Wilmington Trust’s Capital Considerations with Tony Roth
Episode 45: 2022 Capital Markets Forecast: The Adaptive Brilliance of Business
Tony Roth, Chief Investment Officer, Wilmington Trust Investment Advisors, Inc.
Meghan Shue, Head of Investment Strategy, Wilmington Trust
We really spent the past decade using technology to become more efficient and more lean. Companies have been running with very low inventory levels using technologies and marketing techniques like dynamic pricing. This pandemic has been very eye-opening in terms of the vulnerabilities that can occur when you’re operating in such a lean manner.
TONY ROTH: That was Wilmington Trust’s head of Investment Strategy, Meghan Shue. Meghan and I discuss the second theme of our 2022 Capital Market Forecast, which is focused on the adaptive brilliance of business and how businesses are innovating and adjusting to take into account the resource disorder that we’re seeing around the world, both in terms of supply chains, as well as labor market shortages.
Welcome to Capital Considerations, the market and economic podcast that’s fully invested in your success. I’m your host, Tony Roth, Chief Investment Officer of Wilmington Trust.
We’ve certainly been on a wild rollercoaster ride these last two years and like all of us, businesses have been forced to adapt – sorry for the cliché – to unprecedented challenges. And in confronting these challenges, firms are turning increasingly to technology in order to innovate, solve their problems.
Joining me today to discuss our Capital Markets Forecast and how businesses are adapting in brilliant ways to the environment that they’re in and the ones that are doing so are successfully separating themselves from competition is our head of Investment Strategy, Meghan Shue. Meghan is a frequent guest on financial news outlets, including CNBC and many others. Thank you, Meghan, so much for joining us today.
MEGHAN SHUE: Thank you, Tony, for having me. It’s a pleasure.
TONY ROTH: Meghan, when we think about our Capital Market Forecast, which to remind everyone is entitled Economic Arrhythmia: Global Resource Disorder, it’s focused on the problems that have been occasioned by COVID, by the crisis in the form primarily of an excess consumption of goods, which is leading to problems from both a supply chain standpoint and then from a labor standpoint where, there are so many individuals that aren’t in the workforce that historically have been and probably would be had we not had this big disruption. All that comes together relative to businesses in global resource disorder. Whether it be stuff or whether it be people, there’s not enough out there for businesses to actually deliver to customers. And so, I think the place to start is to talk about these underlying trends and what are companies doing about it.
MEGHAN SHUE: Tony, you’re absolutely right and when we think of global resource disorder, we are really talking about pressure on both the demand side of the economy and the supply side of the economy, where the demand side is really the result of nearly $6.5 trillion of federal stimulus since the pandemic, consumer savings sitting at nearly $3 trillion above pre-pandemic trends. And then you combine that with labor market shortages that have really put strains on businesses in the manufacturing side, as well as the transportation and delivery and that’s where we get into these supply chain disruptions that we’ve been seeing.
So, companies have in some cases done a remarkable job of adjusting to these challenges and proving their resiliency. And in the short term, I would say it’s all about survival. So, take the chip shortage as an example, which we all know has wreaked havoc on the auto industry. companies like Toyota have had to cut production by 40% over several month periods. Other automakers, like GM and Mitsubishi have sent cars off the production line missing key technology features that we’ve become so used to, heated and ventilated seats, blind spot monitoring. So, companies have really had to make some difficult choices just to keep production lines running.
Other interesting kind of anecdotes that we’ve seen are taking a near-term hit to the bottom line in order to maintain customer loyalty. Peloton is an example. They, they’ve had some challenges of late. They’ve resorted to spending $100 million to ship their bikes by air, which is ten times their usual transportation cost.
And so, we’re watching all of these companies make these short-term, really sacrifices in some cases just to stay relevant. Longer-term, there are some interesting trends that are taking place where there’s a, really a re-shift and a re-think of priorities.
TONY ROTH: So, let’s talk about what companies are doing to try to provide some immunization in a sense from these kinds of problems that might occur going forward, whether it be dislocation from a China problem. Situation seems to be getting worse there. Or whether it just be more unexpected events.
MEGHAN SHUE: The longer-term strategy is changing. We really spent the past decade using technology to become more efficient and more lean. Companies have been running with very low inventory levels using technologies and marketing techniques like dynamic pricing, where they change the price based on real-time changes in demand, to run these just in time inventory models. This pandemic has been very eye-opening in terms of the vulnerabilities that can occur when you’re operating in such a lean manner.
TONY ROTH: And, you know, I wonder how much money do they save by having the parts come in when you’re building a car or building some type of electronics that might have hundreds of parts in it if they come, if the parts come in a week instead of a month before they’re actually going to be assembled, how much money they’re really saving by doing that. And they’re creating a lot of risk, right?
MEGHAN SHUE: Absolutely. And it depends which type of inputs you’re talking about. Some of them that might have fewer substitutes, companies will look to hold a higher inventory level of going forward. And that’s all been illuminated by this pandemic and how risky it can be to run that lean.
So, what we’re seeing is really a shift from just in time inventory models to what we’re calling just in case inventory models. Those key components that there are no substitutes for, or you cannot produce the good without it, you’ll hold a higher inventory level of going forward.
TONY ROTH: So, what is the best way, Meghan, that companies actually create, if you will, that redundancy in a supply chain? Is it by vertically integrating so that they have more control over the components? Is it moving the creation or manufacturing of those components closer to home? Is it just creating more of a cushion in the time between which the components arrive and when ultimately they go into the assembly process?
MEGHAN SHUE: I would say probably all of the above, depending on which industries you’re talking about. Technology is a key part of it, and we’ve had a number of technologies that have really opened up the ability to have transparency in supply chains. And I think that transparency is really important. and also the redundancy. Think about the ability to automate. We were following a rocket manufacturer. So, this is a very complicated thing that they’re making, a rocket. And yet, they’re operating through the use of 3-D printing, cloud technology, AI, robotics. They’re operating and producing these rockets with a single person in the manufacturing facility and that I think removes a lot of the risk that we’ve seen from disruptions in the labor market.
You also have things like blockchain, Blockchain has some really compelling applications for the supply chain where it can increase transparency, increase security at different nodes of the supply chain. That’s another risk reduction method.
If you think about goods coming off of a ship and having to be signed for by a person, there’s a lot of room for error. For fraud and theft, frankly. And so, these technologies are allowing companies to have more visibility into where their products are at every point on the line.
TONY ROTH: Well, it’s interesting, because not only is it going to provide more durability in the supply chain, but it actually, from a quality control standpoint anytime you can eliminate, discretion of a human being you are, assuming that the automation is set up correctly, you’re enhancing the quality of the output and minimizing the variability of the output. We can’t talk about this without touching on China. And one always worries that the situation in China goes downhill quickly. And what are companies doing to potentially diversify away from China?
MEGHAN SHUE: China is a key node of the supply chain network, the manufacturing network. And the pandemic, coming right on the heels of a trade war with China, has really exposed the vulnerability, not only of the US but of the world to China and having too much concentration, whether it be of manufacturing or assembly or distribution coming from China.
So, just a couple of stats that I find very compelling, some you might be aware of already. China provides nearly 80% of the world’s rare earth elements, which are key inputs for a number of forward technologies. They produce 70% of the acetaminophen and 80% of the blood anticoagulants used by the US. So, a real pharmaceutical reliance on China, as well as accounting for nearly 30% of global manufacturing output.
So, this is an area that we’ve quietly become very reliant on, and I think that the pandemic has been very illuminating in terms of the need to monitor and reduce that risk going forward. So, we’ve seen early evidence of diversification away from China. It’s interesting. There’s a company, I believe it’s pronounced Kima, and they do onsite inspections and environmental audits. And they’ve seen a doubling of demand for their site inspection services in areas like Vietnam, India, and Bangladesh since 2019; whereas, China inspections have come down by 20%.
What we’re seeing is diversification of the supply chain. And, you know, there’s a, been a lot of talk over the years in terms of onshoring and bringing production back to the US, reversing the progress we’ve made in terms of globalization. I don’t really think of it that way. In fact, I think of it as the next phase of globalization, where you’re going to see more diversification, technology that makes the labor cost, the relative labor cost differential from country to country less relevant so that countries can take a more local operational presence in a particular area and reduce some of the risk that way.
TONY ROTH: When you think about the awesome scale, if you will, of global integration and the number of dependencies that we have on Chinese production. It seems almost inherently a unsurpassable hurdle to be able to really meaningfully diversify the supply chain.
For example, Apple, they’re so tied to China that while they’ve done a great job managing an incredibly challenging scenario and produce a good outcome for Apple so far, should the Chinese become quite isolated, you know, one worries about the potential for them to use these different levers to create significant disruption in the global economy. How much do you worry about that?
MEGHAN SHUE: I think it’s definitely a risk, particularly in certain industries. A lot of the technologies, chip manufacturing it’s become quite evident that there’s an uncomfortable reliance on China. And I think that the political environment has become very tenuous at best, and we will likely see companies and countries for that matter from a political perspective trying to reduce some of that risk and exposure.
But you, you’re alluding to an interesting point, which is that the Chinese consumer is still a bit of a goldmine for a lot of companies and too big to ignore, especially as we look at the Chinese consumer and the middle class specifically growing. So, I think we’re going to be seeing companies that have to retain a foothold in China in many cases.
TONY ROTH: Well, it’s going to be interesting to see what happens over time It’s something that we do keep a very close eye on, obviously, from an investing standpoint. Before we talk about portfolios and what we’re doing to mitigate the risks that we’re talking about, let’s just talk about companies and the labor market. How are companies dealing with these labor problems,
We know they’re doing lots of things to increase productivity. W hat are the other things that they’re doing to keep and attract employees?
MEGHAN SHUE: Yeah. Well, the first and most obvious is paying their workers more.
TONY ROTH: That always helps.
MEGHAN SHUE: So, we’re seeing that. That does help. It’s the first, usually the first step. And as long as companies are able to pass those price increases on to consumers, which so far they’ve been able to do, they can afford to pay their workers more. So, we’ve seen a number of companies in some cases significantly increase their minimum wage to keep up with what they’re seeing from some of the bigger companies like Wal-Mart and Amazon that have made very public increases in their minimum wages as well.
It goes beyond just salary though. There’s been sweetening of benefits as well, expanding benefits packages, maybe including educational support as well. And so, that’s all kind of in the pay bucket.
The second is really how companies are using technology to enable their workers and have them be happier, more productive. So, think about Target, which just put out an app for all their workers to more easily and quickly see and change their shifts, to be able to get visibility into when they’re working. And just a small thing, but something that can really improve the experience that workers have with a particular company.
Remote work is also something that we ourselves are all grappling with and familiar with. And I think companies are really using this as a bit of a way to sweeten the pot, if you will. And what I mean by this is giving workers the ability to work hybrid or work fully remote in some cases and allowing them to work in more affordable parts of the country but paying them on a nationalized pay scale. So, that is a real benefit to somebody who can lock in a remote job and work in a less expensive part of the country but get paid the same amount as anybody else.
TONY ROTH: Yeah. You know, we had a recent podcast with Julia Pollak, the Chief Economist of ZipRecruiter. We spent a lot of time in that conversation highlighting the idea that companies that are sort of beating the drum to bring their employees back to work are going to be the ones that probably lose out on long-term versus companies that are really exercising creativity around how can they create the kind of spontaneous collaboration from a remote configuration.
And it was really eye-opening to hear Julia talk about those kinds of strategies and techniques that companies are using to try to find ways to not only increase productivity and happiness but retain employees without having to increase their cost base.
MEGHAN SHUE: Absolutely. I do think this is a very pivotal point and the companies that can use those technological resources effectively, because that’s essentially what you’re talking about is allowing remote work through the use of technology, the ones who can do that effectively I think will be the most successful. But, of course, we can’t have a conversation about technology and labor without addressing the elephant in the room, which is that the higher wages go, and the faster technology develops, the more likely companies are to make investments to automate or digitize that, some of those roles that can be done with technology. A consumer goods company told our equity analyst that essentially as the price of labor goes up, it’s basically reduced the payback period of that investment. So, they can see the return on their investment for technology in automating some of these roles but some of them much quicker. And I think that’s the real risk and the balance that we’re going to be seeing with the labor market.
TONY ROTH: And it’s a great time for companies to lean into that type of investment, because ten years ago there were five unemployed employees that were searching for a job for every job opening in the economy. Today, the number’s 0.7. And so, from a political standpoint and a community standpoint, companies should take advantage of the window that they have to create that type of efficiency through automation when they have the coverage of having a relatively low unemployment rate in terms of job seekers that are actually employed.
MEGHAN SHUE: The other coverage that they have is that there is a lot of liquidity out there to fund these investments and I think that’s a key driver as well. We’ve got a ten-year treasury yield that’s struggling to gain much traction above 1.5%. Companies have the ability. They’re sitting on about $5 trillion worth of cash. They have the ability to refinance existing debt. The conditions are ripe for putting some of this money to work.
TONY ROTH: So, let’s pivot to where the rubber meets the road, which is the investment portfolio. How do we cope with trying to deploy assets in an environment where the equity market is at very high levels, high valuations; we, our forecasting rates to go up at the ten-year level, sort of a benchmark point on the yield curve; and, therefore, bonds are relatively unattractive. So, the typical 60/40 portfolio probably not going to work in some of the scenarios that could be problematic for the markets.
So, how do we invest portfolios to take advantage of our base case forecast, which is a nice growth period ahead of us, soft landing in GDP sort of settling into maybe a 3.5% growth year for next year and even the year after, with moderating inflation. Yet at the same time, we could have a higher inflation environment. We could even have a stagflation environment if the supply chain problems don’t resolve themselves, as we sort of expect them too. But we could be wrong. How do we deploy assets in a situation like today?
MEGHAN SHUE: We use the economic cycles as a foundation for how to think about framing portfolios. And so, in that context we are in a decelerating economic phase. And the next phase will be crucial, because we could either reenter acceleration, so a reaccelerating economy, or move into an early contraction or a recessionary period. And our best thinking is that we will be continuing this expansion.
I think what’s really key is that while we are decelerating, we are decelerating off of very, very elevated levels for growth and earnings.
MEGHAN SHUE: So, in decelerating to above trend levels of growth at least tends to be a very favorable environment for equities. We also see inflation as coming back down to more normalized levels, think 3% on the CPI by the fourth quarter of next year. And so, in that environment that high inflation receding also tends to be favorable for equities.
So, we have an overweight to equities right now. But in this particular place where we find ourselves, you know, at a crossroads in a number of different ways, diversification is incredibly important because there is a very big spread between the returns of different asset classes in an early contraction period versus a reacceleration period and that tends to be a switch that can happen very quickly. So, while we have our view, we recognize that there is I’d say, you know, from a statistical point of view a fatter tail, so a higher probability of some more extreme type of scenarios, whether it’s inflation or growth. And I think in that scenario you just have to be really careful to be diversified, get exposure across asset classes.
So, while we’re overweight to equities and underweight to bonds, you don’t want to abandon your bonds.
TONY ROTH: It’s important to recognize that if we did have a unexpected poor outcome for the economy, municipal bond portfolio, we’re potentially a taxable bond portfolio should hold up relatively well, because while credit spreads might expand, on the other hand we would expect rates to stabilize and ultimately go down and that would provide a tailwind to the valuations of the bonds that have already been issued that are in client portfolios. So, the diversification really does work in that sense.
The other area of diversification that for our clients that qualify that’s critical are the private market offerings that we have, where at any point in the investment cycle there are really interesting opportunities to take advantage of, on the one hand it could be growing companies, growing disrupters across the economy, and where the economy may be suffering, distressed companies, whether it be on the equity or on the debt side. Let me ask you within the equity market given our base case scenario for continued economic growth, moderating inflation, where do we think the best opportunities? Is it here at home? Is it the Apples and Amazons and big tech companies still? Where do you think we should be placing our bets?
MEGHAN SHUE: So, if we’re thinking about the equity market, first on a – through a regional lens, we are overweight across both US and international economies. But we’re placing a slightly larger bet right in the international space. Valuations, at least in US large cap, are quite elevated. There’s a, not only a lot more room for kind of making up of lost economic ground in areas like Europe or Japan and the UK, but there’s also more attractive valuations. So, if we can get past the COVID-19 and the different variants, then we could see some potentially really nice returns over there.
If you’re thinking about this through a sector or a factor lens, we are still slightly overweight to more cyclical factors and cyclical sectors. So, on a sector basis, think about energy, materials, industrials, and financials, all which should benefit from continued economic growth, higher interest rates, maybe a steepening of the yield curve. But don’t forget about technology, because that’s what so much of our conversation has been about. So, on a longer timeframe, think about the structural trend that we’re seeing with technology. I think you have to participate there. We’re looking for areas of the tech sector that have a little bit more value, not the highest-flying companies that just don’t fit into our valuation framework. But there is a lot of opportunity over a three-to-five-year time horizon in the tech space.
TONY ROTH: Yeah. And if we go back a couple years to industrial revolution capital market forecast, we really emphasized the power that technology companies would have going forward, which has frankly only been accelerated as a result of the pandemic. And when you think about the rails upon which the economy operates, really almost everything we invest in today has a technology angle or a technology lens to it.
MEGHAN SHUE: Yeah. I would agree with that.
TONY ROTH: Let me summarize three takeaways from the conversation today. First, global resource disorder is not only a problem today, but it’s going to continue to be a problem for some time in the future, both on the supply chain side and the labor market side. The solution to this problem is going to continue to be technology. Companies will need to continue to use technology in creative and novel ways in order to manage things from labor market, supply chains to ensure that they minimize the risks that are imposed to their businesses, and they continue to service their clients as broadly as possible.
And that leads directly into our second takeaway, which is specifically on supply chains. And the idea is that companies need to build redundancy into how they operate their businesses, specifically as it relates to sourcing materials. And that might mean building from a vertical standpoint capabilities around duration and delivery of components closer to home. It may mean creating more inventory of components that ultimately go into the assembly of their products. Or it may mean creating plants that have redundancy so that if one plant were to become inoperative for whatever reason they could shift capability or production to a different plant.
Diversification continues to be a very important part of our approach to investing. We have a base case scenario that involves a soft landing in the economy, that moderation of inflation. There is a chance that we’re wrong here and if we’re wrong and we end up with a shorter economic cycle that leads to a contraction, we want to make sure that we hold onto bonds in our portfolio, cash in our portfolio, private markets in our portfolio, and that will provide a cushion in a downside scenario.
And we do think that given our base case scenario that having a market weight in technology companies that are formally categorized as such coupled with a cyclically oriented overweight in the portfolio is really the right way to invest, because as the economy eventually shifts back towards consumption of services to more economically sensitive areas of the economy, such as travel, leisure, finance, we would expect those areas of the economy to really outperform. So, that’s how we are positioned today.
So, with that, Meghan, I want to thank you so much for your insights. And you’ve joined many of our podcasts in the past and we look forward to having you again.
MEGHAN SHUE: Thank you so much for having me.
TONY ROTH: I want to remind everybody that you can find the entirety of our 2022 Capital Market Forecast on wilmingtontrust.com. I encourage you to download a PDF or read through the website. And, of course, lastly encourage everyone to visit wilmingtontrust.com, where you can subscribe to Capital Considerations, on Apple Podcast, Spotify, Stitcher, or your favorite podcast channel. Thank you all so much for listening today.
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