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
industry.