It is a challenging environment for investing, and current macroeconomic and financial market conditions have pushed many investors toward supposedly safer investments. Past efforts by monetary authorities around the world to increase economic growth have been relatively unsuccessful as worldwide growth is now well below desired levels. This lack of growth combined with the battle against recessions has led central banks to adopt unconventional and untested tools. Investors are nervous that politicians and bankers have exhausted their remedies to restore normalcy. And they, like the central bankers, are essentially asking if they should stay the course, or should they go and try something new. The Clash’s 1982 song of “Should I Stay or Should I Go” (currently in a Choice Hotels ad) describes our plight rather well. Given the very large flow of funds out of stocks and into bonds during the first quarter, it appears that many investors have chosen to go!
Investors’ fear of a recession has increased as central bankers continue to maintain a dovish posture by not raising interest rates. Several Eurozone countries have been employing a negative interest rate policy (NIRP) recently and now that the Bank of Japan has joined them, approximately one-third of all global sovereign debt, valued at $7 trillion, is now priced at negative nominal yields. In theory, and in past practice, lower interest rates spur investing, risk taking, higher spending and inflation. Whether negative interest rates are the same as lower rates is open to question and economists are debating whether this theory is still valid or if there are unintended consequences. While the U.S. is not using negative interest rates, and is unlikely to do so in the foreseeable future, the topic is worth exploring since we are still very much tied to the world economy.
Sweden is possibly at the forefront of determining which tools work best to create economic growth and some inflation. The world needs both growth and inflation to successfully work its way out of the large amounts of debt created by the numerous quantitative easing programs of the past several years. Sweden’s negative interest rate policy has been successful in growing its economy to its desired full-employment level but, it has also contributed to a very strong housing market, which some believe is close to over-heating. Sweden’s baseline inflation is close to zero while the central bank has a 2% target. One policy maker was quoted “It’s a strange world, with high growth, low inflation, and negative interest rates.” The Riksbank’s main worry is that low inflation will lead consumers and investors to expect lower inflation, leading to lower wage demands by workers. Lower pay raises in turn help keep a lid on inflation, and the cycle repeats. Time will tell if Sweden can successfully create only economic growth and inflation through the use of very low or negative interest rates, or if it also creates an
asset bubble which, when burst, undoes that growth and inflation.
The U.S. Federal Reserve is operating with a different set of constraints than is Europe, Japan, and China, and even Sweden, for that matter. Growth in the U.S. appears to be stable and
possibly rising, but is not at the desired level. While the U.S. may be able to tolerate higher rates, anemic growth abroad is limiting the Fed’s options because of the impact higher rates here would have on our trading partners. Like Sweden, U.S. home prices in certain areas are also over-heating, in part due to low mortgage rates. Fear of low pay raises is well founded, but there seems to be an intensifying movement in the U.S. to raise pay regardless of the level of inflation. California and New York are at the forefront of the $15/hour mimimum wage movement which means this will likely spread. Economists are split about the ultimate impact but, barring a recession, that may not matter. If the minimum wage does increase materially, one impact should be to push mid-range pay scales higher. Some believe that higher wages will ultimately result in higher tax revenues, higher consumer spending and less government spending on welfare and safety net programs. The impact on corporate earnings could be negative unless higher wages lead to greater pricing power.
Our outlook for the financial markets is that interest rates will rise gradually throughout 2016 such that by year-end, the Fed will have raised short term rates twice. The yield curve will maintain its positive slope and thus, longer term U.S. Treasury yields could exceed 3%. We do not expect a recession since the Fed is adamant about focusing on economic growth and full employment. Earnings of S&P 500 companies in 2015 were negatively impacted in part by the strength of the dollar. The stronger currency made U.S. companies less competitive versus their foreign rivals and economic weakness in Europe and China lowered demand even further. Low oil prices, while helping the consumer, were a secondary contributor to weak earnings. Finally, low interest rates constrained financial services earnings. These headwinds should abate by the end of the year and could very well become tailwinds.
Stock prices have been range bound for the past two years, gravitating between about 1900 and 2100 for the S&P 500. Earnings have also been declining for six quarters resulting in their
being nearly 18% below their 90 year trend (see chart). Current valuation for stocks is appropriate given the level of interest rates. Thus, when corporate earnings recover, stock prices should do well. If a recovery is delayed, stocks will likely continue to trade in the past two year range since dividends are providing a floor to a potential decline. Stocks currently yield 2.1% which compares very favorably to the 1.7% yield on 10 year US Treasury Notes. Stocks are certainly more volatile than bonds, but in the long run, they should create more wealth as they have for decades.
Finally, our answer to “Should I Stay or Should I Go” is that staying the course is the best decision given current conditions. While central banks will continue to fight for growth, interest rates will eventually begin a slow upward move. Health should return to the financial markets and investors will once again be rewarded for taking on risk.
The Jetsons Revisited
Fifty years ago, Hanna-Barberra presented the Jetsons as the family of the future in one of its classic cartoons. The opening scene of the program shows George Jetson, the patriarch, flying a personal space craft to drop his children off at school and Mrs. Jetson at the shopping center on the way to his job. Many of us expected that flying cars would have been a reality years ago given the pace of technological development. However, automobile transportation has undergone very limited change in the last eighty years. Ownership and traffic have exploded, but the basics of driving a gasoline powered four wheeled vehicle around town or for longer trips has remained a constant. There are three developments in the automotive industry that bear watching given the extensive economic and lifestyle impacts associated with these changes. The first two developments are more evolutionary while the third is revolutionary.
In response to the OPEC oil embargo from the 1970s, Congress enacted Corporate Average Fuel Economy (CAFE) standards which dictate the fuel economy of fleets sold by car makers. If the manufacturers do not meet the mandated averages, the US government fines them. These standards started at 18 miles per gallon in 1978 and rose to 27 mpg by 1984 and stayed there for about 25 years. The current standard is 35.5 and scheduled to rise to 54.5 mpg within the next 9 years by 2025.
To put these requirements in perspective, the average car and light truck will have to be as fuel efficient as today’s Prius. These increased efficiency gains are dramatic and industry appears
poised to meet these requirements.
Closely related with fuel efficiency, vehicles are changing from internal combustion engines to electric engines. Tesla has demonstrated that electric vehicles can perform as well or better than gas vehicles at the upper end of the market. While less than 1% of vehicles sold are electric across the country, electrics represent over 3% of sales in California. Mass market vehicles such as Chevy’s Bolt are scheduled to hit the market next year. The Bolt will travel 200 miles on a charge, go from 0-60 mph in less than 7 seconds and retail for about $30,000 after a $7,500 tax credit.
The transition to electric vehicles will not be painless. The major issue to solve involves charging and the infrastructure necessary to quickly recharge a growing fleet of electric cars. One example is that there have been numerous news stories on confrontations over access to Tesla’s super-charging stations that are supposed to be limited by those passing through on longer trips, but instead are utilized by local owners as their go-to charging stations.
The final development that is poised to explode in the automotive industry involves self-driving vehicles. Google is testing extensively self-navigating cars and has 73 permitted cars with 200 plus drivers on the public roads in California. Apple, Uber and Tesla are also rumored to be committing significant resources to solve the challenges associated with driverless cars, but their efforts are much less transparent than Google’s.
In theory, self-driving cars should be able to move far more people much more safely on the existing roadways than currently. Traffic densities could increase and accidents would decrease markedly as drunken and distracted driving disappeared.
The economic impacts of these changes in the auto industry are far reaching. What happens to the future demand for oil if the average new car is as efficient as a Prius within the next decade? Electric cars still require charging, but this energy will be produced by natural gas with an increasing contribution from renewables.
The impacts from self-driving cars could be even greater. I believe cars will morph from an individual ownership item to a utility. There will be no reason to own a car and maintain it yourself when you are able to summon one from a fleet to take you wherever you want to go. The insurance industry will change dramatically as car premiums plummet and are replaced by some sort of public insurance program that is much more cost effective. These changes may occur over decades, but the pace of change will be surprisingly rapid once it begins.
Potential Opportunities from Change
These developments within the global auto industry are highly likely to drive above-average growth in a number of technological areas. We have recently spent time considering two investments with major presences in areas relating to fuel efficiency as well as safety and the trend toward the vehicle increasingly becoming a digital ‘hub.’
While we believe internal combustion engines (ICE) will eventually lose share to electric, within the ICE space today—which still represents 99% of cars on the road - there are several technologies that are taking center stage in order to help auto makers meet CAFE standards and produce more environmentally friendly vehicles. Two such technologies relate to the turbocharging of engines as well as dual-clutch transmissions—both of which can generate as
much as 50% improvements in fuel efficiency. A third technology recirculates exhaust gas from the car into the cylinders, thereby dramatically reducing emissions of nitrous oxide and helping cars meet new EPA standards.
Borg Warner (BWA) produces the leading solution for auto Original Equipment Manufacturers (OEMs) in all 3 categories. Demand for their drivetrain and turbo products is strong, driven both by demand from consumers (“pull”) and fuel efficiency mandates from governments around the world (“push”). We like BWA’s business because the products they manufacture are highly engineered which means higher barriers to entry for competitors as well as more pricing resiliency with OEMs. A recent acquisition of Remy International also gives them entrée into drivetrain technology for electric vehicles. We recently purchased a position in our value oriented portfolios following a large drop in the share price after BWA reported slower than expected growth due to foreign currency impacts from a strong US dollar (2/3 of their business is outside the US) and slower auto production in China.
We have also spent time analyzing Harman International (HAR) recently. The company is known by many as a ‘sound’ company providing high-quality audio electronics, headphone and speaker equipment—both in the car, home and concert halls—through the Harman, JBL and Infinity brands. What many don’t realize is that the company has more recently become THE ‘go-to’ provider for security and software and embedded infotainment systems within the “connected” or “intelligent” car. HAR has built a multi-billion dollar backlog with many of the world’s auto makers for integrated infotainment/ navigation systems as well as for cameras and bumper sensors. More recently, through acquisitions, HAR has established a leadership position in software services and cybersecurity for the car. These features are becoming increasingly important as technology companies such as Apple, Google and Tesla, and many auto OEMs, are rapidly investing in autonomous car technology as well as in ‘smart’ audio and infotainment solutions that provide drivers with intelligent and personalized solutions in the car. The electronics and computing content in the average car has been climbing steeply for years—the car is verging towards becoming a digital device in itself. An increasingly large number of ‘updates’ to software that now resides in the car is arriving over-the air (OTA). Doing so can repair issues with the car remotely or add functionality through wireless software updates, as well as prevent the need for recalls and/or the expense of bringing the car back into the dealership. HAR’s Red Bend software has become the de-facto leader in proving OTA updates and cyber security for a number of OEMs. Tesla has already introduced over 75 features via OTA using Redbend, from raising the ground clearance of cars to boosting acceleration. The recent hacking of a Jeep Cherokee through its telematics system has also highlighted security vulnerabilities as cars add more digital technology, and many auto experts believe every car on the road will have OTA capability and cybersecurity software within 3 to 4 years. We expect HAR’s backlog to benefit meaningfully from these technology trends within the automotive