect inflation rates to rise modestly going forward, the forces contributing to subdued inflation in the U.S. economy are as follows:

• The inability of most companies to increase prices
• Technological advances which are decidedly deflationary
• Debt levels that are high and rising
• Globalization continuing to lower input costs
• Highly accommodative monetary policy allowing for productive investments to further lower costs

Noted investment strategist, Ed Hyman of Evercore ISI recently highlighted two other unusual inflation headwinds. “First, many deals lead to cost-cutting, which keeps downward pressure on wages. And it should be noted that the corporate tax cuts could be deflationary.  That is, companies might take tax cuts as an opportunity to lower prices.” The other day the Wall Street Journal reported that grocery stores were absorbing the price increases in many food items rather than pass them on to customers for fear of driving business to new, lower-cost competitors.   The combination of greater internet access and smartphone use makes price increases difficult if not impossible as consumers have more immediate price information at the point of sale when making purchasing decisions.

Investors should not anticipate directional shifts in these forces, nor should they anticipate dramatic changes in the trajectory of inflation barring an exogenous event such as a terrorist attack or geopolitical misstep. Globalization and technological advances are a part of a secular trend, while the accommodative monetary policy stance from global central banks should adjust only gradually over several years. Additionally, the amount of debt in the global economy continues to grow so it is safe to say that debt will continue to weigh on inflation expectations. At the same time, there is still $11 trillion in global government bonds with negative yields and interest rates should remain low with only a gradual upward bias as the global economy improves. Based on the parameters of the tax reform bill, we are not completely confident that what is being presented as a pro-growth initiative will materialize and may in fact be counterproductive in promoting balanced growth because there are so many moving parts in the analysis of the details.

Growing Divergences in Global Fortunes

To better understand the mounting concerns about income inequality, one can look at a comparison of the Forbes 400 lists of the wealthiest people in the United States in 1982 and today. In 1982, the total wealth of the Forbes 400 list was equivalent to 2.8% of U.S. GDP, but today that has grown to almost 15%. During those 35 years, U.S. GDP per capita grew four-fold, while the net worth of the Forbes 400 grew 29-fold.   As of the most recent figures, the top three wealthiest Americans have a net worth of over $250 billion or more wealth than the bottom half of Americans combined. The 2017 Forbes 400 have a total net worth of more than $2.65 trillion or more than the GDP of the United Kingdom or the bottom 64% of the U.S. population. At the same time, one in five U.S. households have zero or a negative net worth with 60% of those not having enough savings to cover a $500 emergency. This degree of income inequality is not unique to the U.S., and has been one of the contributing factors to the rise of populism globally as well as the polarization of political parties in many nations. Increasing concerns about those being left behind has also led to support for consideration of Universal Guaranteed Income programs.   As part of the solution for the United States, Congress may need additional spending to promote skills training initiatives as well as make significant investments in our digital, education and transportation infrastructures.

There has also been considerable evidence of an uneven distribution of the benefits from global growth in the U.S. and global stock markets. Of the returns of the S&P 500 this year through 11/21/17, roughly 28% has come from a handful of technology-related companies, and 71% of the returns were from the top 50 companies. Perhaps there is no better example of a narrowing of beneficiaries than Apple which introduced its first iPhone in 2007. Today Apple has a market capitalization of approximately $900 billion making it the largest company in the S&P 500. To highlight just how uneven the playing field really is one can look at Apple’s corporate cash of $269 billion which would rank as the 11th largest company in terms of market capitalization in the S&P 500, and on a net cash basis (subtracting debt) it would rank as the 35th largest company in the S&P 500.   Most of the largest companies in the world today are technology companies with China’s Tencent, Alibaba and Baidu also among the world’s fastest growing and largest in terms of market capitalization.

Insights from the Q3 Earnings Calls

In this Outlook, we wanted to present some insights shared by corporate executives from the third quarter conference calls and earnings transcripts.   Industries and companies are being transformed and redefined, and the winners are proactively driving the changes and adapting, while the losers are being disrupted or just plain overrun. Several key takeaways from the earnings reports include the impact of technological advances on the ability to deliver better products with lower costs and greater value. Perhaps the biggest takeaway is that the changes coming in the next few years will likely be unlike anything we have seen to date. A recent China Daily article cited a report from the Boston Consulting Group which forecasts for China “that as information technologies continue to revolutionize industries like retail, entertainment, finance and manufacturing, the country’s digital economy will reach about $16 trillion by 2035, up from $1.4 trillion in 2015.” This year China’s GDP is estimated to be nearly $12 trillion. We remain convinced that market participants continue to underestimate the pace and magnitude of the changes that lie ahead in the coming years as things that were once unimaginable become reality. While these companies may or may not be owned in client accounts, we have chosen these excerpts or quotes as they highlight some of the longer-term changes occurring across industries that will impact the competitive landscape.

In Technology – IoT, mobility, data, 5G and China

Applied Materials CEO Gary Dickerson, excerpt from Q3 transcript

“We are at the start of a completely new wave of growth. The Internet of Things, big data and artificial intelligence have the potential to transform entire industries and create trillions of dollars of economic value. From transportation and health care to entertainment and retail, future success is dependent on capturing, storing, and understanding vast amounts of data. This is driving major innovations in sensors, memory, storage, and especially compute, which is key to turning raw data into valuable information.”

BOINGO CEO David Hagan, excerpt from Q3 earnings transcript

“In the immediate term, the continued acceleration of mobile data growth continues to put capacity constraints on existing macro cellular networks, which in turn drives the need for products like Wi-Fi offload and small cells. In the longer term, as 5G comes to fruition in 2019 and beyond, this provides an opportunity for an incredible long-term cycle.”

GDS CEO William Wei Huang, Aug 8, 2017, Q3 Call

“Cloud adoption continued to takeoff in China. Currently it is around a $2 billion market in terms of annual revenue, representing around 1% of total IT spend. But we share the view of the leading industry players that it is rapidly heading towards a $20 billion to $30 billion market. This transformation is happening at a faster pace in China than in the U.S. Alibaba and Tencent are reporting consistent triple-digit growth rates for their Cloud business. In our view, cloud service providers together with some of the large internet companies’ account for more than 70% of new demand for data center capacity.”

Defense

KRATOS CEO Eric DeMarco, excerpt from Q3 transcript

“Over the past 20-plus years, the U.S. military has focused on winning the fight at hand, the war on terrorism in Afghanistan, Iraq and elsewhere. During that time, our nation’s adversaries have been investing heavily in new technologies and systems to catch up with and potentially surpass the United States and its allies’ national security capabilities. In response, innovation, technology infusion and recapitalization of systems to address peer and near-peer adversarial capabilities and U.S. operational readiness has begun. As a

result of these perceived threats, national security and defense related budgets are anticipated to increase globally, including for the U.S. and its allies.”

Raytheon CEO Tom Kennedy, October 26, 2017, Q3 Call

“One area where we are seeing strong demand is within Integrated Air and Missile Defense… GMD (Ground-based Midcourse Defense System) is the United States’ anti-ballistic missile system for intercepting incoming warheads in space during the midcourse phase of flight. It is a major component of our country’s defense strategy to counter intercontinental ballistic missile threats. We also continue to see very strong demand for Integrated Air and Missile Defense solutions in the international market. For example, earlier this month, Congress was notified of a $15 billion sale of seven THAAD fire unites and related equipment to Saudi Arabia. In addition, Japan has indicated that it is pursuing missile defense solutions to protect its homeland.”

Automotive

Visteon, CEO Sachin Lawande, October 26, 2017, Q3 Call

“The emergence of smartphone integration technologies such as Car Play and Android Auto have created the new product category of display audio, which extends the traditional audio system with smartphone projection technologies. Display audio is rapidly becoming the preferred option for entry infotainment …Infotainment systems are also undergoing a transformation from the traditional closed and proprietary systems of today that are not upgradable, to connected application platforms with support for web services and downloadable apps. Advanced cybersecurity and over-the-air update capabilities have emerged as key requirements of both display audio and infotainment systems.”

NVIDIA CEO, Jen-Hsun Huang, November 9, 2017

“In automotive… we announced DRIVE PX Pegasus, the world’s first AI computer for enabling Level 5 driverless vehicles. Pegasus will deliver over 320 trillion operations per second, more than 10x its predecessor. It’s powered by four high-performance AI processors in a supercomputer the size of a license plate.”

Energy

Anadarko Petroleum Chairman, Robert Walker, excerpt from Q3 earnings transcript

“You’ve heard us, and heard a lot of our competitors talking about the use of big data and the use of artificial intelligence, and in particular, machine learning. I think all of us are in very early innings… And so I’m pretty optimistic that our ability as an industry to lower our break evens will largely come in the future from technological advances and the applications of technology that we’ve not historically either used or used fully.”

Risks in the System

While we remain positive on the outlook for the continuation of the synchronized expansion of the global economy for 2018, we must keep in mind the risks present in the system that can impact longer-term investment strategies. The risks we are focused on are geopolitical, social and economic. The geopolitical risks are top of mind as investors remain concerned about missteps relating to North Korea’s nuclear provocations, the ongoing proxy war between Saudi Arabia and Iran, tensions in the North China Sea, questions about the European project and shifting U.S. positions on foreign policy. From a social perspective, growing income inequality, education gaps and changes in the skills needed to compete in the job market going forward are among the primary concerns. In addition, the growing populist movement and ongoing concerns about immigration will continue to affect social conditions.

The fragility of the global economic system rests, in large part, on the fact that the excessive debt loads were amassed in a time when technological advances were not nearly as fundamental a part of the economic system as they are today.   The rise in populism, nationalist sentiment and income inequality have been three of the unintended consequences of the monetary and fiscal policies that were implemented to aid the recovery following the global financial crisis. A few key policy decisions such as the use of quantitative easing (the printing of money) by central banks were designed to stimulate economic activity, but some austere fiscal policies were put in place which ran counter to the growth intention of monetary accommodation. These policies were implemented at a time when technological advances and globalization had already been negatively impacting employment in the developed nations. As you can see from the first chart below, the United States, China, India and Canada have benefited, while the United Kingdom, Spain, France and Italy have not. Japan, which is showing signs of improvement recently, has had almost 30 years of economic struggles and still faces significant debt and demographic challenges. The U.S., China and Canada are among the leaders in the development of new technologies, and this has played an important role in driving growth. The U.S., Canada and India also benefit from favorable demographic characteristics. The European nations and Japan have seen positive economic results in recent quarters, but are facing severe long-term demographic challenges.

Global debt remains high and continues to weigh on growth. Central bank policy remains a risk as each bank attempts to normalize interest rates and reduce the roughly $15 trillion that was added to central bank balance sheets since 2008. If the reduction in accommodation is not done in a measured way, then the central banks’ actions could tilt the global economy into a recession. For the U.S., there has never been a time when the Federal Reserve was reducing its balance sheet while the U.S., with the new tax law, will be running such large and growing fiscal deficits.

Investment Implications

“China has been busy creating a cashless society, where people can pay for so many things now with just a swipe of their cellphones — including donations to beggars — or even buy stuff at vending machines with just facial recognition, and India is trying to follow suit. These are big trends, and in a world where data is the new oil, China and India are each creating giant pools of digitized data that their innovators are using to write all kinds of interoperable applications — for cheap new forms of education, medical insurance, entertainment, banking and finance.”

– Thomas Friedman, NY Times, November 29, 2017

The investment outlook for 2018 remains positive for U.S. equities, especially those that are leading the transformation. Our ongoing portfolio strategy has three areas of focus – high-quality growth, high-quality dividends and opportunistic investments. The emphasis remains on selecting companies benefiting from disruptive technologies, rising defense spending, changes in the financial and healthcare industries, increasing U.S. consumer spending and the shift to a more service-oriented global economy led by China and India. Despite the potential for increasing government regulation, taxation and scrutiny, disruptive technology companies should continue to benefit as the Internet of Things (IoT) becomes more widely adopted and the industry moves closer to the introduction of 5G. We especially favor the leading companies with strong growth characteristics that are driving changes in cloud computing, big data, autonomous vehicles, the internet of things, artificial intelligence and augmented reality. We continue to concentrate on companies that are gaining market share, maintaining or improving profit margins, increasing free cash flow, restructuring to gain more efficiency, increasing pricing power and/or growing dividends. Strong balance sheet companies that can more aggressively invest in the future growth of their businesses should be more highly rewarded as will those with the ability to repatriate large overseas cash balances. U.S. small capitalization companies also stand to be significant beneficiaries of further improvements in the economy, tax reform, strong consumer spending and increases in capital expenditures.   We remain cautious on fixed income investments given the risk/reward dynamics, expectations for a less accommodative monetary policy stance from central banks and gradual interest rate increases from the Federal Reserve and other central banks.

One factor that will likely weigh on investor sentiment is that the national debt is forecast to be rising by $1.5 trillion due to the tax plan and this is coming at the later stages of the business cycle. However continued capital spending will lower costs, keeping a lid on inflation rates and interest rates.   Due to the uniqueness of the business cycle and the characteristics of the current environment described, we do not believe that the prospect for corporate earnings growth in 2018 is fully priced into the market. Furthermore, we do not believe that the benefits of tax cuts for small businesses and the likely subsequent investments in technology to improve productivity are being appreciated. As Wall Street analysts raise their earnings and market forecasts to reflect the lower corporate taxes and continued improvement in the U.S. and global economies, investors should see again positive equity market returns in 2018. The economic benefits of the reduction of unwieldly regulatory costs by the Trump Administration continues to feed through the system as many regulations have been delayed, suspended or overturned. While the tax plan does not effectively address critical issues regarding entitlements, education, infrastructure, inequality or deficits, it will likely provide a boost to the U.S. economy next year especially if corporations aggressively repatriate cash from overseas.

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. As evidenced by the comments from business leaders in this Outlook, the investments in innovation will have a profound impact on our daily lives.

From the escalation of tensions with North Korea (DPRK) to tragic hurricanes to continued dysfunction in Washington D.C., there are plenty of issues weighing on investors’ minds, and yet the U.S. and global economies continue to gradually improve. In times like these we are reminded that among the best characteristics of the United States and its people are the resiliency and the ability to pull together following crises to come back even stronger. The terrible damage of the recent hurricanes and earthquakes will have an impact on many lives for an extended period, while having economic, financial and political implications as well for the United States. The resolve of the American people will be tested further as the nation seeks the best solution for the troubling situation developing with North Korea’s nuclear capabilities. At the same time, Congress is struggling to enact the necessary fiscal policies required to achieve sustainable growth, while the Federal Reserve works towards a less accommodative monetary policy stance. While it is easy to get caught up emotionally in the negative issues, the outlook for U.S. equity investing remains positive in our view, as corporate profits should continue to improve, interest rates should rise only modestly and inflation remain stubbornly subdued. Given the current economic and geopolitical backdrop, we thought it appropriate to offer some perspective on four key questions on investors’ minds.

• How should investors think about the nuclear capabilities of North Korea?
• What is the impact of the storms on the investment Outlook?
• What does the recent announcement of the Fed to reduce its balance sheet mean?
• Where can investors find opportunities given the current environment?

As we stand today, the three major stock market indices continue to make new highs. The global economy has been performing quite well led by a resurgence in North America, Europe and India as well as the strong performance of China heading into its important October leadership conference. In the United States, consumer net worth is approaching $97 trillion up from its low of approximately $51.5 trillion in Q4 2008. Employment at home and abroad has improved significantly since the financial crisis and continues to do so. Yet as of the time of this writing, there is a growing uneasiness among many investors. We would again advise investors against market calls on being in or out of the market. Historically, efforts to time the market have produced significantly worse outcomes than riding out the market fluctuations. Instead of reacting to the market, investors should focus on owning the businesses that are the beneficiaries of the economic outlook and that meet investors’ goals.

How should investors think about North Korea’s growing nuclear capabilities?

“The U.S. and South Korean warmongers are going reckless in their move to conduct war games against the DPRK at the time when U.S. President Trump made rubbish about the total destruction of the DPRK at the UN General Assembly, pushing the situation of the Korean Peninsula to a more uncontrollable catastrophe.”

– News as reported on the official webpage of the DPR of Korea

Today the world is a more risky place following Pyongyang’s latest, and most serious, nuclear provocation. As the quote above highlights, North Korea’s actions are now perhaps the most destabilizing force in the world, and follow several decades during which the leading nations had been working to reduce the size of nuclear arsenals through a series of bilateral arms control agreements. Currently nine countries have known nuclear capabilities including the U.S., Russia, China, U.K., France, India, Pakistan, Israel and North Korea. According to the Arms Control Association, the U.S., Russia, UK, France and China negotiated the nuclear Nonproliferation Treaty (NPT) in 1968 and the Comprehensive Nuclear Test Ban Treaty (CTBT) in 1996 in order to prevent more nations from gaining nuclear capabilities. Israel, India and Pakistan are viewed as Non-NPT Nuclear Weapons Possessors after having never signed the NPT. North Korea withdrew from the NPT in 2003, and has been testing since then. However, the recent actions and outright defiance of President Kim are forcing other countries to act. Ideally, the global community would like to see the DPRK stop its program. However, it is unlikely that North Korea will forego its nuclear capabilities. Therefore the most probable strategy, short of military conflict or regime change, will be to attempt to limit the program through a combination of more severe economic sanctions, diplomatic pressures, cyber countermeasures and continued show of military force. As things stand now, containment appears to be the most likely outcome.

China is a key player in resolving the problem as it is North Korea’s only global ally and its biggest trading partner. However China will be holding its leadership conference in late October and will take only limited action prior to that time. Furthermore, President Xi does not want to be perceived to be taking direction from the U.S. or any foreign body as China has been actively working to cement its position as a global power. North Korea has strategic value to China as it provides a border buffer between it and South Korea. China does not want to see North Korea destabilized as it would likely lead to a massive refugee exodus to its Northeast region which is already experiencing economic difficulties. As the major provider of energy to the DPRK, China could pressure President Kim by shutting off its supplies, but the pipeline infrastructure is so old and fragile that it may crumble in the restart making this option difficult.

“The international configuration and balance of power has undergone profound changes: the traditional and nontraditional threats have become more salient; global growth lacks robust driving forces; the trend of anti-globalization goes rampant; and the challenges for humankind to realize a lasting peace and orderly development are unprecedented.”

– Foreign Minister Wang Yi, China Daily

As a consequence of greater global conflict, global defense spending is increasing from the current levels of approximately $1.7 trillion. The United States accounts for 39% of global spending at roughly $670 billion annually. Bearing in mind that for several years the U.S. had a policy of budget sequestration, this resulted in under-investment in our defense capabilities. The armed services experienced a reduction in training initiatives that played a role in several recent naval accidents in the Pacific. The trend in spending is now reversing as evidenced by the increasing backlogs of our defense companies. U.S. defense companies are benefitting from the increases in defense spending from other nations as well. Most importantly, U.S. defense companies represent a small percentage weighting in the S&P 500 index, so institutional portfolios that are replicating the S&P weighting have been under represented with exposures of 2.5% or less. It is our view that these businesses continue to represent strong investments that generate significant cash, have robust orders, maintain high and/or growing backlogs, and are raising dividends and continue to repurchase stock. These businesses are not dependent on economic activity, but rather on national security issues and geopolitical conditions. Therefore, defense companies should continue to have higher representation in client portfolios than the S&P 500 index offers as the geopolitical situation remains unstable.

What is the impact of the storms on the investment Outlook?

“Hurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship. Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term.”

– Excerpt from the FOMC statement dated 9/20/17

Regardless of one’s views on climate change, measured temperatures have been rising globally and the implications may be far-reaching for consumers and investors. While the FOMC could be correct in its view that the storms are unlikely to materially alter the course of the economy, we believe that it will change its character as the reconstruction and infrastructure needs can alter the supply and demand of the factors of production. As shown in the chart from the Environmental Protection Agency (EPA), water temperatures have been rising in recent decades. In fact, the higher than average water temperatures off the coast of Florida allowed Hurricane Irma to increase its speed and inflict even greater damage across the state. According to reports, Irma had sustained winds of 180 miles per hour for a record 37 hours besting the previous record of 24 hours. The National Weather Service reported that Harvey set the record for rainfall in the continental U.S. as the storm poured 51.88 inches of rain into Texas, while the earthquake in Mexico was one of the worst in the last 100 years. Investors should expect that future storms will be more powerful than those of the past. Rather than argue about the science of climate change, investors should focus on the investment implications such as the future values of coastal real estate, the cost of insuring against more violent storms, the need to replace all the damaged and destroyed goods, and the required spending to rebuild homes and infrastructure in those hard-hit areas. Additionally, the storms must have an impact on monetary and fiscal policy going forward.

The storms further highlight the fact that the United States must address its chronic underinvestment in its infrastructure as the needs can no longer be postponed. The American Society of Civil Engineers (ASCE) has issued several reports grading the system, the spending required and the shortfall going back to 2001. At that time, the required investment to keep the infrastructure in a state of good repair was $1.3 trillion, but due to political neglect the pre-storm figure had risen to an estimated $4.6 trillion in 2017. Already technically in bankruptcy, Puerto Rico has been devastated by Hurricane Maria, and the U.S. must find the dollars needed to aid in the rebuild of this island nation as well as deal with its chronic debt issues. Three key factors working against the near-term recovery of Puerto Rico are the impact on tourism and pharma manufacturing as well as the ongoing population drain. Puerto Rico’s pharmaceutical industry represents roughly 25% of the island’s Gross Domestic Product (GDP). Tourism accounts for nearly 7% of Puerto Rico’s GDP. These two industries have been particularly hard hit and the timing makes the economic challenge even worse as we are heading into the prime months for tourism.

According to the Washington Post, “Senate Democrats, emboldened by the GOP’s failure to unilaterally pass a health-care bill, are launching an effort to win bipartisan support for the investment of $500 billion in taxpayer dollars in infrastructure improvements.” The Senate Democrats and Republicans generally agree on the need for infrastructure spending, but do not agree on how to fund it. There is a growing conflict between the needs of the U.S. and deficit spending. The big question that remains is whether the challenges facing the nation today force politicians from both parties to act based on practical realities rather than ideological considerations. For Congress, that means increasing deficit spending and reaching across the aisle to achieve its pro-growth agenda.

What does the recent announcement of the Fed to reduce its balance sheet mean?

“Meanwhile, Ms. Yellen reminded us that the Fed – indeed, several central banks – are yet to solve the “mystery” of low inflation; and this at a time when productivity is generally subdued and the relationship between unemployment and wages is behaving in a historically peculiar manner. All of which serves also to highlight structural uncertainties, including those associated with technological and demographic change, distrust of institutions and experts, and Brexit implementation.”

– Mohamed El-Erian

The Federal Reserve announced it will begin the process of reducing its balance sheet which has grown from a pre-crisis level of approximately $750 billion to $4.5 trillion. It is the start of a process to return to a more normal monetary policy stance, but we must bear in mind that it is a process that will take several years. The persistently low level of inflation has confounded the FOMC, economists and professional investors to the point where Federal Reserve Chair Yellen admitted in a recent press conference that she “cannot say that the Committee clearly understands what the causes are.” There are different explanations for the lack of inflationary pressure. One view is that the changes are structural in nature and have been fostered by rapid technological advances and globalization. With the easy monetary policy financing aggressive investment, technology is creating greater deflationary forces in many industries than would typically be experienced at this stage of the economic recovery, suggesting that the changes might be structural. The counter view is that the factors suppressing inflation are transitory, and that inflation will pick up in the coming quarters.

From our perspective, the initial stages of the balance sheet reduction program should not have a material impact on interest rates, inflation rates or the markets since much of the money created through quantitative easing remains on the balance sheets of banks and has not been lent out. Therefore, the pace suggested by the Fed should have little actual impact, but may be misinterpreted by market participants causing some added volatility in the equity and bond markets. Furthermore, investors should anticipate that the economic setting will force the Federal Reserve to continue its measured approach. Without substantive fiscal initiatives, economic growth should remain in the 2-3% range, interest rates should rise slowly and inflation will remain muted. Until the full impact of the damage from the hurricanes is known, monetary policy moves will be cautious and gradual, and this should be positive for equity investing as it should extend the business cycle.

Where can investors find opportunities given the current environment?

“Whenever I hear people talk pessimistically about this country, I think they’re out of their mind… It has been 241 years since Thomas Jefferson wrote the Declaration of Independence. Being short America has been a loser’s game. I predict to you it will continue to be a loser’s game.”

– Warren Buffett

Excessive focus on the concerns described in this Outlook diverts the attention of investors away from the opportunities to protect wealth and build capital.   As Warren Buffett says so eloquently, those with a longer-term perspective will do just fine as there are many positives that do not garner the same headlines. These include rising U.S. consumer net worth, a global economy that is experiencing synchronized growth with improving employment figures, and most importantly, corporate earnings that continue to rise not just in the United States but globally. Over the next year, investors should continue to benefit from the ownership of leading technology companies including semi-conductors and semi-conductor equipment companies, defense companies, healthcare companies and select consumer businesses. Small capitalization stocks should benefit from tax reform or tax cuts which we might see passed in 2018. If Congress is able to enact tax reform, high taxpaying businesses could see an increase in earnings of over 10%. Additionally, the Administration has moved to reduce regulation of several industries and that should continue to have a positive effect on corporate earnings for those companies as well. Small cap companies should also benefit from increased merger and acquisition activity in a market flush with cash. Additionally, the market continues to misprice many of these businesses as they often fall through the cracks due to the fact that they are less followed than large companies.

As a leader in technological innovation, U.S. companies are maintaining an exceptional pace of innovation. No one should assume that technologies have reached a level of maximum utilization. For example, Google search queries experienced an estimated 46% increase from 2016 to 2017 growing by 1.58 billion searches per day. YouTube video views grew by nearly 1.9 billion per day for a 48% increase. As internet speeds increase with the introduction of 5G technologies, the internet of things and artificial intelligence, the ability to access, process and store yet greater volumes of information will lead to even greater changes for the way we live and work. In the emerging economies of India and China, the introduction of new technologies is paving the way for the next stage of growth as these nations are rapidly transforming their economies and raising living standards for over 2.5 billion people. As positive as is the outlook for many in the technology industry, as so often happens the success and disruptive nature of a few leading companies is making them the target of increased regulatory oversight and taxation in the not-to-distant future. As such some of these leaders may be facing new headwinds after a period of unusual success.

In a recent post in Forbes, Bill Gates put the outlook in perspective, “The next 100 years will create even more opportunities like that. Because it’s so easy for someone with a great idea to share it with the world in an instant, the pace of innovation is accelerating–and that opens up more areas than ever for exploration. We’ve just begun to tap artificial intelligence’s ability to help people be more productive and creative. The biosciences are filled with prospects for helping people live longer, healthier lives. Big advances in clean energy will make it more affordable and available, which will fight poverty and help us avoid the worst effects of climate change. The potential for these advances is thrilling–they could save and improve the lives of millions–but they’re not inevitable. They will happen only if people are willing to bet on a lot of crazy notions, knowing that while some won’t work out, one breakthrough can change the world. Over the next 100 years, we need people to keep believing in the power of innovation and to take a risk on a few revolutionary ideas.”

We share Mr. Buffett’s and Mr. Gates’ views that the United States should remain one of the world’s leading nations from both a geopolitical and economic perspective. We also believe that the technological changes that lie ahead will be as exciting and disruptive as any experienced in the last 100 years. We would strongly recommend against being on the sidelines as winning businesses continue to change the world. The conviction as to the views expressed in the Outlook are reflected in our heightened exposure in client portfolios to the companies that are the primary beneficiaries.

Disruption: to break apart; to throw into disorder; to interrupt the normal course or unity of

Distraction: to draw or direct (something, such as someone’s attention) to a different object or in different directions at the same time; to stir up or confuse with conflicting emotions or motives

The world is in a state of flux, and the uncertainty caused by the rate and magnitude of change is unsettling for many people. This is especially the case for the middle class in developed economies who have been and are struggling to keep up. At the same time, the global economy continues to grow modestly, and the changes of the past decade have raised living standards for more than 2 billion people in the developing world. While it is easy to get distracted by news headlines, excessive focus on short-term concerns diverts investors from the opportunities presented by the disruption and ongoing changes as well as the rising living standards in the developing world. U.S. corporate profits should continue to improve, interest rates should rise modestly and inflation remain subdued. Current economic conditions suggest a positive backdrop for the second half of the year and into 2018. Notwithstanding the dysfunction in Washington DC, we remain positive on well-selected equities representing businesses whose earnings continue to rise.

In recent Outlooks we highlighted several powerful forces impacting the global economy today – namely, technological advances, globalization, demographic trends, central bank policy, debt burdens, immigration, terrorism and frustration with government institutions. These forces combined with the challenges of a low-growth developed world are causing a re-think of politics and business. In recent weeks, the surprising planned acquisition of Whole Foods Market by Amazon, the stunning results of the French election of Emmanuel Macron’s government and the elevation of 31-year old Mohammed bin Salman (MBS) as crown prince and successor in Saudi Arabia combine to highlight the disruption of traditional thinking with respect to global business and politics today. Recently, several central banks, including the Federal Reserve, have indicated their intentions to begin the long process of weaning their respective economies away from the excessively easy monetary policies to which we have grown accustomed. In this Outlook we discuss the challenges presented to policymakers, update our thoughts on the impact of technology on businesses and jobs, and address the investment implications as we head into the second half of the year.

A Look Back at the Past Decade

“There is growing polarization of labor-market opportunities between high- and low-skill jobs, unemployment and underemployment especially among young people, and stagnating incomes for a large proportion of households and income inequality. Migration and its effects on jobs has become a sensitive political issue in many advanced economies.”
– Technology, jobs and the future of work, McKinsey Global Institute May 2017

While much has changed in the past decade, we thought it would be worthwhile to share some of the big picture facts about the global economy and business to offer some perspective after having undergone one of the most severe financial crises in history. As shown in the chart below, global Gross Domestic Product (GDP in U.S. dollars) grew by 51.6% in the 10 years since 2007 with the United States having grown by over 30%. China, now the world’s second largest economy, has grown its GDP from $3.6 trillion to approximately $12 trillion. Today the United States and China account for over 40% of global GDP. From 2007-2017, the world’s population has expanded by an estimated 805 million to 7.37 billion people. According to the IMF, global GDP per capita grew roughly 22% from $8,651 to an estimated $10,560 in 2017. With the exception of the United States and Canada, there has been very little GDP or population growth in the developed economies. At the same time, China, India and Brazil have each experienced growth in both GDP and populations even with their own challenges during the past 10 years.

From a stock market perspective, the S&P 500 index peaked in October 2007 at 1565 with trailing twelve month earnings of $89.35 per share. Today, the S&P 500 index is trading at about 2430 with forward earnings projected to be $138. To help support the global economy following the financial crisis, central banks increased their total assets from a pre-crisis level of $6.4 trillion to an estimated $18.5 trillion today. According to the Council of Economic Advisors Economic Indicators report (May 2017), U.S. corporate profits before taxes have grown by 30% from $1.748 trillion in 2007 to an estimated $2.274 trillion today but were up 64% from its low in 2008. However the makeup of U.S. business has shifted considerably in the last decade as the financial crisis and technology innovation has changed market leadership in a material way. Our world has changed in so many ways since the first iPhone was introduced on June 29, 2007. There have been over 1.2 billion iPhones sold since its launch, and today we live in a more connected society. An example of how business leadership has been altered can be found in brand leadership. As shown in the chart below, 6 of the top 10 global brands today are technology companies as compared to 3 of the top 10 in 2007 and that is not counting Amazon one of the most disruptive companies of the past decade. We suspect that when we look at the top global brands in 2027, the list will be very different in company names but not in the leadership role of technology companies.

While technological advances have benefitted many, especially those in developing economies, these same advances have disrupted the labor markets in developed nations leading to greater inequality and political instability. Technological advances and the lack of wage growth and inflationary pressures in the developed economies are highly correlated. Their impact on the middle class, who are the key drivers of growth and rising living standards, is being reflected in the muted growth rates of these economies. The labor market issues in the United States have become increasingly complicated as there are over 6 million job openings available, yet the number of long-term unemployed remains stubbornly high as there is a substantial mismatch of the skills of the unemployed with those needed for the available jobs. One could argue that we don’t have a jobs problem but rather a skills problem as we have shifted to an ideas-based economy from a manufacturing-based economy.   According to the McKinsey report one-third of the new jobs created in the United States in the past 25 years were types that did not exist previously. The study also highlighted the positive impact on employment. As stated in the report, “A 2011 study by McKinsey’s Paris office found that the Internet had destroyed 500,000 jobs in France in the previous 15 years — but at the same time had created 1.2 million others, a net addition of 700,000, or 2.4 jobs created for every job destroyed.”   From a jobs perspective, global policy needs to focus on re-training the labor pool with the skills needed to be productive in the new economy.   For the U.S., needed jobs will have to be filled through either rapid skills training or immigration, or else competitive wage increases for the existing pool of workers will increase inflation pressures.

The Lack of Inflation Challenging Policymakers Globally

“Weak productivity growth and uneven distributions of economic gains limit growth going forward, especially in advanced economies. The slow pace of economic reform and of private sector balance sheet repair continue to depress investment and productivity growth, reinforcing headwinds from longer-term trends such as aging populations, slowing innovation, and slow progress in raising female labor force participation. Combined with insufficient support for those who bear the burden of adjustment to technological change and global economic integration, these forces put a ceiling on future economic prospects as the current cyclical boost runs its course.”

– Excerpt from the IMF Briefing Note to G-20 Leaders

The fear of technological advances destroying employment opportunities and increasing income inequality has weighed heavily on the psyche of market participants and policymakers. At the same time, the limits of highly-accommodative monetary policies employed by central banks have been reached, and fiscal policy has not been employed as it should have been in recent years. During the month of June, central bankers from the Federal Reserve to the Bank of England (BOE) to the European Central Bank (ECB) expressed the desire to move to a less accommodative policy approach. While the global economy continues to experience improving but muted growth, the stated desire is partly out of necessity as the central banks worry about the lack of firepower to stimulate their respective economies if needed in the future. In our April 18th Outlook, we wrote about the need for the Federal Reserve to emphasize a gradualist approach in raising interest rates and reducing the size of its balance sheet. Based on our reading of the latest minutes, the committee members seem to agree with our view of the need for gradualism.   We would suggest the same applies to the BOE and the ECB as there is a lack of inflation in the global system as wage growth remains anemic, commodity prices subdued, demographics worsening, and debt levels still high. With proper fiscal policy absent in the U.S., the U.K. and Europe, this is a sub-optimal time for central bankers to be too aggressive in tightening monetary policy.

Noted investment strategist Ed Yardeni has, for some time, stated that the easy monetary policies of the central banks had the effect of creating deflationary conditions rather than the inflationary ones that many had anticipated by providing low-cost capital for businesses to heavily invest in productive technologies to reduce labor costs and the prices of goods. Unfortunately, governments in the developed economies were not pro-active in taking advantage of these low interest rates to finance critical spending needs in infrastructure and re-training the labor force. The combination of these secular forces is suppressing inflation and should prevent central banks from tightening excessively which is helping to create a positive environment for equity valuations, and they should act to extend the business cycle.   Investors should be watching the central banks’ actions to make sure that the policy shift does not choke off growth and tilt the economies into recession. So far, the Fed’s Janet Yellen, the BOE’s Mark Carney and the ECB’s Mario Draghi have done an exceptional job in supporting the economic recovery.

Revisiting the Third Wave

“The Internet of Things (IoT), sometimes referred to as the Internet of Objects, will change everything—including ourselves. This may seem like a bold statement, but consider the impact the Internet already has had on education, communication, business, science, government, and humanity. Clearly, the Internet is one of the most important and powerful creations in all of human history. Now consider that IoT represents the next evolution of the Internet, taking a huge leap in its ability to gather, analyze, and distribute data that we can turn into information, knowledge, and ultimately wisdom. In this context, IoT becomes immensely important.”

– Dave Evans of Cisco’s Internet Business Solutions Group (IBSG)

Regular readers of the Outlook are well aware of our positive view of technological advances continuing to drive one of the most critical investment opportunities for the next several years. Several major technology trends are converging – cloud computing, big data, autonomous vehicles, the internet of things, artificial intelligence and augmented reality – and the development and commercialization of these technologies are creating opportunity for investors. The confluence of these advances is changing the way we live and shifting supply and demand and pricing dynamics for goods and services. This is presenting a multi-year opportunity by extending the business cycle for many businesses in the technology food chain. In our February Outlook, we introduced Steve Case’s concept of the Third Wave in the evolution of the internet, a phase where the internet becomes integrated into every part of our lives. The first phase laid the foundation with the building of the internet. The second phase, gave us search, mobility and e-commerce.

In recent years improvements in wireless technology have driven a surge in demand for products that can take advantage of faster mobile download speeds. In 2009, wireless carriers introduced “4th-generation” wireless technology (or “4G”), offering data transfer speeds approximately 10 times faster than those available on 3G technology. This same wireless technology is driving a growing industry of products that can “talk” or interact with one another over wireless, helping them become “smart” devices. One example would be a home security monitoring system that can turn on when triggered by motion and then send images to a central monitor or a customer’s smart phone. Another would be the integration of semiconductor chips into automobile dashboards, delivering information on traffic or weather patterns. These chips require new technology allowing rapid processing speeds but with low power utilization and easy integration with Wi-Fi / Bluetooth and user-friendly software programs. Today’s higher-end car models have approximately $1,000 of semiconductor content compared with just $300 for introductory models according to Cypress Semiconductor Corporation. As today’s luxury devices become tomorrow’s standards, demand for processing chips for the auto sector are expected to grow at high-single-digit to low-double-digit rates between 2016 and 2021. Additionally, connectivity for the home is expected to drive double-digit demand growth through 2021. These demand drivers are presenting multi-year opportunities for the leading companies positioned to service this growth. Furthermore, a new 5G wireless infrastructure is expected to be introduced over the next few years allowing us to access, process and store data at speeds and in volumes at multiples of what is available today.

Currently gaining a great deal of attention and capital investment is artificial intelligence (AI) which has the potential to disrupt the competitive landscape for industries and companies. Businesses that are quick to adapt can create value in the following ways – smarter research and development as well as business forecasting, more efficient production and maintenance, more targeted sales and marketing and enhanced customer experience. Industries that are employing AI include telecommunications, auto, financial services, utilities, transportation and logistics, retail, education, healthcare, travel and tourism to name a few. We previously touched on the increase in download speeds that 5G will have on information available to be accessed and its required data storage. German car-maker BMW has partnered with Intel, Delphi and Mobileye to develop its capabilities in-house. The NY Times recently reported that BMW had hired more information technology specialists last year than mechanical engineers as it needs huge data processing and analytic capabilities. According to the article, “the company has a fleet of 40 prototype autonomous cars it is testing in cooperation with its partners. BMW uses artificial intelligence to analyze the enormous amounts of data compiled from test drives, part of a quest to build cars that can learn from experience and eventually drive themselves without human intervention. After test sessions, hard disks in the cars are physically removed and connected to racks of computers at BMW’s research center near Munich. The data collected would fill the equivalent of a stack of DVDs 60 miles high.” These cars are producing so much data that it has to be stored in a data-center on site because it is too much to be transmitted to remote data centers via the cloud. Now multiply this type of application by thousands of other applications by thousands of companies in various industries in each country around the globe and one gets a sense of why data is the new currency for businesses. This puts companies like Amazon, Google, Apple, Facebook and other of the top global brands at the forefront of data ownership.

Investment Implications

There are many important issues that will create greater volatility in the markets including the nuclear provocations of North Korea, the Brexit negotiations, ongoing cyber and terror attacks just to name just a few. Based on the current conditions, our ongoing portfolio strategy continues to focus on three things – high-quality growth, high-quality dividends and opportunistic investments. The two biggest themes represented in our portfolios continue to be technology and defense which we believe are experiencing extended cycles. In addition, we expect financial and healthcare companies to benefit from a variety of catalysts including deregulation, while we also favor companies benefiting from increasing U.S. consumer spending and the shift to a more service-oriented global economy led by China and India. Like many, our team is disappointed that Congress in Washington has not enacted any of the fiscal policy initiatives we have written about in past Outlooks.   To achieve growth rates in the U.S. beyond 2.0 – 2.5%, we believe that tax reform, infrastructure spending and repatriation of overseas corporate cash are necessary and should be done now to take advantage of current low interest rates.

Companies that are able to aggressively invest in the future growth of their businesses should be more highly rewarded. In recent years, many corporations have only been able to improve their stock performance through financial engineering. As interest rates begin to rise, companies with good growth rates and strong cash balances should be well rewarded.

The combination of easy money and technology which led to greatly- increased U.S. production have altered the global oil markets leading to lower prices. Over the past several years, U.S. oil production has risen from 5.5 million barrels per day (bpd) to approximately 10 million bpd. The U.S. is in the position to export light crude (easy to refine) and import heavy crude which our refineries are uniquely able to process as opposed to those overseas refineries which require light crude. We expect the result will be sustained pressure on oil prices globally, greater strains on oil-producing nations dependent on oil revenues and the chance of additional instability and social unrest in those nations. Our views on the supply and demand dynamics impacting oil prices are underscored by the decision of three OPEC nations to plan initial public offerings to monetize their oil assets to diversify their economies. Moreover, we anticipate that industry consolidation will accelerate in coming quarters as the high-cost projects are draining the earnings and cash flows of the major oil companies. This will likely force them to seek out lower-cost production and reserves through acquisition to replace existing reserves.

At the same time, global developments will impact investor sentiment and short-term behavior. The United Kingdom has begun the process of negotiating its exit from the EU, and several European nations, particularly in France, Italy and Germany, have major elections this year. North Korea and Russia remain aggressors and the focus of geopolitical discussions between the U.S., China and other leading nations. Importantly for investors, the Outlook calls for the Fed to remain accommodative, the business cycle to be extended and the backdrop for equities to remain positive.

Rather than focus on short-term market moves, investors should remain focused on targeted investment opportunities in the areas we have emphasized over the past year. With the U.S. economy and consumer confidence improving, the outlook for small capitalization stocks has also improved. Small cap companies represent an area of undervaluation that may present some interesting opportunities for investors.   When and if corporate and personal tax cuts are enacted, infrastructure spending occurs and overseas cash is repatriated, U.S. companies and consumers will be major beneficiaries. Whether these initiatives occur in late 2017 or 2018, the expected direction of change is positive for the economic outlook and common stock valuations.

Once again, the world’s fragile geopolitical situation has again taken center stage with the tragic and despicable use of chemical weapons by the Assad regime in Syria, ongoing nuclear provocations by North Korea and deadly terrorist attacks in Stockholm and Egypt. In a sharp reversal from his opposition to Syrian intervention during his campaign, President Trump ordered an attack on a strategic target in Syria in response to Assad’s use of Sarin gas on civilians including children. President Trump approved the strike on the evening that he hosted China’s President Xi for the initial meeting between the world’s two most powerful leaders. With a single move, President Trump sent a message to Assad, North Korea, President Xi and the rest of the world that the United States will act forcefully and unilaterally, if necessary. This statement was particularly important considering the role that China will likely need to play in helping restrain North Korea’s nuclear ambitions. Given the Chinese government’s long-standing anti-interventionist position, the prompt U.S. response caught many off-guard and was further evidence of the unconventional approach by the new Administration.

Importantly, for investors concerned about the geopolitical situation and its impact on the markets, current economic conditions suggest a positive backdrop heading into the second half of the year and into 2018. Notwithstanding soft patches in the economy that are likely on the horizon, we remain positive on equities even with a possible pullback in the coming months. We are also encouraged by the economic improvements in Europe and Asia as well as the market’s ability to shrug off negative news. While the meeting between President Trump and President Xi did not yield any major announcements, it should be viewed as a positive first step in the relationship between the two leaders as President Trump was respectful of the Chinese leader and avoided the anti-China rhetoric that was so much a part of his campaign. China’s Communist Party has a big leadership conference in the fall and President Xi needed to show his strength to his country and the rest of the world. According to Cabinet officials, one development coming out of the meeting was the agreement to work towards a 100-day plan to review the trade relationship with China and to better cooperate in addressing North Korea’s nuclear program as it had reached an urgent stage. In addition, both sides agreed to subsequent meetings to discuss economic cooperation and security issues including cyber threats. For those trying to make sense of the long-term relationship between the U.S. and China, the Chinese Foreign Ministry website provided some insight as it reported a statement from President Xi’s discussions with President Trump as follows: “We have a thousand reasons to get China-US relations right, and not one reason to spoil the China-US relationship.”

Deregulation: The Bridge to Other Pro-Growth Initiatives

“Business Roundtable is not proposing that all regulations on this list be repealed, although some are so deficient they cannot easily be fixed. Others can be improved, however, by providing additional compliance flexibility, which will help to reduce unnecessary costs and compliance burdens. While addressing existing regulations that are unduly burdensome is vitally important to help jump-start American business investment and job creation, Business Roundtable believes that fundamental regulatory process reforms are key to ensuring long-term success.”

– Business Roundtable February 22, 2017 letter to Gary Cohn, Director of National Economic Council

In the United States, one of the most critical elements driving the positive sentiment among business leaders is the emphasis by the new Administration on reducing or eliminating inappropriate and excessive regulations. At ARS, we believe that it is essential for our government to better thread the needle when it comes to regulating business by balancing the risk of overreach with failing to ensure the proper safeguards on the system. The Business Roundtable, an association of chief executive officers of leading U.S. companies working to promote sound public policy and a thriving U.S. economy, has suggested that “a smarter approach toward regulation is needed to strengthen economic growth and job creation.” Businesses large and small have cited deregulation as perhaps the most important pro-growth initiative to drive increases in spending and hiring. President Trump has already taken several steps including placing a freeze on new regulations, lifting restrictions on the energy industry and asking government agencies to prepare a list of unnecessary regulations currently on the books. According to President Trump’s legislative affairs director, Marc Short, the previous administration authored more than 600 major regulations with an estimated cost to the economy of about $740 billion. To reduce regulation, this Administration has also asked Congress to employ a little-used piece of legislation called the Congressional Review Act (CRA) to undo 11 pieces of regulation with two additional regulations under consideration. Government agencies can also choose to selectively enforce regulations, and their willingness to do so might provide an additional boost to the economy. At a time that Congress appears to be struggling to repeal and replace the Affordable Care Act and reduce or reform taxes, deregulation is a tool that can be a bridge to push the economy forward until those pro-growth initiatives can be passed.

Banking remains one of the most regulated sectors and appropriately so. Some experts have blamed the 2008 financial crisis on the repeal of the Glass-Stegall Act which was originally designed to protect the system through the separation of investment and commercial banking. Gary Cohn, the former President of Goldman Sachs and a key member of the Trump Administration, has recently suggested that Glass-Stegall be reconsidered. The main regulation put in place to address many of the issues believed to have contributed to the financial crisis was the introduction of Dodd-Frank legislation which includes the Volker Rule. While well-intended, Dodd-Frank was complex, costly and burdensome both on the banks as well as on their regulators. This has been a complaint of bankers for years including in the recent annual shareholder letter by Jamie Dimon, CEO of JPMorgan Chase. The point was further driven home by outgoing Federal Reserve Governor Tarullo who served as the primary regulator for the major banks. In his final speech, Governor Tarullo said, “Several years of experience have convinced me that there is merit in the contention of many firms that, as it has been drafted and implemented, the Volcker rule is too complicated. Achieving compliance under the current approach would consume too many supervisory, as well as bank, resources relative to the implementation and oversight of other prudential standards.” It is estimated that only two-thirds of the Dodd-Frank regulations have been implemented. Designing the regulatory framework that allows the system to function properly and provide the necessary protections for consumers is critical.

Gradualism is Required for an Extended Business Cycle

“The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run… This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.”

– Federal Open Market Committee statement released March 15, 2017

In response to the 2008 financial crisis, the Federal Reserve under Chair Ben Bernanke announced in March 2009 that it would introduce the most unconventional and highly accommodative monetary policy initiative in history to stave off deflation and stimulate the U.S. economy. Since that time, market participants have been eagerly awaiting a return to normalcy.   This year on March 15th, the Federal Open Market Committee (FOMC) took another step toward normalization by raising the federal funds rate for the third time in three years by 0.25%, while suggesting further increases of 0.50% by the end of the year.   Based on the Committee’s projections below, real interest rates should remain at or below 1% for several years which means that even though interest rates will rise in coming quarters, the Federal Reserve’s monetary policy will remain supportive of the economy. The FOMC recently announced that it will consider starting to reduce its $4.5 trillion balance sheet later this year which would be a form of monetary tightening. The stock and bond markets initially sold off on that news in what has become a typical short-term overreaction to a Fed statement. It is notable that while the balance sheet has expanded from around $900 billion in 2008 to its current level, a significant portion of the money created remains parked in the Fed in the form excess reserves and it has not been lent out. As it is not circulating in the economy, a measured reduction in the Federal Reserve balance sheet should not create economic headwinds.

The Federal Reserve is emphasizing a balanced approach to stimulating the economy without overdoing it. It is critical to the Committee that its plan to hike rates and reduce its balance sheet does not create an economic slowdown and force it to backtrack. During the Presidential campaign, the Federal Reserve was criticized by President Trump, but the Fed is doing its part to support the Administration’s pro-growth initiatives with its measured approach to raising rates. The Fed’s current path will aid the much-needed spending required for the United States to maintain and update the nation’s infrastructure by keeping borrowing costs relatively low.

The Federal Reserve is highlighting its gradual approach to normalization because it sees an improving economy but also one with ongoing challenges. Unemployment has improved considerably in recent years, wages are slowly rising, housing is improving and consumer net worth has reached new highs. While monetary policy has helped arrest the deflationary effects of the financial crisis, there are secular forces which will continue to suppress inflation and which should work to keep interest rates below normal levels for longer than many market participants may be anticipating. These secular forces are technological advances, globalization, aging demographics in much of the developed world and excessive debt levels. Each of these presents a distinct challenge for monetary and fiscal policy makers who are struggling to put the United States economy on a sustainable growth trajectory. Because these are longer-term challenges, investors tend to acknowledge them but then promptly revert their focus back to shorter-term issues such as the policy agenda of the Trump administration or the upcoming elections in Europe. Investors with a longer-term focus should bear in mind that secular forces are helping to create a positive environment for equity investments as they will extend the business cycle.

Technology Leadership Continues

In recent quarters, we have written about technological advances and how they are changing the way we live. These advances are being driven by research and development spending.   The Wall Street Journal recently reported that the top three companies in cloud computing – Amazon, Alphabet’s Google and Microsoft – collectively spent $31.5 billion in 2016 for an increase of 22% over 2015.   Adding in Apple, AT&T, Verizon and other technology and telecom companies and the amount of spending rises significantly. As the capital requirements to maintain leadership continue to rise, the big are getting bigger. And that is even before data requirements grow with the introduction of 5G and continuous growth of the Internet of Things (IoT). In the February 28, 2017 Outlook, we wrote about the increase in download speeds that 5G will have on information available to be accessed and its required data storage. One area where the impact of technological advances will be seen is in autonomous cars. According to Intel, the average autonomous car will soon create 4,000 gigabytes of data per day based on just one hour of driving. The new cars will have hundreds of on-vehicle sensors to record data with cameras, sonar, GPS and radar being big drivers of data creation. Intel’s CEO Brian Krzanich, in a speech to the auto industry, estimated that “one million autonomous cars will generate 3 billion people’s worth of data.” This does not even begin to address the additional information that will be generated by devices designed for residences. Government spending on technology also continues to grow rapidly, and one area of significant spending will continue to be by the military’s growing need to improve cyber defense. These are just a few examples as to why we believe that we are in a unique, multi-year cycle for technology.

Investment Implications

Investors should expect to see continued volatility in the markets. Our ongoing portfolio strategy focuses on three things – high-quality growth, high-quality dividends and opportunistic investments. Our emphasis remains on selecting companies benefitting from positive trends in cloud computing and mobility, rising defense spending, changes in the financial and healthcare industries, increasing U.S. consumer spending and the shift to a more service-oriented global economy led by China and India.   We especially favor leading technology companies with strong growth characteristics that are driving changes in cloud computing, big data, autonomous vehicles, the internet of things, artificial intelligence and augmented reality. ARS has spent substantial time researching the beneficiaries of greater infrastructure spending and will look to increase our investments in this area as our conviction grows that Washington is taking steps to make the investments our nation requires. We continue to target companies that are gaining market share, maintaining or improving profit margins, increasing free cash flow, restructuring to gain more efficiency, increasing pricing power and/or growing dividends.

Companies that are able to more aggressively invest in the future growth of their businesses should be more highly rewarded as there is a growing view that many corporations have been able to only financially engineer their performance improvements in recent years.

At the same time, global developments will impact investor sentiment and short-term behavior. The United Kingdom has begun the process of negotiating its exit from the EU, and several European nations, particularly in France, Italy and Germany, have major elections this year. North Korea and Russia remain aggressors and the focus of geopolitical discussions between the U.S., China and other leading nations. It is easy to be distracted by the headline news. Importantly for investors, the Outlook is that the Fed will remain accommodative, the business cycle is likely to be extended and the backdrop for equities should remain positive.

Rather than focus on the short-term market moves, investors should focus on targeted investment opportunities in the many areas we have emphasized over the past year. With the U.S. economy and consumer confidence improving, the outlook for small capitalization stocks has also improved and yet these companies have not participated in the strong returns so far this year. Small cap companies represent an area of undervaluation that may present some interesting opportunities for investors. When and if corporate and personal tax cuts are enacted, overseas cash is repatriated, and infrastructure spending occurs, U.S. companies and consumers will be major beneficiaries. The combination of these forces should increase after-tax earnings for companies whether it should occur in 2017 or 2018. Irrespective of the specifics and timing of these policies, the direction of change is positive for the economic outlook and therefore for equities.