Q1 2016 – “The Disruptors Are Here!”

April 8, 2016

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.