Q4 2016 – “And the Pendulum Swings…”

Q4 2016 – “And the Pendulum Swings…”

The past year will be remembered as a year of surprises whose consequences will be felt throughout 2017 and beyond. And while the nationalism movement has seemingly been oscillating for several years, the pendulum came to a standstill and started to swing the other way this past June when the United Kingdom voted to leave the European Union. The antiestablishment momentum continued into November when Donald Trump caught the world off-guard and became the 45th President of the United States.

While many pundits were calling for a market crash on the night it became apparent that Donald Trump had clinched the electoral votes needed to make him the President-elect, the market ignited with exuberance and finished the year with a total return of 11.96% measured by the S&P 500 Index.

The capital markets had their share of challenges throughout the year. After finishing 2015 with a relatively lackluster return of 1.38% for the S&P 500, the first month and a half of 2016 appeared to be the end of the current bull market which began in March of 2009. By mid-February the S&P 500 had dropped by about 15% from the beginning of the year and this decline combined with skittishness of the global economy led the Federal Reserve to take a more cautious stance with their intentions of increasing U.S. interest rates throughout 2016.

Recall that in December 2015 the Federal Reserve forecasted four rate increases throughout the year. In short order, the market responded favorably to the prospect of rates staying lower for longer and distressed debt which had previously sold off, particularly bonds issued by energy companies, returned to favor as investors sought yield and bid up such speculative bonds. As a result, the BofA ML High Yield Master II Index, a commonly used benchmark measuring the performance of lower quality, non-investment grade bonds, surged 17.49% on the year.

Meanwhile within the equity markets, 2016 was a year that favored value stocks over growth stocks by a wide margin. The Russell 3000 Value Index advanced 18.40% for the year versus a 7.39% gain for the Russell 3000 Growth Index. Value stocks are traditionally characterized as those with lower price-to-earnings ratios, lower price-to-book ratios, and higher dividend yields while growth stocks typically have higher growth rates, greater earnings potential and consequently higher valuation measures.

Most of the disparity between the value and growth benchmarks can be attributed to the strong performance and larger weight of the energy sector in the value index. With the prospect of a more balanced supply and demand crude oil market and OPEC’s production cut promises at the end of 2016, energy was one of the best performing sectors of the market. Another larger value weighted index component, basic materials, was the strongest performing sector of the year, with steel companies leading the charge as clear beneficiaries of a Trump Administration.

With the swing in the pendulum, we see a number of tailwinds and headwinds for investors in 2017 and beyond. The tailwinds are quite obvious even without any passed legislation as the new administration will be noticeably more business-friendly. Progrowth policies and other reforms outlined by President-elect Trump centering around corporate tax reform and eliminating much of the regulation enacted over the past several years has been well received by many industries. Additionally, permitting U.S. companies to repatriate cash held overseas with minimal or no tax consequences could allow nearly $2.5 trillion to return to the U.S. with the potential to be invested back into the U.S. economy.

Another prospective major tailwind for the U.S. economy is President-elect Trump’s proposed $550 billion infrastructure investment plan to improve the transportation network throughout the U.S. All of these initiatives are powerful forces encouraging businesses to spend and invest, but they are major secular changes that won’t happen overnight and could take years to unfold. Even if individual and corporate tax cuts are passed this year, they aren’t likely to take effect until 2018.

As we have brought up numerous times throughout the years, corporate tax reform is imperative to help U.S. companies compete in the global marketplace. When evaluating potential government action, it is always prudent to distinguish between intentions and reality, but assuming the tax cuts become a reality, the business expansionary cycle should continue even though by economic standards it is in the late stages of a normal historical cycle as we will be annualizing its eighth year in March.

In addition to potential governmental action, an additional tailwind that is being provided to the U.S. economy is the significant increase in consumer confidence post-election. During the last week of December, the Conference Board’s Consumer Confidence Index climbed to 113.7, the highest in 9 years, driven primarily by hopes for the future. Increased confidence typically means increased future consumer spending, which in addition to the increased business confidence could propel the U.S. economy to achieve the 4% Gross Domestic Product growth promised by President-elect Trump on the campaign trail.

While things look extremely positive for Main Street, there are a number of headwinds that we are monitoring. One significant headwind is the stronger U.S. dollar. (see Graph 1) Since mid-2014, the dollar is up nearly 25% with its latest surge coming after the U.S. election (its highest level in over 13 years). If the dollar continues to strengthen, it could have long-lived economic consequences creating risks for U.S. manufacturing activity, corporate profits, exporters, commodity producers, and foreign dollar-denominated debt issuers. While Japan and Germany are among the countries benefiting from a stronger dollar as their exports become cheaper compared to U.S. goods, the stronger dollar is less welcomed in emerging markets, as it puts pressure on their central banks to raise interest rates to prevent further depreciation of their currency and to contain inflation. Central banks throughout the world are walking a fine line with the process of normalizing interest rates against the ability of heavily indebted economies to absorb higher interest costs.

One of the primary drivers of U.S. dollar is the prospect of higher interest rates domestically. We believe rate increases in 2017 will likely be modest at best, with the Fed projected to raise rates three times throughout the year. Since the rate hike in December 2015, the Fed was very circumspect with rate increases in 2016 only increasing short-term interest rates by 25 basis points this past December. This was only the second time that the Fed Funds rate has been increased since 2006. Nonetheless, given the reflationary and pro-growth policy platform of the Trump Administration, it is widely anticipated that the Fed will pick up the pace of rate increases as long as the U.S. economy gains momentum. While the prospects of higher rates will be well received by savers, it will likely be years before rates are back to “normalized” levels from a historical perspective. Regardless, when comparing Germany’s 10-year Bund yield of 0.20% versus the U.S. 10-year Treasury yield of 2.45%, foreign yield seekers are buying dollars to obtain the higher yields that U.S. bonds provide versus similarly-rated foreign securities.

Another headwind worth noting is China. While there are a significant number of unknowns with President-elect Trump and his potential policies, he has been quite vocal of his disdain for China’s unfair trade practices in world markets. This will be a key hotspot for investors to monitor throughout 2017. Even though the bantering back and forth on unfair trade practices seems to occupy media headlines, internally China could be dealing with a more pressing issue of its large quantity of non-performing loans. While China’s officials estimate its non-performing loans to be about 1.5% of outstanding loans, some independent analysts predict it could be as high as 22%. Regardless of the exact level, the best scenario for mitigating their potential debt problem is a wave of economic growth in China. But the headwind provided by President-elect Trump clearly could hamper the world’s second largest economy in achieving this seemingly daunting goal. This is particularly true in an age when discussion regarding trade is peppered with protectionism, nationalism, tariffs, and renegotiating trade agreements. None-the-less China will continue to attempt to drive domestic consumption as it becomes less competitive in the world’s platform on labor costs than it was a decade ago.

Europe’s nationalist movement that started with the UK vote in 2016 could continue into 2017 with three key national elections set to take place in Germany, France, and Netherlands. Regardless of the outcome of those elections, the pendulum that is already in motion will provide headwinds and tailwinds for U.S. investors throughout 2017 and beyond.

As professional investors, we take an agnostic view of politics and rely on secular growth trends that provide investment opportunities regardless of which political party has control. And on that basis, we see plenty of growth opportunities for investors both in the U.S. and abroad.

Q3 2016 – “A Saver’s Dilemma”

Q3 2016 – “A Saver’s Dilemma”

The third quarter ended with the stock market higher by 3.85% as measured by the S&P 500 Index. The Federal Reserve (Fed) maintained its target range for the federal funds rate at ¼ to ½ percent. When the Fed increased short-term interest rates last December (for the first time in nearly a decade), market watchers, including ourselves, described the likely slow and well calculated trajectory of future rate increases as “glacial”. Glaciers are perceived as slow moving, but recent observations from Greenland in 2012 recorded that country’s largest glacier moving at about 150 feet per day. To put that into perspective, the Fed’s target rate is at the same point as last December while Greenland’s glacier is nearly eight miles down the road. Perhaps finding a slower moving analogy to describe Fed policy would be more appropriate.

While there were no changes to interest rates in the period, the official Federal Open Market Committee (FOMC) statement read that “the case for an increase in the federal funds rate has strengthened,” validating the street’s expectation that a rate increase could be coming this December. Regardless, we don’t anticipate a “normalization” of interest rates to anything remotely close to historical norms anytime soon. From 1990 to 2007 the 10-year Treasury note’s yield averaged 5.8%. Today it’s below 2%. For investors relying on fixed income investments, finding yields reflective of normal based on the past two decades is a difficult proposition without reaching way out on the risk spectrum, see graph below.

Last year the Fed projected that rate policy increases throughout 2016 would result in the fed funds interest rate reaching a target range of 1.25% to 1.50% by year-end. As we now know that is nearly 100 basis points above the Fed’s current policy range. We believe rates don’t have a realistic chance of reaching those levels until the end of 2017, or even 2018, as the trajectory of rate increases continues to flatten from last year’s guidance. Multiple factors are causing the Fed’s cautious stance but the lack of global growth and wage inflation seem to be the primary concerns at this time. In March, Federal Chair Reserve Janet Yellen stated that “a lower level of unemployment might be needed to fully eliminate slack in the labor market, drive faster wage growth, and return inflation to our 2% objective.”

As mentioned in our previous newsletters, the unemployment rate is a key indicator of the health of our economy, and the “slack in the labor market” to which Yellen is referring is the measure of the quantity of unemployed resources. With less “slack” there is a higher probability that wage growth will materialize as employers must pay more to retain and hire employees as a result of the tighter labor market. As wages increase, consumers are likely to spend more, and since consumer consumption drives 70% of the nation’s Gross Domestic Product (GDP), an increase in wage inflation could provide a tailwind to the economy and offer the Fed with the necessary improvement in economic data to justify moving towards a “normalization” of interest rates.

Although the Fed has not quantified its desired wage growth target, we can analyze data back to 1990 and calculate that when the unemployment rate falls to approximately 5%, wages typically grow about 4.2% annually. For comparison, wages have increased by only about 2.6% over the past 12 months ending September 30. The good news is that the 2.6% annual wage inflation rate ending September is greater than the 2.4% annual increase reported at the end of August. Whether or not this is the catalyst to get inflation to the central bank’s 2% goal, only time will tell. Taking everything into consideration we believe that it shouldn’t be a surprise to investors if the Fed raises rates by 25 basis points in December.

In spite of the low inflation measured by the Fed, there are many expenses impacting consumers in real ways that often leave them wishing that sub 2% inflation was a true reflection of their daily household expenses. For example, tuition for an undergraduate degree from one of Kansas’ state universities has averaged annual increases of 7.55% since 1989. It is not surprising that college students thronged to Bernie Sanders during the Democratic primary race out of frustrations over the cost of higher education.

Next, healthcare expenses which consumes nearly 17.4% of the GDP, is another area that has seen significant increases in real costs to households and businesses over the past several years. Annual healthcare insurance premium increases are being reported in the 5% to 6% range for 2017 renewals. It’s worth noting that there is some difficulty in accessing the true increase in healthcare expenses, as consumers opt for larger deductibles and copays to dampen the annual increase in premium costs. According to a recent Kaiser Family Foundation study, a nonpartisan think tank addressing health policy issues, the average family’s healthcare insurance premiums increased 3% between 2015 and 2016, to $18,412 annually. In talking with family, friends, and neighbors, we are all aware that health care costs are a significant expense households absorb today.

Given this backdrop where do we see the investment opportunities going forward, you might ask? Looking across all the major asset classes, we favor equities as the primary means of growth. We believe there is potential for capital market appreciation but we expect it to be accompanied by an increase in volatility. Increased choppiness is not unusual for an extended bull market and we are seven plus years into the current bull period. Looking back, we believe the market is similarly positioned to where it was at this time last year with the additional uncertainty produced by the upcoming Presidential election which may add to volatility. On a valuation basis, in terms of is the market cheap or expensive, we don’t see it as overly priced based on historical measures. The S&P 500 Index is trading at a Price to Earnings (P/E) multiple of 16.8 as of September 30th, which is fairly reasonable compared to the 25-year average of 15.9.

In our view there are pockets of the market that are expensive, but those always exist regardless of where we are in the cycle. Also supporting our case for stocks is historical data that has associated rising stock prices with rising rates when yields, as measured by the 10-year Treasury note, are below 5%. Once yields start to trend above 5%, investors become more attracted to locking in those yields and capital typically flows out of equities, causing a negative relationship between yield movements and stock returns. Recall that the yield on the 10-year note is currently less than 2% and well short of this 5% inflection rate.

Income-focused investors have had to change traditional investment strategies by incorporating more dividend paying equities into their portfolios as the supply of bonds has decreased. Fixed income yields have been influenced by the actions of foreign central banks and their quantitative easing and bond purchases have pushed down long-term yields around the globe. As of mid-September, Barron’s reported that there were approximately $12.6 trillion of global bonds yielding less than zero. This is a significant increase over the $8.7 trillion in negative yielding bonds as of June 30th. To put this number into perspective, the total US Federal debt outstanding at the end of the quarter was approximately $19.3 trillion. Imagine being one of the 500 million people living in a country whose central bank has adopted a negative interest rate policy, where the borrowers get paid and the savers penalized.

Negative interest rate polices have forced investors throughout the world to seek yield abroad, and that has resulted in capital flowing into the United States contributing to our low rates. Only a coordinated plan of rate increases between the world’s central banks will result in more normalized interest rate levels globally. However, the increase in debt throughout the world to record levels ($152 trillion as reported by the International Monetary Fund, a number more than two times the size of the global economy), makes the likelihood of rates increasing substantially slim.

Growing federal deficits and a rising debt-to-GDP ratio in the US will make fiscal policies designed to stimulate and invigorate the economy, such as tax reform or increased infrastructure investment, a challenge. The Congressional Budget Office (CBO) recently quantified the magnitude of policy changes needed to meet various goals for the Federal Debt. Assuming that lawmakers set out to ensure that federal debt held by the public (currently 75% of GDP) remains unchanged by 2046 would require cutting noninterest spending or raising revenues each year beginning in 2017 by 1.7% of GDP, or $1,000 per person.

The graphs below illustrate the significant increase in US treasury debt over the past few decades. Regardless of who wins the Presidential election in the US, there will likely be a push for fiscal stimulus as the new administration will want to put their thumbprint onto the economy. With the national debt levels presented above, it will be challenging from a budget perspective to do so without some type of give and take. The United States is in a difficult position in terms of getting interest rates back to what most of us perceive as normal. We may very well be at a “new normal”, and investors will have to bear more risk in achieving yield as a source of income.

At Kornitzer Capital, we have a seasoned high yield investment team that is constantly seeking prudent opportunities for attractive yield in higher quality non-investment grade corporate debt, convertible bonds, and dividend growth stocks. Over the past decade, equities have become a larger mix of income producing portfolios, and will likely remain so in the foreseeable future, until we believe yields and the supply of bonds reach a more desirable level.

Even the Fed itself might be moving towards other investments. Speaking by video at a Kansas City Fed conference during the last week of September, Janet Yellen said that the Fed, as has happened with some overseas central banks, might find itself hitting a ceiling on the amount of U.S. government bonds it could purchase. In that case, the Fed, she stated, would have to move on to other assets such as corporate bonds and stocks. While we wouldn’t expect the Fed to implement this activity in the short-term, the mere mentioning of it as a possibility is worth noting.

In summary, expect an increase in volatility that will provide opportunities. Any short-term dislocation by world events should be short-lived as this market continues to have room to grow. As always, we greatly appreciate your continued support and will continue to work diligently to be good stewards of your capital in meeting your investment needs.

Q2 2016 – “Is The Demise of Globalization Near?”

Q2 2016 – “Is The Demise of Globalization Near?”

The status of globalization took center stage this past quarter with the United Kingdom’s June referendum (Brexit) to leave the European Union. It was the highest turnout in a UK-wide election since 1992 and fairly evenly divided, as the “leave” camp won by a 52% versus 48% margin. Stock markets dropped world-wide the day after the results but had subsequently recovered most of the initial losses within the week following the vote.

There is no certainty in how the UK and the EU will proceed with the separation process. As of the printing of this newsletter, the UK has not yet invoked Article 50 of the Lisbon Treaty, which is necessary to begin negotiations of its separation from the EU. While this is the first time a nation has opted out of the EU, in 1982 Greenland, one of Denmark’s overseas territories, voted to leave the EU (ironically at similar margins to the UK vote). It took nearly three years to negotiate its exit deal. Obviously the UK’s integration into the EU’s economy is more significant than Greenland was at that time, so there is a high probability that this will be in the headlines for years to come. The most immediate impact has been the sinking of the British Pound to a 31 year low. The day of the referendum, it took 1.5 dollars to buy one British pound, and on July 5, 2016 the conversion ratio was 1.3, a level it hasn’t seen since 1985.

The turmoil that Brexit will have on the European economy has impacted interest rates in the US, as investors seeking relatively safe interest-bearing securities have driven interest rates lower (see Chart 1). In the first part of July, the U.S. 10-year Treasury Note yielded 1.367%, a yield not seen since the 1940’s. At the June Fed meeting, Janet Yellen, Chairwoman of the Federal Reserve, gave a cautious outlook for rates after the May monthly employment numbers reflected loss of momentum in the labor markets. The Fed also lowered projections for how much it will raise rates in the years ahead, and this was before the results of the Brexit vote were known. As of July, this is the longest period in 40 years between the first rate hike and the second, with nearly seven months transpiring since the first rate hike in a decade last December. The Fed will continue to be data dependent, but unless things change materially for the better in the coming months, the Fed will likely keep its rate policy unchanged for the rest of this year. The impact to the United States in a post-Brexit world should have minimal economic impact. Exports make up less than 14% of U.S. GDP, according to the World Bank, and the UK accounted for just under 3% of total revenues for the companies in the S&P 500 last year.

Potentially the concerns of the negative perceptions that globalization has had on economies by the Brexit vote could have an impact on businesses throughout the world. But even after the Brexit vote outcome, key leaders of the “leave” campaign were very clear in stating that they would like to continue the current economic relationship with Europe, just not so on the regulatory and immigration policies. In a world where growth continues to be elusive, eliminating access to end market for your products seems irrational self-inflecting pain. Nonetheless, during periods of low growth, the discussion around protectionism and nationalism tends to flourish as politicians seek ways to explain the lackluster growth. Even in the United States, trade is becoming a heated topic as the November election nears. We will leave the debate of the merits of the North American Free Trade Agreement (NAFTA) and Trans-Pacific Partnership (TPP) to the rhetoric of the politicians, the media, and pundits to sway the masses, but in reality, there are more powerful forces driving the change in globalization than the polling booth. With the importance of globalization to U.S. companies and the likelihood that it will remain in the forefront of the headlines for months now, it is beneficial to understand what drove globalization, what companies are saying about it, and most importantly, what it means to you as an investor.

Looking back on history, there are numerous advancements that could be considered as stair-step improvements in the globalization of goods, but none have been more impactful than an idea conceived in the mind of a 24-year-old truck driver, Malcom McLean, in 1937. While he waited hours to unload his delivery of cotton bales at the shipyard, he observed the inefficiencies of the process of unloading each trailer of its cargo and lifting each non-standardized crate into the hull of the vessel. His idea was to develop a system where he could drive his trailer up to the vessel, have the trailer detached from its chassis, lifted onto the vessel, and depart to pick up his next paying customer’s load.

It took McLean nearly 20 years to bring this idea to fruition, but the primary driver to build his first container ship was increased regulation. States were starting to levy fees and weight restrictions that were costing his business. Travelling by water would eliminate those fees and be more cost competitive than trucking alone. He sold his trucking business and entered the shipping business with his first vessel, Ideal X, which was capable of carrying 58 containers. At the time of its first voyage, hand-loading a ship cost $5.86 a ton. Using his specially designed, standardized 20 ft. containers only cost 16 cents a ton. Thus, the globalization of materials, parts, and labor began to grow rapidly, and today, nearly 90% of commerce ships by sea on vessels capable of carrying over 19,000 containers. Companies are no longer confined to their local geographical reach for labor and end markets, but can access the world. Not only have companies based in the U.S. benefited by offshoring manufacturing to low cost regions, consumers have been able to benefit through lower prices. Additionally, globalization has helped develop emerging economies by enriching its citizens that are now transitioning from providing for their basic needs to having the ability to purchase more discretionary items.

Nonetheless, several years ago globalization started to take a new dynamic. The global labor cost differential started to tighten, and the cost advantage that certain emerging economies had in the 1990’s and 2000’s began to disappear. Specifically in China, companies have disclosed that some Chinese employees were being paid the equivalent, if not more, than their colleagues based in developed economies. As discussed in our first quarter’s newsletter, China realizes that they are losing their low labor cost edge and is aggressively investing in automation to remain competitive. In May, China’s Midea launched a bid to acquire German robotics specialist Kuka AG to further advance that goal. The key for emerging and developing economies to benefit from globalization is to maintain that labor cost advantage, but in an age of automation and robotics, the regions that are able to incorporate technology on the manufacturing floor will be the winner going forward. A recent tour of Ford’s Claycomo, Missouri, assembly plant that produces the Ford F-150 and Ford Transit models highlighted the importance of automation on the assembly floor. For the past decade, robots have replaced a majority of the high costing labor jobs, and technology has eliminated the need for highcost trade specific labor, such as welders, from the assembly line. There is no welding done on the F-150, all of the body panels are connected with adhesive and rivets. Much of the human interaction on the assembly line is towards the final assembly, which tends to be lower costing jobs. Technology and automation will continue to change the labor costs mix in the manufacturing process.

With the digitalization of the economy through robotics and automation in the manufacturing process, the location of manufacturing is changing. Once the labor cost differential is eliminated by incorporating technology into the manufacturing process, companies start to incorporate other factors into the decision process on where to locate manufacturing to address end markets efficiently. Factors such as tariffs, fees, and local labor laws and regulations start to have less influence on the locale when automation is taking over the work. As a developing economy ages, the natural tendency is for the local governments to increase regulatory oversight, which also tends to increase the cost of operating within that jurisdiction. According to the World Bank Group, over 70% of regulatory reforms recorded in 2015 were carried out by developing countries.

U.S. companies are increasingly putting emphasis on “speed-to-shelf” and “speed-to-market” and some are moving manufacturing to Mexico from China. But this also works in the opposite direction, as developing economies become consumers, companies are “exporting” smaller manufacturing facilities to serve local markets, versus large footprint facilities serving world markets. Globalization is not going away, but is changing, as one would expect that businesses are always seeking opportunities to provide a service or product to their end markets more efficiently and cost competitively. Presently there has never been a cheaper time to transport goods from across the world, given the overinvestment by shipping companies and excess shipping capacity. Nonetheless, the environment is one where often the origin and destination charges to take the container on and off the vessel are more than the cost to transport the container on the open sea.

The nearshoring trend is not confined to only U.S. companies. Throughout the world more and more companies are using nearshoring to reduce operating costs, and with the U.S. being the largest economy in the world, it will stand to benefit from this growing trend. The same drivers that influenced McLean to come up with his Container ship are driving the considerations to regionalize manufacturing, and regardless of the alarmist tone of anti-globalization headlines, businesses have already started to adjust to this new environment through the benefit of advancements in technology.

Where does all of this change in globalization leave the U.S. investors? The U.S. markets will continue to be a safe haven for world-wide investors. The economy in Europe was already on fragile ground before the referendum and will likely be lackluster for the foreseeable future, regardless of the European Central Bank stimulus programs. As investors continue to seek out income options, yields will continue to be pressured lower for longer. With yields collapsing in the rest of the world, the U.S. bond market is one of the few places investors are flocking for yields, pushing U.S. corporate yields lower. We still caution investors that are tempted to reach out on the risk spectrum to capture greater yield and rather continue to be focused on quality high-yield bonds with attractive yields. Dividend paying stocks continue to be attractive, particularly with the increase in volatility giving investors good opportunities to secure relatively attractive dividend yields in quality companies. Relative to the U.S. Treasury 10-year Note, currently there are 318 companies in the S&P 500 now paying a higher yield. We continue to target common stocks with dividend yields of 3 – 4% in companies that have intentions to continue to raise their dividends over time. Don’t be fooled into running for the exit doors when the news blares for new calls for tariffs or protectionism. Companies have already been adapting to a new globalization environment, and out of new challenges, just as McLean demonstrated, are new opportunities.

Q1 2016 – “The Disruptors Are Here!”

Q1 2016 – “The Disruptors Are Here!”

The Dow Jones Industrial Average and the S&P 500 Index rallied 9% from the intra-quarter lows in February to end up 2.20% and 1.35%, respectively for the first quarter of the year. Investors’ concern weighed on the market early in the period as global economic growth continued to struggle, but market sentiment quickly turned to one of hope as central banks throughout the world continued to be willing to try all options to stimulate their economies with accommodating monetary policies. The volatility during the quarter is typical of an extended bull market, now in its seventh year. What exactly was the catalyst for the market’s sharp reversal during the quarter?

In February, the European Central Bank (ECB) President Mario Draghi launched a second major stimulus boost after data showed that inflation in the euro area slid back below zero. Inflation has languished below 1% in the Eurozone for more than two years. Over the past two decades central banks in developed economies throughout the world have pursued a 2% inflation level as a preferred level of acceptable inflation that is neither too high, nor too low. At that level, central banks have greater flexibility to lower nominal interest rates in an attempt to stimulate the economy. However when inflation is near zero central banks are reluctant to lower nominal rates or “go negative” for fear that it would influence people to hoard cash rather than deposit it in the bank. Additionally, very low inflation rates also increase the cost of servicing debt, which is problematic for highly indebted economies. Unfortunately, the lack of inflation throughout the world has forced Europe and Japan to resort to negative interest rate policies in hope of spurring economic growth. It’s worth noting that for the time being negative interest rates are currently only applied to certain intra-bank deposits and are not impacting customer bank deposits directly.

While the concept of negative rates isn’t new, the willingness by central banks to actually implement them is. It seems like only yesterday that the ECB President Mario Draghi uttered his vague promise to do “whatever it takes” to save the euro, but this upcoming July marks four years since making that pledge and economic growth in Europe continues to be elusive. Unfortunately, the monetary policies that have historically worked to stimulate the economy appear to be ineffective in the current environment.

Given the global growth concerns above, the trajectory of the U.S. Federal Reserve interest rate increases for 2016 began to appear unrealistic. The market’s perception was confirmed when the Fed announced at its March meeting that it will proceed cautiously with interest rate increases, and projected increases will be at a slower pace than initially estimated during the December meeting. Instead of rates increasing by a full one percentage point as laid out by the Fed in that meeting, rates are now expected to rise only one half of one percent (50 basis points) this year. While the goal was to get short term rates back to “normalized” levels, the Fed Funds rate will likely exit the year around 75 basis points. When compared to historical levels this could be described as “abnormal”, not “normal”.

The major concern for the Federal Reserve is that the weakness currently being felt worldwide could impact the U.S. economy. This concern is primarily due to the impact of a stronger dollar. As the only developed economy in the world with the intent of increasing rates back to “normalized” levels, along with the rest of the world continuing to keep rates near zero or venturing into negative interest rate territory, demand for the U.S. dollar will increase making it appreciate in value relative to foreign currencies. The dollar’s rise in value against other currencies since mid-2014 has, in effect, made our exports more expensive to foreign buyers. Likewise, the stronger dollar also makes imports into the U.S. less expensive, which can pinch domestic company profits and potentially subtract from U.S. GDP growth. Given lackluster global growth, proceeding with caution is the most prudent move the Fed could communicate to investors. This goes not only for the U.S. economy, but also for global economies which don’t need the world’s largest economy (the U. S.) to sink into a recession.

Many have speculated on why inflation has stayed so low even after significant stimulus by central banks? Some economists point to globalization that has driven down prices; others note the world’s aging population that is changing purchasing habits. While these are plausible explanations, there is another factor that is getting less press from the media: the digitalization of the economy. While some consider digitalization to have started with the dot.com craze of the early 2000s, the innovation being implemented into the economy today is disrupting legacy industries and changing how real business is conducted throughout the world. Technology by itself is deflationary, and when layered upon better asset utilization or dramatically increased production capacity through innovation, it accelerates the deflationary impact to the economy. This is perhaps the most significant secular trend that makes it “different” for the central banks to create inflation this time. Regardless of their hopes and efforts, near zero, or negative interest rate policies and quantitative easing may be here to stay for many years.

Perhaps the most tangible example of disruptive innovation changing the supply and demand dynamics which led to deflation can be illustrated through what has transpired over the past decade in the United States oil and natural gas production. Nearly a decade ago, the United States was the destination of last resort for OPEC, as most oil and gas exports started to gravitate towards Asia. The United States had a real problem, which had the potential of escalating into a crisis. But through the ingenuity of oil and gas companies that developed fracking technology the world is now awash in oil and gas. The new-found excess capacity has changed the supply equation so much, that the pricing power OPEC once had is now minimized. New technology enabled better utilization of the assets the United States always had which impacted global markets. It is this type of disruptive innovation that is now being implemented in a vast array of industries throughout the world.

The internet has made it easier to utilize assets by efficiently matching demand and supply. For instance, millions of vehicles are used primarily for transportation to and from work. Uber and Lyft, two ride-hailing service companies, have disrupted the transportation business by making it easy to hail one of their approved drivers with a smartphone app. General Motors, which recently made an investment in Lyft, plans to put its cars in the hands of Lyft drivers. Lyft has disclosed that more than 150,000 people have applied to be Lyft drivers but they don’t qualify because their cars are too old or don’t have four doors. GM’s pilot program would allow Lyft drivers to lower their costs to access GM’s pool of vehicles as the drivers provide a certain number of rides during the month. This pilot with GM and Lyft is the first step in preparing for a future of ride-sharing programs that use self-driving cars, with the program’s hubs eventually being stocked with autonomous cars that consumers could hail on demand. Or better yet, in the near future, instead of leaving your car in the parking lot while you are at work, you could put your car in “self-driving” mode and have it work for its keep as a taxi. While autonomous vehicles seem far in the future, the capabilities are nearer to being a reality than most think. A simple app started it all, matching an individual that had a car with a person needing a ride. The capital required to build an Uber or Lyft company with vehicle capacity would be staggering.

The lodging industry has undergone a similar disruption with sharing services through private company Airbnb, which provides a website for people to list, find, and rent lodging. It was founded in 2008, and already has listings throughout 190 countries. In 2014, Airbnb supplied 115,000 rooms in the United States, 2.3% of existing hotel capacity. Adding similar supply with budget hotel rooms would have cost approximately $10 billion. The legacy lodging companies gained a global competitor that appeared literally out of thin air, through the internet.

The same concept of using technology to better utilize owned assets within the sharing economy is growing in heavy construction equipment, where contractors that own expensive and intermittently used assets that aren’t necessarily critical to have access to at all times. Caterpillar made an investment in privately owned Yard Club in May 2015, whose platform brings broader set of owners and renters together to benefit both parties. The renters of the equipment have access to hard to find machines that are pre-checked for quality, while the owners earn incremental income on capital tied up in idle assets. This reduces the amount of capital required by the industry by significantly adding capacity to the industry, to the detriment of legacy rental companies such as United Rentals, Inc. (URI).

Advancement in Robotics and Artificial Intelligence (AI) is having widespread deflationary pressures worldwide as improvements have increased the speed, flexibility, and adaptability of robotics and technology into industries, while simultaneously lowering their overall costs. In the past robotic automation used to be reserved for multinational conglomerates. Today it is rapidly being adopted across a vast range of manufacturing, logistics, commercial, and consumer applications.

China is aggressively investing in automation to remain competitive within manufacturing in the global marketplace. Employing Chinese factory workers has been getting more expensive over the years. There is also an issue of fewer of them being available, which continues to feed wage growth. And while China has a population over 1 billion, its working-age population is in steep decline, falling by nearly five million last year. China has been viewing advanced robotics as a key to raising productivity and keeping economic growth strong as the country transitions to a more service-based economy. Soon China will have more industrial robots than any other advanced economy. For example, Foxconn, a Taiwan-based company that employs over a million workers to assemble iPhones and other Apple products in mainland China, wants robots to take over 70% of its assembly work within three years. The World Economic Forum predicts robots and artificial intelligence will result in a net loss of 5.1 million jobs over the next five years in advanced economies. To put that into perspective, since February 2010, private companies have created 14.4 million jobs in the U.S.

We recently toured a manufacturing facility (located in a low labor cost geographic location) of a company that manufactures customized products for consumers. During the tour, the company’s engineers presented to us from its innovation lab, where they are given the task of seeking ways to drive down costs and inefficiencies from the manufacturing process. Examples given were: developing custom materials that could vary the width and shape to minimize waste and implementing laser technology to replace custom drills to reduce processing time from 13 seconds per item to 2 seconds with limited polishing requirements. Additionally, the company is on the forefront of using 3-D printing technologies and is close to making a revolutionary advancement in its process with its in-house development that should decrease its manufacturing footprint by at least 50% within the next five years and significantly increasing manufacturing efficiencies, and decreasing costs.

Innovation is changing the cost dynamics in more than just the manufacturing realm. Amazon (AMZN) spent $775 million to acquire Kiva Systems in 2012 to use its robots to efficiently move products from its distribution center to its fulfillment center (see above photo), eliminating the need for human workers traveling around the warehouse locating and picking items. Amazon recently renamed Kiva Systems to Amazon Robotics and appears to be content on using this technology internally. Similar technology is already being used within the hospital setting, dispensing drugs throughout the hospital.

Streaming services, such as Pandora (P) and Netflix (NFLX) have had significant impact on the cost of media to consumers, to the detriment of the music industry and cable providers. Technology’s capabilities and affordability are allowing companies that embrace innovation to reimagine how to deliver services and products to consumers in a new and preferred way. Restaurant chain Panera (PRNA) is implementing technology throughout their stores to allow consumers to order online or at an in-store kiosk. While at first glance this seems insignificant, incorporating technology into a business is all about getting better utilization out of the company’s assets. In Panera’s case, the company is ‘outsourcing’ its cash register function to a combination of the customer and technology which frees the Panera employees to address other duties within the restaurant. While it isn’t Panera’s implicit desire to offload its internal work to its customer base, Panera’s goal to provide a convenient way to enhance the customer experience has a deflationary impact to its employee base.

These are only a few examples of the disruptive innovation impacting economies throughout the world, but the deflationary impact to the economy is clear. Likely it will continue to overwhelm the efforts of the central banks to reach that desirable 2% inflation goal, but as clients of Kornitzer Capital Management, it doesn’t need to overwhelm you. For the past 20 plus years, we’ve been focused on long-term secular growth trends such as the disruptive innovation above. Kornitzer Capital manages science and technology funds that since 1998 have been seeking investment opportunities in companies engaging in innovative strategies that lead to shareholder wealth creation. As an investor, there are two factors that will greatly impact portfolios in the near future and beyond; legacy businesses being displaced by disruptors, and the temptation to seek income yield in riskier assets. Careful consideration is given to which companies are worthy of your investment, and with the rapid pace of innovation adopted by disruptors, the legacy companies comprising major stock indexes could be a dangerous proposition going forward.

With the likelihood of lower interest rates for a longer period of time, investors needing investment income will be tempted to reach out on the risk spectrum to capture greater yield. We would caution those tempted to do so. For our income clients, we are currently targeting common stocks with dividend yields of 3-4% in companies that are likely to increase their dividends into the future. Within fixed income, we are focused on quality high yield bonds with attractive yields. We are witnessing an acceleration in the pace of innovation of artificial intelligence initiatives into the broad economy that is just at the cusp of significant commercialization disruption. The legacy companies will have to adapt or be left behind.