— 2023 Q2 UPDATE —
Quarter 2 Returns:
Source: Y-Charts
Visual Source: Author
See important disclosures at the end of document
Equity Style Snapshot Benchmarks: Large Value – CRSP US Large Cap Value Index Total Return, Large Blend, CRSP US Large Cap Index Total Return, Large Growth – CRSP US Large Cap Growth Index Total Return, Mid Value – CRSP US Mid Cap Value Index Total Return, Mid Blend – CRSP US Mid Cap Index Total Return, Mid Growth – CRSP US Mid Cap Growth Index Total Return, Small Value – CRSP US Small Cap Value Index Total Return, Small Blend - CRSP US Small Cap Index Total Return, Small Growth – CRSP US Small Cap Growth Index Total Return> The Center for Research in Security Prices (CRSP) is a provider of research-quality, historical market data and returns. Once securities are assigned to a size-based market cap index, they are made eligible for assignment to a growth or value index using CRSP’s multifactor model. Securities are scored and ranked for both Value and Growth factors, then ranked. Investors cannot invest directly in a benchmark.
Year-to-date Returns:
Source: Y-Charts
Visual Source: Author
See important disclosures at the end of document
Equity Style Snapshot Benchmarks: Large Value – CRSP US Large Cap Value Index Total Return, Large Blend, CRSP US Large Cap Index Total Return, Large Growth – CRSP US Large Cap Growth Index Total Return, Mid Value – CRSP US Mid Cap Value Index Total Return, Mid Blend – CRSP US Mid Cap Index Total Return, Mid Growth – CRSP US Mid Cap Growth Index Total Return, Small Value – CRSP US Small Cap Value Index Total Return, Small Blend - CRSP US Small Cap Index Total Return, Small Growth – CRSP US Small Cap Growth Index Total Return> The Center for Research in Security Prices (CRSP) is a provider of research-quality, historical market data and returns. Once securities are assigned to a size-based market cap index, they are made eligible for assignment to a growth or value index using CRSP’s multifactor model. Securities are scored and ranked for both Value and Growth factors, then ranked. Investors cannot invest directly in a benchmark.
The AI Revolution:
Google searches for “Artificial Intelligence” from 2004 to present:
Source: Google Trends
In this quarterly update, I would like to discuss the shifting investor perceptions regarding the productivity growth and earning potential of the top AI companies, sparked by the AI revolution. This transformative change has led investors to reevaluate their strategies and outlooks.
Over the past year, particularly since March 2023, we have witnessed impressive returns from leading AI companies such as Nvidia, Google, Microsoft, Amazon, Meta, Netflix, Tesla, and Apple (they have accounted for virtually all of the gains in the S&P 500 this year) as some have created groundbreaking AI technologies that will disrupt traditional business models and some are believed to be positioned well to take advantage of this.
However, the true impact of AI extends beyond the companies directly involved in its creation. Drawing a parallel to the internet's invention, we observed that while internet-based companies initially thrived, the broader economy experienced the greatest long-term productivity growth as businesses across sectors adopted online platforms, digital processes, and automation. Similarly, our stance is that AI is expected to drive significant productivity gains across industries, benefiting labor-intensive companies with thin margins.
While the current surge in valuations for AI companies may be appealing, it's important to recognize that the potential for growth may lie in companies that have yet to participate fully in this trend. As AI becomes more accessible and integrated into various sectors, businesses that effectively leverage its capabilities stand to gain substantially. This presents an opportunity for them to experience significant productivity gains and unlock new avenues of growth.
Furthermore, the societal impact of AI reaches far beyond individual company valuations. As AI enables increased automation, improved decision-making, and resource allocation, entire economies will thrive. Companies that have not yet participated in the current surge in valuations may benefit from the positive ripple effects of AI adoption across industries.
As always, it is essential to maintain a balanced approach to investing, carefully considering the long-term potential and opportunities arising from the AI revolution. It is important to note that, just like in other large thematic trends, trying to pick a winner in an emerging industry is usually a losing strategy. Instead, we aim to shift our portfolios to capture the longer-term trends without overcommitting to any particular idea. Proper diversification and strategic asset allocation form the foundation of a successful investment strategy. However, being aware of these potential longer-term regime changes in the economy and market can add alpha on top of these foundations.
Inflation, Interest rates, and the economy:
Outside of the AI, the current longer-term question that every investor is trying to gauge is the direction of inflation. In economic analysis it is important to identify and answer a fundamental question that will kick off a domino effect of other answers. In other words, we want to establish a casual link between economic factors.
For example:
Inflation direction answers -> Federal Reserve policy stance -> interest rate levels -> financial asset valuation -> asset allocation
Granted, there can be reflexive effects here and the order of this information can change during different market cycles, but for the current market environment this appears to be a decent representation of the chain of causality.
To properly analyze the inflation question, it is helpful to first answer which timeline we are answering the question for. Therefore, this leaves us with 2 questions to answer about inflation instead of 1.
Cyclical (less than 1 year) inflation measured by CPI:
Structural (greater than 1 year) inflation measured by CPI:
Cyclical CPI:
Cyclical inflation, as measured by CPI, is what most market participants seem to be concerned about because they intuit that if inflation comes down to the Fed’s target, then this period of high inflation is over, and we will go back to the pre-covid world with asymmetric downside risk (i.e. deflationary pressure). However, what gets less attention because market participants are not generally looking at inflation as a multi-period dynamic variable, is the topic of structural inflation (inflation lasting a few years or more). Structural inflation is the longer term trend, that is more embedded in the current economic environment than cyclical inflation and I view it to be the more important question for long term asset allocation. For readers with an economic background, I am posing structural inflation as parallel to the long term growth trend in the economy while cyclical inflation is the business cycle around that long term growth.
CPI inflation has shown smaller increases this year due to a few different factors but mainly due to decreases in energy prices. Year-over-year energy prices have plunged from the highs (around $120 a barrel) of last year down to the current price of around $70 a barrel (over a 40% decline).
Source: Fred
This has happened due to global recession fears from central banks raising interest rates to combat inflation, continued major releases from the strategic petroleum reserve (down from 621M barrels in the SPR in September 2021 to 348M barrels today), and Russian oil being redirected to the BRIC nations (Brazil, Russia, India, and China) after it was expected that all Russian oil would come offline due to sanctions. Demand fears were exasperated by the regional banking crisis that happened in Q2 which led to OPEC restricting supply to keep prices around $70 a barrel for most of the quarter.
Strategic Petroleum Reserve:
Source: Y-Charts
Oil prices coming down has been the major catalyst for CPI to increase at a lower rate than it did last year, with CPI now going lower than core CPI (which is stickier and less volatile).
Source: Y-Charts
Unfortunately, the factors that have caused oil prices to be depressed over the past 12 months are not long-term solutions to the energy crunch, which is currently driving most of the rise in CPI downwards.
If the labor market remains strong over the next 6 months recession fears will begin to wane which will remove the lack of oil demand narrative from the equation. The United States will not be able to draw from the SPR indefinitely, although it has already been drawn down further than most thought would happen. Last, with the BRICS nations pushing for their own currency that is backed by gold, this releases some of the demand for US dollars to buy oil with which should put a longer-term downtrend on the value of the US dollar. If the value of the US dollar goes down, that increases the cost of oil in US dollars.
Structural CPI
Structural CPI is more important for strategic asset allocation than cyclical CPI but understanding the forces of structural CPI requires longer term analysis of the forces driving the economic landscape. While cyclical CPI is on a downswing, looking at historical context and the current environment, it appears that there is asymmetric upside pressure for inflation to persist longer term.
The first reason for this is that the United States is running a budget deficit around 6% of GDP and is forecasted to average a budget deficit of 6.1% of GDP, or around $2T per year for the next 10 years.1
Source: Fred
Fiscal spending is inflationary in nature and with monetary policy at odds with fiscal policy, the government is rolling over its debt into higher interest rates which increases the deficit further. Here is a look at the interest expense as a percentage of GDP.
Source: Fred
These interest expenses will serve as direct payments to savers which will increase demand throughout the economy, and further increase deficits that need to be financed, essentially snowballing.2 The last time the government ran fiscal deficits as a % of GDP this large for a sustained period was during WWII. To control the issue of a runaway deficit and bring debt/GDP back in line the Fed of the 1950’s ran yield curve control where they kept interest rates much lower than the rate of inflation, essentially defaulting on the government debt in real terms. However, this time the Fed is using its toolkit to try and bring down inflation by raising interest rates rather than keeping them below the rate of inflation. This policy is fundamentally at odds with the policy ran after WWII which was used specifically to control for the enormous fiscal deficit. This policy might deliver the worst of all words considering the Fed’s low interest rate policy most likely is not a main contributor to goods inflation (which is what they are currently trying to fix with high interest rates) but rather asset price inflation, which you can read more about hereMARKET UPDATE3. The Fed is targeting goods inflation indirectly through reducing the wealth effect, but fiscal deficit spending is the problem that directly contributes to money in the economy and that is showing no signs of slowing.
Unfortunately, with fiscal policy at odds with monetary policy, we get higher interest rates on our debt combined with the goods inflation effects of deficit spending. This policy may eventually lead the fed to having to become the main purchaser of government debt in the future, which would be the equivalent of helicopter money. This would be highly inflationary policy that would be the exact opposite of what the Fed is trying to currently accomplish.
The second reason is that the world is increasingly changing their supply chains away from China due to political pressure. India and other emerging markets such as Mexico are the main benefactors of these changes. For example, EY reported the following in June of 2022, “Leading industrial products manufacturers have also recently announced investments in the US and Mexico to shorten their supply chains, reduce risks, and position themselves closer to their North American markets.” 4 China provided the greatest deflationary force in the world over the past 30 years by allowing companies to import their low-cost goods and growing labor force from their economy. However, with the demographic issues in China and political tension between the western world and China post covid-19, companies are increasing turning away. This combined with a longer-term trend for the BRIC nations to buy oil in their home currency (reducing their demand for US dollars and strengthening their currencies) means that the US will be importing higher cost goods in dollar terms as the dollar weakens. Ultimately, the switching of supply chains and negative demographic trends of China are the removal of a large deflationary force at best and outright inflationary at worst.
The third reason there is an asymmetric upside pressure to inflation is the energy markets long term outlook. Over the past 30 plus years the world has focused on investing in renewable energy sources to try and phase out oil, but even with hundreds of billions of dollars in subsidies, renewables still account for a relatively small percentage of global energy supply.5 According to the International Energy Agency, “In 2022, renewable energy supply from solar, wind, hydro, geothermal, and ocean rose by close to 8%, meaning that the share of these technologies in total global energy supply increased by close to 0.4%, reaching 5.5%.”6 This means that only 5.5% of total energy supply is created by renewables, an astonishing low figure after decades of subsidies to increase this percentage. This leads to the inevitable fact that we are going to be reliant on fossil fuels much longer than we hear in the media and from popular culture today.
This fact is an unfortunate one for inflationary pressures because oil supply follows something called a Hubbert Curve, which is a method for predicting the production rate of any finite resource. When applied to oil it essentially means that oil gets more costly to find and drill as time goes on because all the easy discoveries are found first. Although the United States was able to delay this inevitable curve by discovering fracking, we are back on the descent of this curve.7
This reality combined with the fact that oil companies are now spending less than 40% of their cash on new drilling, whereas the long-term average used to be 100% reinvestment rate, we could see production become squeezed over the next 5 plus years.
With lack of reinvestment by oil companies due to political pressure to move away from oil and towards renewables, combined with production inevitably becoming more difficult over time, and renewables not living up to their promises, we are positioned to have more expensive energy for a longer period. This is inflationary in nature because energy is the fundamental input into most business and consumer spending. Ultimately, the Fed fought deflation from 2010 to 2021 with low interest rates and quantitative easing and the underlying factors that caused that fight to be deflationary have fundamentally changed. While we will most likely go through periods of higher inflation and lower inflation over the next 5 plus years, the pressure should be on the upside to inflation rather than the downside. The regime seems to have shifted in this post covid world.
Conclusion:
With CPI coming down on a cyclical basis but potentially not a structural basis, we could see the Fed have higher interest rates for longer. This bodes well for value stocks (low P/E ratio), high quality debt (low credit risk), and short duration bonds.
While it's important to stay informed and up to date with current events, it's equally important to approach news with a level head and avoid sensationalized headlines. It is always advisable to look at the bigger picture, to have a sound understanding of economic and financial systems, and to make informed decisions based on this understanding.
Here at K2 Financial Partners, our main mission is to help you reach your financial goals. If you have any questions or concerns, please don't hesitate to reach out to your financial advisor here at K2 Financial Partners. We are here to help you!
Sources:
1. The Budget and Economic Outlook: 2023 to 2033 | Congressional Budget Office (cbo.gov)
2. How Much Do Labor Costs Drive Inflation? | San Francisco Fed (frbsf.org)
3. K2 Financial Partners | MARKET UPDATE
4. Why global industrial supply chains are decoupling | EY - Global
5. Analysis of Federal Expenditures for Energy Development (nei.org)
6. Renewables - Energy System - IEA
7. Hubbert's peak prediction vs. actual oil production in the United States (ourworldindata.org)
8. Federal Reserve Economic Data | FRED | St. Louis Fed (stlouisfed.org)
The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. Past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss. Diversification does not guarantee a profit or protect against a loss.
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Consumer Price Index (CPI) measures prices of a fixed basket of goods bought by a typical consumer, widely used as a cost-of-living benchmark, and uses January 1982 as the base year.