The Year Ahead-- Looking Beyond 2023
At this time of the year, traditional year-ahead forecasts emanate from “Wall Street. Our Commentary, in two parts, will first look into next year. Then, more critically, beyond 2023 to take advantage of long-term investment opportunities created by ongoing economic uncertainties and financial market volatility.
The period post COVID and February 24th—the Ukraine war--will likely produce geopolitical restructuring that will result in an economic and investment environment that will differ importantly from that experienced during the last decade. The Ukraine war will likely bifurcate or better still trifurcate global political and economic forces. The remainder of this Commentary will try to outline some key changes that could result and the investment opportunities.
Not only currently, but In this decade, the key supply shortage will prove to be labor. This decade the U.S. will experience the slowest workforce growth in fifty years. That growth rate will still look positive when compared to actual declining workforce numbers in other major countries and regions (see Figure 1.) Over the next ten years, China’s long-term workforce decline will likely limit its future role as factory to the world. Low priced imports, such as those from China, contributed to a 40% decline in U.S. durable prices over the period from 1995-2020. With that change, globalization’s contribution to bringing down inflation will also be muted. With the supply-chain lessons learned during the pandemic as well as from China’s zero-COVID policies, many corporations will gradually right-shore a growing proportion of their Chinese supply-chains to either other low cost Asian countries or to regions outside of Asia. This shift will not likely be either rapid or easy due to the complexity of global supply chains. Nonetheless, the trend away from globalization will likely speed up (Figure 2.) Of the regions outside of Asia, North America, with the largest consumer market, will likely receive the greatest benefit from this shift. Reshoring new facilities to this region will increase the resilience and mitigate future risk for corporate supply lines. At the same time, best cost strategies will also be adopted to efficiently manage inventories using shorter supply lines. Limited U.S. work force growth will also force increasing capital investments focused on automation and information technologies. Labor intense industries, however, that cannot easily adopt automation technologies, will likely shift their production from outside North America to Mexico. North-south transportation systems will likely see substantial growth from Mexican trade over the next decade.
Population Change Aged 20-64 (2020=100)
Source: Natixis, The Daily Shot
Trade as a Percent of World GDP
Source: World Bank, NY Times
For some perspective, between 1816 and 1945, a state disappeared every three years from invasions. By sending his tanks across the Ukrainian border on February 24th, Putin ended the thirty year period of relative peace that followed when the Berlin Wall fell in 1989. With the Ukraine war, the world then split into three groups, developed democracies, the third world, and the two authoritarian nuclear powers—Russia and China. The trifurcation of the world will lead to a reduced form of globalization. U.S. Secretary of the Treasury Janet Yellen describe one form-- friend-shoring—in which the democracies build supply chains through their economies. In effect, it would mirror military alliances among the democracies such as NATO and those in the Pacific. Friend-shoring will increase the potential for supply chain and trade resiliency to offset reduced globalization over the next decade.
In the use of new technologies, the war in Ukraine resembles the Spanish Civil War of 1936-39. That war enabled Germany to test new military technologies and strategies which it eventually employed in World War II. In similar fashion, the Ukraine war will prove to be a beta test site for battle testing state-of-the-art weapons and information systems. The head of NATO’s Allied Command Transformation said, “Ukraine had shown how future warfare was likely to be fast-paced and highly contested not just on the ground or in the skies but also, most important in cyberspace.” Changes involve less human involvement at the point of battle with the use of drones—both air and naval—to carry the attack—countered by anti-drone weapons. Software will be developed to control swarms of attacking drones. As a result, similar to friend-shoring, the democracies will likely be forced to beef up military alliances and spending. The U.S. military spends nearly 2 ½ times that of China. However, Figures 3 shows China’s spending accelerating compared to the U.S. More specifically, U.S. total defense spending currently stands below its historical average as a share of GDP and will likely decline further relative to GDP (see Figure 4.) Comparable spending can be somewhat misleading, however, based on higher costs experienced in this country. For example, the U.S. spends nearly ten times as much as India for the same number of active troops under arms. No doubt, post-February 24th, the democratic countries will step up their defense spending with particular focus on new technologies. Domestic and non- U.S. suppliers of defense and cybersecurity equipment and systems will likely see substantial growth.
Top Military Spenders
Source: Global Futures
Defense Discretionary Spending (% of GDP)
Defense Discretionary Spending (% of GDP)
The 2022 Inflation Reduction Act (IRA) includes strong incentives for Green energy capital spending. Of the approximately $386 billion of Green energy spending, the IRA provides substantial tax credit incentives totaling $265 billion to kick start Green energy projects (see Figure 5.) This aggressive transition to clean energy will prove metal intense, particularly copper, compared to current sources of energy and transportation (see Figure 6.) In addition, the IRA provided nationalistic incentives to bring mineral sources and processing back to this country but also to friendly countries (see Figure 7.) According to McKinsey, globally, mining capital expenditures fell from roughly $250 billion in 2012 to $130 billion in 2020. To meet the so called Sustainable Development Scenario (SDS) in 2050, demand for key metals will need to grow ten times their current volumes. Whether or not demand growth eventually reaches that forecast, rapid growth of capital spending for metal supplies and processing facilities will be required to meet growing Green energy demands . Goldman Sachs Research estimates that from 2016-2020 annual capital expenditures on green energy projects totaled about $1.2 trillion. For this decade, the firm projects that spending of $2.8 trillion will ultimately be needed as a first step to reach a net zero goal by 2050. With the lengthy time it takes to construct metal mines and processing facilities, in our view, “picks and shovel” suppliers of equipment and services necessary to construct and maintain these sources will be the first to benefit.
Inflation Reduction Act Estimated Federal Tax Incentives by 2031 ($Bn)
Source: U>S> Department of the Treasury, Congressional Budget Office, Goldman Sachs Global Investment Research
Minerals Used in Clean Energy Technologies Compared to Current Uses
Source: International Energy Agency
Share of Processing Volume by Country for Selected Minerals (2019)
Source: World Bureau of Metal Statistics (2020), Adams Intelligence (2020) for Rare Earth Elements, International Energy Agency
Equities—The period post COVID and the war in Ukraine will likely produce forces leading to geopolitical and economic restructuring. These changes will lead to future economic and investment opportunities that could importantly differ from those experienced during the last decade. Therefore, while recognizing the current market risks, long-term investors should consider gradually taking advantage of attractive valuations on select quality investments that will supply the demands arising from these changes. The mark of quality companies include strong balance sheets along with growing free cash flow and earnings, and most importantly, as outlined in part I of this Commentary, growing dividends. In doing so, investors should seek out those sectors that will be benefit from the changes outlined in this Commentary including, but not limited to:
Energy— green, and nuclear suppliers but not forgetting fossil fuels necessary to maintain electric reliability and energy security during this transition.
Security—domestic and non-U.S. defense companies
Agriculture—"precision farm technology” and systems and equipment suppliers
Metals—meeting the growth of alternative energies and electric vehicles
Automation Technologies—supplying productivity improvements to offset global labor shortages
Fixed Income—With the end of zero interest rate policies, cash becomes a more important income generating asset. Employing cash, using short-duration Treasury notes and bills, should provide investors with both income and a counter against the high level of economic and financial market uncertainties. In the case of bonds, investors need to determine both how long they expect elevated inflation to persist and when and how deep the economy will slow. These two counterforces should determine the timing and allocation to longer-duration fixed income securities. As 2023 progresses and these forces evolve, lengthening bond duration will likely prove increasingly attractive. Alternative investments can also be used for that portion of the portfolio historically committed to fix income; alternatives tend to be less correlated with stocks and bonds. That diversification will prove particularly valuable with today’s high level of economic and investment uncertainties.
Private Equity and Venture Capital--Economic growth depends on both workforce and productivity growth. With slowing U.S. workforce growth, increasing productivity will be key to economic expansion. Venture capital and private equity should provide one source of answers to improving productivity—both information and automation technologies-- as well as rewarding to investors.
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