In his 2020 investors meeting, the great value-investor Warren Buffett said: “American magic has always prevailed, and it will do so again”. In the 19th century, Otto Von Bismark, the great Prussian statesman credited with creating modern Germany, was quoted as saying: “There is a Providence that protects idiots, drunkards, children and the United States of America”.
Both men are still correct. There is something truly special about our nation despite periodic infighting within the family. It seems like whenever things appear to be at their worst, someone or a group of someone’s are figuring out the next “new thing” that propels us towards greater heights.
I started with these thoughts because it’s important to keep the long term in mind when we are facing near-term difficulties such as the declining market values of 2022 and the seeming chaos emanating from Washington DC. These are temporary difficulties that we need to transcend, nothing more.
Including dividends, the S&P500 is down 19.1% year-to-date, which is a far cry from the extraordinary returns we’ve come to expect since the Covid lows. While we’ve done better, I’m afraid we’ve slipped into negative territory as well. The chart below tells the story.
The stocks that we’ve been adding to our portfolios are ones that we believe can thrive over the next five years. In particular, we own stock in companies that continue to enjoy strong demand for their products. Unfortunately, it appears that we may be heading into a general “liquidation” mode in the markets and that may require more aggressive actions to safeguard client portfolios.
It is critical for us to manage through the “transition” stage where an old cycle turns into a new cycle. These transitions are often accompanied by pessimism and self-doubt by the majority and optimism by the few who prepared ahead of time.
The next most important thing for us to get right is having the right mix of companies for the future and that requires looking forward. It’s something we have spent quite a lot of time doing over the past six months and we’ve come up with these major themes that will propel the US economy over the long term. As such, we are optimistic that we are on the right path.
There are four major themes that we believe will dominate over the next five to ten years along with a fifth theme that we consider a potential serious risk. They are:
- Some manufacturing returns to the USA.
- US gets serious about energy.
- US agricultural sales are in a secular growth phase.
- China, Europe, and Russia enter a secular decline.
- A global war cycle is a possibility.
The construction of new manufacturing facilities has increased by 116% over the past year, led by semiconductors, aluminum, and steel among others. Companies such as Intel, Taiwan Semiconductor, Novelis, and Nucor are leading the way by building manufacturing plants to take advantage of the growing trend of moving operations back from China.
But this is just the start of what we expect to be a much bigger trend as corporations come to realize that China is suffering from a demographic crash and the extraordinary missteps by the Chinese Communist Party. More on that later in this piece.
The important takeaway is that the US is starting to get back on a sustainable economic path. Over the next ten years, I’m hoping we return medical technology, pharmaceuticals, metals, and high end technology manufacturing to the US. It will take years for the US companies to book higher earnings as a result but it will eventually follow. For now, there are companies that supply these industries that will see increased revenues and we hope to invest in those companies over the next five years.
Climate Change and Energy
Climate change is a topic that has turned into a crusade against carbon-based energy instead of a discussion of the optimal mix of energy sources to drive our country in the 21st century. At its core is a flawed study that seeks to connect rising CO2 levels in our atmosphere with rising world temperatures despite the fact that US temperatures were higher 100 years ago on average.
Abraham Lincoln once said: “I am a firm believer in the people. If given the truth, they can be depended upon to meet any national crisis. The great point is to bring them the real facts.” Going back to the 19th century, the US has kept detailed records about the weather, recording both temperatures and weather events across the country. These historic accounts were at odds with the global warming thesis until well-intentioned academics adjusted the temperature readings to “fit” their thesis. Such is the strength of belief in global warming.
Much of the blame for rising energy prices this summer can be laid at the feet of the climate change movement with the rest being attributed to the invasion of Ukraine. You could say that US citizens are bearing some of the weight of Europe’s over-reliance on Green Energy because we are forced to share our gasoline, diesel, coal and natural gas to offset shipments from Russia.
The blue line is the change in the price of gasoline that can be directly attributed to climate change policies. After February of 2022, it becomes a combination of Ukraine and climate change policies.
Americans were perfectly happy going along with the climate change rules until those rules started to impinge on their lives. My expectation is that Americans will send a new slate of Congressmen to Washington in November seeking a more balanced approach to energy policy and that is where we expect to find opportunities to generate returns for clients.
I expect that when we look back on the period from 2010 to 2022 we’ll see where the creative destruction of climate change policy allowed for a new energy platform that gives our nation a competitive advantage throughout the 21st century. We have what every other nation wants – abundance of oil, natural gas, coal, and uranium. We also know where solar and wind generation is viable. This will allow us to pick and choose the right energy mix for the needs of each region in our country.
If managed correctly, the US will have an enormous advantage over the rest of the world. We even have the semiconductor and sensor technologies that allow us to use these forms of energy at optimal efficiency.
Whereas nobody is happy when they fill up their gas tanks, paying close to $5 per gallon, there is actually a much needed benefit that coincides with the windfall profits accruing to energy companies – they’re getting their balance sheets cleaned up. From 2012 to 2014, companies grew recklessly, loading up on debt to buy shale oil properties that were never profitable enough to cover debt obligations. Since November 2020, these companies have been warned against making further investments in oil/gas properties such that they have temporarily become cash machines. When more reasoned energy policies are enacted in the future, energy companies will be in a good position to take advantage of these opportunities thanks to this unexpected period of high profits.
Green energy has largely failed in terms of cost, efficiency, and reliability but the technologies to produce green energy are anything but failures. I expect to see these technologies slowly incorporated into all forms of transportation and industrial production. Wind and solar are not appropriate for base load power generation because wind and solar are variable by nature. It’s not always windy or sunny. In fact, Germany has invested aggressively in both but the country is neither sunny nor windy. They’ve paid for capacity equal to 150% of their base load needs but only get roughly 10% of their daily needs from Green Energy when accounting shenanigans are put aside.
Germany gets the vast majority of its electrical power from dirty old coal and imports from France, which is largely nuclear. Because coal fired plants take 24-36 hours to start up and shut down, the Germans keep them running most of the time and simply disconnect them from the power grid on sunny/windy days. It’s a charade but a politically palatable one.
Climate change is an investment theme for us because we believe that Americans will vote to continue using carbon-based energy but with attention to conservation and efficiency which has heretofore been a low priority. But before we can act on future investment ideas, we’ll need to get past the current weakening of energy demand brought on by high prices.
Proponents of the climate change thesis seem to be happy with the result but I’m afraid they’re bringing on an economic downturn with these policies. A recession may not be primarily caused by higher gas prices but it will be a significant contributing factor. Below you can see the decline in demand for gasoline in the US due to higher prices.
We have an abundance of all three forms of energy and we know how to consume it in a clean fashion that does not hurt the environment. When coupled with a rapidly declining China, which is by far the biggest environmental offender on Earth, we should see a vast improvement in the environment over the next twenty years despite increased usage of fossil fuels.
Americans love big vehicles. During the 1950’s through the late 1970’s bigger was better because gas was cheap for much of that period. When technology improved allowing for the extraction of shale oil and gas, the pick-up truck and SUV became the choice for Americans.
Led by climate change activists, the Biden Administration has used Presidential authority through the USDOT to push through new fuel standards that increase 8% per year for model year 2024 to 2026, then 10% annually thereafter. Suffice to say, these standards are not popular with the average American.
We see opportunity in the used car market where people can purchase older vehicles in order to keep the traits they favor while spending on parts to return older cars to newer condition. There are companies we believe can profit from this trend, at least until we come to a national consensus on efficiency standards. Fortunately, our ideas have done better than the industry.
Electric cars are favored by the climate change advocates but I don’t believe they are ready for broad acceptance. Even with government assistance, they are still far too expensive for the average family and they are much less convenient and efficient than gasoline/diesel powered vehicles.
Ultimately, I expect the winning combination of vehicle to include both gas/diesel and electricity in a hybrid form but we won’t see a large assortment of such models for at least a year or more. For now, we like where we are invested.
I never get tired of expounding on the virtues of the US. Once again, we are the biggest and most efficient producer of food in the world and I believe the industry will be a good place to earn investment returns for at least the next few years.
Having recently completed some research on Chinese agriculture, my conclusion is that the Chinese will have to keep increasing their purchases of externally sourced agriculture products until they run out of US dollar reserves. At the core of this thesis is the observation that the Chinese people are rapidly losing confidence in domestically sourced food.
Some of this seems unbelievable but it’s been sourced from official Chinese agencies. For starters, 80% of Chinese groundwater is polluted and 60% of urban groundwater is heavily polluted. When I first read about this, I thought it had to be a mistake because groundwater is by definition filtered through many layers of earth. What I recently learned is that China has been pumping 16 billion tons of polluted industrial wastewater back into the ground each year.
The reason is that ground water levels have been dropping by 1-3 meters each year due to urbanization and agricultural uses. This has resulted in subsidence or the sinking of major cities of 11 centimeters per year. To prevent the problem of sinkholes across the country, they started pumping polluted water back underground. Because this polluted groundwater never gets filtered, the Chinese have destroyed their ability to safely irrigate crops using well water – forever.
As an example, in the Pearl River Delta, which is a huge Chinese industrial center, the groundwater contains 161 micrograms of arsenic per liter. This is 11X World Health Organization standards. There are whole villages in China known as “cancer villages” where as many as 80% of the residents have the same form of cancer.
Over the Fourth of July weekend, I saw a video that showed that China’s leading gourmet ice cream maker produced “ice cream” that doesn’t melt in hot temperatures! We already knew that mothers of Chinese newborns refuse to buy domestic baby formula because of toxic additives routinely added. This has resulted in outages of baby formula across North America and Europe this spring because Chinese middlemen were able to purchase all of the formula on the market.
In 2021, China got 20% of its food from outside the country and that appears to be going higher because China’s land has been so depleted that farmers have to use 5X as much fertilizer and pesticides to grow crops. With Ukraine, Belarus, and Russia no longer supplying agricultural fertilizer due to the war, China will be unable to produce food in many parts of the country.
This will also hamper food grown in South America which requires more fertilizer than North American farms. The result is that the US will be able to export ever increasing amounts of food for the next five years.
The chart below shows what I mean. We were fortunate to take some gains on previous positions early in the year and we’re looking for an advantageous entry point for more investments in this area.
It’s not just China that needs US agriculture, it’s much of the developing world. Countries throughout the Middle East and Central Asia import much of their food and historically Ukraine has been a major supplier for these developing nations. It won’t be long until a number of countries like Sri Lanka face starvation and the US is one of the only nations with the latent excess capacity to supply these struggling populations.
US farmers and agricultural middlemen have the ability to minimize global suffering and to do so by earning a profit for investors. It’s a win-win situation.
A year ago, I wrote about how demographic data is the best at predicting economic growth out of all other indicators. With this in mind, China, Russia, and Europe are headed for much smaller economies. Here’s a chart of Germany’s birth rate from 1800 to 2020. Keep in mind that a birth rate under 2.0 indicates a falling population.
China and Russia are experiencing similar, if not worse results. The Chinese and the Russians know they are in demographic decline and also know that they have a small window of opportunity to carve out a bigger piece of global influence. This goes a long way towards explaining why Russia chose to go to war in Ukraine and why there is a good chance that China tries to invade Taiwan in the near future.
This aggression has been good for our defense investments and will likely continue to remain a strong driver of revenues over the next five years. In particular, the US and its allies will need to replace the spent weapons supplied to Ukraine since February. The fighting also underscores the need for such advanced weapons as the Lockheed F-35 fifth generation strike fighter.
The biggest risk of all is if global trends devolve into a war cycle.
Global War Cycle
People who regularly study and practice cycle theory believe there are regularly occurring cycles of human contention that range from 8.8 years to 17.7 years all the way up to big conflicts that occur every 53.5 years. I don’t believe wars run on time but I do believe in cycles of human behavior that make periodic warfare inevitable.
The great Prussian military general and theoretician Carl von Clausewitz once wrote: “war is the continuation of politics by other means.” When we consider Russia’s “special operations” in Ukraine, it’s exactly as described by von Clausewitz. Russia spent decades attempting to bring Ukraine back to “Mother Russia” unsuccessfully so Vladimir Putin chose “other means.”
I’m afraid that the same option is being considered by the Peoples Republic of China in their desire to bring Taiwan under Chinese Communist Party control. Like Russia’s invasion of Ukraine, China’s attempts to take Taiwan are a terrible idea but as long as Taiwan represents a Chinese nation that is faring better than the mainland economically and socially, it’s a threat to the CCP. It’s the reason both Hong Kong and Macau were brutally subjugated.
Yet another flash point is Iran where the Israeli’s don’t want the Shia nation to develop nuclear weapons. We’ve been warned that a strike may occur at any time.
I pray that we don’t step over the threshold and make war inevitable but keeping a strong exposure to defense stocks is the right approach for now. Our focus has primarily been cyberwarfare and electronic warfare companies but many of these companies also supply weapons for kinetic warfare. Here’s a look at the performance of these stocks.
The global economy is heading for a fall as we have been expecting. China, Europe, Japan, and the emerging markets are getting slammed by rising interest rates, supply chain issues and high inflation. It’s going to get worse, perhaps much worse because global central banks have little choice but to raise interest rates to fight inflation.
We can see from the chart below that copper, which is very useful as an indicator of the global economy, is showing warning signs. In effect, the price of copper is telling us that the global economy is starting to fall apart, no doubt led by China.
In China’s case, they continue to experience lockdowns due to Covid because Chinese healthcare companies never mastered mRNA technology which has allowed US companies to rapidly develop vaccines. Chinese leaders can’t import vaccine because that would be an admission that they are not as technologically savvy as they want mainland Chinese to believe. This leaves them no other option but to lockdown cities when they get an outbreak.
Because China is a critical part of the global supply chain for manufactured goods, Chinese companies are unable to fulfill orders on a timely basis and when they do produce the goods for export, the global shipping industry is further thwarted by long waits to unload at ports. The result is that global companies have lost faith in Chinese production and are rapidly moving operations to other low cost venues such as Vietnam, India, and Indonesia to name a few.
This trend is bad but it gets worse when you consider that China imports 85% of its energy and more than 20% of its food. They need US dollars to purchase food and energy yet they aren’t able to bring in dollars because they can’t produce goods for trade. This is going to be a critical problem for China and it’s why I believe they will run out of dollars sometime in 2023.
If this happens, China will sink into chaos and they will export that chaos to much of the world.
I have long believed that Europe has been headed for a decline from developed world status. We can already see evidence that Greece and Italy are well on their way but this sharp economic decline is shifting to the core of Germany and France.
Energy is one of the primary problems for Europe because they have very little carbon-based energy besides coal. They have oil and gas in the North Sea, belonging to Norway and the UK but little else. This is why they have grown dependent on Russia over the past few decades and why I believe they are pushing the climate change agenda so aggressively.
Germany has made the worst moves by succumbing to political pressure from their Green Party and closing up their nuclear power plants in favor of wind and solar energy. As I mentioned earlier in this piece, they have roughly 150% of base load capacity needs in renewables but they don’t get enough wind or sun to generate sufficient energy. In essence, they have massive and expensive wind and solar farms that don’t produce much energy. This has destroyed their competitiveness in world markets.
Thanks to these energy policies, Germany has become dependent on natural gas from Russia. As such, the nation has been forced to conserve what little gas they can obtain in order to have enough to heat homes this winter. Conservation efforts include not being able to take hot showers or cool their homes in summer.
Besides lacking energy, the EU suffers from excessive regulation in just about every economic endeavor. Bureaucrats in Brussels and Paris try to micromanage everything such that they’ve made a horrible mess of the broader EU economy. This is why the UK was wise in breaking free from their grip.
We can see where the euro has been falling versus the dollar and is now close to parity for the first time since 2002. This sharp drop in the euro makes their inflation problem even more severe. I expect it to continue dropping versus the dollar.
Taking everything into account, Europe is headed towards economic irrelevance. I expect young Europeans to attempt to emigrate to more hospitable economic zones and ultimately, the end of the European Union in favor of regional economic blocs.
The GeoVest Approach
We believe the next ten years will be quite different than the previous ten years, particularly in relation to consumption versus investment. The Baby Boom generation is retiring and historically that has resulted in lower levels of consumption. The Millennial generation is in their prime consuming years but in general, they’ve been hampered by a lack of employment opportunities and high prices for housing.
Accentuating the move from consumption to investment, the global supply chain has been permanently broken by China’s inability to fulfill its production obligations for consumer goods. This will take some time to move production from China to other nations including the US. The result will be poor earnings growth for consumer companies as well as higher prices for some manufactured goods due to scarcity.
All of these factors suggest that we’re in for a period of transition in the economy and the markets. It’s our job to manage through this period and have our clients positioned for another round of prosperity once this inter-cycle period is over. Thank you and it’s our continued pleasure to serve you.
Philip M. Byrne, CFA