Ignore market noise and look to longer-term fundamentals
Roughly a month ago, on May 5, investors awaited news of a sweeping U.S./China trade deal, but instead President Trump shocked the world by announcing the implementation of incremental punitive tariffs, signaling an apparent breakdown in negotiations. When U.S. financial market futures opened for trading several hours later, the news was instantaneously reflected in market pricing, leaving little opportunity for investors to “trade the news.” This phenomenon, which we term “discontinuous pricing,” has become a persistent market theme over recent years (see first graph), as the real-time dissemination of every bit of market-moving news has squeezed the alpha generating capabilities from those investors who traditionally relied on reacting quickly to profit from an “information advantage.”
Rapid news dissemination and discontinuous pricing inhibits “Trading the News”
Fortunately, a straightforward solution can be found in this world of information hyper-transparency, which is that successful investing actually means that people need to invest again, as opposed to trading news flow. Thus, the most effective portfolios are aligned to the large structural influences that are playing out across the global economy and that will drive the growth and distribution of future cash flows. Of course, we make some allowance for incrementally tweaking positions based on the headlines, and for hedging against extreme outcomes, but in short: longer-term cash flow is more valuable than news flow.
Accordingly, we place great emphasis on how the world’s major contemporary “battle-lines” are being drawn, and not surprisingly they are in the locations where future economic value is thought to exist, which is similar to historical experience. As a case in point, the wars of long ago often revolved around control of necessary resources: land, food and water. Later, the colonial wars of independence and revolutions, up until the early 20th century, can be seen as advanced versions of the same theme – a battle for trading routes, spices, vast tracts of arable farmland, and lastly industrial commodities. More recent history has seen numerous Middle Eastern conflicts, which isn’t surprising, given the incredible global reliance on oil. And since this region controls a third of global oil production, and can act as the world’s swing producer, the involvement in these wars by the world’s largest consumer (U.S.) was also no surprise. The arena for the “wars” of today and tomorrow, however, will be quite different, but the conflicts will continue to center around perennial themes of national wealth and economic potential.
Trade dispute not about soybeans, or natural gas: It’s all about tech
While some wars will still emanate from the energy patch, given the trillions of dollars of residual value that remains in oil, the future geopolitical conflicts will be explicitly technologically-oriented; around such topics as global spectrum usage, 5G connectivity, etc. Given the vast and indomitable value that is at stake over the future of technology, how it evolves, and to whom that value will accrue, it should not be surprising that this would become the next site of political and economic conflict. Indeed, the cash flow generation potential of these capabilities is seemingly limitless considering their asset-light business models, nearly immediate global penetration, and the invaluable services they provide to global consumers. The current trade disputes between the U.S. and China are, of course, at the epicenter of the battle. A harbinger of things to come can be seen by the fact that China’s imports of integrated circuitry have finally outpaced that of industrial commodities over the past decade (see second graph). Further, the stakes could not be greater for investors, for the appropriate positioning of their portfolios going forward, and for the need to embrace these big-picture realities, which is vital for success in markets today.
Tech services have become the battleground upon which economic actors fight
Accordingly, it’s useful to estimate the nebulous values of technological cash flows; just to get a sense for what’s really a stake here, a task that’s just as difficult as attempting to quantify the intangible value of existing technology. As a thought experiment, when services like GPS, and its app equivalents, like Google Maps or Waze, are free to use, how can their monetary value be calculated? One method is to estimate the consumer surplus that these services provide and to then estimate what consumers might be willing to pay for them. For instance, would the world’s nearly three billion smartphone users pay a nominal subscription fee to utilize GPS capabilities, similar to say, a Netflix subscription? If so, it implies that the enterprise value of GPS is well into the trillions of dollars. As for the internet as a whole, the numbers are even more staggering. Reasonable private sector estimates of the annual consumer surplus that accrues to internet users approaches $2,500 per person, which when married to modest assumptions about multiples, implies that the enterprise value of the internet today could be more than $200 trillion, eclipsing global GDP many times over.
Given this staggering context, it is a near certainty that the trophies for the winners of the “wars” for technological supremacy will be immense. But another significant macro consideration is the incredible dis-inflationary influence of these technologies. Whether it be agriculture, oil, retail, etc., the battles for economic markets nearly always result in reconfigured supply curves that are pushed out to the right, and are made significantly more elastic. Marrying that supply chain evolution with inherently deflationary technological innovation, and with the emergence of free consumer services (again, think Google Maps or Waze), structural headwinds to inflation are likely to be with us for years to come. As such, we see the Federal Reserve as increasingly pragmatic and adaptive, meaning we can comfortably own duration as a ballast to risk in our portfolios again.
The implications for investment
Considering these monumental structural trends, why are economists and investors still so intently focused on auto sales, retail sales, and monthly inflation readings, which may have been the drivers of economies, interest rates, and investment valuations of prior economic cycles, but are no longer as critical today. In fact, with real-economy volatility increasingly depressed on a secular basis, those traditional market signals are quickly becoming obsolete, in our view. Instead, contemporary investing needs to pivot off of where cash flow is going to be generated in the future, where debt is required to support it, and what factors could create volatility related to its pursuit. While headline economic volatility is quite low, disruptive influences abound that make security selection paramount.
Clearly, the “winners” going forward will be entities that have an ability to enhance their return-on-equity (ROE) with persistent growth in revenues and margins. Pricing power is the critical component of this equation. Just as ubiquitous information has squeezed the alpha out of financial market “fast followers,” so too has information transparency eroded the producer surplus of old-world businesses. Not surprisingly, technology services and healthcare sectors have enjoyed the steady growth that comes alongside pricing power, while the goods sectors are notable laggards. Devoid of pricing power, some goods-based companies have turned to increased leverage to boost ROE, but while leverage can help optimize one’s capital structure, leverage can also be a potential threat, if EBITDA growth and cash flow generation are not there to support increased debt levels. Therefore, we’re in search of entities that can strike the appropriate balance between durable pricing power and margins, and optimally levered cash flows.
We think these themes will dominate the macro investment discussion for many years to come and we are evolving our investment process accordingly. Along the way there will be bouts of uncertainty and volatility as the war for the claims on this massive future value unfolds, which the current episode of trade frictions clearly illustrates. As the markets endeavor to digest the next trade-related Tweet, we are staying calm and are confidently positioned in high-quality carrying assets, and where appropriate are adding equites via the sectors and names that will likely be the long-term victors. We continue to underpin this positioning with copious amounts duration, which has been restored as a highly dependable hedge that also carries well.
Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income, is Head of the Global Allocation Investment Team, and is a regular contributor to The Blog. Russell Brownback, Managing Director, is Head of Global Macro positioning for Fixed Income, and he contributed to this post.