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Download Outlook NowThe Global Economy Remains Remarkably Resilient

In a period marked by significant global upheavals and economic challenges, “Finding Opportunity Where Others May Not” outlines the resilience of the global economy and the unique investment opportunities that emerge in times of disruption.

Executive Summary“Despite gloomy predictions, the global economy remains remarkably resilient, with steady growth and inflation slowing almost as quickly as it rose. The journey has been eventful, starting with supply-chain disruptions in the aftermath of the pandemic, an energy and food crisis triggered by Russia’s war on Ukraine, a considerable surge in inflation, followed by a globally synchronized monetary policy tightening.” -Pierre-Oliver Gourinchas, IMF’s Chief Economist, April 16, 2024

The past 15 years have been among the most difficult for investors to navigate as the combination of the most accommodative monetary and fiscal policy the world has ever witnessed was employed to counter the world’s multiple crises described above by Mr. Gourinchas. The escalation of the conflict in the Middle East and the resulting uncertainty on its resolution, and that of the Ukrainian conflict, continue to shift the narrative for policymakers and investors. There have been three periods of significant disruption for U.S. investors since our firm’s inception in 1971 – the 1970s, the 2000s, and today.

On an April 30th Zoom presentation for our clients, Arnold Schmeidler and Sean Lawless discussed how we have used the same investment process for over 50 years to navigate those past periods successfully, and shared our thoughts on where we are finding opportunities in areas where others are not. With over nine decades of investment experience between them, the conversation between Arnold and Sean offered some fascinating perspectives on the current environment, and they shared a few investments that reflect the exposures in client portfolios. This piece will summarize the views expressed on that call and provide a sense of where we are finding opportunities today in industries and exposures.

Outlook HighlightsNavigating Past Periods of DisruptionHistorical disruptions have often reshaped market dynamics, presenting both challenges and opportunities. Understanding these phases helps in strategizing for current and future investments.

The Current Phase of DisruptionToday’s disruptions include technological advancements like generative AI and significant geopolitical shifts. These factors necessitate a reevaluation of investment strategies to align with the evolving global economic landscape.

Opportunities in Unconventional AreasDespite market volatility, there are substantial opportunities in areas that are not the focus of mainstream investment strategies. By looking where others are not, investors can find valuable prospects in undervalued sectors.

Investment Focus and StrategyThe Outlook stresses the importance of a forward-looking investment approach, emphasizing flexibility and strategic adaptation to leverage disruptions into opportunities.

Our PerspectiveARS Investment Partners, LLC remains committed to a proactive and insightful investment approach that not only navigates but also capitalizes on periods of significant economic and geopolitical disruption. By focusing on a long-term perspective and adapting to new economic realities, we continue to identify and exploit investment opportunities that others may overlook. This commitment to strategic foresight and flexibility is key to our continued success and ability to deliver value to our clients even in the most challenging times.

DisclaimerThe information provided in this report is for informational purposes only and is not intended as investment advice, or an offer or solicitation for the purchase or sale of any financial instrument. This report is provided on the condition that it does not form a primary basis for any investment decisions. The opinions and analyses included in this report are based on current market conditions and are subject to change. ARS Investment Partners, LLC will not be responsible for any investment decisions based on this report. Please consult with a qualified financial advisor before making any investment decisions.

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Executive Summary

The global economy is undergoing tremendous changes requiring investors to step back and take a fresh look at their portfolio positioning. The complexity of the current environment is challenging traditional investment thinking regarding the impact of monetary and fiscal policy on inflation, interest rates, and corporate profits, especially given the potential for change stemming from the introduction of generative AI and the ongoing issues with the climate transition. This piece explores the divergence between the market’s expectations for rate cuts and what the Federal Reserve is most likely to do, a key differentiator between the market and ARS. Our consistent stance has been that rates would remain elevated for a longer duration than the market expected, a view that has gained greater acceptance in recent days. The United States economy and businesses remain standout opportunities, and we expect capital flows to continue to favor the U.S. and its leading companies. Today, investor portfolios should emphasize sectors such as industrials, materials, healthcare, energy, and technology, and active versus passive management. Given the differences of this period versus previous ones, we believe that investors need to rethink their portfolio positioning.

“Think about the race of artificial intelligence … think about the geopolitical tension and the threat of fragmentation we will have to deal with over the next years. The higher debt levels after the pandemic and the energy price hikes, which has shrunk our fiscal space to finance transformation, and given … little growth perspective of the global economy. Has 2023 given me hope? … I would put it this way: It was a call for action because we have to rearrange some policies and … probably we are at the beginning of an era of new structural reforms.”

– German Finance Minister Christian Lindner, January 19, 2024

We are living at a point in history unlike any other. The aftermath of the events of the past 15 years has exposed cracks in the foundation of the world order, the global economy, and the markets. However, the negative sentiment which is so pervasive in society today is also overshadowing investment opportunities that will reshape industries and foster a necessary productivity boom as we enter the age of accelerated computing and generative AI. At the same time, the global economy is transitioning to one which may best be characterized by a return to more historic levels of interest rates while we experience major geopolitical, economic, and social transformations. This shift is forcing governments, businesses, and consumers to adjust to the highest interest rates seen since 2008. Yet unexpected to many, the global economy has proven more resilient than many economists had anticipated as growth has surprised to the upside, inflation has moderated, and employment has remained strong. With concerns regarding the upcoming U.S. election, the further escalation of conflicts, elevated levels of debt, worsening demographics and immigration issues, this is certainly plenty for investors to contemplate.

Throughout our 53-year history, ARS has often seen the world through a different lens than other investors which has led to portfolios with differentiated holdings and sector weightings versus the typical institutional portfolio. We believe that today, many investors could be asking the wrong questions regarding the economy and the markets as they are hoping for further support from central bank policy to boost returns by cutting interest rates. Many investors rely on thought processes and computer models that are grounded in past cycles. However, this approach has led to inaccurate conclusions, as they do not account for the significant differences in the current environment compared to those in the past. The next few years will continue to be unlike any previously experienced since these transformations have important implications for public and private capital expenditures, consumption, and investments. Market participants should ask themselves: Is my portfolio invested based on market hopes and anticipations or is it aligned with what is more likely to happen?

Are We Asking the Right Questions?

“We have a strong economy. Growth is going on at a solid pace. The labor market is strong: 3.7% unemployment. With the economy strong like that, we feel like we can approach the question of when to begin to reduce interest rates carefully.”– Jerome Powell, Chair of the Federal Reserve, February 4, 2024

For some time now, most market participants have been asking “how soon and by how much is the Fed going to cut rates?” but the better question is “why should the Fed cut rates now?” The Federal Reserve’s mandate is to achieve maximum employment and price stability while maintaining economic growth. Based on those measures the U.S. economy is in surprisingly good shape. The just- released Consumer Price Index (CPI) and Producer Price Index (PPI) reports indicated that the inflation fight is not yet won as the January numbers came in above market expectations. Chair Powell’s remarks reiterated the views expressed in our January Outlook as we felt the market’s expectations for rate cuts were not consistent with our read of the economy and the Fed. The challenge for the Federal Reserve is that they do not know where interest rate policy should be set so as not to be too restrictive or too expansionary, in order to achieve its goals. Since the December meeting, market participants have dialed back expectations for the amount of interest rate cuts from 1.75% to around 1.00% for the year. Clearly, the market got ahead of itself as the Fed member’s December Summary of Economic Projections only called for 0.75% reduction, or three 0.25% cuts.

The Fed does not embark on a policy change of lowering interest rates without a valid reason, and while reasonable people can disagree, Chair Powell believes that the timing is not yet right to begin reducing rates and ARS agrees. Both monetary and fiscal policy work with long lags, meaning its impact may not be felt for 12–24 months, and the market has underappreciated the continued strength of the economy given the massive scale and duration of approved fiscal spending programs. That does not mean that the Fed might not need to lower rates at some point, but there are three key factors that market participants may not be weighing enough. First, the markets may be missing the scale and the impact of the monetary and fiscal support provided to the U.S. system since the pandemic. This includes the several trillion dollars of support from the Infrastructure Investment and Jobs Act, Inflation Reduction Act, the Chips and Science Act, and the National Defense Authorization Act which will see funding of projects continuing for several more years with additional spending from the private sector and state and local governments. Second, the markets held the belief that monetary policy tightening, such as what we have experienced during the past 24, months always causes a recession. It also typically causes a financial crisis like the one narrowly avoided last year with Silicon Valley Bank. The post-pandemic period has seen industry after industry experience some slowing and, for many, a recession. It is just that the impact has not all hit at the same time allowing the economy to continue to grow above expectations. Finally, the U.S. consumer today is vastly different from past periods as more baby boomers are moving into retirement with $75 trillion in net worth and time on their hands to spend it. While many families are struggling with paying bills and have seen their excess savings drawn down considerably, the boomers can continue to be significant spenders and help to offset some of the slower spending of others. Moreover, the federal government will continue to spend, offsetting any potential weakness in consumer spending.

Why Does This Matter for Investors?

2024 ARS focuses its research efforts on defining the global environment and identifying undervalued businesses that stand to benefit. Why so much focus on monetary and fiscal policy and, in particular, the outlook for inflation, interest rates, and corporate profits? It is because the basis for securities valuation is dependent on these three inputs. The following are our current views on each.

Inflation — There are many reasons the Fed may not be motivated to cut rates as it has made excellent progress on bringing inflation down towards its 2% target while maintaining solid growth and full employment. If the Fed is too aggressive on rate cuts, it could further stoke inflationary pressures by stimulating more spending. Additionally, the problems of China and Germany, two of the world’s biggest manufacturers, have helped strengthen the U.S. dollar which means that U.S. imports cost fewer dollars, in effect lowering prices, thereby helping to do some of the Fed’s work. Finally, labor shortages and increasing wages for 2024 will put upward pressure on costs and inflation, reinforcing the Fed’s patient stance on lowering rates.

Chart 1. U.S. Fed Funds, 10-year Treasury and 30-year Fixed Mortgage Rates 1971 to Today

Interest rates — What would cutting interest rates do at this time? In the near term, it would be good for short-term growth, for the markets by expanding price/earnings multiples, for new homebuyers as well as highly indebted companies and governments. However, it would also likely reignite inflationary pressures which the Fed is determined to avoid. Chart 1 illustrates the levels for the Federal Funds Effective Rate, the market yield on 10-year treasuries, and the 30-year Fixed Rate Mortgage average since 1971. While current rate levels are high compared to the experience of the past 15 years, they are not high on a historical basis. Given current conditions, it is not likely that we will see rates trend much higher, but also not much lower barring a major event or a significant policy misstep.

Chart 2. U.S. Corporate Profits Before Tax

Corporate profits — A question for investors to consider this year is “can markets produce another year of positive returns given the economic headwinds?” Chart 2 illustrates U.S. pre-tax profits growth from the 1940s to today. What is particularly impressive is the tremendous profit growth in recent years given the challenges of the post-Great Financial Crisis (GFC) period as pre-tax profits jumped from $1.9 trillion in 2006 to $3.6 trillion last year. That jump does not yet take into account the additional profitability that companies will realize with the productivity increases coming from generative AI and other technological advances. After an almost 15-year period of massive monetary and fiscal policy stimulus providing tailwinds for corporate profits, the tighter money conditions that exist today will favor those companies with strong balance sheets, competitive moats, and relatively inelastic demand for their products. Many large corporations have announced layoffs and other efficiency initiatives designed to manage profitability in what many CEOs are projecting to be a challenging environment. Notwithstanding this, we are excited about the opportunities to invest in select sectors, industries, and companies. Coming into the new year, ARS felt investors would experience positive returns from many U.S. equities, and nothing has transpired to date to change that view.

Are You Positioned for What Lies Ahead?

“One of the most striking aspects of the generative AI revolution is that it is just getting started. Its main drivers — computing power, data, talent, and funding — are compounding at a scale and speed that will accentuate its disruptive forces. No wonder it has risen to the top of the agenda for chief executives in an ever-increasing number of companies and industries.”
– Mohammod El-Erian, President of Queens College, Cambridge, and advisor to Allianz and Gramercy. Financial Times, February 15, 2024.

What the markets will do in the near term is anybody’s guess, but it is in times like these that businesses innovate and adapt to create new opportunities for investors to build and protect capital. Many investors have no problem investing when the markets have a clear direction as they tend to just follow the crowd. However, this is not one of those times since current market dynamics favor individual stock selection over index investing, and the United States market over most global markets.

Moving forward, ARS expects a prolonged global low-growth environment with big opportunities for a limited number of countries and companies. The countries that will benefit will be those with relatively favorable demographics, fiscal policies to support the ongoing transitions, access to capital, dependable sources of energy, national corporate champions driving the technological revolution, and low dependence on adversary nations for key resources. ARS sees the world through a different lens than most investment firms, and that results in highly differentiated portfolios as reflected by our overweights in the energy sector; industrials sector including defense and reindustrialization beneficiaries; materials sector which is critical to technological leadership, the energy transition, and national security; healthcare sector which stands out as a leading beneficiary of generative AI, and the technology sector with a focus on cloud, data infrastructure, semiconductor chips, and capital equipment providers.

We favor companies that are among the leading beneficiaries of the reindustrialization of the U.S. economy, those that are driving productivity increases to offset rising labor costs, enhancing healthcare outcomes, and those that are critical to national security. A fundamental theme is the growing demand for and use of advanced technology to increase productivity, lower costs and raise living standards. Additionally, the businesses that will reward investors in 2024 will be those with relative inelasticity of demand for their products. We expect corporate earnings to continue to increase, but the benefits will not necessarily flow to all companies equally. Investors should anticipate periods of volatility, but since we anticipate rising corporate earnings, it should not be a surprise to see the markets continue to make new highs in 2024.

Published by the ARS Investment Policy Committee:

Stephen Burke, Sean Lawless, Nitin Sacheti, Greg Kops, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor, Tom Winnick.

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

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

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

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Executive SummaryFollowing last year’s strong market performance, U.S. investors should see equity markets continue their upward trend, but it will not be a straight line. The outlook for the next 12 months will likely be determined by the impact of domestic and global politics which will affect the prices investors are willing to pay for current and future earnings of businesses. There remains continuing concern for the protection of purchasing power of the U.S. dollar given today’s levels of debt and deficits. We believe the current investments in technology, defense, industrials, materials, and healthcare companies will be important beneficiaries of this outlook, serving clients well over the next 12–24 months.

“Markets and policymakers would be well advised to focus on how much the world has changed in the past few years. The inflation roundtrip is neither simple nor complete. The resulting shift in the configuration of the global economy and financial markets will be felt for years.”

– Mohammed El Erian, President of Queens College, Cambridge, and advisor to Allianz and Gramercy

Last year’s market performance surprised many investors who were too pessimistic about the economy following big market declines in 2022. As shown in Chart 1, a Bloomberg Survey of investors forecast that the S&P 500 would end 2023 around 4000 which was far below where the markets ended the year at 4769.83. Coming into 2023, ARS held the contrarian view that we did not believe that a major recession was a realistic outlook. We believed that inflation had peaked and that the Fed and other central banks would slow or stop interest rate increases, and this would allow the market to find firmer footing.

Additionally, we felt that there were many world-class businesses that were not only attractively valued after the 2022 market pullback but would also be the primary beneficiaries of the multi-year capital spending that has been programmed into the economic outlook. Despite our more favorable outlook, the markets exceeded our expectations, particularly given the powerful performance since the last Federal Reserve meeting in December. Therefore, it is no surprise that 2024 began with profit-taking in many of last year’s best performing stocks.

Chart 1. S&P 500 Performance Versus Average 2023 Year-End Forecast

The outlook for the next 12 months will likely be determined by the impact of domestic and global politics which will affect the prices investors are willing to pay for current and future earnings of businesses. In addition to next year’s U.S. presidential election, the outcomes of general elections in more than forty nations must be taken into consideration. Given the already fragile state of world affairs, the results of these elections will have significant implications for domestic and international politics, economics, and societies in the coming period. In most of these countries, these elections are occurring at a time when the immediate demands of voters far exceed the ability of most governments to deliver on both the short-term and longer-term societal needs given existing debt burdens and rising fiscal deficits.

Chart 2. Countries Holding General Elections in 2024

*Correction, October 27, 2023. This figure has been corrected to include data for Mexico.
Source: Center for American Progress

It is against this backdrop that market prognosticators are making predictions for 2024. As negative as most forecasters were coming into last year, the forecasts for 2024 are more positive as inflation has eased and the market anticipates rate cutting from the Fed and other major central banks. We would note that the market must digest some unusual events including the prospect of an escalation in the current conflicts and the need for a divided and ineffective Congress to be able to address significant national security and budgetary issues in the near term. Further complicating the outlook is our belief that we will need to finance the large U.S. national debt and growing deficits with shorter-term maturities, diverging from the past when it was easier to issue longer-term maturities. This puts additional strains on the Congress and the Federal Reserve to get it right.

Given the many forces that could impact earnings over the next year, investors should emphasize stock selection over owning the broad market indices. We continue to favor companies that are among the leading beneficiaries of the reindustrialization of the U.S. economy, those that are driving productivity increases to offset rising living costs, enhancing healthcare outcomes, and those that are critical to national security. The most important common theme is the growing demand for and use of high technology to increase productivity, lower costs and raise living standards. Because we expect corporate earnings will continue to rise overall, the markets could reach new highs in 2024 though investors should anticipate significant volatility.

The Geopolitical/Political Transformation and the 2024 Elections

“The year 2023 saw the greatest global resurgence of armed conflict since 1945: 2024 will be worse. We are living, if not through a World War, then a world at war, the great post-globalization jostling to divide up the spoils of what was once America’s unipolar imperium. This will be as epoch-defining a period as the late Forties were for Britain or 1991 for Russia.”

– Aris Roussinos, UnHerd columnist and a former war reporter

2024 may be remembered as one of the defining years in history as democracies are under siege. In addition to the upcoming Presidential election in the United States, general elections will be held in forty nations around the world. The elections begin in Taiwan in January and are followed by Russia (March), India (April), the UK (May), the EU (June), and the U.S.(November). As shown in Chart 3, some forty nations representing an estimated 41% of the world’s Gross Domestic Product (GDP), and 42% of the world’s population will hold general elections. Newly elected leaders will need to deal with unpredictable geopolitical risks involving two wars with no clear end in sight, ongoing conflicts between the U.S. and China, and the need to address massive immigration challenges for Europe and the United States which have become major economic, security and political issues.

Chart 3. 2024 Elections by the Numbers

2024 Elections

Global leaders are facing a challenge as the world has shifted from a prolonged period of détente and globalization to global fragmentation and more restrictive terms of trade. At the same time, many nations are experiencing worsening demographics, rising debt servicing costs, slowing growth, energy supply concerns, and increasing domestic divisiveness. By failing to make the necessary investments in critical infrastructure, leaders in many nations wasted a decade of near zero interest rates and now have large debt-servicing costs.

The wars are increasing fears of migration crises as the forced displacement of millions is stoking greater nationalistic sentiment and growing support for far-right parties. The recent election of Geert Wilders as the Dutch Prime Minister may be a sign of things to come in global politics. A far-right candidate, Mr. Wilders ran on a platform of anti-Islam, anti-immigration, anti-climate change, and anti-EU, and he won. While it is too early to call this win a trend, sentiment among voters has been shifting to the right. It would not be a surprise to see a more nationalistic focus in the West which would play right into the hands of adversaries to take advantage of the distractions caused by domestic issues typical in an election year. China, Russia, North Korea, and Iran are not just watching to see if the political dysfunction stemming from these elections creates the opportunity to further take advantage, they are already taking advantage of the perceived weaknesses of the democracies.

As indicated by each candidate’s low approval ratings, many voters in the United States are so dismayed by the choice between President Biden and former President Trump that there is talk of a third-party candidate entering the race. While both are clear frontrunners in their parties at this moment, support for each is shaky. As voters head to the polls in 2024, the implications for investors cannot be understated as highlighted in the quote from noted investor Paul Singer of Elliott Investment Management, who said recently, “the world is now completely dependent on the good sense of leaders to avoid an Armageddon. It is hard to avoid a conclusion that investors are not nearly as worried as they should be.” While we are not as pessimistic as Mr. Singer, we agree in concept with his sentiment as leadership will be the key to better outcomes.

Investment Implications

“I think there’s still a risk that the market is probably underestimating that we’re not going to quite make as much progress on inflation as people hope and that there’s not going to be quite as much room for Fed easing as people hope.”

– Larry Summers, American economist, and former Treasury Secretary

As the world continues to adjust to the changing nature of the global economy and the rising risks of an escalation of war, ARS expects a prolonged lower-growth environment. However, specific companies could see an acceleration of growth under these circumstances as we experienced during the pandemic. Another example of this occurred in WWII involving the railroads, which emerged from near bankruptcy to become among the market’s best investments during those years. The wars today now involve the competition for technical superiority on air, land, sea and in space.

We have begun to see signs of a broadening of the stock market from the well-publicized Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla) which is important for the stock market to continue to make new highs this year. The two biggest opportunities stem from stimulants in the system that did not exist before — the climate transformation and more advanced technologies including the introduction of generative AI. While both are incredibly important and exciting opportunities over the intermediate to longer terms, ARS anticipates a bumpy ride for investors until the related businesses achieve more rational valuations and higher earnings to support the current hyped-up expectations.

One of the most attractive investment opportunities for this year is one that underperformed last year, and it involves industrial commodities including copper and rare earths. One area where the battle for technological supremacy is being fought is over rare earth materials that are essential for the clean energy transition and for future advances in military and industrial technologies. In fact, China recently announced that it will be restricting the export of select refining technologies for rare earths which should make the handful of producers in the West even more valuable than they are today. Client portfolios will continue to emphasize leading companies in technology including leading-edge semiconductor/equipment and the cloud, industrials for infrastructure and national security, energy involving both fossil fuels and renewables, materials essential to support the industrial/military complex, and pharma/biotech which are lowering costs, as well as those businesses with strong balance sheets and solid dividends.

In the realm of investment management, it’s crucial to acknowledge that decisions must often be made with incomplete information, and rarely do we see economists and market strategists having such a wide range of forecasts as we see today. The primary cause is the challenge of determining the course of inflation and interest rates which are two of the three key inputs into securities valuation followed by the outlook for corporate earnings. In fact, much of the market’s enthusiasm in the recent period stems from the view that the Fed would aggressively be cutting rates this year beginning in March. ARS agrees with Mr. Summers and believes that the market misinterpreted the Federal Reserve Summary of Economic Policy (SEP) forecast which had shown three cuts in 2024. In an economy with near-record levels of employment and rising wages, it is difficult to foresee a scenario in which the Fed will reduce interest rates and ease monetary policy to the level of current expectations. Consequently, the market is likely ahead of itself.

In order to offset the continuing structural decline of the purchasing power of the U.S. dollar, investors would be better served owning well-selected equities over bonds. There has never been any economic period where good investments could not be found, and we are confident the current investments in technology, defense, industrials, materials, and healthcare companies will be important beneficiaries of this outlook, serving clients well over the next 12–24 months.

Published by the ARS Investment Policy Committee:

Stephen Burke, Sean Lawless, Nitin Sacheti, Greg Kops, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor, Tom Winnick.

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The manifold forces driving today’s economic activity and the outlook for the coming period will result in an economy that differs markedly from anything we have experienced. The many forces at work include the return to more historical interest rates, geopolitical fragmentation and attendant dangers, the reindustrialization of the United States economy with leading-edge technology resulting in greater productivity, the climate transition, and a realignment of the world order. In all past cycles, the monetary and fiscal policies of the US could always work together to cushion the economy from significant economic setbacks. Today, however, this is no longer the case. Since we are already running record-high fiscal deficits at the top of a business cycle, fiscal policy can no longer be used to cushion an economic downturn without creating a major economic dislocation. Therefore, the entire burden is on the Federal Reserve’s monetary policy. The previously mentioned political environment also would appear to make a unified Congressional response to any economic dislocation difficult.

Given present conditions, it is easy to overlook the opportunities being presented in the markets today. For some time, we have defined three major shifts occurring simultaneously: a meaningful increase in the cost of living, a realignment of the world order, and the reindustrialization of the global economy. These changes and the subsequent policy responses are defining the most critical investment opportunities for the next decade, creating additional revenues and profits for those that benefit. However, market participants need to factor in one major shift into their investment thinking: the need to adjust the security selection process to this higher-for-longer, but more historically normal, interest rate environment. With the cost of capital rising from near zero just 18 months ago, investors will need to reassess their current portfolios and focus on companies best positioned for this new economic era. In recent times, the stock market returns have been driven by a handful of mega-caps, including Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia, and Tesla. These companies account for around 30% of the S&P 500 market cap and over 60% of the 2023 market returns, according to S&P Global. The current market dynamics are leading to a broadening of opportunities to include industries such as industrials, energy, materials, and others that were previously underinvested.

Coming into the year, most market participants were too pessimistic, and many are now coming to grips with a stronger stock market and a more resilient United States economy despite the obvious ongoing challenges. Back in January, ARS had a divergent view as we saw the U.S. economy being stimulated by the massive fiscal policy support, particularly the American Rescue Plan, Bipartisan Infrastructure Act, CHIPS and Science Act, and Inflation Reduction Act. Coupled with the need to address the climate transition, use advanced technologies to increase productivity, and upgrade national security in the face of global fragmentation and increased risks, we expect these forces to continue to drive capital flows into the United States and offset some of the headwinds facing the economy. The U.S.’s historic economic strengths, including our reserve currency status, the depth and maturity of our capital markets system, and the abundance of a dependable supply of energy, tend to reassert themselves in times of global stresses, and this is the case again today.

Inflation Is Moderating, Cost of Living Is Rising

“Inflation has moderated somewhat since the middle of last year, and longer-term inflation expectations appear to remain well anchored, as reflected in a broad range of surveys of households, businesses, and forecasters, as well as measures from financial markets. Nevertheless, the process of getting inflation sustainably down to 2 percent has a long way to go.”

– Jay Powell, Chair of the Federal Reserve, September 20, 2023

Chart 1. Federal Funds Effective Rate — 1980–2023

We are coming to the end of the “new normal” or easy money era that helped define the post-Great Financial Crisis period, and this change will have major implications for investment strategy. Chart 1 shows that the federal fund’s effective rate had been held at near zero for more than a decade and then abruptly raised to 5.25% over the past 15 months. Similarly, the European Central Bank (ECB) has raised rates from a low of -0.50% in 2019 to 3.90% today on one of its three key benchmark rates. For some time, Fed Chair Powell has been steering the market perception to what it considers a more appropriate policy for the health of the economy for the medium- and longer-term.

Chart 2. Federal Funds Effective Rate (1954–2023)

The reality is that the markets are returning to more historical levels of interest rates as shown in Chart 2 which illustrates the fed funds rate back to the 1950’s. Current interest rates are at levels where the economy has experienced reasonable growth in the past, but it will likely be some time before we achieve significantly higher levels of growth as we have had in the past.

Chart 3. Consumers’ Excess Savings Highlights the Gap Between the Haves and Have-nots

The Federal Reserve’s measure of the Core Consumer Price Index does not capture changes in food and energy costs; therefore, consumers face higher costs of living than those captured by the CPI. At the present time, the recent wage increases won by many workers have yet to be fully reflected in the system. For example, California Governor Newsom just signed legislation increasing the minimum wage for fast food workers to $20 per hour, and the UAW is seeking wage increases in the 30% range over 4 years, plus benefits and a shorter work week.

Cost of living is the measure of a basket of essential items that a household requires. Recently, Moody’s projected that the median-income U.S. household’s basket of essential goods and services has increased by $734 per month versus 2 years ago. The median income level is approximately $74,500 and the cost-of-living increase annualizes to $8,808. Gasoline prices are on the rise, food prices remain high, and wages are rising forcing companies to adjust by increasing prices or finding ways to cut costs. Insurance is another area where households are experiencing higher costs, with auto rates being raised by 7.5% to as high as 15%, and homeowners’ policy rates are increasing as well. While wage gains continue to be pushed through, many workers find the cost of living a significant challenge.

Risks Present in the System

At the start of the year, the World Economic Forum published its Top Ten Risks 2023 report addressing the severity and impact of the risks to the global system over the next 2 and 10 years respectively. At the top of the list for the near term were the cost-of-living crisis, weather, geopolitical concerns, failure to mitigate climate change, and social and societal polarization. Longer term, climate remains at the top of the list, as well as ongoing geopolitical considerations and forced migration. While many of the longer-term issues are obvious, the solutions are complicated, expensive, divisive, and require significant planning and global coordination. Aside from the risks facing the world stemming from the inflation fight, global fragmentation, and the war in Ukraine escalating or expanding in Europe and to other theaters such as Asia, the Middle East, and Africa, there are other more immediate issues for the global and United States economies.

At the press conference following the recent Federal Open Market Committee meeting, Chair Jay Powell highlighted five developments he is watching to help the FOMC determine the trajectory of the economy. These involve:

1.The UAW strike

2.Possible government shutdown

3.The resumption of student loan payments

4.Higher-for-longer interest rates

5.Impact of the recent rise in oil prices

ARS would add a few other issues we are monitoring, including the possible return of austerity policies in Germany and Europe, weakening military support for Ukraine, demand for U.S. Treasuries to finance the deficit, commercial property weakness, and a debt blow-up, possibly coming from China. Additional considerations for the United States involve the availability of workers with the skills for today’s economy and the failure of Congress to address the many shortcomings of U.S. immigration policy properly. And we also have a critical Presidential election next year with two front-runners with the most unfavorable polling results in recent history. Geopolitical risks remain elevated and may even increase as China’s economic woes pressure President Xi and the Communist Party to act on Taiwan. We believe that the risks, such as those described above, often mask many of the best opportunities available as investors tend to seek safety rather than opportunities in times of heightening uncertainty.

ARS Views into Year-End and Beyond

“We are entering a world of major transitions in labor markets, energy markets, and geopolitics, all of which can lead to larger and more frequent relative price shocks.”

– Christine Lagarde, President of the European Central Bank, September 5, 2023

As the world continues to adjust to the unusual nature of the global economy, ARS expects a prolonged low-growth environment with big opportunities for a limited number of countries and companies. The two biggest opportunities stem from stimulants in the system that did not exist before as they do today — climate change and generative AI (artificial intelligence). While both are exciting for the intermediate and longer term, ARS expects investors will experience a bumpy ride until these areas have more rational valuations to support the near-term hyped-up expectations. The countries that will benefit will be those with relatively favorable demographics, fiscal policies to support the ongoing transitions, access to dependable sources of energy, national corporate champions driving the technological revolution, and low dependence on autocratic nations for key resources. Importantly, much depends on three big issues: the extent of China’s economic woes, the ability of central banks to tame inflation without causing a severe recession, and the ability of the world to adjust to higher interest rates that will remain higher for longer than currently anticipated.

Below are some key points for investors to consider:

1.Interest rates will remain higher for longer as the Fed needs to avoid a recession due to the current fiscal and monetary position of the United States, while the global system is dealing with a strong dollar, slower growth, higher rates, and more persistent inflation.

2.Given the low-growth environment, companies will have big opportunities to implement productivity enhancements to protect profit margins and increase productivity to offset rising costs and labor market challenges.

3.The U.S. remains the best house in a bad global neighborhood due to its distinct competitive advantages, including its leadership position in advanced technologies, and should continue to attract capital from around the world.

4.It is especially important for investors not to overvalue the qualitative opportunity and focus on the quantitative — watch out for taking excess risk on qualitative factors unsupported by reasonable valuations.

5.The current environment favors the ownership of business versus fixed income due to the continuing loss of purchasing power in bonds.

6.Governments will need to monetize their debts and deficits as budgets are mostly fixed with little opportunity to reduce spending due to massive needs for nations to address big-ticket items including the climate transition, infrastructure spending that can no longer be postponed, the digital transformation and labor market issues (availability and skills).

Despite what is a difficult outlook, we are particularly positive about investing in the companies that are best positioned to benefit in the transition to the next “normal,” and many of these businesses are not well represented in the typical institutional portfolio. We believe AI will have a tremendous impact on every industry, but one industry we are most excited about is healthcare, and the potential impact on significantly reducing costs and improving healthcare outcomes in the U.S. Presently, annual U.S. healthcare spending is approximately $4 trillion or 16% of gross domestic product (GDP) which is much higher than other nations. A few ways that AI will transform healthcare include accelerated research and development, enhanced medical diagnosis and treatment recommendations, personalized patient engagement and adherence, predictive analytics, automating administrative tasks inherent in the system, drug discovery, analysis of medical images, and reduction of errors. With the development and introduction of vaccines, the pandemic showed what the industry can do when it is focused and supported. While incredibly impressive, we believe this effort is nothing compared to what lies ahead.

Our team continues to identify a select group of companies that are selling at attractive valuations with reasonable to robust growth characteristics, and the ability to navigate the challenges described in this Outlook. As previously mentioned, we favor energy (fossil fuels and alternative energy sources), steel, rare earth, semiconductor and capital equipment, defense, and healthcare companies which will be among the primary beneficiaries. Given the risks in the fixed-income markets, high-quality, dividend-paying companies are attractive vehicles to offset higher living costs and provide protection of capital from the erosion of purchasing power. Moving forward, opportunities for equity investors will be shaped, in part, by the focus of governments and corporations’ spending on specific segments of the economy. This focus will also help offset some of the challenges consumers may encounter due to increased living costs.

We see an outlook unfolding that is vastly different from any we have previously experienced, marked by different economic circumstances that will create new investment opportunities.

Published by the ARS Investment Policy Committee:

Stephen Burke, Sean Lawless, Nitin Sacheti, Greg Kops, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor, Tom Winnick.

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

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“The greatest danger in times of turbulence is not the turbulence — it is to act with yesterday’s logic.” – Peter Drucker These are turbulent times as evidenced by significant bank failures, an attempted coup in Russia, ongoing tensions over Taiwan and trade, and the debt ceiling debacle in Washington, DC. The combination of the […]

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“Uncertainties are exceptionally high, including because of risks of geo-economic fragmentation which could mean a world split into rival economic blocs — a ‘dangerous division’ that would leave everyone poorer and less secure. At a time of higher debt levels, the rapid transition from a prolonged period of low interest rates to much higher rates — necessary to fight inflation — inevitably generates stresses and vulnerabilities, as evidenced by recent developments in the banking sector in some advanced economies.”

-IMF Managing Director Kristalina Georgieva, March 25, 2023

The economic outlook has changed. As a result of the recent collapse of three regional banks, the Federal Reserve’s policy of rapid interest rate increases and quantitative tightening have been importantly affected. The recent issues in the banking system have the effect of tightening credit, slowing the economy, and therefore reducing inflation – accomplishing what the Fed has been trying to do with its rapid increases in interest rates. The troubles in the banking system now have the Federal Reserve facing three issues – fulfilling its mandate to maximize employment, maintaining price stability, and now protecting the soundness of the financial system. This last point has added a new element to the Fed’s decision-making process and future policy actions. On March 12th, the Fed created the Bank Term Funding Program (BTFP) to support American businesses and households by making additional funding available to eligible banks to ensure their ability to meet the needs of all their depositors. Additionally, the US and other nations set up currency swap lines to ensure that the global system had ample availability of dollars. Both these initiatives, while not well publicized, may prove to be key to providing ample liquidity and restoring confidence in the financial system.

While the current market backdrop remains challenging, the investment opportunities presented by the real economy (goods and services) rather than just the financial side of economic activity now stand out. Given our expectations that banks will tighten lending standards, the US consumer will not likely be spending at the same level as in the past and thus will not be the same driver for growth in the near-term. Rather, investors should now focus on the areas where recent legislation is promoting rising spending by Federal, state, and local governments, and corporations. This legislation is assuring rising demand and production now and for the rest of the decade. In our January 12th Outlook ARS introduced three critical, multi-year transitions – the cost-of-living increase, the realignment of the global geopolitical order, and the re-industrialization of the global economy – that are occurring today and have major implications for investment strategy. These and other factors help explain why there is no historical precedent for the current economic environment, and why so many investors struggle to make sense of the conflicting messages of economic strength and weakness in the economy.

We continue to favor those companies supporting the clean energy transition, improving productivity, lowering healthcare costs, and ensuring national security. Our team has identified high-quality companies with strong balance sheets and solid dividend growth benefitting from the current economic outlook. We have been underweight in financial and consumer-oriented stocks, businesses with weak balance sheets (especially those with elevated levels of short-term debt), and those whose unsustainable demand has begun to have a negative impact on their outlooks for earnings and cash flow.

The Accelerator and Brake Economy

Market participants have struggled to make sense of the equity and bond markets this year as policymakers are driving the economy with one foot on the accelerator, stemming from Congress’ accommodative fiscal policies (Inflation Reduction Act, Chips & Science Act, National Defense Authorization Act). The other foot is on the brake as the Fed had abruptly shifted from its ultra-easy monetary policy to significantly tighter conditions (higher interest rates) over a particularly short period of time. One of the biggest challenges for effective implementation of monetary and fiscal policy is the fact that the economic impact can take up to 18 months to be fully felt, and consequently the effectiveness of the Fed’s policy and legislative acts will not be completely manifested until some future date. In response to the pandemic and war in Ukraine, the world has experienced the most aggressive monetary and fiscal policy initiatives in history. Policymakers felt the need to provide a forceful response to prevent the global economy from hurtling towards a depression.

The playbook from the Great Financial Crisis (GFC) led markets to first look toward central banks to provide immediate support to the global economy by lowering interest rates and enacting a new QE program (quantitative easing or the printing of money). Governments also implemented fiscal policy initiatives aimed at providing support to workers and businesses impacted by the crisis. As shown in Chart 1, the combination of monetary and fiscal stimulus from February 2020 to May 2021 totaled $30.95 trillion on a $100 trillion world economy. In the United States, policymakers’ responses totaled $12.3 trillion or 57.4% of US GDP. The level of response was unprecedented, and this was before Congress enacted the Inflation Reduction Act, the CHIPS and Science Act of 2022, and the National Defense Authorization Act in the past year.

Chart 1. Unprecedented Policy Response to Unprecedented Problems Globally

After a decade of central banks’ attempts to lift inflation above 2%, it appears that a higher level of inflation now is embedded in the world economy. With the United States and global economies returning to more traditional interest rate structures, investors need to assess whether their current portfolios still have the same or better risk characteristics than they had a few months ago. The March inflation reading for Europe remained stubbornly high leading to the most recent 0.50% benchmark rate hike by the European Central Bank (ECB). The challenge for policymakers in the United States is further compounded by the need to address the debt ceiling and restore trust in the banking system, while battling inflation and a slowing economy with a critical election next year.

Thoughts on the Troubles in the Banking System

“Banking is a business that can be a very good business, when run right. There’s no magic to it. You just have to stay away from doing something foolish. It’s a little like investing. You don’t have to do anything very smart. You just have to avoid doing things that are ungodly dumb.”

– Warren Buffett

Chart 2. A Crisis Waiting to Happen

The German economist Rudi Dornbusch once said, “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.” The failure of Silicon Valley Bank (SVB) and others in the system was slow to develop and then happened with a speed that surprised even veteran investors. During periods of easy monetary conditions (ultra-low interest rates) such as we have experienced since 2009, investors typically take on risk which does not appear to be excessive at the time but is obvious in hindsight. This was the case when, after a decade of near zero interest rates, rates spiked up, access to capital slowed quickly, and importantly, confidence in the safety of the system was questioned.

The early assessment of the current banking crisis suggests that many factors contributed to the problem of Silicon Valley Bank with some being external and some being bank-specific errors. These include:

1. Uninsured Deposits – As shown in Chart 2, this vulnerability was building in the US banking system since 2013. Over 90% of the deposits at SVB and Signature Bank were uninsured at the time of the failures, and uninsured deposits are much more vulnerable to runs.

2. Lengthened Maturities – Many banks extended the bond maturities in their balance sheet holdings prior to the Fed starting its dramatic interest rate policy reversal to counter inflationary pressures which increased the banks’ risk profiles. This shift occurred late in the economic cycle and made the banks more vulnerable to interest rate increases.

3. Monetary Policy Changes – The actual reversal of low interest rate policies (in reaction to inflation), was done so quickly that a problem was inevitable in hindsight. Since monetary conditions were easy for nearly a decade, it would have been ideal for the Fed to take longer to tighten conditions. However, the pandemic, the war in Ukraine, and supply chain problems created a spike in inflation that forced the Fed to raise rates much faster than ideal. Chart 3 illustrates the speed and magnitude of this tightening cycle compared to previous ones. It was totally unrealistic for a financial system that was a decade in the making to adjust in just 10 months.

Chart 3. Comparing Federal Funds Tightening Cycles

Source: Evercore ISI

4. Regulatory Changes – The Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) was introduced to overhaul financial regulation following the Great Financial Crisis. According to the Senate brief on the law, the aim of the act was “to create a sound economic foundation to grow jobs, protect consumers, rein in Wall Street and big bonuses, end bailouts and too big to fail, prevent another financial crisis.” Dodd-Frank was followed by The Economic Growth, Regulatory Relief and Consumer Protection Act (2018) which rolled back some aspects of Dodd-Frank. One change was that it raised the threshold from $50 billion to $250 billion under which banks are deemed too big to fail. While reasonable people might disagree, this change was likely a factor in the SVB failure and was lobbied for by many mid-sized banks, including SVB CEO Doug Becker. It is notable that Mr. Becker also served as a Director of the Federal Reserve Bank of San Francisco up until March 10th, the day the bank was closed by regulators.

5. Mistakes by Management – In the process of reducing risk for the banks, the 2010 Act also changed the revenue opportunity for some, while the low interest rate environment hurt the ability to earn fees on deposits. While there is still much we do not know about what exactly occurred at SVB, the failure is likely the result of problems involving concentration risk of its business, weak risk management, and greed.

A. Concentration Risk – First, the bank had tremendous success over the past decade as it became perhaps the most important banker to the startup community. It provided startup businesses with corporate loans and cash management services, personal loans for the founders of those businesses, investment and deposit services, and similar services to the employees of these startups. In short, its success in the hottest sector in the US lead to an unanticipated concentration risk in a highly volatile industry.

B. Risk Management – When interest rates rose at a much faster rate than its risk models might have projected, securities that were meant to be held to maturity, and therefore valued at full maturity value on SVB’s books, were required to be revalued to the current lower values (marked-to-market) when too many deposits were withdrawn in a run. Additionally, it has been reported that SVB was without its Chief Risk Officer for 8 months at the time of its collapse.

C. Greed – Finally, the bank increased the risk on its balance sheet by extending the maturity of its bond portfolio to increase its revenues (net interest margins). This in turn made it more susceptible to a rapid increase in interest rates and a run on its deposits. When investors stretch for yield late in an expansion, the additional income is usually not worth the associated risk. The Fed was clear in its communication regarding the path of interest rates, but SVB and others with large levels of uninsured deposits seem to have chosen to ignore the interest rate risk that each was accepting to boost earnings and its share price.

Investing for a Non-Traditional Investment Cycle

Our investment process is focused on identifying the beneficiaries of the current economic environment and avoiding those areas of the market that are negatively impacted by the problems in the global economy. Based on our assessment of the United States economy, investors should focus on investing in areas where governments and corporations are spending and investing rather than relying on the consumer as the driver for growth as inflation is limiting consumer spending, and confidence is shaken by recent bank failures. The economic slowdown resulting from now tighter lending standards will likely achieve what the Fed was embarking on to slow inflation in the first place. Volatility and market declines are now yielding better investment opportunities among the beneficiaries of the Infrastructure Act, the Chips Act, and the Defense Authorization Bill.

Recent interest rate declines are likely to stimulate home buying as mortgage rates have fallen and housing permits, a leading economic indicator, have risen. Currently, there is a housing deficit of three to six million homes while some 75 million millennials are entering their home buying years. Because investing in much of the financial sector has become more difficult, investment choices have narrowed resulting in capital flows and investment interest that is more focused toward companies that benefit from strong and rising demand, have strong balance sheets, are not difficult to analyze, and are in secular uptrends. In addition, national security remains one of the most critical areas that will continue to attract capital as tensions between democratic and autocratic nations remain elevated with no resolution expected in the near-term.

There is a continuing gap between US job openings and the smaller number of available workers due to a labor pool that is unlike the prior periods. In particular, there is a shortage of skilled workers that includes teachers, assembly line workers, electricians, health care professionals, construction workers, engineers, and workers for most economic activity. In January, there were more than 5 million more positions than people to fill them. Demographic trends play a leading role. The US working-age population shrank in 2018 – the first time since 1960. Baby boomer retirements picked up and fewer young people entered the labor force. From 2017 to 2022 the working-age population grew by 1.7 million people while between 2000 and 2005 working-age population growth was 11.9 million people. Challenges from this issue can be dealt with by raising the social security age (which also helps the funding problem), accelerating the use of advanced technology to substitute for labor, increasing productivity through medical breakthroughs, releasing infrastructure spending (which has begun), improving childcare policy (the Chips Act requires companies receiving $150 million or more to make childcare available to employees), and passing an effective immigration policy that the country needs.

Overall, the cost of labor has been rising and the Federal Reserve monetary policy of slowing economic activity and trying to create unemployment would only have the effect of slowing supply when increases in supply lowers inflation. At the same time the infrastructure spending legislated along with the Chips Act serves as a stimulant to economic activity while the Fed is trying to slow activity. One foot is on the brake, the other on the accelerator.

While there are considerable stresses in the global economy, it is in times of economic stress and dislocation that some of the best investment opportunities are presented, and yet many investors are more concerned about risk avoidance than seeking opportunity. However, the two do not need to be mutually exclusive. The stresses in one part of the economy often create opportunities for other parts of the economy. ARS client portfolios are currently positioned to benefit from the clean energy transition by owning both fossil fuel and renewable energy companies, defense companies, industrial commodity and materials companies (steel, copper, and rare earths), and biotech, with characteristics that include strong balance sheets and quality dividends. Our financial sector exposure has been minimal and our fixed income portfolios have been invested to balance yield with preservation of capital, rather than stretching for income.

As we are approaching the end of the rate-hiking cycle in the United States, we believe that equity valuations will begin to find firmer footing. While there are several longer-term issues which may keep inflationary pressures elevated including labor shortages, the clean energy transition, and changes in terms of global trade, innovation remains key to addressing many of the world’s most pressing problems. Critically, the reindustrialization of the global economy that is occurring is creating a generational opportunity for the manufacturing sector and the United States economy overall. In closing, we are reminded of another quote from Mr. Buffett that we feel is an appropriate reminder for investors as he once said, “Bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.”

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

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Alpha Vee, Capital Research and Management Company, and Principal Global Investors Expand their Presence with Additional Strategies

WEST PALM BEACH, Fla., March 7, 2023 – SMArtX Advisory Solutions (“SMArtX”), a leading innovator in unified managed accounts (UMA) technology and architect of the SMArtX turnkey asset management platform (‘TAMP’), announced it has added twenty-five strategies to its UMA platform, increasing its already substantial manager roster that features most of the world’s leading asset managers. ARS Investment Partners and Piton Investment Management are new to the SMArtX platform, while existing platform firms Alpha Vee, Capital Research and Management Company, and Principal Global Investors all added new strategies.

ARS Investment Partners added its ETF and equity-focused strategies, while Piton Investment Management is now offering its fixed income solutions to SMArtX clients for the first time. Alpha Vee and Principal Global Investors each deployed one additional strategy in March, but Capital Research and Management Company was the largest contributor with 17 new strategies. The new American Funds strategies encompass their class F-2 shares, joining another 17 American Funds strategies featuring class F-3 shares.

The full list of new strategies includes:

Alpha Vee
- Risk Managed Enhanced US Equity
Capital Research and Management Company
- American Funds Conservative Growth and Income F-2
- American Funds Conservative Income F-2
- American Funds Global Growth F-2
- American Funds Growth F-2
- American Funds Growth and Income F-2
- American Funds Moderate Growth F-2
- American Funds Moderate Growth and Income F-2
- American Funds Preservation F-2
- American Funds Retirement Income – Conservative F-2
- American Funds Retirement Income – Enhanced F-2
- American Funds Retirement Income – Moderate F-2
- American Funds Tax-Aware Conservative Growth and Income F-2
- American Funds Tax-Aware Conservative Income F-2
- American Funds Tax-Aware Growth and Income F-2
- American Funds Tax-Aware Moderate Growth and Income F-2
- American Funds Tax-Aware Moderate Income F-2
- American Funds Tax-Exempt Preservation F-2
ARS Investment Partners
- Core Equity
- Focused All Cap
- Focused ETF
Piton Investment Management
- Taxable Managed Yield
- Taxable Intermediate
- Tax-Exempt Intermediate
Principal Global Investors
- Blue Chip Equity

“Client demand continues to drive the growth of the SMArtX UMA platform, which enables us to add so many great firms like ARS Investment Partners and Piton Investment Management,” said Evan Rapoport, Founder and CEO of SMArtX Advisory Solutions. “We’re continuing to reinforce the platform in response to the adoption of SMArtX technology by advisory and enterprise firms alike.”

SMArtX’s continued growth is driven by two main applications of its technology: the off-the-shelf TAMP offering, which is built using SMArtX Advisory Solutions’ proprietary UMA technology, and the ability to further deploy tailored UMA technology through APIs to meet the mandates of large enterprises, RIA platforms, and hybrid broker-dealers.

“The implementation of SMArtX not just as a technology vendor, but as a business partner helping our clients build their firms by establishing new revenue centers and scaling efficiencies is one of the core tenants of our growth,” said Jonathan Pincus, President and COO of SMArtX.

About SMArtX Advisory Solutions

SMArtX Advisory Solutions is an award-winning unified managed accounts technology provider and manages SMArtX, a turnkey asset management platform (‘TAMP’). SMArtX’s API-first, cloud-native technology operates within a modular, micro-services architecture, providing clients a tailored solution catered to their unique specifications. SMArtX is available as an off-the-shelf TAMP for advisors seeking wider selection of investment product and ease of use, while automating the investment processes and simplifying the everyday tasks of managing client accounts. SMArtX also licenses its proprietary technology to enterprise firms looking to create, customize, or upgrade their existing managed accounts technology as a standalone or fully integrated solution. SMArtX is the managed account technology and TAMP platform of choice for multiple RIAs, broker-dealers, and asset managers.

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“Thisbattle cannot be frozen or postponed. It cannot be ignored. This struggle will define in what world our children and grandchildren will live.”
-Ukraine President Volodymyr Zelensky in 12/20/22 speech to U.S. Congress

For more than 5 decades we have written our Outlooks to serve two purposes: (1) to represent our roadmap for our investment security selections and (2) to inform our clients and prospects of our thinking. Our Outlooks reflect our view of the world and our investment approach to manage risk, capitalize on opportunities, and generate strong returns for our clients. Economic conditions determine interest rates, inflation rates, and corporate profits which in turn determine the valuations of common stocks. Therefore, a key focus of ours is to identify companies that are well-positioned to capitalize on and benefit from major forces and disruptions in the system. The world is at an historic inflection point with broad economic, geopolitical, and social implications as President Zelensky’s quote describes. Global economic activity is experiencing a sharper-than-expected slowdown with inflation at levels we have not seen in decades, and this is occurring at a time when governments are facing shared challenges with other nations including national security, food and energy crises, and climate change, to name a few.

We see three key changes occurring and they will require investors to re-assess their investment strategies. The three key shifts are the cost-of-living increase, the realignment of the global geopolitical order, and the re-industrialization of the global economy. The magnitude and suddenness of these changes has led to a re-rating of valuations across asset classes for most of this past year. For market participants, the biggest adjustment for investors in the coming quarters will be adapting to a less stable geopolitical environment with higher living costs and the possibility of a global recession. At the same time, the re-orientation of global supply chains and the advent of digital process automation are promoting a shift in manufacturing and production closer to home. This is a fundamental change for the global economy and a major boost for the United States. While the challenges are great, innovation continues to accelerate and will change virtually every sector and industry. Major economic shifts, such as the one occurring today, typically create new market leadership as shown in Chart 1.

The United States stands as the strongest and best-positioned economy, and it’s reasonable to expect a significant increase in capital flows to the U.S. While it is easy to see a recession hitting the United States, any recession experienced at home will have a very different character than previous ones due to the enactment of several recent major legislative changes and the shifting of industrial activity to North America. Regardless of the degree of any recession the U.S. may experience, our team continues to identify businesses selling at attractive valuations with strong balance sheets and above-market growth rates which, in our opinion, are not yet being properly recognized.

The recent zero-interest rate environment favored passive and index investing which led the market to overvalue growth companies with little to no earnings. The increase in interest rates has continued to force a reset of valuations. As a result, 2023 will continue to be a stock-picker’s market where the most likely beneficiaries will be companies whose fortunes are augmented by recently passed major legislation for the broad infrastructure needs of the U.S., reshoring of manufacturing and leading-edge semiconductor technologies, and national defense. In addition, the worsening demographics of the world population are putting greater stress on governments to reduce healthcare costs and improve outcomes particularly through the application of advanced biotechnologies. We are particularly positive on the beneficiaries of this outlook despite the overall negative sentiment which is so pervasive today.

Cost-of-Living Increase

“Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures… The war and related events are contributing to upward pressure on inflation and are weighing on global economic activity.”
-Federal Reserve FOMC Statement, December 14, 2022

With the dramatic increase in the cost of living, the Fed is committed to bringing inflation down to the 2% goal it continues to articulate. The last inflation statistic was 7.1%. We continue to see wages rise through legislated minimum wage increases, an 8.7% social security adjustment, labor contracts that compensate for inflation, a shortage of skilled labor and now the reshoring and investment costs of the American manufacturing supply chain. The Fed will likely, over time, move away from it’s 2% inflation goal. The increase in both buying power and U.S. economic activity now being firmly established suggests that the Fed will have to raise its 2% target. Therefore, the purchasing power of the U.S. dollar will erode more rapidly, and investors should be careful shifting to fixed income securities with longer-term maturities and should instead focus on the highest quality equities, and those that pay strong and growing dividends to protect their purchasing power.

Global Fragmentation: The World at an Inflection Point

“The international community is facing changes defining an era. We are reminded once again that globalization and interdependence alone cannot serve as a guarantor for peace and development across the globe. The free, open, and stable international order, which expanded worldwide in the post-Cold War era, is now at stake with serious challenges amidst historical changes in power balances and intensifying geopolitical competitions. Today we are in an era where confrontation and cooperation are intricately intertwined in international relations.”
-Japan’s Ministry of Defense National Security Strategy, December 2022

The existing world order is being redefined due to the unusual events of the past few years, intensifying geopolitical competition in the international community. As a result, leaders of each country are being forced to rethink existing trade and security relationships. NATO nations have a target of 2% of Gross Domestic Product (GDP) for defense spending, but many members are now only starting to fund to that level. In October, the U.S. issued its updated National Security Strategy, followed by Japan issuing its report in December. Both are calling for significant increases in spending for defense with Japan targeting to double its spending. Japan is particularly interesting since it has had a more pacifist approach since WWII, but it is one of a handful of critical partners to help challenge China’s ambitions in the Asia-Pacific region.

Japan maintains its policy of “Proactive Contribution to Peace” but the report highlights its concern that some nations are unilaterally trying to upset the status quo, and they have accelerated actions to achieve these goals. Germany announced a significant increase in its spending earlier this year to be in line with NATO’s 2% of GDP target but has since backed off that goal as the demands on the government are only increasing with food and energy costs on the rise, its economy weakening, and social stresses increasing as evidenced by the recently failed coup attempt. Leaders around the world are being forced to make difficult choices as the demands on governments far exceed the fiscal wherewithal to fund all the needs. Furthermore, the scope of national security has expanded to include those fields previously considered non-military such as economic, technological, and others, and thus the boundary between military and nonmilitary fields is no longer clear-cut.

In its recently released National Security Strategy report, the U.S. addressed what it considers the twin challenges facing our nation – out-competing our rivals to shape world order and tackling shared challenges including climate, food and energy security, and the pandemic. The leaders of China and Russia, among others, have very different visions of the future. Each would like to see the United States’ role on the global stage diminished, but what is really at stake is a contest of ideologies between democracy and autocracy/dictatorship. China is the one nation with both the desire and capability to challenge the U.S. and reshape the international order in a way that favors China and hurts the United States and its allies.

Re-industrialization of the Global Economy

The manufacturing sector of the United States has struggled for decades to compete with lower-cost labor around the world. Companies were under enormous pressure to outsource production to low-cost countries or risk losing competitiveness. That process is reversing as the world’s problems converge with the considerable competitive advantages that the U.S. enjoys, particularly its supply of energy resources, rule of law, and a culture of innovation. Beginning with the previous administration’s focus on China’s anticompetitive practices and intellectual property theft which was followed by supply chain disruptions due to the pandemic and the war in Ukraine, the United States now stands to become a premier global manufacturing region. In support of this, the U.S. government is beginning to provide incentives, such as tax breaks, to encourage businesses to locate factories in the U.S. and to invest in research development. As shown in Chart 2, there were nearly 350,000 manufacturing jobs that came to the U.S. last year versus only 6,000 jobs in 2010. The rise in the number of jobs created by the return of manufacturing from China and elsewhere to the U.S. is the result of companies bringing jobs back and foreign companies seeking a more stable production environment. Europe is losing some of its competitive advantage due to the war and rising energy prices. A core element of the shift is the need to secure stable and trusted supply chains. We cannot stress enough the importance of this shift and its longer-term implications.

With all these jobs coming to the U.S., unemployment down to 3.5%, and over 10.5 million job openings in the United States, Congress needs to address our flawed immigration system and adapt a policy that will address the current and future labor shortages and skills gaps. Like most leading economies, the U.S. has a rapidly aging workforce with declining birth rates making a proper immigration policy an even bigger priority. Given current conditions, securing our border and developing a policy targeted at filling critical shortages across industries would be in the best interest of the country and must be a top priority for Congress.

Investment Opportunities in Three Acts

For many years we have deplored the deterioration of our infrastructure but finally legislation has been passed to spend $1.2 trillion to rebuild roads, bridges, create high-speed internet access for those who don’t have it, improve our ports, airports, clean water, electric vehicle chargers, upgrade and strengthen our electrical grid, as well as a focus on climate change mitigation. Because the transportation sector is the largest single source of greenhouse gas emissions, $39 billion of new investment is committed to modernize public transit as well as $90 billion in guaranteed funding for public transit over the next 5 years. Including additional targeted areas for this legislation, it is estimated that the U.S. could add 1.5 million jobs per year for the next 10 years. Just with respect to railroads, $66 billion is allocated for additional rail funding to modernize the Northeast corridor and bring first rate service to areas outside the northeast and mid-Atlantic. Further, the global shifts described in this Outlook spell increasing demand for the components and materials required for wind power, solar power, conversion of the vehicle fleet to electric propulsion, and the expansion of the electrical grid. In short, the resulting productivity improvement will be a powerful antidote to inflation over time as the benefits to higher living standards become clear.

Two more pieces of legislation, the CHIPS and Science Act of 2022 (“Act”), and the $858 billion Defense Authorization Bill, will also result in a significant expansion of the U.S industrial base. In 1990, the U.S. manufactured 37% of the world’s semiconductor chips and today we produce only 10%, but that is about to change. With the introduction of the $280 billion CHIPS and Science Act in August of last year, Congress took an important step toward ensuring that the United States will remain a leader in the production of advanced technologies. The national security aspect of the Act recognizes that Taiwan-based companies account for about 73% of global market share for semiconductor production today. Therefore, it is vital for the U.S. to dramatically reduce its dependence on Taiwan which is being targeted by China. The CHIPS Act includes an estimated $39 billion worth of investment tax credits over the decade. The Act also calls for $13.2 billion in workforce development which is particularly significant as the Department of Commerce estimates that an additional 90,000 workers will be needed by 2025. There is $2 billion allocated to focus solely on legacy chip production for the auto industry, national defense, and other critical infrastructure, including charging stations. It is worth noting that companies receiving federal incentive funds under the Act are prohibited from expanding or building manufacturing capacity for advanced semiconductors in countries considered to be a national security threat.

Since the introduction of the Act, the private sector has announced dozens of projects to increase manufacturing capacity in the U.S. including over 40 new projects involving the construction of new facilities and enhancement of existing sites as well as the facilities that supply the industry, nearly $200 billion of private investments announced across 16 states to increase domestic manufacturing capabilities, and 40,000 new high-quality jobs have been announced for the industry. Both domestic and foreign companies such as Global Foundries, Intel, Samsung, TSMC, Texas Instruments, and Micron are planning to build or have under construction at least 9 new fabrication facilities. It takes about 3 years and some 6,000 workers to build one facility at a cost of at least $10 billion. Taiwan-based TSMC alone plans to spend $40 billion in the U.S. Estimates of expenditures total several hundred billion dollars. Manufacturing equipment can cost as much as $250 million per machine and each plant can require at least 35,000 tons of steel to construct. When taken all together, the numbers are considerably larger than the total manufacturing investment announced by the Administration. Bear in mind that manufacturing jobs have a high multiplier effect adding an estimated 3-4 jobs to the economy for each manufacturing job created, making a tight market for skilled labor even tighter.

These conditions should also push companies to incorporate more robotics and automation into the U.S. manufacturing system. The Act is designed to allow the U.S. to control access to advanced technologies for economic competitiveness and national security reasons.

The war in Ukraine has forced global leaders to refocus on the importance of strong military capabilities as a form of deterrence. The heroic and innovative defense by the Ukrainians is also redefining the future of war as we have seen drones, cyberattacks, and other non-traditional forms of warfare used effectively against what should be a superior military. In response, NATO nations are stepping up their spending, and the United States is as well. The Defense Authorization Act calls for a 4.6% pay increase for both troops and the civil employees of the U.S. Department of Defense. In its new National Security Strategy, the U.S. identifies China as the biggest concern with Russia and other terrorist state actors also a key part of the strategy.

The Defense Bill will increase the munitions stocks if China were to act against Taiwan. This will involve the largest number of multi-year procurement contracts that has been authorized in recent history. To make sure the industrial base and those allied nations can meet the demand required for Ukraine, bureaucratic red tape will need to be reduced. While the Act runs 4,400 pages, we note that 11 battle force ships are authorized for procurement and the early retirement of 12 ships has been reversed. The Navy’s budget had been to build 8 ships and decommission 24. The bill also advances air power, land warfare capabilities, advanced munitions, sea power, undersea warfare, aircraft procurement, and weapons procurement with production increases. In addition, $1 billion is allocated for the National Defense Stockpile to acquire strategic and critical industrial materials.

After a difficult year in the markets, it is easy to dismiss the public markets as an attractive area to find opportunities in 2023, and that would be a big mistake. Unlike the past decade, financial market returns could struggle with weak economic growth with the key difference this time being materially higher interest rates, a higher cost of living, and much more limited bandwidth for governments to provide fiscal and monetary support. While there are major differences between then and now, the bursting of the tech bubble in 2001 led to a major shift in market leadership, and ARS was able to identify areas to protect and build capital in the subsequent years by investing in previously underfollowed and underappreciated parts of the economy. Today, we recognize that there are defense, steel, industrial companies, and commodity producers selling at particularly attractive valuations with strong balance sheets and relatively strong growth rates that we believe will be among the market leaders in the coming period. Moreover, many stocks have declined from their highs by anywhere from 20-70% in the past year. While many stocks deserve to be down that much as their businesses never justified their lofty valuations, there are others that are now selling at highly attractive valuations. Lastly, the increase in global interest rates has provided investors with more attractive bond yields, however, equity investors should be better able to offset the inflationary impact on the purchasing power of the dollar over time than fixed income investors. As market participants adjust to the changes highlighted in this Outlook, new leadership is likely to emerge and investors with the vision to look beyond the next quarter or two should be well rewarded.

Wishing our clients and friends a happy, healthy and peaceful New Year.

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

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

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

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

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

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

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

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

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

The Growth of the Digital Economy – Innovation and Productivity

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

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

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

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

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

Investment Implications

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

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

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

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

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

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

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

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

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

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