Investment Update, Third Quarter 2016

There has been no shortage of newsworthy events this year. We’ve endured terrorist attacks on multiple continents and a widespread epidemic, Zika. In a historic move, Britain voted to leave the European Union. The crisis in Syria continues to displace millions of people. Economic prospects in many countries around the world, including the U.S., seem even more dependent on accommodative actions of central banks than usual. As a result, every sentence uttered by a central banker has received extraordinary scrutiny. In this noisy atmosphere, it is critical for investors to remain focused on the important underlying, and sometimes less sensational, factors that influence investment outcomes. In this quarterly update, we thought we’d highlight some of the trends that shape our current portfolio construction and will likely influence our investment strategy for years to come.

The Intersection of Demographics, Productivity and the Fourth Industrial

Population aging is one of the most important demographic trends worldwide. Population aging is most acute in the more economically developed countries of the world. Typically, as countries grow wealthier, fertility rates drop. Population aging is also a large concern for the most populous country in the world, China, due to the one-child policy introduced in the late 1970s. Declining fertility rates, improved health and increased longevity are swelling older populations dramatically.

By 2050, the number of people 60 and older will increase from 900 million to 2 billion, going from 12% to 22% of the world’s population. By 2020, for the first time in history, people aged 65 and over will outnumber children under age five. Improvements in nutrition, sanitation and healthcare are reasons why most children today reach adulthood and why most adults reach old age. The longer you live, the longer you’re likely to live.

The demographics of aging pose a headwind to economic growth. This can be clearly seen in the long-term trend of dependency ratios. Dependency ratios reflect the percentage of people 65 and older to the working-age population (defined as ages 15-64). As the name implies, the higher the ratio, the more workers need to produce to satisfy the standard of living for all. Some of the countries that currently are among the largest contributors to global GDP are the most demographically challenged, including Japan and those in Europe.

Dependency Ratios


Economic growth is a function of labor worked and labor productivity. Growth in both labor supply and labor productivity have been weak in recent years. Weak labor supply growth is almost certain to persist since demographic trends are predictable and essentially irreversible in the short and intermediate term. Fewer births eventually lead to slower labor force growth and in some instances, even labor force declines.

That leaves productivity. Productivity is defined as output per hour. Productivity growth is the primary driver of a rising standard of living. From 1995 to 2005, U.S. real GDP growth was 3.4%. Since 2005, GDP growth has averaged 1.4%. The 1995 to 2005 period saw big enough productivity gains to offset demographic headwinds. However, these gains began to dissipate in the middle of the last decade, even before the financial crisis began. The current slow pace in productivity gains is puzzling since technology seems to be permeating our daily lives at an ever-increasing rate. Big advancements tend to come in waves. We think transformative innovations are on the horizon and we are optimistic about the next decade.

Three industrial revolutions have occurred over the past 250 years. Each has produced quantum leaps in productivity and standards of living. The First Industrial Revolution used water and steam power to mechanize production. The Second used electricity to create mass production. The Third used information technology to automate production.  

We are now on the brink of a Fourth Industrial Revolution, which was a major topic at this year’s World Economic Forum in Davos, Switzerland. The Fourth Industrial Revolution consists of a wide range of new technologies that combine the physical, digital and biological worlds. Intelligent automation will connect digital systems to physical systems creating autonomous solutions where machines make decisions and take action with no human involvement. It is in its infancy.

One example of how digital and physical systems are combining for improved productivity is warehouse automation. The rapid growth of e-commerce is placing pressure on fulfillment networks, not just for e-retailers  but for all retailers. Autonomous mobile robotic systems are being developed and deployed that combine physical characteristics with embedded intelligence and application software. These robots are overturning the business of storing, handling and moving goods among storage racks in distribution centers. They travel untethered at speeds up to 25 miles per hour, in aisles as narrow as 28 inches, storing and retrieving objects.

For retailers, the three big costs of distribution centers are labor, time and real estate. Robotic automation can cut labor costs by 80% and reduce the size of warehouses by up to 40%. These robot systems work 24/7 without breaks, functioning in “lights out” warehouses that require human intervention only for repairs and process issues.

Another industry that may be both revolutionized and disrupted by new technologies is the automotive industry. The car is arguably one of the most underutilized and time-consuming machines on earth. Cars are in operation for an average of one hour per day for a utilization rate of 4%. Considering that most of the time only one seat in the car is occupied, the utilization rate on a per seat basis is roughly 1%.

Globally, there are approximately one billion cars that each travel about 10,000 miles per year. At an average speed of 25 miles per hour, this amounts to 400 billion hours of time spent operating a vehicle and doing nothing else (other than being distracted talking on a phone). Another 100 to 200 billion hours can be added for passengers unproductively confined to an essentially unconnected car.

Three trends will likely converge to disrupt an automobile industry that has barely changed in 100 years. First, shared vehicles will move the industry from a privately owned and operated model to a fleet management model. Mobile technology and data management are already making this possible. Second, autonomous vehicles will eliminate the single biggest inefficiency, the human driver. Again, technology and data will be at the core of this transformation. And third, electric vehicles with better battery packs will become more efficient and more economical when used in the context of shared autonomous fleets.

Today the auto industry sells machines to consumers who buy parts, gas, insurance, parking and repairs year after year and then repeat the process every six years or so — all for the privilege of driving an hour a day. In the future, automotive transportation will afford consumers mobility while they pursue other activities. The car will become the fourth content screen alongside the PC, phone and TV.

The Fourth Industrial Revolution will be characterized by an acceleration of innovations, faster and broader diffusion of those innovations and disruption of many traditional business models. It will boost productivity growth and add to global market capitalization. Significant shareholder value will be created by first movers, enablers and disruptors.

Capital Markets Update

The S&P 500 Index generated a total return of 3.85% during the third quarter of 2016. This brings the year-to-date return to a respectable 7.84%. Importantly, the beginning of the third quarter marked a complete reversal in sector performance. During the first six months of the year, the two strongest S&P sectors were Utilities and Telecom, with returns in excess of 20% each. During the third quarter, these sectors were both down over 5%. They were the weakest sectors in the Index in the third quarter.

Conversely, Technology and Financials, which both lagged the Index in the first half of the year, posted the strongest gains in the third quarter.

The rotation in market leadership is encouraging. It is unusual for equity markets to rise with defensive leadership. More stable stocks such as Utilities and Telecoms tend to do best when fear is high and economic prospects grim. On the other hand, cyclicals such as Financials and Technology outperform when the outlook brightens and growth accelerates.

The latest batch of global economic indicators show the global economy is more or less stuck in secular stagnation. It’s neither boom nor bust. The third quarter was the first this year in which international markets broadly outperformed the S&P. The MSCI World Index generated a return of almost 5%, which brings its year-to-date return to 6.06%.

Ten-year bond yields rose slightly in the quarter to 1.59% from 1.47%. Yields fell to a low of 1.36% during the second quarter, having started the year at 2.27%. Globally, long-term bond yields have been moving higher, albeit gradually. We expect the same to occur in the U.S.