Charts of the Month - August '23

5% is Normal

It’s not crazy. It’s not irresponsible. This isn’t a ‘new’ normal.

Historically speaking, it’s a very normal cost of capital that businesses were somehow able to navigate for pretty much all pre-GFC history.

Recency bias aside, this is what a sustainable cost of capital for a mature economy looks like.

And now that Jackson Hole has just wrapped up, it sounds like, for the first time in our lifetimes, the Fed is actually prepared to do the right thing. Not necessarily the easy thing but do what needs to be done to slow down the excesses and force resiliency upon households, corporates, and even the Treasury.

Some J. Powell highlights from the Tetons:

• “We’ll keep at it until the job is done.”

• “Two months of good data are only the beginning. Twelve month core inflation is still elevated”

• “GDP growth has come in above expectations and above its longer trend… but persistently above-trend growth could put further progress on inflation at risk and could warrant further tightening of monetary policy.”

• “We are prepared to raise rates further if appropriate and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.”

I’m not at all forgiving the huge issues they created post-GFC (or even post-.com bubble) and, alongside the Treasury, just how badly they overdid it during COVID. But I’m also not interested in living in the past.

So what does this mean?

As Roger detailed in last week’s Research piece (Our Framework for Higher Yields), rates are going to be higher for longer as the Fed seems to be okay with breaking a few things along the way, and rightly so: equity markets haven't given the Fed any credit that they’ll keep rates higher for longer, and the economy has given no reason to even begin thinking about easing. It's time corporates actually begin thinking long term (increased capex and R&D) instead of continuing to capriciously allocate capital focusing on short term gains:

“Companies in the S&P 500 spent more money repurchasing their own shares in 2022 than any other calendar year in history, according to S&P Dow Jones Indices. S&P 500 buybacks totaled $922.7 billion in 2022, up from $881.7 billion in 2021.” – WSJ

No one wants a higher cost of capital, but we all know we need it.

Long-Term Trends Don’t Mean Forever

A quick look at U.S. GDP drivers.

We all know the story: China enters the WTO in 2001. The Western world collectively begins to outsource the production of ‘things’ to the East, which reduces the cost of consumable goods. With the cost of goods down, the West focuses on higher margin services and exports ‘thought leadership’ to the world. Less grease, more excel.

In the U.S., in 1997, the Industrial sector (including manufacturing) made up 39% of the economy, services 72%, and agriculture the remainder.

Since then, GDP has grown at a 4.2% CAGR, industrial and manufacturing GDP has lagged at 2.9%, and services have outpaced at 4.6%. Do the math and services now represent 78% of U.S. GDP.

The ratio of Services-to-Industrial in 1997 was 1.8x (services were 80% bigger than industrial production) but has since ballooned to 2.7x (170%).

Today, however, shifting geopolitical forces have forced government policy (IRA, CHIPS, IIJA) and corporates to rethink their capex spending, and our big bet is that this ratio has likely peaked, and a slow, but eventually meaningful reversion is underway. And by the way, this is a Western trend, not a U.S. one.

A lot more on this to come on this theme in the weeks, months, and years ahead…

Construction vs. Tech

Peter Thiel made famous the line, “You can invest in companies that deal in bits or you can invest in companies that deal in atoms.”

Basically, asset-light businesses deal in bits (tech) and asset-heavy businesses deal in atoms (industrials).

The prevailing investment theme of the last 20+ years has been tech, tech, and a little more tech.

Because of this, many (including ourselves) have paid less attention to the atoms side of the investment spectrum. But those who did have been handsomely rewarded.

Construction & Engineering (C&E) is an industry within the broader Industrials sector, which includes other atom-heavy components like Aerospace & Defense, Semiconductors, and Industrial Conglomerates, to name a few.

The relative returns above may seem shocking, especially the 5-year (crushing tech). But they might become a little less surprising when we peel a layer back and look at revenue growth.

Call me double-shocked.

Companies like WillScot Mobile Mini (WSC) are keeping up with the mighty Nvidia, and MYR Group, an electrical construction company, driving as much revenue growth over the last 5 years as Amazon.

As we think through and build out our medium to long-term investment framework, industries within the Industrial sector are going to get a hard look.

Returns and revenue growth aside, there are multiple large-scale, structural shifts taking place simultaneously:

• The GDP drivers chart from above and the exogenous forces that are weighing on the Services-to-Industrials ratio (primarily Geopolitics driving critical supply chain shifts, nearshoring, and reshoring), and then factor in

• the headwinds that an industry like tech is facing (antitrust lawsuits in the U.S. and Europe against Google, FTC lawsuits against Meta and Amazon, the European Commission’s ongoing investigation into Microsoft’s use of Team’s vs Salesforce’s Slack)

• And the tailwinds Industrials have at their back (government spending coming from the IIJA, IRA, and CHIPS plus corporate risk management teams being forced to spend to secure supply chains).

This is not to say that tech is going away and that every industrial firm is going to win the decade. But, if we were betting on the next 10 years, given the information we have at our disposal today, there appears to be a flood of capital chasing a rotation into atoms (into bits as well… insert your favorite ‘AI’ buzzword here).

If that Services-to-Industrials ratio shifts even a little closer to 2x, that means trillions of dollars being poured into companies that build ‘things’ instead of ‘break things’ over the coming decade. And by ‘things’ we don’t mean another SaaS CRM, dating app, or food delivery service.

Ah, and the BLS seems to be acknowledging this forecast as well…

If you enjoyed this piece, we very much recommend you give our Research tier a try.

Research is a once-per-month report that dives deep into 5-10 investment themes at the intersection of Geopolitics and Macro.

Here are the 5 themes we covered last week:

1. The First Real Challenge to Xi’s Grip on Power

2. Our Framework for Higher Yields

3. Gold’s Cup and Handle

4. Brazil’s Macro Case of Normal

5. The Unexpected Winners if Global Aerospace & Defense Spending Continues to Rise

These types of stories and investment thematics are at the core of what we're doing here at Lykeion and make up the foundation of our Research tier.

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As always, we'll see you out there...