The Times They are a Changing
Change is generally gradual. It progresses so slowly that it goes unnoticed until there is an inflection point, an event or events that make the new direction undeniable. We think we are at an inflection point and believe the next decade will be very different than the last for investors.
Change is coming because the economic and political forces that shaped recent history are unlikely to continue in the coming years. Until recently, inflation was almost non-existent. It was assumed that China was a benign and predictable source of economic growth. Climate change was a threat for the future but had no immediate consequences. The US political and capitalist economic system wasn’t perfect, but still a model for the rest of the world. Every major world economy had an aging population but the ratio of workers to retirees was sustainable.
Low interest rates and even lower inflation alongside the increased productivity of capital light business models meant the greater the risk, the quicker and more substantial the return. The battle between growth and value was settled. Growth was more important than profits, or so we thought, but the world is changing. The realities of today will necessitate changes. Here’s how we plan to navigate it for clients.
For most of the past decade the overriding fear of central bankers around the world was deflation not inflation. To protect their economies from the destructive forces that ensue when the value of assets erodes, they embarked on stimulative economic policies of lower interest rates, less than zero in some cases, and printed massive amounts of cash. This is changing.
The initial inflation spike was likely transitory as a sudden release of pent-up demand from lockdowns, supply chain constraints, and energy disruptions contributed to price increases. But transitory is an ill-defined word, and inflation has stuck around longer than expected. Barring a sudden downturn in the economy, central bankers will turn from fighting deflation to battling inflation. That means we will see higher interest rates, less stimulus, and price increases in a wide variety of goods and assets over the next few years.
Some argue that once supply chain issues subside, we will go back to technological innovation bringing down costs. It’s possible, but inflation is hard to stop once it ramps up. With the global shift to “on-shore” manufacturing to build cars, computer chips, and mine for metals, it’s entirely feasible that we will be in a new normal of higher inflation.
What does this mean for investors? First, don’t panic! We’ve been through this before. We managed money when inflation and interest rates were a lot higher than they are today, so we have the game plan. In the simplest of terms, we fight inflation owning assets expected to go up in value and avoid assets that are vulnerable.
An easy example is cash versus tangible assets like equities, real estate, and commodities. Inflation means cash goes down in value while most assets increase in value. While the knee-jerk reaction to higher interest rates and shocks to the system from commodity price spikes might be to hide in cash, in the long run it is the exact wrong thing to do to maintain purchasing power and standard of living.
If inflation does sustain a 4 or 5 percent increase, it’s likely that bond yields will increase to a higher level, helping us earn a higher return from that part of the portfolio as we reinvest maturing bonds at higher yields. As the Federal Reserve exits the bond market, we expect yields to increase to attractive levels that will make them a real alternative to equities. We also expect that equities will eventually go up for companies that have pricing power. Lastly, we know that most commodities will increase by at least the rate of inflation with occasional spikes that will be much more dramatic.
THE NEW WORLD ORDER
As we write this, Russian tanks are rolling towards the Ukrainian capital and a new cold war will surely follow. The economic consequences of this atrocity will be felt mostly in Europe but also in worldwide commodity markets. But spring is coming. While Russian oil and gas is a potent weapon in the short run, as the Saudi’s found out, oil and gas are fungible assets that can be replaced, particularly in a period of slower economic growth.
China is by far the greater threat to the world economic order because they have been a major contributor to economic growth and a buffer against inflation as a producer of lower cost goods. That may be ending. It will end with a bang if they are foolish enough to invade Taiwan, but it will end eventually anyway as their population ages, their capacity to amass debt meets its limits and their foreign policy becomes more confrontational as authoritarian regimes inevitably do. For investors this means slower world economic growth and greater volatility.
Again, we managed money when things were made in other places than China and companies had to depend on somewhere else for new markets, and we can do it again. Not because we are geniuses but because great, mostly US companies know how to diversify their supply chains and create compelling products that will sell throughout the world.
For most of the last century the US was the model for the world thanks to political stability, the rule of law, and good governance. We still are, but the deep divisions that threaten our election integrity, challenge our legal system, and potentially make portions of society ungovernable could change that.
The stability of the US dollar could be affected by the continued erosion of the position of the US in the world economy and confidence in our political order. In a world where vast sums of money can move almost seamlessly between currencies the dollar could lose its status as a benchmark and turn into just another commodity to be traded.
To which we have always asked: Compared to what? Will the Euro ever look more stable? Probably not, especially with a war on its doorstep. The Swiss Franc is too closely tied to the Euro zone to be taken seriously as an alternative. China is a world player, but it wants a weak currency to support its exports. Plus, China isn’t exactly the beacon of fair and free markets.
BITCOIN OR GOLD
Which inevitably leads us down the cryptocurrency rabbit hole. If we can’t trust any of the fiat currencies, then shouldn’t we feel more comfortable in a “currency” that is not reliant on an authoritarian regime or a capricious central bank?
We are skeptical that crypto can be the new storehouse of value. It is hard not to see a speculative trade with similar patterns to dozens of other manias we’ve seen come and go with disastrous endings. Without the support of governments or any intrinsic value, it is built on the belief that somebody will pay you more for it tomorrow than today. Remember, usually trades that go hyperbolic on the upside inevitably have a similar downside.
On the other hand, given the geopolitical situation, why wouldn’t citizens of Russia and Venezuela want to hold their assets in a “currency” that can’t be manipulated by their governments. It’s easy to fantasize about the possibilities, but China showed us that if a country wanted to stamp out Bitcoin, it can do so.
Bitcoin aside, there are interesting innovations taking place in the crypto economy and what has become known as Web 3.0. Really smart people are leaving Google and Facebook to build new companies and technologies based on blockchains and crypto tokens. We are following these as potential disruptions for the companies that we own. In the meantime, buyer beware.
Conversely, gold has been a better hedge for volatility than crypto. As the market corrected during the first quarter, the S&P fell 12% from its highs. Over that same period, Bitcoin was down 16%, the US dollar up 2%, while gold was up 12%. Gold loves instability which accounts for its current performance but its most important characteristic for US investors may be as a hedge against a weak dollar. That said, we are optimists and believe that even with the new world order, the US can still right the ship. If this belief were to faulter, we could look to gold as a vehicle to maintain the purchasing power of our clients. That would be real sea change for us.
World and individual country demographics are one of those changes that happen gradually but when they hit, they change everything. We already mentioned that China’s growth rate is expected to slow as its population ages. The consequences might not be as dramatic as they were in Japan, now in their third decade of economic stagnation, but it is likely to be profound. The US and Europe are facing similar challenges which leaves the world with few alternatives to slower growth. This will be a check to inflation for decades to come. That doesn’t mean we won’t see spikes like we are currently experiencing, but the result is that competition for high quality growth assets will remain strong.
A warming planet is another change that happens gradually, but the effects are overwhelming when they hit. The cost to insure that shoreline or vacation home in the woods is just the beginning. It will require massive spending on infrastructure to mitigate the effects of CO2. An investment we are ill prepared to make with already massive deficits.
Fortunately, technology is coming to our rescue. Soon electric cars will be cheaper than gas guzzlers and they will go over 500 miles on a 20-minute charge. Solar and wind already have a cost advantage over coal, oil, and gas generation, and cheap storage will transform the electric grid for the better. Like many major changes to the world economy from the steam engine to the railroads and then cars, the transformation will be full of fits and starts, scams and busted plans, but it will happen, and the winners will prosper. We are looking for winners.
That doesn’t mean we are “all in” on ESG (Environmental, Social, Governance) investing. It might sound controversial, but much (not all) of what is pawned as ESG on Wall Street is just pretty pictures and high fees. The biggest beneficiaries of ESG are the rating agencies, paid by the companies they rate. At least during the financial crisis, there were real metrics to use for calculating bond ratings (even if they were flawed). ESG ratings are an evolving system, created with noble intentions, but extremely subjective.
Our goal is to invest in companies that are doing the right thing for the environment, shareholders, and customers, not just because we think it is the right thing to do, but also because it’s good business. We actively seek companies investing in renewable technologies, and who incorporate diverse thinking and people into their boardroom, but we struggle putting an ESG label on it to make clients feel better.
In fact, the flow of assets into ESG products has created unsustainable conditions. Take electric vehicles, which are clearly the future. At the beginning of 2022, the value of the 3 largest US based “pure play” EV companies (Tesla, Rivian, Lucid) was ~$1.25 trillion. The US typically sees between 14 and 18 million cars sold domestically in any year. Last year these 3 sold less than 400,000. If you added in the value of Ford ($80bn), GM ($87bn), and Stelantis ($58bn), that’s nearly $1.5 trillion of market cap, and this ignores VW, Daimler, Toyota, BMW, and Honda.
In 2019, that same set of companies was worth less than $200 million, even though roughly the same number of cars (supply chain issues aside) will be sold in the coming years, albeit with an increasing percentage of electric. It’s as if the market forgot that making cars is a capital intensive, competitive, cyclical business, where most companies eventually go out of business.
As we suggested in our thesis about climate change, technology just might be the thing that saves us. Saves us from the next pandemic as we develop faster and more powerful vaccines. Makes the world flat, so that we can communicate everywhere at very low cost. Enriches our lives in ways that we don’t even fully understand today.
That’s a lot to ask of a bunch of engineers and scientists but it looks like they are on it. The recent advancements in technology are not gradual, they are logarithmic. They are advancing at a compound rate. Look at gene sequencing that targets specific proteins in specific cells to let the body cure itself. Cheap energy is within our grasp as we can build low-cost solar cells and storage with the holy grail of nuclear fusion potentially only few years away. Over the next decade fortunes will be made as these advances change our world. That’s great news for prudent investors who can participate in the changes we are about to witness.
STOCK SELECTION – GROWTH VS VALUE
During the pandemic, we watched in amazement at the meteoric rise in stock prices for high growth technology companies. The tide has turned, and most stocks are down 50-75% from their highs. Many are great companies, but markets got ahead of themselves thinking Covid growth would translate into perpetually higher long-term growth rates. It’s very likely there are bargains in this group, and we are sifting through the wreckage.
The internet and software permanently changed the pace for which a business can grow. Still, some of these highflyers aren’t the quality businesses the market anticipated. Business models overly reliant on investor cash to grow may no longer be in vogue, especially as the Fed drains money from the system to fight inflation. Not to mention that growth attracts competition.
We love companies with strong, growing, and sustainable revenues, but ultimately try and pay a price that allows the company to grow into its valuation. We ignore the pundits who push their SPACs onto susceptible retail investors. We keep diversified so that in changing markets, we still have exposure to commodities. In a world that becomes more fractured, we believe that building things matters. Software changed the world, but it doesn’t work without a resilient energy grid, modern chip fabs, and advanced manufacturing. These industries may not deliver our clients immediate, eye-popping returns over night, but we prefer consistency and resiliency through market cycles.
Years ago, we were asked to describe our investment philosophy. We said it was “Traditional Investing and Modern Thinking.” We apply the lessons learned over years of experience to the new realities of today. The first lesson is to try to avoid manias, regardless of how much short-term money is piling in or how revolutionary the concept appears.
The second is that no matter how clear somebody’s crystal ball appears, don’t base your investment philosophy on their predictions. In this newsletter, we laid out arguments as to why inflation could remain elevated while also pointing to aging demographics, a Chinese slowdown, and technological innovation that will do their best to try and pull it back down. We are prepared for a world that wrestles with both sides of the equation.
We do this by following the most important lesson, which is that good value comes in many shapes and sizes; From boring consumer companies, to fallen tech angels, to innovative software and manufacturing companies. We look for sustainable business models that can continue providing strong shareholder returns in a rapidly changing world and try to purchase them at a price that doesn’t require perfect execution in an imperfect world. The new realities of today will necessitate changes in our investments but not our investment philosophy.
Compass Asset Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.