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Strategy Update

The Bottleneck Economy

We live in a complex, globalized economy, where every product we buy is in some way dependent on the smooth operation of a massive trade network. From the obvious, like our smartphones, to local produce labeled and packaged with materials from across the globe, everything is connected and reliant on the proper functioning of this network. The pandemic has thrown this system into chaos. The specific issues are too numerous to count, but all can be traced back to one of three problems that were born of the pandemic last year.

In the depths of the pandemic recession, many companies faced the prospect of bankruptcy without government assistance. In this context, it made good business sense to operate conservatively. Existing inventories were spent down or maintained at minimum levels, given the future uncertainty. But the economy recovered far more quickly than anticipated across many industries. As it did, many businesses were exposed with a bare minimum of inventory to sell. By this spring, the measure of inventory to sales matched a historic low, leaving the economy as a whole with very little slack and exposed to any supply disruptions.

As inventories dwindled, a change in consumer behavior revealed our supply chains were more fragile than we knew. Put simply, in the last year we all bought more stuff as we sat at home. Rather than going out to dinner or on vacation, we bought furniture, electronics, and gardening supplies. An economy that was already reliant on overseas goods making their way to our doorsteps became even more so during the pandemic. Many restaurants are still half-full, but the ports around Los Angeles are experiencing the highest volume in their history this year, as we all collectively change our spending habits.

Lastly, an ongoing labor shortage has left many companies scrambling to simply keep their doors open, let alone run efficiently. Millions of people are either unemployed or have dropped out of the labor force since the start of the pandemic. Nearly every company we follow has mentioned this as a present or looming problem in the discussion of their business prospects. FedEx complained of a major delivery hub operating with only 65% of the necessary employees and JB Hunt, the nation’s largest trucking company, says it is unable to find more drivers. Such labor shortages clearly affect the transportation of products around the world.

Any one of these developments would have challenged the seamless operation of our globalized economy. Taken together, the combined effect of lean inventories, shifting consumer spending patterns and a labor shortage have crippled the economic supply chain. Ports are overcrowded, trains are backed up for miles, automobiles are on backorder for months and the cost of shipping anything is rising at a rapid pace. Still, the U.S. economic picture is relatively positive compared to others. As many here worry about the holiday shopping season, Germany and China are scrambling to secure enough oil and coal to ensure households and industries can keep the lights and heat on this winter.

Current Strategy

Despite the difficult situation for many companies, there is reason for optimism. First and perhaps most significant, the sheer gravity of the problem has catalyzed politicians and executives. Wages are rising, hours are being extended, and a collective focus on the problem is likely to accelerate its resolution. Furthermore, we are once again on the downside of a coronavirus spike. A resumption of something echoing normal life means that parents can return to full work with kids hopefully remaining in school; semiconductor plants in Malaysia will be allowed to return to normal operation after prior shutdowns; and our spending habits can shift back to a more sustainable balance between goods and services. As investors, it is always critical to remember how far into the future the stock market typically projects. The next several quarters could prove challenging, but the longer path back towards normal economic activity is probably the smarter wager to make today.

Ford Motor is a good illustration of this contradiction. Automobiles stand out as one of the sectors most sabotaged by the current supply chain chaos. Dealerships have no inventory and cars are on backorder for months as the industry waits for semiconductors. Yet underpinning this backlog is also a tremendous amount of pent-up demand, particularly for new EV technologies. Despite what are certain to be some challenging months ahead, Ford is pushing ahead with an $11 billion investment in new plants in Tennessee and Kentucky, creating 11,000 jobs and producing electric trucks in 2025. Short-term pessimism is taking a back seat to longer-term optimism, and we see this narrative playing out across many companies and industries.

We did little to change our investment positioning in the most recent quarter. Through the end of last year and the beginning of this one we had begun to reorient our mix of investments to companies that stand to benefit from a reopened economy, industrial and manufacturing growth, and a more even economic recovery. The supply chain crisis has tested this thesis, but we think it will abate in the months to come, and that many of our investments stand to benefit in the process.

Inflationary pressures have continued through the summer. What the Federal Reserve labeled as transitory forces have proved far stickier, with inflation starting to move bond yields higher. Our heavy position in cash versus longer bonds has been the correct approach for over a year now. Low-yielding cash is never a permanent solution for an income-focused investor, but there are times, like the past year, when cash is far preferable to long bonds, which have lost 10% or more in value in many cases. Yields should continue to rise in our view, which would continue to pressure bond prices. However, this forecast has to be tempered with a good dose of uncertainty, and as such, we anticipate resuming staggered Treasury bond purchases that would accelerate as yields rise.