The Real World and the Digital World
As the U.S. economy and corporate America discover new ways to adapt and grow in a global pandemic, stock markets continue to wow investors with double-digit returns (18% in 2020 and 16% in the first nine months of 2021). Despite strong overall market performance, a vast divide has emerged between industries in the last 18 months, signifying a stark contrast between the fates (and returns) of the digital and “real world” economies.
What’s more, the economy and markets are approaching a fork in the road, as politicians negotiate a stalemate over the budget deficit and debt ceiling. A compromise will likely keep the nation’s financial plumbing intact, while failure to act may lead to real job losses on Main Street. This quarter’s market newsletter explores the tensions we see in this digital divide and the related market impacts.
Main Street and the Fed’s digital printing press
As this letter goes to print, Congress is working to prevent a government shutdown, while also avoiding a default that could stem from failure to raise the debt ceiling. Many investors expect the government to solve both problems—or at least kick the can until later in the year. However, if politicians fail to keep the printing presses rolling, we could see confidence decline and real financial pain for many ordinary Americans relying on federal payments.
Jerome Powell and Janet Yellen are waiting in the wings at the Federal Reserve and Treasury as political parties negotiate fiscal policy in the center ring. Powell is inching closer to reducing emergency stimulus measures such as monthly bond purchases. If the curtain closes on the government shutdown and debt ceiling suspense in October, the Fed may pare back its bond buying program as soon as this year or early next year.
Looking ahead, stable fiscal and monetary policy (which remains accommodative) could help the real economy fully recover from pandemic-related stresses such as high inflation and millions of job losses stemming from the 2020 Covid recession. If this soft-landing scenario plays out, Powell and the Fed are likely to start raising interest rates in late 2022 or early 2023 to avoid an over-heating economy. Higher rates may also lead to more attractive bond opportunities for investors.
Cloud computing and the Port of Los Angeles
As the government hammers out a financial compromise to keep the real economy moving, the private sector is dealing with another division. The pandemic has created supply and demand shocks that appear to be separating digital winners from real-world losers.
How did we get here? In sum, global consumer demand has fully recovered from the Covid recession, but supply chains have struggled to keep pace. Covid-related factory closures and semiconductor shortages in Asia have wreaked havoc on trans-Pacific shipping, as demonstrated by the flotilla of container ships waiting to enter the Port of Los Angeles. Fires, floods, and a tight trucking market have further hampered delivery times even after goods enter the U.S.
These real-world challenges have depressed earnings results and investor sentiment for companies trying to satisfy consumer demand for physical goods. Truckers, air freight and railroads making up the S&P 500 transport index have returned only 4% through October 1—well below broad markets—as they try to patch an already strained logistics network.
Despite the gloom and doom in the real world, skies are sunny in the digital economy. Cloud computing providers have seen stock prices rise 30% to 60% year-to-date, as they soar above the mess on the ground. Other digital tech companies providing online ads, sales and marketing software, cyber security, and IT services are also performing well as they meet customer needs electronically.
What’s next for the digital and real worlds? As bad as it may seem now, our sense is global logistics companies will gradually recover from the current quagmire, although the journey may be bumpy (and longer than some investors expect). We anticipate continued growth for digital tech companies as underlying customer demand increases. However, we may see moderation in red-hot growth rates, particularly as interest rates rise.
How are we positioning?
We are navigating the digital divide with patience, research, and diversification. We continue to favor full equity allocations with exposure across sectors because we believe that we are in the early stages of a recovery in the real economy and that Fed policy will likely remain supportive. We continue to identify companies in both digital and “real” sectors that may exceed investor expectations over the next several quarters. Our sense is these favorable trends offset risks such as supply chain challenges, fiscal policy changes, and investor sentiment that is well above long term averages.
As we look towards the fall and year-end, we will be focusing on potential resolution for near-term challenges including government budgets, the debt ceiling, and weak links in global supply chains. Over time, we expect both fiscal and logistics problems to fade, allowing more stable growth in the economy and corporate earnings. Divisions between the digital and real worlds may start to blur, revealing additional investment opportunities that meet our core investment principles, remaining ever mindful of your goals and objectives.
We wish you all the best this fall as we approach the holidays and make time to celebrate with family and friends.
Michael Bailey, CFA
Director of Research
Michael Mussio, CFA, CFP®
All opinions expressed in this newsletter are not intended to be a guarantee or forecast of future events, do not constitute a solicitation to buy or sell securities nor are they a complete description of our investment policy, the markets, an investing strategy or any securities referred to in the newsletter. Opinions expressed herein are not intended to be used as investment advice and are subject to change without notice based on market and other conditions. Different types of investments involve varying degrees of risk, and there is no assurance that any specific investment will either be suitable or profitable for a client's or prospective client's investment portfolio, and no one should assume that any information presented here serves as the receipt of, or a substitute for, personalized individual advice from FBB Capital Partners, its research team or its portfolio managers. The value of investments and the income from them may fluctuate and can fall as well as rise.