What a finish to the year and decade! In 2019 bonds rallied and stocks soared, capping off a decade of recovery for the global financial markets. Propelled by an accommodative Federal Reserve and a strong US consumer, the S&P 500 rose 31.5%, an impressive figure considering how concerned some were to start the year. Looking back 10 years to a time when unemployment was nearly 10% and 157 banks were about to fail, marking the nadir of the banking crisis; a near tripling of the S&P 500 over the following decade seemed improbable at best. Even more unlikely was that over the coming decade the worst annual return would be the 4% loss in 2018. The financial system has recovered and markets moved more than 100% beyond their prior highs, making a lot of money for our clients and those who managed to look past the negative news flow and stay invested. As we turn the page on a new decade, we are optimistic about the future, but our expectations are tempered after a decade of 13% annualized returns which came in an almost linear fashion. We expect a more volatile market and a return profile closer to historical averages for the next decade.
Nevertheless, as we focus on the underlying fundamentals and secular growth stories, we are encouraged about the future. The innovations over the past decade create a tremendous foundation for the next wave of technology and human advancement. From drug discovery to breakthroughs in alternative energy, we believe there will be incredible achievements that change the world as we know it. Because the competition will be fierce, not all boats will rise with the tide. Companies will need to navigate challenges including political intervention and trade disputes which will likely create significant distinction between those who are prepared and those who are not.
Before & After… A Decade of Improvement
The Race is On
The trade dispute with China has likely heralded a new era in separation between our two countries. Despite the possibility of reaching a trade deal, the technology industry has begun to bifurcate as national security becomes a critical focus. Some have called it the start of a new technology arms race with China and they may be right. With the sensitivity of network infrastructure and security software, and a mistrust of one another, both China and the US are looking to reduce the reliance and use of the other’s technology. This is leading to a race to innovate. Huawei, the leading Chinese networking company, has been blacklisted by the White House. The blacklisting restricted US companies from selling software and components to Huawei without a special license. This disruption has pushed Huawei to change their supply chain and refocus their sales efforts while US companies have done the same in response to similar Chinese restrictions.
Computing power, cyber security, and artificial intelligence will shape the future global leadership as some of the largest emerging threats are related to cyber attacks. An example of the competition is in next generation computing technology, specifically Quantum Computing. Quantum computing can process far more complex calculations than traditional processors by coding with infinite states versus the traditional two states of zeros and one. China has begun aggressively investing in technological advancement including committing the equivalent of billions of dollars to establish a Chinese National Laboratory for Quantum Information Sciences and funded a multi-billion-dollar quantum computing mega project as they call it. The US passed the National Quantum Initiative Act in December of 2018 authorizing $1.2B to be invested in quantum projects through 2023.
“Computing power, cyber security, and artificial intelligence will shape the future global leadership as some of the largest emerging threats are related to cyber attacks.”
Although government funding may favor China, US companies including Google and Microsoft are investing heavily in next generation technologies and have patent portfolios that give the US an early lead. As in the space race in the 60’s we are hopeful that although the motives may not be altruistic, the winner will be individuals who will benefit from some very significant advances. With so much at stake, the separation is only likely to increase as innovation progresses. In China, Facebook and Google have long been blocked as they don’t comply with state regulation. WeChat, Baidu, Tencent, and Alibaba (which we own) have helped fill the gap and we expect more examples of this to come. Chinese startups have come a long way and not only are these companies able to fill the void with products of similar quality, but they are also building a product from the start that is focused on the needs of the local market. This is manifesting itself through the development of many Chinese focused products that are outperforming the dominant international brands and changing the landscape completely.
Regionalism, the New Twist on Globalization
It is becoming increasingly likely that the next decade will be shaped by a new wave of regionalism. With a rise in populism and nationalism, policies are starting to shift making cross border trade more difficult. Over the last 40 years globalization has driven significant optimization in supply chains and manufacturing. This has resulted in increased corporate profitability and lower prices for consumers. Once the Soviet Union fell and China started opening their markets, outsourcing surged.Multi-national companies rushed to capitalize on new sources of cheap labor in Eastern Europe, South East Asia, India, and most notably China. Over time, the price advantage has eroded as more companies identified the opportunity and wages and input prices rose. The local economies also developed as local businesses started to attract the best labor and compete directly with foreign companies. Eventually, the people and governments started to question whether they even need the foreign companies in their markets at all and began to push back.
In China specifically, due to the incredible cost advantage of operations and the opportunity to sell to more than a billion people, companies were willing to ignore things like knockoffs and IP theft. It was historically thought of as the “cost of doing business” and believed the Chinese couldn’t do much with the technology they stole. Today, Huawei and others have proven that is no longer the case with technology that is not only competing with but also winning against the global technology and manufacturing leaders. The theft of IP is now a real risk to a company’s business and when that is combined with the rising cost of labor in China, the motivation to outsource operations there becomes reduced.
“Technology advancement has led to a surge in automation and business analytics that has allowed for machines to replace low skilled jobs, and for inventories to be managed in a more on-demand way with less excess.”
Companies are continually pressured to deliver the best returns for shareholders. For many years, adjusting manufacturing locations and supply chains to take advantage of lower costs was a great way to do so. As a result, the S&P 500 saw operating margins expand to record levels. Over the last decade something significant has changed. Technology advancement has led to a surge in automation and business analytics that has allowed for machines to replace low skilled jobs, and for inventories to be managed in a more on-demand way with less excess. Robotics, 3D printing, and laser milling have created simplified manufacturing lines that don’t require human intervention and can be built on a smaller scale, closer to the end customer. These advancements are creating opportunities for companies to build factories locally with better results at the same or lower costs. BMW setting up their factories in South Carolina and Apple moving production to Arizona and Texas, were not simply benevolent acts, they were calculated economic decisions driven by technological capabilities as well as financial motivations. They both avoided tariffs, increased the speed of their product to a key end market, and modernized each facility with cutting edge technology and automation. Just-in-time inventory was just the tip of the iceberg. Automation, business analytics, and the Internet of Things will continue to transform the way products are made and delivered to end users. Furthermore, localization of products and a more diversified manufacturing footprint can enable better tailoring to local market preferences. Not only can a company be more efficient but it can also be more competitive and sell more product.
An Adjustment to the Business Cycle
Our understanding of markets is limited to what we have available to study. As such we are mostly limited to understanding the equities markets from 1920, and primarily in the US as that is the best data that we have. The Federal Reserve and most academics have built their framework for understanding markets on this data which has generally worked to explain recessions and expansions. The typical cycle was composed of a rebound in demand, expansion of credit, ramp up in production and inventories, and eventually inflation, over-supply, and then a collapse. That cycle is likely to persist in its purist sense, but we see the inventory cycle impact being more benign. As previously mentioned, advances in supply chain management and business analytics have created a much quicker response to changes in demand, reducing the risk of excess inventory. Examples such as Kickstarter campaigns and flexible manufacturing lines, have obviated the idea of getting a big bank loan to build a bunch of products in the hope that someone will buy them; that is over for now.
“Cycles are likely to be longer and less tied to input inflation. The cycles will likely be driven by credit markets and less by inventory cycles.”
We are not quick to argue against history, but we believe that the current environment is one that will differ slightly from the past. Cycles are likely to be longer and less tied to input inflation. The cycles will likely be driven by credit markets and less by inventory cycles. Less volatile markets are attractive in many ways but a frequent testing of credit markets helped in some part to control excesses as banks were forced to reduce their risk from time to time and closely examine their loans. As we saw in 2008, when the system goes too long without being tested the damage can be significant. For us, this means our focus is on the valuation of our holdings and the underlying strength of the credit markets. As the Federal Reserve has begun to shift away from a resolute focus on inflation, we hope they focus on the stability and risk profile of the credit markets, not just maximizing employment. This shift concerns us as it could create a dangerous inflationary environment left unchecked. We are focused on that theme and will go deeper into that topic in our next letter.
An Update: A Gut Check to Start the Year
Geopolitical and political events are likely to create uncertainty and volatility over the course of 2020 and beyond. The targeted attack on Major General Soleimani and the counterattack on bases in Iraq are the latest in a series of retaliatory interactions between Iran and the US. Innately we are concerned by any geopolitical conflict, and particularly one that could have a dire result from a humanitarian perspective. Thus far from a financial perspective the markets seem to be handling the news relatively well. The largest reaction has been in the oil markets. Our judgment is that cooler heads will prevail, and we will avoid escalation. We are watching the developments closely to determine if there is any appropriate action to take in client portfolios. At this time, as long-term, data driven investors, we believe that our asset allocation is appropriate, and no significant action is warranted.
After the strong returns last year, we are mindful that the forward journey to higher markets (or returns) will not be linear. Some have called for a catch-up rally in international markets, which we see as possible, but we believe this will be a year of incremental discernment. Last year only 11% of the S&P 500 had a negative return and only 5% were down more than 10%. At higher valuations, earnings results will matter more and air pockets will be exposed in weaker holdings. We like that set up because as investors in individual stocks, we believe that our portfolio is in great shape to withstand further examination and continue to benefit from the trends we have identified. Fixed income, gold, and covered call writing create a balance to our equities, positioning us well to weather an increase in volatility. It also creates the staying power to realize the future potential of the companies in our portfolios.
We look forward to upcoming conversations with you and sharing in person the positive results of 2019. Thank you for your continued confidence in our judgment as we manage your assets and implement wealth strategies to help you achieve your financial goals.
MARKET COMMENTARY DISCLAIMERS
This commentary contains the current opinions of the authors as of the date of publication. All opinions are subject to change at any time. This commentary has been distributed for informational purposes only and is not meant to convey a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell securities or investment services. The opinions and statements set forth do not consider the investment objectives or financial situation of any particular individual or group of individuals. Individuals will need to consider their own circumstances before making an investment decision.
Information contained herein, including market forecasts and forward-looking statements, are derived from proprietary and nonproprietary sources Bainco deems to be reliable; Bainco does not, however, warrant the completeness or accuracy of the information obtained from these sources.
Past performance is not a guarantee of future results.