Overview
Sophisticated institutional investors and risk managers can be hit with bullets and bonbons (excuse the alliteration) over the next 12 months. This installment aims to identify items that are likely to have significant effects on portfolios.
In the meantime, it has been a very good year. On our subscription side, we were fortunate to flag the problems at Boeing, Intel, and the auto companies. On the private debt side, we continue to be the credit rating agency of choice for a significant portion of private debt. Below are our comments on rapidly developing situations.
Potential Portfolio Bullets
I. Legacy Auto Companies – The increased range, reduced prices, and growing appeal of electric and hybrid vehicles continue to pressure the legacy OEMs. For anyone having doubts, the following headlines are indicative of some inherent challenges:
- Striking Volkswagen Workers Numbered Nearly 100,000 on Monday, Union Says¹
- Stellantis CEO Carlos Tavares Steps Down from Jeep Maker; Shares Slide ²
- General Motors Takes $5 Billion Hit from Ailing China Business ³
- German media reveal the full extent of the German car crisis ⁴
Figure I: Share of Global Light-Vehicle Production
Commentary: Our view is simple: the auto companies have massive operating and financial leverage. Therefore, a slight reduction in sales or margins translates into a significant reduction in earnings. Watch for some filings in the next 18 months.
II. Legacy Chip Companies – It is typically a negative sign when the government spends significant sums to support a particular sector. Our view is that chip-making leadership has shifted to the ARM/TMSC Alliance, of which Nvidia and AMD are leading members. The dismissal of Intel’s CEO is a recent reminder of this shift.
Commentary: New leaders could emerge with advances in quantum computing and other technologies.
III. Western Europe – Historically, France and Germany have led the European Union and were considered bulwarks against threats from Russia and possibly China. Unfortunately, that bulwark is weakening due to the decline in the auto industry, an aging population, and rising energy prices. Energy prices may moderate with an end to the Ukraine War, but additional costs are likely to be incurred via defense spending and rebuilding Ukraine.
Commentary: The chaos in the French government is a distraction, but the more consequential item is likely to be continued layoffs such as those contemplated by VW.
IV. China – For better or worse, the major economies are concerned about the recent actions of China and are responding with tariffs and other restrictions. Meanwhile, China has made significant strides in areas such as electric vehicles, solar power, and low-cost cellular phones. The major challenges are high regional government debt levels, residential overbuilding, and persistent bellicosity regarding Taiwan.
Commentary: Perhaps a larger concern is whether the government takes some drastic action to distract citizens from problems.
V. Utilities – This area is interesting in the sense that some sectors are demanding significant increases in power stemming from AI-supporting data centers and the growing adoption of electric vehicles. However, on the negative side is the continuing growth and declining costs of solar power generation and storage. Perhaps the best perspective on the sector is that significant disruption is likely over the next several years.
Commentary: Distribution services may be hit the hardest, while generation could be spared, at least until new, low-cost solar power becomes available.
VI. Traditional Manufacturing & Services – Our premise is that over time, with improvements in hardware and software, robots will become common in various industries. Perhaps only five years remain before unsupervised self-driving becomes viable, followed by air taxis within another five years. Combine these developments with an overall decline in energy prices due to affordable solar power, and the result is upheaval in various traditional activities. For those paying attention, a significant portion of the market’s recent gains have come from firms focused on AI and chips.
Commentary: As we have witnessed numerous times (e.g., Motorola, Ericsson, IBM, GE, DEC, etc.), legacy leaders typically struggle after major technological shifts.
VII. Domestic Defense Industry – The defense industry has performed well under the current administration, with the abandonment of massive arms in Afghanistan and contributions to Ukraine. However, with the fading presence of neo-conservatives, support for wars—and defense spending—is likely to diminish. Lastly, the DOGE seems focused on reducing the Pentagon’s budget.
Commentary: An often-overlooked factor is that much of this spending is essential for America to maintain its global interests, particularly in light of China’s increased bellicosity.
Potential Portfolio Bonbons (i.e., Positives)
I. United States Debt – There is little doubt that the overall debt has grown faster than GDP over the past several years.
Commentary: There is a long history of Washington focusing on bloat, with Newt Gingrich’s “Contract with America” being a recent example, though results have fallen far short of the rhetoric. However, we expect the incoming administration to focus on the issue and thereby temper spending growth.
II. Real Estate Collapse – On a weekly basis, there is news on the overhang in real estate, particularly in the commercial sector. However, some perspective is helpful:
The overall US CMBS delinquency rate increased to 6.40%, an increase of 42 basis points for the month. (The all-time high on this basis was 10.34% registered in July 2012. The COVID-19 high was 10.32% in June 2020.) ⁵
Therefore, while the rate is at a recent high, it is still materially lower than the rates during COVID and in 2012.
Commentary: This issue has been on the radar for the past five years. The problem should temper over time given the push for returning to the office for work, the long-term nature of some leases, the conversion of some properties from commercial to residential, and the decline in interest rates and spreads.
III. Recession – Over the past three years, there has been ongoing talk of an imminent recession due to the extended rally, the end of COVID-era government support, and weak results from the Conference Board index. Additional concerns have been raised about elevated interest rates and their likely fallout for various businesses.
Commentary: Our view is that inflation is responsive to changes in the money supply. If the money supply does not continue to expand rapidly, and if the Fed responds appropriately, interest rates should align with inflation. Given proper action, both inflation and interest rates should eventually moderate. The chart below should provide some reassurance, as treasury rates have moderated, and spreads are now at more manageable levels.
