Required Homework

EMR October 2021

Great Upheavals Create Major Investment Opportunities

Dear Reader

The investment outlook is rather bleak, driven mostly – but not solely – by lagging productivity, fears of rising inflation, and high and rising governmental indebtedness, as well “unwarranted” fears of an impending equity market correction.

What does the chart on long-term indexed equity indices suggest?

Poorest performance = NIKKEI
Mediocre performance = UKX and CAC
Best performance = SPI, DAX & DJIA.
Does the chart imply something about productivity and/or on something else?

Why the Focus on Productivity?

Over the years, we have learned that the best-performing companies (represented here by the respective stock index) in some sense can be quantified by the interaction of productivity, inflation growth and currency performance. Recently, however, productivity gains have been increasingly hampered by governments’ deficit spending. It is a fact that in the past those sectors of the economy that have been able to improve their productivity while providing “new” equipment (through innovation and technological progress) have experienced a significant boom and have prospered significantly. What role have currencies played is an interesting question. In this sense, we are not surprised that the SPI, the DJIA and the DAX perform so differently compared to the NIKKEI, the UKX and the CAC index. We do assume that equity markets are not an inflation hedging instrument but a play-ground for currency specialists! It can be deduced from the chart on real GDP that the problems dominating the current technological progress point to a difficult identification exercise of the companies and industries with the highest potential capabilities to solve the productivity problems, inflation expectations and currency reactions. We thus continue to focus on the innovative spirit of each company and/or sector of the economy. The focus must thus be on the power to innovate, to counterbalance the power to tax = the power to destroy.

The available real GDP data for the five industrialized nations clearly show us that there has never been a similar correction since the early 1980s, with the exception of the period from 2008 to early 2010!

The chart shows that the Swiss economic activity reacted with a “substantial” lag to the downward revisions of real GDP in the USA, Germany and the UK. The development in Japan is much more pronounced for the recession period 2007-2010.

The level and quarterly rate of output per hour, as published by the U.S. Bureau of Economic Analysis, are much less volatile than real GDP, relative to quarterly rates of change. Why this is so is the real question. Could it be that short-term productivity is much more sensitive to inflation – and, in particular, inflation expectations – than to general economic activity? Long-term analysis suggests that productivity responds much more quickly to general activity. In recent years, there has been a strong adjustment of productivity to the sectoral environment, which has not always been immediately visible in the macroeconomic data (real GDP). This is certainly due to the fact that companies have had – and will continue to have – new products and appropriate capabilities to increase productivity, both at the sectoral and company level. We all know that certain sectors fade over time while others emerge – just think of the changes in the automotive industry in the past, compared to the expectations of chip-driven automotive production.

How to Benefit From Productivity Changes

We take the liberty of asking the reader how he/she can benefit from the expected/feared productivity changes?

A rather arrogant way to start answering this very tricky question implies that one should preferentially invest in stocks that have historically shown the best productivity gains and a coherent response to significant productivity changes, i.e. stocks of companies that recognize and quickly respond to signs of a productivity turnaround?

If this approach may seem too difficult, there is another way, which is to reduce exposure to companies and industries with the worst productivity histories, either in the short term or, more importantly, in the long term. Our contextual argument is to take seriously the fact that turnarounds are sometimes quite dramatic, especially for companies or industry sectors with high debt burdens. A dramatic productivity turnaround, such as the one we are currently experiencing, is often accompanied by dilutive financing and a high debt burden. In such a case, the contextual argument is: “Buy the problem solvers” or with the corresponding slogans: “Invest in the doctors, not in the patients”.

Conclusions for Investors

Our conclusions should be seen as a specific consequence of an extraordinary shift toward technological innovation and away from the traditional “output per hour worked”. We should take the impact of new technology ever more seriously.

This also means that even if inflation were to fluctuate by 2% (which is historically low), equities would continue to perform better than fixed-income securities and money market instruments.

As a result, the USD is expected to rise against the EUR, the YEN and the GBP. The fact that the CHF, EUR and JPY have recently fluctuated in quite narrow ranges against the USD must be taken into account, also because the dark clouds in the currency sky do not bode well …

Any suggestion is highly welcome.



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