Transportation Disruption Revisited

In late April, Tesla put its self-driving cards on the table, and it’s a strong hand. With a powerful new super-computer now in every car rolling off the production line, the company is hardware-ready and has the world’s largest testing fleet.

In theory, all that’s left is 16 months of neural network software development. In reality, it’s probably more like 2-3 years, given that the current stumbling block has to do with curb recognition in parking lots. Still, at some point not far in the future, government regulators will have to make the call: should Tesla vehicles be allowed to drive themselves? If the answer is yes, Uber and Lyft may get a major new competitor.

Armed with autonomous electric drive trains that cut fuel and maintenance costs (and with a new battery pack that can last a million miles starting 2021), Tesla could potentially charge fares that are a fraction of today’s prices while enjoying robust margins. They’re not the only ones eyeing the potentially lucrative ride-hailing market – at last count some 90 firms are looking to get in on the game. So fares are likely to fall at some point. And when they do, many consumers may stop replacing their older vehicles, resulting in a sales drop for all vehicles except electric self-driving.

Meanwhile, Israeli firm Eviaton has designed a battery-powered commuter plane that can carry nine passengers up to 650 miles. Flying at half the speed of today’s commercial jets, its fueling cost could be 25 times lower than comparable prop planes, setting the stage for a new crop of regional airlines and air taxi services that never got off the ground in the past.

On the delivery service front, earlier this year the FAA certified Google’s Wing Drone delivery service to operate as an airline, and Amazon is almost ready to start testing its Prime Air delivery drone, which can fly up to 15 miles. It’s designed to carry packages weighing five pounds or less (over 75% of Amazon’s deliveries are under that threshold).

So what does all this mean for investors? For automakers, the race to develop autonomous electric vehicles is looking more like a race for survival. Among tech firms, the AI revolutionmay turn out to be more of a tailwind for chipmakers than software developers. For energy companies, the price of oil might be vulnerable if low-cost electric ride-hailing services displace 5% of the miles driven by internal combustion vehicles globally. Shipping companies could lose market share on multiple fronts. And while electric utilities and auto insurance firms might seem to be on firmer ground, any large ride-hailing operator knows it can lower its costs by self-insuring and generating its own solar power.

In this kind of environment, the seemingly risky bet on technology disruption might actually be the firmer footing, while classic value stocks might remain cheap for good reason. With those thoughts in mind, we continue to favor domestic large-cap growth stocks, while underweighting value stocks and other defensive groups.

Estimated Medium-Young Population Ratio vs. P/E for S&P 500

Second Quarter Review
The market continued to climb the proverbial "Wall of Worry" in the second quarter, but volatility ran high as investors reacted to the continuing drama on the trade front and the Fed’s shift to a more accommodative stance. While individual investors remained largely bearish due to a mildly inverted yield curve and the perception of heightened political risk, corporate stock buyback programs continued at a near-record level as corporate leaders showed confidence in the outlook for their own firms. On top of that, a healthy level of deal-making and IPOs suggested that institutional investors were upbeat as well.

For the quarter, the S&P 500 gained 4.3% amid weakness in other stock groups, most notably the Russell 2000 which rose only 2.1% (mainly because of recession uncertainty). On a year-to-date basis, the two indexes are up 18.5% and 17.0%, respectively. In most cases, the stock side of our portfolios trailed the S&P 500 due to small-stock exposure, although accounts that were 100% invested in our sector portfolio finished slightly ahead of the index for both the quarter and the first half.

The Barclay’s Aggregate Bond Index rose 3.1% during the quarter for a year-to-date return of 6.1%, reflecting gains from declining interest rates and the Fed’s dovish shift. The bond side of our portfolios remained invested in higher-yielding corporate bond holdings, and logged similar gains for the quarter while finishing slightly ahead of the index on a year-to-date basis.

We think the market is more worried about a recession than it should be. Our portfolios are positioned to benefit as perceived recession risk subsides over time, and we haven’t seen any reason to change that strategy in recent months. Our reasoning is two-fold. First, we don’t think the U.S. economy will get badly hurt by tariffs in any scenario. Second, an inverted yield curve does not mean much in today’s era of stable oil prices. Here’s some background on both topics.

There’s no question that the Smoot-Hawley Tariff Act of 1930 turned a really bad recession into the Great Depression. But it was not the Depression’s root cause. For that we must blame the technology disruption of the day: the internal combustion engine. Increasing popularity of motorized transport in the 1920s led to rapid displacement of the horse and buggy system, which at the time was fueled by roughly one-third of the world’s agricultural output. As oil became the dominant energy source for land-based transportation, an agricultural glut of epic proportions ensued, causing a global collapse in agricultural prices and farmland. Back then, some 20% of U.S. jobs were in the agriculture sector, and most of them vanished between 1920 and 1930.

So let’s get real on today’s tariff threat. U.S. exports are only 12% of GDP, and imports are only 15%. Most of what we export is high value and difficult to replicate, whereas most of what we import is low value and easily made elsewhere. Consider a Chinese consumer buying a domestically-produced laptop containing U.S. chips. A 25% tariff on U.S. semiconductors probably means this consumer has to work roughly five extra wage-hours to cover the laptop’s increased cost. Contrast that with a U.S. consumer buying a Chinese-made coffee-maker, where the same 25% tariff might translate to 15 minutes extra wages. Now consider that China buys a trickle of our high-value exports, whereas we import a flood of their low-value goods. In a heavy tariff situation, the main result would be that the production of low value goods would move out of China. Recession? Maybe in China, but here at home it’s hard to see anything more than a modest slowdown.

Some see the inverted yield curve as the nail in the coffin for this record-long expansion. While the indicator has a good history of predicting recessions, it’s not a case of cause and effect. In the past, the beginnings of almost every recession (including the Financial Crisis) were rooted in an oil price spike. Following that, the Fed would turn hawkish and stay that way a little too long. Finally, the yield curve would invert and a recession would take hold a short time later.

Going forward, we may never again see a significant spike in oil prices, thanks to the shale oil industry. These producers are farming massive amounts of oil out of deeply buried rock; that’s something most countries cannot do for lack of geography, capital, water, or property rights. Soin this new era of stable oil prices, there is no implied limit to the length of an economic expansion. We may still see an occasional mild yield curve inversion (as is the case today), but it won’t mean anything because it wasn’t preceded by a debilitating surge in the price of crude.

Jack Bowers

Jack Bowers
President & Chief Investment Officer

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