“In Investing, What is Comfortable is Rarely Profitable.” Robert Arnott

The outlook for global economic growth is plagued by uncertainty today. Just how far will the U.S. and China go in their efforts to win the current trade war? Will the U.K. arrive at a solution to the ongoing Brexit impasse? Will central banks around the globe continue their easy money policies?

At the industry level, it seems hard to pinpoint another time in history too when so many were witnessing deep, fundamental change. In payment systems, upstarts like Apple Pay are threatening to unseat well entrenched competitors like Visa and Mastercard (also see page 2). In healthcare, public policy initiatives aimed at controlling costs may undermine the basic business models of hospitals, drug distributors and pharmaceutical companies. In the media sector, the war to capture consumer “eyeballs” is forcing unprecedented consolidation and change.

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In periods of perceived heightened risk, it is helpful to take a step back and consider the long view of history. Take a look at the chart below of the VIX. This investment index, a popular measure of expected stock market volatility, tends to rise when stocks are falling and shows when heightened jitters are creeping into the market. Over the past 20 years there have been at least 10 periods when the VIX spiked above 30. While most of us remember the 2008-2009 recession, many have forgotten the anxiety produced during the summer of 2011 (European Sovereign defaults and the downgrading of U.S. debt) or fall of 2015 (fears of slowing economic growth and falling oil prices). In behavioral finance, the tendency to place more emphasis on recent rather than old information is referred to as Recency Bias. As investors, this trait gets us into trouble when we assume that current conditions (bad or otherwise) will continue into the future. This, of course, may be true but it is not necessarily true.

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Investors should also keep in mind the idea that they receive a return precisely because they are taking on risk and, all else being equal, the more risk you assume, the greater the potential return. Over short periods of time, the stock market’s gyrations are driven by the very human emotions of fear and greed. The result? If you are investing correctly, you are likely living in a constant state of dissatisfaction. If the market is up, you wish you had invested more in the market and if it is down, you will always think you have too much invested.

So, what is an investor to do in the face of such uncertainty? Investing is as much about understanding yourself as it is understanding the markets. Conduct an honest assessment of your own ability to tolerate risk by which I mean either temporary or permanent loss of capital. If principal preservation is more important to you than capital appreciation, your portfolio should hold a good slice of more stable things like bonds and cash. And don’t forget diversification within each asset class. At its heart, the concept of diversification is really an admission that we don’t know what the future holds. An adequately diversified portfolio will never keep pace with the market’s highest-flying sector like tech today, but it will never behave like the worst either.




The Yield Curve as Recession Predictor…

Economists and policy makers are spending a lot of time talking about the yield curve these days. This bond market metric plots the yields investors receive for different maturity bonds. Because they demand more compensation for holding longer-term debt, the yield curve typically slopes upward to the right (see chart below ). On rare occasions, however, the curve inverts and longer-term maturities offer lower yields than shorter-term maturities.

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So why should we care about a bunch of lines on a graph? The yield curve recently inverted, a development that occurred just prior to 9 of the past 10 economic downturns. The lag time between the yield curve inversion and the actual onset of recession ranged from 8-20 months with an average time of one year. To understand why the yield curve might have predictive powers consider that prevailing interest rates are actually a reflection of millions of investors’ views. When these investors expect the Federal Reserve to lower rates in reaction to a slowing economy, they flood into higher yielding long-term debt. This increased demand drives down long-term yields relative to short-term yields.

Several economists, however, are now suggesting that the outlook may not be as bad as it seems. More specifically, they claim that the increased demand for long-term Treasury debt comes not from investors’ fears of recession but from other recent developments in the bond market. To meet post-crisis regulatory requirements, banks have had to boost their reserves of ultra safe assets like Treasuries. Meanwhile, insurance companies and pension plans looking to reduce funding risk have also soaked up long dated bonds. Finally, the U.S. government may be playing a role. The U.S. Treasury finances most of its growing budget deficit by issuing short-term debt. This increased supply is likely driving up short-term relative to long-term rates.

Before you breathe a sigh of relief, consider the possibility that the yield curve may be less a predictor of recessions than a cause of them. The reasoning here is pretty straightforward. Banks fund their lending activity with short-term borrowings. When these funding costs go above what they can earn on long-term loans, lending dries up and with it general economic activity. Further, businesses may react to yield curve inversions by cutting back capital spending and other investment plans.

While the yield curve’s inversion can’t be viewed as a positive, investors should take a deep breath before running for the exits. First, measures of the “real” economy like unemployment and consumer confidence are holding up pretty nicely and research has shown that when the yield curve is flashing red and the real economy is doing well, it’s best to pay attention to the real economy. Second, economic predictions are notoriously bad (consider that most economists failed to see the global financial crisis coming).

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Unfortunately, we cannot know with any accuracy when the next recession will hit. But if history holds, when it arrives it will be neither fatal nor permanent. How to prepare? Make sure your current mix of bonds, stocks and cash is in line with your overall tolerance for risk. And don’t forget to hold sufficient cash to cover short-term (3-12 months) spending needs. In a down market, nothing soothes the nerves like cold, hard cash.

5G, Not Just Another Phone Upgrade…

Industry experts expect great things from 5G, the latest generation of wireless technology. To understand why, it helps to know a bit about how cell phones function. Cell phones convert voice and data into electrical signals and then transmit those signals over radio waves to the nearest cell tower. The cell tower then passes the signal along either through physical phone lines or by radio waves to the end destination.

The infrastructure used to transmit and receive signals today, everything from chip sets to antennae, has been designed for lower radio frequencies. Thanks to the explosion of mobile usage, these frequencies are getting saturated. Dino Flore, a Technology VP at Qualcomm, estimates that there are over 8 billion cellular connections today. Without change, the strain on the existing network will cause transmission failures and delays.

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Fortunately, engineers from around the globe have been working together to develop new cellular architecture standards capable of handling the growing network demands. 5G, which transmits data at higher frequencies, is the result of these efforts. In addition to increasing network capacity, 5G also reduces “latency” or the time it takes for devices to respond to each other. When fully deployed a 5G network, for example, will be able to connect 1 million devices per square kilometer, or transfer a full length, high-resolution film in 2 seconds. Industry experts believe this reduced latency will spur significant innovation. In medicine, for example, 5G could improve doctor/patient relations through higher quality video-conferencing and allow remote surgical procedures. Though less revolutionary, gamers could enjoy a more seamless streaming experience.

While promising, a full rollout of 5G will take time. The new network’s technical requirements make widespread adoption particularly expensive and challenging. High frequency signals are more fragile and, as such, require a vast number of close range micro cells and antennae. Technology consulting firm Greensill estimates that 5G related spending could hit $2.7 trillion by 2020. These investments will be challenging for network carriers like Verizon who must figure out how to get consumers to pay for their enhanced service.

China is furthest along in the race to build out a 5G network where firms like Huawei hold a significant share of 5G patents. On the infrastructure side, Deloitte estimates that since 2015, industry leaders Huawei and ZTE have deployed 10 times as many cell sites as we have here in the U.S.

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The recent move by the U.S. to prevent domestic tech firms from exporting network infrastructure to China on national security grounds highlights how high the stakes are in the race to gain technological advantage. While these trade spats may slow down the pace of 5G adoption, they are unlikely to stop it. Handset manufacturers in both the U.S. and China are already releasing 5G phones albeit with limited range. Denying Huawei chips and other technologies may actually backfire and cause them to speed up efforts to develop homegrown technology solutions.

If history is any guide, I would not dismiss 5G’s potential impact. Ten years ago, 4G’s rollout lead to the rise of whole new businesses like Uber and Airbnb. I would expect this time to be no different.


Technologies That Will Change the World in 2019...

By all accounts we are living in a period of robust technological improvement. Innovations from smart phones to artificial intelligence are fundamentally changing lives and altering the way business is done across a wide range of industries. Historically, technological innovation has been the “secret sauce” that has fueled economic growth and the rising living standards that come along with it. But a strange thing has occurred over the last decade. Since 2007, productivity growth in the U.S. has averaged just 1.3% a year. This rate is less than half the gain recorded from 2000-2007 and well below the 2.1% annual average since 1941.

Economists have been scratching their heads trying to figure out what is behind these weak results. Some, like Martin Feldstein from Harvard, think we simply have a measurement problem. He argues that the way we measure productivity - - generally the amount of goods and services produced per hour worked - - does not capture the value associated with qualitative improvements. Google Maps, for example, does not provide a much different output than physical maps do, but it is a lot easier to use. Others, such as Northwestern University’s Robert Gordon, are less optimistic. He contends that today’s innovations do not have as much of an economic impact as blockbuster innovations of the past, like the electric light bulb. A third group argues that technological innovation occurs in waves. The wave begins with the introduction of a “general purpose” technology such as artificial intelligence. The real economic impact, however, is only felt once it is widely adopted and commercialized.

My guess is that all three of these theories play a part in the recent anemic productivity statistics. Artificial intelligence may not be the next “electric lightbulb” -- Siri dialing a phone number for me is certainly convenient but it is hardly a groundbreaking innovation. But this technology is still in its infancy and may yet prove disruptive in a number of ways.

Each year, the MIT Technology Review prints a list of the technological developments expected to have the most impact on human life. The author of this year’s list is none other than Contributing Editor and Microsoft founder Bill Gates. Mr. Gates’ emphasis this year is in keeping with Martin Feldstein’s more optimistic view of the world. Many of the developments on his list focus on improving the human condition. Just over half involve healthcare. The gut probe in a pill and wearable health monitor, for example, both are aimed at improving patient outcomes, while the self-contained toilet is focused on reducing disease in the developing world. Innovations that focus on cleaning up the environment also feature prominently on the list.

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Mr. Gates, one of the world’s leading technologists, is optimistic about the future, and his selections reflect that view. While he still thinks that much can be done to extend life, especially in some of the world’s most disadvantaged areas, he believes strongly that new technologies can help enhance personal fulfillment. This shift would represent quite an achievement if viewed from a longer term historical perspective.