by Rick Rieder, CIO, Fixed Income, Blackrock
Rick Rieder and team describe how revolutionary changes taking place in corporate business models will impact investing for years.
The rise of a frictionless business model…
Long before it was possible to “CC” an infinite number of recipients on virtually any and all electronic communications, a so-called “carbon copy” was the circulation method of old typed, or written documents, placed over carbon paper and the under-copy sheet itself. When copies of business letters were so produced, it was customary to use the acronym "CC," before a colon, and below the writer's signature, to inform the principal recipient that carbon copies had been made and distributed to the parties listed after the colon (Source: Wikipedia, December 2020).
Obviously, in today’s digital world, the idea of a physical carbon copy seems downright prehistoric. Even familiar marketing channels, like radio and television, are flirting with obsolescence, at least as far as new advertising dollars are concerned. Given that the cost of being added to the distribution list of an email, or social media post, is virtually nothing, there’s no wonder that your inbox/home feed is persistently jampacked with new material. But today, we find that the world is increasingly distributing not just information, but goods and services, as though using a digital “CC: All” model. That’s to say an economic model that is effectively frictionless, and costless, in a growing number of industries, for the marginal user/customer/subscriber. Indeed, anyone with connectivity can communicate, advertise and interface today with extraordinary ubiquity, and at virtually no cost. This was the case before the 2020 pandemic completely turbocharged this phenomenon, which leaves profound implications for the post-pandemic world.
…Meets with unprecedented policy stimulus
With recent announcements about positive vaccine efficacy, combined with visibility around a credible distribution plan that can eventually create herd immunity, the pandemic era is likely close to its last innings. And thanks to historic stimulus in reaction to the onset of the pandemic, the real economy that is emerging from this crisis has a tremendous amount of underappreciated momentum. Major developed market (DM) central banks have increased global liquidity by a staggering $7.5 trillion in 2020, according to data from the Federal Reserve, the Congressional Budget Office and Bloomberg, representing nearly 30% year-over-year growth from an already large stockpile. Moreover, the pandemic version of quantitative easing (QE) has facilitated direct injections of liquidity to the real economy via monetized deficits. In fact, U.S. money supply (as measured by M2) has grown by nearly 25% during 2020, shattering previous records. Direct injections of broad money by central banks are perhaps the single most potent monetary policy tool in the modern economy. It is likely that mean-reverting velocity in a post-election, and eventually post-pandemic, world will catalyze that injected broad money to create some truly impressive nominal GDP growth going forward. It is also likely that still more doses of policy stimulus are in store for 2021.
And an organic economic recovery that is underestimated
Alongside of that policy-induced momentum comes durable cyclical real-economy tailwinds. Despite a modest slowing in November, the recovery of the labor market is in full swing. From the depths of the crisis, continuing unemployment claims have fallen 76%, representing the return of more than 18 million jobs. In fact, the labor market is already becoming stretched in some services sectors and the eventual onset of vaccine-built herd immunity will bring back millions of additional jobs, particularly in the travel, leisure, and education sectors. Retail and industrial sector inventories are setting record lows and are in dire need of being rebuilt. Meanwhile, pandemic-induced transit bottlenecks have been impeding consumption, a phenomenon that will be quickly alleviated with the reopening of ports.
Further, as we contended recently in our commentary Taking stock: 11 themes to consider as we look toward 2021, supporting an already solid economic recovery is a gargantuan, Covid-driven, systemic build-up of cash and savings. In fact, U.S. personal savings is $1.42 trillion higher than It otherwise would have been as a result of Main Street stimulus. In the three months since the expiration of supplemental unemployment benefits, total U.S. savings have continued to grow at roughly $200 billion per month for a total increase of $634 billion. The combination of U.S. commercial bank deposits and money market assets together are now larger than the size of the U.S. economy, shattering previous record levels. Additionally, U.S. consumers have opportunistically embraced this windfall to pay down debt, and households have also utilized historically low interest rate levels to reset borrowing costs to more favorable levels, with re-financings. All of these factors are durable tailwinds for 2021 growth, in our view.
Further, some left-tail risks are overexaggerated
Many prognosticators point to the potential for an onerous buildup of government debt as a requisite consequence of emergency policy stimulus. In contrast, we firmly believe that smart, and targeted, fiscal policy that generates robust nominal GDP growth can over time help to organically mitigate the potential negative impacts of large single-year deficits, like seen in 2020. Potentially, this could even be accomplished without the need to increase public sector revenues elsewhere, like through raising taxes. Simultaneously, the U.S. Treasury is sitting on a staggering $1.5 trillion of cash as we enter 2021, which provides a significant buffer to help offset pandemic related revenue shortfalls as the economy recovers in earnest. Moreover, net U.S. federal indebtedness has not risen materially during the pandemic, despite the large deficits, largely because the Federal Reserve has financed virtually all of the stimulus.
Other skeptics of the Covid policy response cite the potential for a dangerously weak dollar, or the return of uncomfortable levels of inflation, as likely side effects of large policy driven public sector deficits. To us, however, the U.S. dollar is still the anchor currency for both the real and financial economy, globally. Indeed, the USD is employed for a large majority of international commerce, while more than 80% of global supply chains are financed in U.S. dollars. Similarly, the combination of relatively attractive U.S. dollar yields, and ubiquitous and dynamic, high growth, cash-generating private sector entities drive persistent outsized demand for U.S. financial assets. So, while some USD weakness is not surprising, and is in fact a healthy indicator of returning risk appetite from contractionary levels, we are not worried about capital flight from the world’s reserve currency. And the moderate nature of dollar weakness will likewise moderate inflation’s potential to spike meaningfully, at least from a currency-driven standpoint.
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Headwinds to excessive inflation remain in place…
While some goods will likely see year-over-year price appreciation from some very depressed levels, we find it very difficult to envision the aggregate consumption basket achieving, or sustaining, uncomfortable inflationary pressure. There are simply too many secular deflationary headwinds in the “CC: All economy.” Today’s consumption basket is dominated by services. In fact, just four categories – shelter, medical care, education and recreation make up more than half of the consumption basket. These categories are also more susceptible to the frictionless “CC: All” business model than they are to traditional bottlenecks and capacity utilization issues in a goods supply chain. The pandemic has forced experimentation in online distribution methods from education to recreation, and the only capacity limitations on an online lecture, or an online concert, delivered through a cloud-based server, are the limitations the host decides to install. Old architecture around capacity utilization, and the relationship between utilization and inflation, is being re-written today, and the system is finding new ways to add capacity as fast as it is getting utilized.
Including the remarkable productivity surge currently underway
Another inflation inhibitor is productivity (units of output per unit of labor or capital resource), and the “CC: All” business model is adding productive fuel to the proverbial economic fire. The historic 2020 recession is likely to result in an historic surge in productivity, which is already beginning to creep into the data. Most references to productivity over recent years focus solely on labor dynamics, but we think that is only one variable to consider. Full cycle capital productivity has been greater than its post-war average over the last decade, even as labor productivity has fallen, meaning that multi-factor productivity has been stronger than what conventional wisdom has led many to believe. Furthermore, recessions have traditionally induced significant productivity gains and have allowed corporate profit margins to rebound quickly, a phenomenon that has been abundantly evident over the past two quarters.
It is said that necessity is the mother of invention, and the pandemic has forced businesses to minimize their physical footprint while maximizing their output – with undoubtedly some surprising discoveries around cost efficiencies that would have been unimaginable a year ago. It is very likely that redundant business travel, infrastructure, and labor will never be restored now that those redundancies have been revealed. Through virtual meeting rooms, online advertising and marketing, less real estate infrastructure, and the like, the corporate world is figuring out how to “CC: All” in new ways and operate with an incredibly low level of friction. All of this will drive profound increases in productivity in the years ahead.
Revolutionizing total addressable market
Productivity and disinflation are not the only trademarks of the “CC: All” model. It is also being accompanied by cash flow generation, a lot of which boils down to the size of the Total Addressable Market (TAM) that accompanies the shift toward a “CC: All economy.” In the past, the size and scale of corporate investment tended to dictate TAM, via the buildout of physical marketing and distribution networks. But today the ability to “CC: All” in so many novel ways has upended that relationship, including all the capital expenditures, hard assets, and supply-chain bottlenecks that came along with it. The truncated buildout period of an online marketing and distribution network (as opposed to a physical one) has resulted in a much more rapid generation of cash flow.
For instance, Wal-Mart has done an incredible job of adapting to the “CC: All” business model in recent years, but if they had to build their business again, it is unlikely that they would go through the two decades of intensive capex that was required in the 1970s through 1990s for them to reach the scale that would transition them to cash generation mode in those decades. New players in retail, like Wayfair and Etsy, have reached cash generation mode after investment phases of just eight years and five years, respectively. Both companies still expect to grow, but just as the concept of “capacity” has become more elastic, so the “CC: All” model allows for a much smaller share of fixed costs, a much larger share of variable costs, and hence the ability to generate more cash flow per dollar of sales and at faster growth rates.
Investment implications
The combination of a moderately (but not extremely) weaker U.S. dollar, moderately (but not excessively) higher inflation, a return of post-pandemic aggregate demand, a commensurate return of risk appetite and the real growth afforded by the “CC: All” business model could be extremely beneficial to some previously less loved asset classes, such as commodities and Emerging Markets. Indeed, we have already seen a substantial rise in oil and metals prices since their March lows. While there are a number of tailwinds for broad EM in general, perhaps a commodity tailwind could help the commodity-producing subset of EM, including parts of Latin America, Emerging Europe and the Middle East and Africa. Many EM currencies tend to have a strong correlation with commodities, going back at least two decades, and a commodity-led tailwind can provide a virtuous lift to these countries’ prospects. As commodity prices rise, credit profiles strengthen, currencies strengthen, and purchasing power appreciates, allowing for demand to expand, which can drive commodity prices yet higher; restarting the cycle all over again.
In the bond world it is almost essential to go outside of high-quality fixed income to build a portfolio that might yield 3%-4%. In fact, emerging markets, securitized assets, and parts of the high yield debt universe are asset classes we would turn to in building the balanced portfolio of 2021. And in order to achieve the historical return of between 5.5% to 8% for a balanced portfolio, the equity portion of that portfolio would therefore need to return between 7% and 10%, presumably supplemented by an allocation to alternative assets. Interestingly, it is possible to meet such portfolio-level return while still holding more cash than has historically been the case, keeping some dry powder for opportunities that may arise in future, or as a buffer against near-term volatility.
Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is Head of the Global Allocation Investment Team.
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