Thomas J. Pence
The Knall/Cohen/Pence Group
"When the whole world is globalized, you're going to be able to set fire to the whole thing with a single match" - René Girard
No retrospective of 2020 could possibly omit any mention of the tragedy and turmoil caused by COVID-19. However, to focus solely on COVID-19 is to miss the bonfire for the match. The last few years of dizzying globalization, urbanization, and digitization has created a disruption that dwarfs even the Industrial Revolution. The McKinsey Global Institute has estimated that it is unfolding ten times faster and at 300 times the scale of that previous revolution. The pace of change today is literally exponential and simply unprecedented.
Global Communication, Transportation, and Energy Networks
Scientific models often note how complex adaptive systems become more volatile the more they become interconnected,...vulnerable to very small 'butterfly effects' cascading through the system. Anyone who previously doubted the truth of that statement would have been flabbergasted when animal-to-human transmission of a microscopic Coronavirus somewhere in western China late in 2019 quickly led to the entire world being brought to a halt by the spring of 2020.
From another perspective, 2020 was the defining year of this new, hyper-connected network. Many traditional business models that relied on physical and human capital to achieve scale collapsed, while fluid digital models that could rapidly scale-up have accelerated in resonance with the volatility introduced by COVID-19.
This digital/physical bifurcation was exemplified in May when Zoom's market cap rocketed past the combined value of the world’s seven largest airlines.
If we have learned anything from 2020, it's that we need to dramatically accelerate the pace of our learning to match this rapid growth in our newly emergent system of interconnectivity. This will require us to discard stale approaches and orthodoxies of the past and to cultivate a fresh mindset for this new paradigm. The grand challenge for the year and decade ahead is whether or not our institutions of government and education and the very legal system which underpins our interactions with each other are up to the task.
As Paul Graham said,
“When experts are wrong, it’s often because they’re experts on an earlier version of the world.”
With respect to the governmental side of the equation, these times of rapid change resulted in unprecedented divisiveness across the political spectrum. Elected officials tried to coalesce various forms of unifying political messages to address confusion, unrest, and downright anger from the electorate towards the changes inflicted upon them from a globalized and hyper-connected world. As Yuval Levin wrote in a recent AEI article “It is the task of leaders in populist eras,.. to distinguish different kinds of complaints from one another as clearly as possible…They need to push to the side or disperse the power of those complaints that are rooted in fantasy, so that they don’t render populist movements pointless, ridiculous, or dangerous. But leaders (in populist eras) always confront the temptation to do the opposite: to elevate and champion fundamentally imaginary complaints while ignoring concerns that reflect difficult societal realities.” As Michael Pettis wrote about in his 2020 book “Trade Wars are Class Wars,” in this period of rapid globalization, the easy path taken by many world politicians and governments is to cast the disruptions brought about by such change as a result of “others” doing something to “us.” We believe, often the true cause of the problem is our own governments failing to keep up with the pace of change through effective policy.
With one more administration’s failure now behind us, the cards for the next 2- to 4-year political cycle have been fully reshuffled, notably, not without a shocking display of unprecedented insurrection for any modern era of American democracy. How these cards are dealt may well hold the key to how 2021 will unfold. It will be critical to watch how U.S. consumers and the U.S. economy move past the economic ravages of COVID-19 and how likely we are to learn from this great unforeseen event that came upon us in no small part due to the extent of hyper-connectivity in today’s world.
Any attempt to put this vast collection of conditions, changes, opportunities, and uncertainties into a concise outlook over a limited investment horizon poses an enormous challenge to the author and risks presenting the reader with a formidable volume of material to digest. Therefore, in the spirit of brevity and utility, we will attempt to narrow our focus to what we feel are the most pressing and urgent challenges and opportunities that are likely to present themselves over the next 12 to 18 months.
We think the most critical variables to watch are:
The role of government in our lives
If the implicit promise of the outgoing administration was to reduce the role of government with lower taxes and lower regulation, the incoming Biden Administration makes no secret of the fact that they are going to reverse that. The question is “when?” Consensus expectations (which rarely get it right) currently posit that the narrow margin in the Senate combined with a desire by moderates to get re-elected in 2 years will stand as a sufficient bulwark to any rapid re-regulation and taxation.
The fear here is that any quick moves risk snuffing-out the budding recovery that is underway with the arrival of COVID-19 vaccines. The logic of this approach is to hold back on any anti-growth policies until after the economy is back on solid ground. One key unknown is whether the Green New Deal or related environmental initiatives would be considered anti-growth or not. This also applies to any Environmental, Social, and Corporate Governance (ESG) initiatives that may be imposed upon corporations as part of a broader initiative to address climate change.
As we have written about before, ESG is an idea that has evolved from the Socially Responsible Investing (SRI) movement of 35 years ago to an updated and more activist mindset. This updated view calls upon both the investment industry and the corporations themselves to take a role in changing the behavior of corporations away from a single stakeholder focus (stockholders) to one that considers all stakeholders within our society. The premise of this movement was described by Coburn Ventures recently as follows; “We live in a devolved (failed) version of Capitalism. We all play a role in the system. Many are demanding that business, specifically, play an outsized role in fixing it.” The implications of this are many, but could include government-imposed restrictions on executive compensation, board composition, mandated wage/expense ratios, and restrictions on the use of cash flow and debt for stock buybacks. Last year was truly the tipping point for ESG with records set everywhere. ESG ETFs saw an incredible 1,000% growth over 2019 as per Bloomberg ESG Fund Flows and five of the top ten best-performing ETFs globally followed an ESG approach. We believe ESG asset flows and strategic influence are set to become an increasingly important part of the investment landscape, particularly as Millennials and Gen X investors become a larger component of investable assets. Additionally, while younger investors have historically shown the most enthusiasm for ESG, evidence from Empirical Research suggests that ultra-high-net-worth investors are starting to adopt similar levels of enthusiasm.
The ESG tipping point is clearly a consensus view. Indeed - as we assess the general consensus into 2021, a wonderful “bingo card” from Visual Capitalist outlined what the most common themes are from across 200 different sources.
Source: Visual Capitalist
The role of stimulus in our lives:
Since the 1930s, when the work of John Maynard Keynes became part of mainstream economic policy, governments have looked to fiscal policy as an important policy tool to counter the effects of a weak economy. When used, the question has often revolved around how much stimulus to apply and where to apply it. This time around, the answer to those questions was “lots of it” and “anywhere you can think of!” The chart below from Jim Paulsen at the Leuthold Group shows that the current tally of $10.4 trillion in combined monetary and fiscal stimulus amounts to 7X any level of combined stimulus ever applied in the modern era.
Additionally, several factors make this period unique from prior periods. For one, much of the stimulus went directly into consumer and business hands in the form of PPP loans, loan guarantees, and direct stimulus checks. For businesses that were still able to operate, this amounted to a windfall in a period of low expenses. For individuals who were able to continue working through much of the pandemic with dramatically reduced options for discretionary spending, the result was an unprecedented and rapid surge in personal income and savings. Combine all of this dry powder with the fact that this “recession” has unfolded more like a natural disaster (with rapid recoveries in jobs and wages) and you have a rare combination of strong balance sheets for consumers and businesses, low inventories in most businesses, and high business optimism.
All this points to a powerful coiled-spring effect that could release its energy into the economy late this year if lockdowns are lifted and normalcy returns. Keep in mind that this is BEFORE the additional $2,000 in direct stimulus checks promised by democrats in the Georgia run-off campaigns. To us, it is no wonder why U.S. equity markets have been rallying through the uncertainty, and specifically, why there was a powerful cyclical rally in stocks unfolding at the very moment that the walls of the U.S. capital were being scaled by rioters! One can only wonder what all this means for the role of future stimulus in the form of direct checks to taxpayers. When will subsequent pandemic-related checks be deemed to no longer be necessary? What about aid for those workers unwilling to come back to work? And will direct checks be a tool used to bridge the U.S. economy through all future economic downturns? As Ronald Reagan forewarned 40 years ago; “nothing lasts longer than a temporary government program.”
We think that a critical variable to watch is if government credit guarantees become more widespread or enduring. The importance of the idea that control of the ‘magic money tree’ has been transferred from central banks to politicians cannot be understated. This will likely become a tool that lawmakers will be extremely unwilling to relinquish. If developed governments move from temporary cash handouts to guaranteed local credit, you will have a mechanism for stimulating local economies that we have not seen in recent history.
The U.S./China Relationship:
One of the campaign themes of our outgoing President in the election of 2016 was that “China was ripping us off.” As crude and aggressive of an allegation as this was, it turned out to be mostly correct. Over the ensuing 2 years, most of the Congress and the country have come to accept this view. This led to a round of tariffs that began between our two countries starting in the spring of 2018. Since then, the relationship between these two superpowers has marched steadily downhill. The broad, bipartisan consensus today is that China does not play fair; keeping key markets closed off to the west. Links between the Communist Party and domestic businesses mean many “JVs” (joint ventures) or partnerships have too often been used to seize foreign market share or steal intellectual property. For their part, China has not been inclined to turn the other cheek in the face of these allegations. Quite to the contrary, they have taken it as an outrageous affront that the U.S. would try to lever its power in a unilateral fashion in much the same way it has overpowered smaller export-driven emerging market players in the post-Bretton Woods era.
Dan Wang of Gavekal recently posited that any administration that resolves to take on China in the aggressive manner in which the Trump Administration has chosen “must come to terms not just with a rise of its repressive capabilities, but also with its growing commercial and institutional strengths.” China’s response to U.S. trade aggression has been to double-down on their state-led approach and to call for renewed efforts by state-sponsored champions to innovate and develop their own tools and technologies. Like Japan after WW2, this initiative is massive in scope and amounts to a nationalist “Manhattan Project” to wean the country off its dependence on U.S. suppliers. Should this prolonged action by the U.S. continue, it could make it increasingly difficult for any U.S. manufacturer to make a case that they can be a reliable long-term supplier. In short, the train could be steadily pulling out of the station if the U.S. rejects future pathways toward compromise.
Meanwhile, jailing of pro-democracy advocates in Hong Kong have been on the rise, and strong rhetoric against U.S. military support of Taiwan has led many to believe that a showdown between an independent Taiwan and an expansion-minded China could become a more probable tail-risk event. Admittedly, the odds of such a showdown have likely increased meaningfully with the changeover of the administration in Washington, leaving Beijing unsure about U.S. resolve to intervene and defend Taiwan if provoked.
It is important to keep in mind that the issue is not solely about Taiwan’s critical geographical position, especially relative to Japan. If semiconductors are the building blocks for the modern economy, then a key point to consider here is that Taiwan leads the world in global wafer capacity. Taiwan also now has the second-largest financial system in the world, relative to GDP, and Taiwanese Insurers hold 14% of long-term U.S. corporate bonds. Although it has remained a potential flashpoint for decades, the events in Hong Kong and a recent escalation in rhetoric make this a tail-risk we will be monitoring closely.
Taiwan is the Geopolitical Problem at the Heart of Both the "U.S. Empire" and the "Chinese Empire".
The Digitization of Everything:
The past year could well be remembered as a year when so many prognosticators were unified, yet so very wrong about the direction of markets. With the onset of the pandemic, some of the most outspoken market strategists expressed certainty that we were heading into a major recession/depression that could slash earnings below 2019 levels for many years. Like so many times in the past, when consensus has united around a specific viewpoint, it turned out that nearly everyone was looking at the wrong thing.
The necessities of trying to maintain normalcy amid COVID-19 lockdowns created the conditions for many businesses and consumers to speed up the pace of their advance along the adoption curve of digitizing their businesses and daily transactions. In truth, this was already inevitable before the virus ever appeared. If the markets were undervaluing this digital transition before early 2020, then the staggering speed at which some of these businesses scaled-up as the economy shut down (in many cases at little incremental cost) made it abundantly clear to almost everyone how powerful this digitization cycle really was.
Before COVID-19, everyone was aware of how digitization had transformed the purchase of books, video rental, restaurant delivery, and gaming. However, by July of 2020, the power and imperative of digitization became much more evident to consumers across almost every possible industry vertical. Being able to work, to buy, and to do nearly everything from your home PC, phone, or tablet became an absolute necessity. Five years of forecast eCommerce transition was pulled into a couple of quarters. Almost overnight, businesses who had been under-investing in digital suddenly found themselves uncomfortably behind the curve. As Andy Jassey of Amazon Web Services stated at a customer event in December, “Ninety seven percent of corporate IT spending is still on-premise (non-cloud), so there’s a huge market out there to take advantage of.” He also made a strong case that companies must consider completely transforming themselves in order to “stay ahead of the game, to keep market share (and) to grow in a competitive environment.” The business-to-consumer (B2C) digital acceleration happened in plain sight, but the business-to-business (B2B) transformation has room to run for years to come.
In retrospect, it is likely that most of the 35% sell-off in stocks from late February through the end of March was a rational reaction to the likelihood that traditional businesses would experience a period of depressed revenue, earnings, and cash flow from what turned out to be a major cyclical dip in the economy. However, it’s also equally likely that the 71% recovery from the March lows to the end of the year came in part due to the realization by many investors of the incredible cloud-enabled digitization cycle underway that got an enormous boost in adoption from our collective experience with COVID-19.
The physical-to-digital dichotomy we have highlighted became even more pronounced, again at the expense of the physical.
The Recovery, The Dollar, Inflation, and Interest Rates:
The question on the minds of so many of our clients after election day was whether or not a change in party control would lead to inevitable headwinds for business investment, job growth, and GDP. Our answer consistently since election day has been “maybe,…but that’s really a better question for 2022.” In the meantime, there is a lot of recovery that we have to unpack.
While we had been expressing concerns since earlier in the year that a rollback of tax rates and regulatory relief for businesses could cause a headwind for earnings, investment, and hiring, that was always assuming that we would have largely moved beyond most of the COVID-19 complications by Q4. As it turns out, that part of our outlook was undoubtedly too sanguine.
Our current outlook for the next 12 months has less to do with who is in the White House or controlling the Senate and more to do with trying to calculate how powerful the recovery will be with the myriad of forces that will be working simultaneously to facilitate a recovery back to normal levels of activity. Given the pent up demand, massive stimulus and the current rollout of vaccinations, we suspect that any number of varying policy approaches could still result in a strong 2021 economic recovery.
As we have stated before, the stimulus alone sets up this recovery to be one of the most powerful on record. Not just the amount of stimulus (almost $10.5 trillion with the last bill passed in December) but the very type of stimulus in the form of direct payments to businesses and into the bank accounts of taxpayers. In addition, Congress is talking much more urgently right now about MORE stimulus early this year (possible as much as $2 trillion!) than they are about tax increases and the Green New Deal.
All this amounts to a tremendous amount of growth in personal income ahead (as high as 27% by some estimates), and a sky-high savings rate that rivals levels last seen when the country was coming out of WW2. Nancy Lazar of Cornerstone Macro thinks that the parallels to WW2 and the pent up demand that unfolded in that era is definitely a comparison worth thinking about. Cornerstone’s upside scenario anticipates GDP in 2021 reaching 7% if further stimulus comes through.
Of course, whenever growth is on the rise, we must be vigilant on the inflation front. Many assume that since the Federal Reserve (Fed) has committed to hold the line on rates through most of 2021, that we will see inflation increase well above critical levels of 2.5%, possibly causing a spike in yields. However, before we reach that point, it will be important to watch indicators like the unemployment rate (currently elevated at 6.7%) and the labor force participation rate, which has fallen off of its pre-COVID-19 levels. Both of these suggest that we have significant buffers in place before businesses can absorb all of this slack in the labor market and begin to put upward pressure on wages.
Lastly, the dollar will also be a key indicator to watch. A weak dollar could mean higher inflation while a stronger dollar would likely be associated with higher growth and higher interest rates. Most dollar watchers were alarmed by the fall off in the dollar once COVID-19 had firmly taken hold and U.S. markets had bottomed in late March. However, we suspect that most of this sell-off was related to the strong move the dollar experienced going into the pandemic as global investors made a flight to the perceived quality of U.S. Treasury bonds. If the dollar can continue to stabilize and the aforementioned slack in the labor force can keep inflation in check, we suspect that dollar price swings will mostly reflect the improving economic outlook in the U.S. relative to other world economies.
The Role (and Risks) of Equities:
The consensus view today is that stocks are expensive. However, the utility of that viewpoint to investors is somewhat limited by the fact that it has been the consensus view since the middle of 2016. The exceptions, of course, would be the dramatic sell-off in the stock market in December of 2020 (which quickly recovered) and the frightening decline in stocks in March and April of this year. Unfortunately, anyone hoping to take advantage of those periods had to contend with consensus views at the time that stocks should be avoided completely.
Nevertheless, this time, the evidence is there (or so we are told) that stocks are meaningfully overpriced and that growth stocks, in particular, are exceptionally overpriced. Mike Goldstein of Empirical Research notes that the top 75 stocks (by growth rate) are priced at P/E multiples that are 3.5x that of the market. And he suggests that the effect of record low real Treasury yields (-80 basis points) have had an outsized impact on growth stock returns as a low discount rate assigns a much higher value to longer term earnings. For tech in particular, SaaS names have seen their Enterprise value-to-sales multiples expand to 18x from 12x over the past 8 months while revenue growth has been steadily averaging 35% to 40%. A portion of this multiple expansion has been supported by the drop in interest rates, so if rates move higher, we could potentially see meaningful multiple compression here.
But what we believe is also clear is that many of these growth stocks have much more attractive investment attributes than most bonds and possibly even more than most other stocks in the market. As we have discussed with clients many times in the past, the market’s growth leaders today have significantly more attractive free cash flow margins than growth stocks at any time in modern market history. Empirical Research estimates that the free cash flow margins of the FAANG stocks today at 22% are over 3X higher than the free cash flow margins of growth leaders from the beginning of 2000. Many of today’s leading growth stocks have become asset-light, free cash flow generating machines that continue to produce solid revenue and earnings growth as aforementioned digitization themes unfold across the globe.
So while it’s ok to complain about higher P/E multiples on stocks today, we must remember that higher multiples at the start of a recovery (when earnings are often underestimated) are quite common. It is also quite rational for stock investors to assign higher P/E ratios to stocks when Treasury yields are at record lows. Keep in mind that while the forward P/E multiple on the S&P 500 today is at around 23x, ten-year yields are just a little over 1%. This compares to a P/E multiple of 24x back in the 2000 peak when the ten-year was yielding around 5%.
Admittedly, there is a strong case to be made that after leading the market in 2020, growth stocks could be poised to take a back seat to some of the cyclical sectors of the market that suffered the most under COVID-19 lockdowns.
While a rising economic tide will likely raise most companies as earnings recover, it seems logical that we could see outsized performance from sectors such as airlines, hotels, restaurants, entertainment, and leisure. Additionally, as the yield curve steepens with normalizing rates, the banks could be meaningful cyclical beneficiaries of businesses and consumers investing and spending in the post-COVID-19 months ahead. As the chart below clearly highlights, the outperformance of growth stocks over cyclicals is hardly a COVID-19-era phenomenon.
What we are facing today in global financial markets is indeed a unique confluence of so many factors interacting within a highly complex global system. As mentioned in the introduction, it is imperative that we adopt a rapidly evolving mindset for this new paradigm ahead. Never before in the career of most investors today have we been facing a recovery of this nature, that combines the secular forces of globalization, hyper-connectivity, secular digitization, and a globally synchronized recovery of the economies of virtually every trading partner on earth.
As these forces simultaneously unfold and interact, it may well reveal opportunities and challenges that we have yet to fully contemplate. The potential risks, while too numerous to fully list, include the potential for overshoots and overreaches by both the private and public sector as they seek shorter term solutions to the likely bottlenecks and inequities that unfold along the way. Such challenges could include a rising wealth gap, higher inflation, higher interest rates, greater regulation, burdensome taxes, and determining the proper role of technology in our legal system and culture.
Many technologists today do not fully understand politics, many politicians don't understand technology, and many siloed experts don't understand complex networks. That’s why a key challenge for us at The Knall/Cohen/Pence Group will be to remain focused on change dynamics as they are unfolding and determining their implications on our present and prospective portfolio positioning.
With over 150 years of combined investment experience at The Knall/Cohen/Pence Group, it is our intention to continue to provide and serve our clients with the necessary perspective and temperament for volatile times. While this means building portfolios that can harness the amazing growth potential that lies ahead, it also means keeping a meaningful position invested in companies with strong balance sheets, strong cash flows, and management teams that believe in thoughtful, measured investment. We will also strive to become increasingly diverse in our range of inputs and sources so we can flow flexibly with the river of the new network and avoid getting stranded in the shallows. We are excited for this journey into interesting times and for the opportunities that they surely hold in store for us all.
Thank you for another year of your trust.