Dear Clients and Friends,
This year’s first 7-month stretch for the US stock market felt too good to be true and it turned out that way. Starting in August, we saw some major dousing of the bullish fire that investors had lit under AI stocks and that had started to spread more broadly. However, exiting the year with a positive return, I think is still the base case for most investors even if they are not “top-heavy” in the Magnificent Seven – Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta Platforms. An equal weighted portfolio of these seven stocks has rallied 83% year-to-date, compared to the broad US market as measured by the S&P 500 having returned just over 15%, including dividends. And that 15% includes the magnificent 7! Taken together, the other 493 stocks are essentially flat.
So why not just own The Magnificent 7 and call it a day? Well, that portfolio was hot going into 2022 as well and subsequently lost half its value in the ensuing 12 months. Starting on January 1, 2022 through today, the Magnificent Seven only modestly beat the market and that came with some stomach churning volatility.
Interest Rates: Are We There Yet?
Why has sentiment turned sour and the market south since the beginning of August? Blame the Federal Reserve. Rewind the clock six months and the consensus among investors was that the Fed was done hiking interest rates, and we could look forward to an easing of rates in the not too distant future. Alas, Fed chairman Jerome Powell kept repeating his refrain that rates could go a bit higher yet and stay there for a while, as high inflation was not quite extinguished yet. Moreover, the economic data coming in has been mostly positive, further underpinning the Fed’s confidence in focusing on inflation instead of the other side of its dual mandate: unemployment. Markets seem to have finally gotten the message.
But does it matter that rates may tick up another 0.25% above 5.5% and stay there a few months longer than anticipated? I think it is a case of “Are we there yet?”. Anyone who has young children, has ever been around young children, or was once a child – did I leave anyone out? – knows the agony of being close to, but not quite at the desired destination. “Almost” just doesn’t cut it. Case in point, on a recent road trip my 5-yr old son asked me “are we there yet,” to which I excitedly replied: “2 more minutes!” His response: “oh man, can you let me know when it’s 1 more minute.” But we will get there – to the end of the rate cycle – and if you are more patient than most, this could very well be a good time to buy some interest rate sensitive investments like bonds, Real Estate Investment Trusts (REITs), and utility stocks and wait for the tantrum to pass.
Emerging Markets: No Longer All About China
Typically, I recommend that clients have exposure to emerging markets to capitalize on the high growth rates of developing economies and to diversify US stock exposure. However, from time to time I have taken a pass on investing in emerging markets for certain clients who are not comfortable with owning Chinese stocks for various reasons including poor corporate governance, environmental concerns, human rights issues, and geopolitical considerations. Investing in emerging markets has traditionally meant investing substantially in Asia. Roughly 80% of the emerging markets indices is allocated to Asia and 50% to just China and Taiwan. Investing in emerging markets has thus been analogous with placing a big bet on China and its sphere of influence.
A decade ago, that east Asia tilt sounded like a sure bet, with China ascendent and globalization at the height of its reign. Now, China’s long and stellar rise seems to finally be succumbing to the gravitational pull of a rapidly aging population, increased regional competition, in terms of both cheap and skilled labor, and a global economy that’s reassessing the business & political risks of being overly reliant on China. This is not all bad news for emerging market investors. China’s problems have been well signaled, and its stock market is priced at fairly pessimistic valuations. Any improvements in sentiment, notwithstanding its long-term challenges, could quickly reprice Chinese stocks higher. But more importantly, if China is no longer the only game in emerging markets town, investors ultimately have greater choice, as the geographic opportunity set increases. Interestingly, this year Mexico surpassed China as our largest trading partner. Its proximity to the US, cultural ties, and lack of geopolitical rivalry make it and perhaps Brazil and other Latin American economies viable substitutes for reconfigured global supply chains. Today, excluding China from your emerging market exposure seems increasingly feasible. Excluding emerging markets from your portfolio, however, seems increasingly like a missed opportunity.
The Money Side of Living to 120
The strongest predictor of life expectancy in the US is not BMI or blood pressure, or something like that, but rather your zip code. This is profoundly sad and was not always true. Too few Americans live to their potential life expectancy. However, what is masked by this dour state of affairs, is that our actual potential might soon be 30 years higher than it is today. A recent article in the Economist posited that living to 120 will soon be possible. From the few nonagenarians I know (of) and anecdotally from the stories of others, people in their 90s are perhaps less excited at the prospect of living to 100 than their cheering relatives and (younger) acquaintances. Tacking on another 20 years beyond that seems like a hard row to hoe, unless somehow, the 90s become the new 70s.
I am not a longevity expert, but I broach this topic because it has some really interesting financial implications. For one, if your retirement spending is smaller than the return on your investment portfolio, having another 30 years to compound returns would generate phenomenal wealth. Conversely, if one is worried about outliving their portfolio, how to survive financially for another decade or more past the century mark? It would seem that the wealth disparity will become even more pronounced and beckons a wholesale revision of how Social Security, Medicare, and inheritance taxation is structured.
An aging population would also further skew the ratio between workers paying into Social Security and recipients receiving Social Security. I feel strongly that Social Security will be there for my clients currently aged 50 and older. I think it is highly unlikely that Social Security will be cut when the Trust fund runs out in 2033 or soon thereafter. Social Security would still take in 75 cents through payroll taxes on every dollar paid out and I can’t conceive of a political party not springing to cover the gap. Cutting benefits by 25% would be political suicide, considering how a short-term kick-the-can-down-the-road fix would not be that difficult and considering how seniors reliably show up at the polls. But 25 years hence, the math might just get too hard to keep patching up Social Security and I would encourage younger workers to not rely on it to be a big component of their retirement income.
Clean Energy Acceleration
The next 10 years are going to see a profound change in our energy landscape. It is hard to overstate the scale and speed of this transformation. From a regulatory perspective, gas powered cars will be phased out in the 2030s. But my hunch is that car manufacturers and consumers are going to step on the gas, so to speak, and phase out the non-EVs much quicker. Afterall, who wants to spend $60,000 on a vehicle that will be phased out in a few years? In other words, I think there is a tipping point in the near future, where EV adoption goes non-linear. In my immediate circle, I think I might be the only one who doesn’t have an EV. What, you ask, the green guy doesn’t have an EV? My next car will be, I promise. Besides, not upgrading your car every few years is probably a happy choice for the planet.
The other big change is in the power sector. Today, fossil fuels represent almost 2/3’s of power generation, but according to Morningstar by 2032, 2/3’s of power generation will be carbon free. Wind will grow robustly, but the real mover is solar. Included in the carbon free energy is nuclear and hydro, which are not expected to grow much from today’s baseload and stay at about 20% of the power mix.
How to take advantage of the energy transformation from an investment perspective? Truth be told, investing in clean energy has underperformed the market in recent years. Even, as the Inflation Reduction Act and Infrastructure Bill added billions of dollars in government support to the clean energy sector. Even as renewable energy generation reached cost parity with fossil fuel power in ever more geographies. One lesson I have learned from investing in high growth areas is that high growth does not mean high profitability. However, if the high growth happens in industries with a few dominant players and high barriers to entry, that does mean high profitability. But even that is not necessarily enough. To earn market beating returns, that growth has to surprise the market and prove the skeptics wrong. Perhaps that is why Tesla is a standout green stock and – in many ways – the odd one in.
However, all things equal, it is much better to invest in growing industries than dying ones. So, I think the better lens to look through when assessing the clean energy sector, is the one that brings the losers of the clean energy transformation into focus. Dying industries are not a great hunting ground for superior investment returns, unless you are a proven vulture investor who likes to pick through the scraps. In other words, even if most clean energy companies will not earn a return that is superior to the market, companies in industries that are being replaced or disrupted will fare worse. Perhaps that is the greatest misunderstanding of green investing: it is not so much what you invest in as what you do not invest in because you see the writing on the wall.
As I look out of my office window, contemplating what to do for lunch, I see leaves falling and a cold sky that screams “Uber Eats!” Fall is in full swing, and the holidays are just around the corner. Some say it is a time to slow down, take stock, and enjoy time with friends & family. To me, it always seems like a time where things speed up, I have to sell stock, and I am trying to stop the busy calendar from encroaching on time spent with friends & family. Wishing you all the best and that you may end 2023 on a high note, at a slow pace, and in good company.
Jan P. Schalkwijk, CFA
JPA Global Investments