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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management biweekly geopolitical report for September 23, 2024. I'm Phil Adler. For investors, it can be pretty easy to overreact to day to day market moving events. Confluence chief market strategist Patrick Theran Hernandez joins us today to discuss how a long term roadmap can help investors resist emotional decisions and why recognizing global mega trends is a key part of the process at Confluence. Patrick will be discussing today several of the megatrends you've identified and the implications of each on investments.
Phil Adler:But first, I want to explore a bit more the Confluence process. Recognizing global megatrends and having enough confidence to act on them requires research by experts knowledgeable about much more than just the nuts and bolts of financial markets. How does Confluence Investment Management deal with this challenge?
Patrick Fearon-Hernandez:Oh, hi, Phil, and thanks for having me on the program. And yes, that's an interesting question. First, I think one key for doing macro analysis is to have a team with a diverse set of backgrounds and a wide ranging curiosity. Here at Confluence, our macro team does tend toward academic backgrounds in economics, but we also all have a strong interest in international relations and political science, history, and and even science. That's important because the other essential part of macro analysis is the willingness to track a really, really wide set of news and information sources.
Patrick Fearon-Hernandez:Between us, we probably track more than a dozen newspapers each day, along with lots of newsletters and podcasts. We read voraciously, and we do deep dives into really big datasets with the idea that if you're willing to crunch the numbers like no one else, you can develop a strong sense of where the world is going, and you can see trends no one else is seeing, or you can just be ahead of them.
Phil Adler:And what defines a useful megatrend at Confluence?
Patrick Fearon-Hernandez:Well, I think of it as a big, long lasting investable trend that cuts across multiple countries and markets and is persistent enough that an investor can take advantage of it, either by working to manage the risks it imposes or by buying assets that might outperform because of it.
Phil Adler:Well, let's move on to several megatrends you've identified. One of them is income and wealth inequality. We see this in some of the well publicized statistics in America which display the widening gap between high earners and and workers who have difficulty meeting living expenses. Is this a US phenomenon or is it global in nature?
Patrick Fearon-Hernandez:Well, you're right that it's a recognized issue here in the US, but it's much bigger than that. As I mentioned in the article, several different policy trends and economic changes have boosted inequality, including efficiency policies to bring down inflation starting in the late seventies to big new innovations in information processing, which helped spawn the knowledge economy and gave highly educated knowledge workers an edge. These forces operated in many countries. And so to one degree or another, inequality has risen across the globe, especially in Europe.
Phil Adler:Is there one main reason for this emergence of income and growth inequality?
Patrick Fearon-Hernandez:No. I don't think there's just one thing. As I mentioned in the article, I think it was a confluence of different policies and developments that all arose over the last few decades and mutually reinforced each other, such as, 1, the efficiency cycle in which governments deregulated, cut taxes on capital holders, and reigned in social spending. 2, the victory of the capitalist West over the Communist Soviet Union in the Cold War, which seemed to validate and reinforce the capital favoring policies of the efficiency cycle. Number 3, the policies that the US used to maintain global hegemony, such as keeping the US economy open to foreign imports and free capital flows, all of which spawned a surge in globalization and deindustrialization, especially after China entered the World Trade Organization in 2,001.
Patrick Fearon-Hernandez:And 4, the information technology innovations mentioned above. I think all these forces and, innovations mentioned above. I think all these forces and others combine to create what we now recognize as a a great deal of inequality in the world today. Patrick, would you say the strong dollar
Phil Adler:promotes income inequality in the United States?
Patrick Fearon-Hernandez:Yes. One result of the free capital flows that the US has promoted is that the foreign exchange markets have become highly financialized. In the past, they may have been dominated by importers and exporters, but now the foreign exchange markets are dominated by big institutional investors and financial organizations. Those investors have poured capital into the US, driving up the value of the dollar. And because the dollar has become so expensive in recent decades, it's made U.
Patrick Fearon-Hernandez:S. Exports more expensive on world markets and made imports cheaper. All of which has helped throw relatively less skilled industrial workers out of their jobs and help the knowledge workers and capital owners who manage globalization.
Phil Adler:Is it fair to say that income inequality is the key reason for the rise of populism in the United States and around the world?
Patrick Fearon-Hernandez:Well, I think so. We don't pay attention to inequality for ideological reasons at all. We've only come to focus on it as we try to identify the root cause of today's geopolitical and social tensions. In our view, those who have found themselves at the lower level of income and wealth have begun to rebel against the well educated, well traveled, wealthy elites. They've begun to demand policies that cut the elites down to size and help the working class, and that's a decent definition of populism.
Patrick Fearon-Hernandez:Why is that important? Well, not only has populism fueled the political fortunes of both right wing and left wing populist politicians, but it's also begun to show up in policies. For example, it spurred the protectionist tariffs put into place by former President Trump and maintained by President Biden. We think this populism will continue to affect policies and companies and companies' financial performance well into the future.
Phil Adler:Now are there particular action steps for investors who recognize this megatrend?
Patrick Fearon-Hernandez:One example is the crackdown on free trade agreements among major countries. That, and the erection of new trade barriers, could hurt firms or countries that are reliant on international trade for growth. More broadly, we've argued that the populist crackdowns on free trade has helped spawn shorter, less efficient supply chains around the world. One result of that is likely to be higher and more volatile inflation and interest rates. So investors will likely wanna be careful about having too much exposure to fixed income assets in the future.
Phil Adler:Patrick, Confluence geopolitical reports, in the past have discussed at some length the effects of global fracturing, another megatrend that you've identified and and why this tends to create inflation and also favors defense stocks. I wanna move on now to yet another mega trend, and that is reindustrialization inside countries that want to depend less on foreign production. How rapid is this evolution inside America?
Patrick Fearon-Hernandez:Well, it's pretty rapid, although still perhaps not fully appreciated by most investors. US factory building has jumped dramatically in recent years, and not just because of government subsidies in the Biden administration's infrastructure law or inflation reduction act. New factory building actually started a bit before that. The process of re industrialization now appears to be spawning knock on effects as well. For example, we've seen reports that the new factories being built have started to spur the construction of new warehouses and new apartments for the people who will work in those factories.
Patrick Fearon-Hernandez:Over time, we expect this reindustrialization to create new business opportunities in industries such as railroads, trucking, construction, and even business services.
Phil Adler:And what are the practical takeaways for investors?
Patrick Fearon-Hernandez:We suspect all that new industrial and industrial related business will create opportunities in industrial stocks and related sectors. In contrast, industrial firms among adversary countries such as China will likely face headwinds since they won't be able to sell as much to the US or its allies.
Phil Adler:You've identified green technology and the electrification of power sources as another megatrend to be aware of. But recognizing there may be many missteps along this road, how might this end up encouraging certain investments?
Patrick Fearon-Hernandez:Well, this is another area where I need to emphasize that we're not looking at green technology or electrification for ideological reasons. Those trends have definitely become quite politicized, and we want no part of that. Nevertheless, a trend is a trend. And if it's big enough and persistent enough, it should be possible to identify an asset class that will benefit from it. For example, electrification seems likely to produce great new demand for copper and uranium.
Patrick Fearon-Hernandez:In different confluence strategies and portfolios, we've taken steps to increase our exposure to those assets as a result.
Phil Adler:Among the other megatrends you pay attention to, Patrick, is artificial intelligence and its effect on employment. I imagine investors should pay a lot of attention to this one.
Patrick Fearon-Hernandez:Yes. And I'm sure you're well aware of all the hype about AI and the broader move toward autonomy and automation. It seems pretty clear that these technologies could have huge impacts, including in terms of reducing the demand for labor, at least in some industries or professions. But it could also boost productivity, which would help offset some of the labor shortages we've seen after the mass retirements of the pandemic era.
Phil Adler:And one of the other megatrends we wanna take note of today is demographics. How countries in much of the world are aging. How should investors incorporate this megatrend in their long term strategies?
Patrick Fearon-Hernandez:Population aging, which is now visible in most major countries, will have big economic, social, and financial implications. For years, for example, population aging has already likely had an impact on raising the demand for health care. More broadly, we're seeing some evidence that higher average ages are associated with greater government debt. An international bond investor who's worried about debt, therefore, may want to consider how fast a target country is aging. Also, we think population aging may be associated with labor shortages and higher wage gains and price inflation.
Patrick Fearon-Hernandez:After all, think of how new retirees keep buying food and much of what they did while working, but they're no longer a part of the labor supply. That means continuing demand with reduced supply, which should boost inflation, potentially helping buoy interest rates and hurting fixed income.
Phil Adler:Patrick, does studying a combination of all these megatrends that you've identified draw you to certain broad investment conclusions?
Patrick Fearon-Hernandez:Well, as you may have gathered from our talk here today, the combination of these different trends seems to point to higher consumer price inflation than we saw before the pandemic. We're probably not going back to the 2% inflation of the past. But at the same time, geopolitical tensions and fatigue with the efficiency cycle will also tend to boost inflation. While equities can produce good returns even with somewhat higher inflation than we had before the pandemic, And while commodities can often do well in inflationary environments, we continue to think that bonds will be challenged over time.
Phil Adler:Well, as we close, a couple of more process questions. How often do short term market events seem to contradict megatrends that you've identified, and how do you react?
Patrick Fearon-Hernandez:Well, short term forces actually have a lot of impact. None of these trends pushes an asset's price along a straight line. I think the message here is that if you can identify a big persistent trend, you can have a bit more confidence that short term price fluctuations will reverse themselves. Of course, you can't know how long an asset price will take to start responding to the megatrend again. It's not a perfect science.
Patrick Fearon-Hernandez:All the same, it can help keep your eyes focused on the right thing.
Phil Adler:Finally, can financial markets themselves help you identify the emergence of new megatrends?
Patrick Fearon-Hernandez:I think they can. Surely, doing your own basic research on political trends or technology developments or demographics isn't the be all and end all. Other investors and market participants are also doing their own research and then taking action. So broader trends in particular stocks, bonds, commodities, or sectors of those markets can alert you to the possibility of a trend forming. We've certainly had that happen to us here.
Patrick Fearon-Hernandez:So, yes, keeping your finger on the pulse of the financial markets and different sectors can help key you into the megatrends as well.
Phil Adler:Thank you, Patrick, for your report this week titled 8 megatrends every investor should know. And as always, the written report is available on the Confluence Investment Management webpage. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice, and this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stoll.
Phil Adler:I'm Phil Adler.