Rather than write yet another short-term “Year Ahead” report, it might be much more fruitful to investigate secular investment changes. Market leadership always changes decade by decade, and the leadership of the past decade, which are now lauded as “core investments”, seem highly unlikely to be the leadership of the next decade.
Globalization has historically acted like an expanding and contracting accordion, and our long-standing hypothesis has been that the accordion is contracting. Politics both inside and outside the United States have been supporting our contention. Trade barriers, the fraying of alliances, populist governments, and even military tensions are all on the rise.
Chart 1 shows the Baker, Bloom, and Davis Economic Policy Uncertainty Index for Trade. There have been two periods of extreme trade policy uncertainty. The initial period of the early-1990s was the beginning of the modern period of globalization. NAFTA was implemented and there was significant uncertainty regarding the implications of increased global trade and flexible supply chains. Today’s unprecedented uncertainty (nearly twice the uncertainty associated with NAFTA) is clearly associated with the repercussions of the reversal of free trade.
Chart 2 shows the US trade balance. NAFTA certainly contributed to the deterioration of the US trade balance, but that was expected because of the opening of freer trade with more productive economies. Since 2008 (potentially the true end of globalization), there has been a noticeable change in the trade balance’s trend.
The balance may have deteriorated during the past two years, but the longer-term downtrend appears to be broken.
Some might consider our thoughts about the end of globalization as extremely bearish, but we view them simply as highlighting a potentially potent secular change in the global economy that could present significant long-term investment opportunities.
We are aware these themes may run counter to today’s consensus.
Market leadership will naturally shift if the global economy changes, but investors tend to be slow to acknowledge these changes and prefer to follow past momentum. Accordingly, here are several secular investment themes one should put in a portfolio time capsule to be opened on December 31, 2029:
1) Inflation
2) Emerging Markets vs. Venture Capital
3) Tech becomes dreck
4) Gold
Inflation returns
For the first time in the past 30-40 years, both US monetary and fiscal policies are explicitly pro-inflation, yet investors continue to largely shun asset classes that benefit from higher inflation despite this noticeable policy change. Few investors seem to be considering the combination of the upward inflation pressures of reduced globalization and the US’s current pro-inflation policies.
Economic theory suggests that globalization allows production to shift to the most productive regions, and that improvement in productivity increases competition which puts downward pressure on prices. In fact, globalization and global competitive pricing was one of the primary reasons US inflation was secularly lower than many forecasted. Chart 3 shows globalization’s downward pressure on US prices because core import price increases were consistently below the US Core CPI. In other words, the US has been “importing deflation.” The end of globalization implies less competition, production shifting to less productive regions, and upward, rather than downward, pressure on prices.
Chart 4 highlights that US productivity (measured by the OECD as GDP per hour worked) is not competitively strong. This further suggests a shift of production from more competitive economies to the US could result in higher inflation. The US simply does not have a modern enough and competitive enough public and private infrastructure to support a broad production increase without prices also increasing.
There are also shorter-term inflation pressures that investors are largely ignoring:
1) Current monetary policy is pro-inflation: The Fed has a dual mandate of low unemployment and stable prices, and the Fed just lowered rates three times. The Fed can’t be worried about employment because it is a mere 3.5%, which is a multi-decade low. Thus, the only justification for easing policy is to support higher prices. In fact, there has recently been some discussion within the Fed system regarding raising the Fed’s inflation target from 2.0% to 2.5%. We can never remember the US central bank ever suggesting a goal of higher baseline inflation.
2) Fiscal policy is pro-inflation: One must remember that tariffs, by definition, are always inflationary. The goal of a tariff is to raise the prices of imports so that domestic companies can compete on level ground. Raising prices on a broad scale is called inflation.
3) The five-year trend in core inflation is rising at the fastest pace in 30 years (see Chart 5).
4) The NFIB compensation survey shows US small companies are planning to increase worker wages by the most in 30 years (see Chart 6).
EM vs. Venture Capital
In several earlier reports, we highlighted that Empirical Research Partners’ analysis showed nominal flows to venture capital and private equity funds have now eclipsed the flows into US equities during the late-1990s Technology Bubble. There is also roughly $2 trillion dollars of “dry powder” (i.e., capital committed by investors but not yet called by managers) waiting to be invested globally in venture capital and private equity.
One basic rule of investing is that return on investment is highest when capital is scarce. These recent data suggest that private markets are not starved for capital. Rather, these asset classes seem historically flush with capital. Financial theory argues that the high returns historically associated with venture capital and private equity
are highly unlikely to repeat.
Charts 7 and 8 show how long-term performance trends can defy popular consensus. The first chart shows compounded returns for the Thomson Reuters Venture Index and for the MSCI Emerging Market Index from 2000 to 2009. 2000 (the start point in the chart) was the end of the Technology Bubble, but consensus remained that technology-related ivestments were a critical part of any growth
portfolio. Emerging Markets were at the other end of investors’ emotional scale because EM had suffered a series of financial catastrophes and were accordingly unpopular. However, Emerging
Markets subsequently outperformed Venture during the following decade by nearly 14 percentage points per year.
The situation was reversed by the end of the 2000s. Enthusiasm for Emerging Markets grew as the asset class outperformed, and by 2009/2010 Emerging Markets were considered a critical part of a portfolio. In fact, investors at that time were so enamored with Emerging Markets that many wouldn’t even consider our portfolios because those portfolios had little or no EM exposure. Technology related investments were largely unpopular because they had underperformed during the “lost decade for equities”. Venture Capital significantly outperformed EM over the subsequent decade by almost 20 percentage points per year.
Because technology-related investments significantly outperformed, Venture Capital is now once again considerably more popular than are Emerging Markets. Like the investment consensus in 2000, an allocation to Venture Capital today is widely considered essential by both institutional and individual investors.
There is no scarcity of capital in Venture Capital and returns are already starting to wane, but investors’ appetite for VC remains hearty.
Meanwhile, investors have largely shunned EM. It will be interesting to see how these two asset classes perform over the next decade, but history suggests that EM will outperform VC.
Admittedly, investors must balance the positive sentiment backdrop for EM with the potential negative of contracting global trade. Without being political, it is possible that the world simply
divides into the US and the non-US economies. The ongoing benefits of globalization might not be lost for EM in that case.
Tech becomes dreck
The Technology sector has been the biggest beneficiary of globalization.
No other sector has such dispersed global supply chains or broad range of consumers around the world. A significant contraction in global trade could demonstrably change the profitability and growth trajectory of the sector. Chart 9 shows S&P 500® sectors’ foreign exposures (non-US sales as a percent of total sales). Technology is the most foreign exposed sector.
A contraction in global trade could make growth targets questionable for foreign exposed technology companies, but it is even harder to envision analysts’ lofty growth projections for the largest technology companies if antitrust regulation and disruptive capitalism continue over the next ten years. Table 1 shows the 10 largest Technology and Telecom companies within the S&P 500® as of December 31, 1999, December 31, 2010 and today. Only four companies appear in every column. Although some of the movement within the table is attributable to M&A activity, the table nonetheless reflects how difficult it is to maintain high valuations over long periods of time when success is based on significant and constant innovation.
Gold
We’ve never been “gold bugs”, but it seems appropriate to hold gold if there is a secular contraction in globalization. First, as mentioned, limiting competition through trade barriers is inflationary and gold has historically hedged inflation well. Chart 10 shows that gold tends to appreciate as inflation rises. This certainly is not a perfect fit because there are many factors that influence gold prices. However, similar regressions for either stocks or bonds would yield a flat or negative relationship.
Second, our previous chart on trade uncertainty is one of many measures highlighting the current level of uncertainty is unprecedented, and gold has historically been a hedge against uncertainty and volatility. Third, gold could become a store of value in many parts of the world should the contraction in globalization become dire.
What’s in your time capsule?
Decades are all different, and the investment leadership in one decade has rarely been the leadership in the subsequent decade. We think the biggest investment theme over the next ten years could be the end of globalization.
If we could bury a time capsule and dig it up in ten years, we’d put EM and inflation-sensitive assets in that vault. There’s no guarantee that these themes will work, but we’re confident that the world will look
quite different at the end of the next decade and today’s popular investment themes (like venture capital, technology, and deflationary investments) will ultimately prove inappropriate.
Richard Bernstein Advisors is a participant in the ETF Strategist Channel.