Y = C + I + G + (X – M)

Those who have taken economics courses may remember the equation above, which lists the components of GDP.  GDP (Y) is the combination of consumption (C), investment (I), government spending (G), and net exports (exports (X) less imports (M)).  The recovery that began in 2009 in the United States has been tepid relative to previous recoveries (although better than in most other rich countries) though not because of weak consumption, which in fact has been growing by as much as 2.8% over the last few years, and whose current run rate is 3.2%.  Imports aren’t the problem either.  The U.S. has been a net importer since the 1970s, but imports’ negative effect on GDP has actually shrunk since the Great Recession.  Instead, it is government spending which has been weakest, not rising above 0.5% year over year growth in about six years. 

Both of the leading presidential candidates have espoused increased infrastructure spending as a way to improve on our existing stock and put people constructively (pun intended) back to work.  If fiscal stimulus kicks in, especially in the form of real investments in U.S. infrastructure of all kinds, but particularly transport infrastructure, it would in turn lead to more private investment, increased consumer spending, and a more bullish stock market.

Our Fully Depreciated Infrastructure

The state of infrastructure in the United States is terrible, the worst of the rich countries – or so it seems.  The Metro system of Washington, DC – relatively new, having been built in the 1970s – may need to close down in part for months at a time for renovation.  Children in Flint, Michigan run a real risk of permanent nervous system injury due to lead in the drinking water.  A blackout in Southern California in 2011 left seven million people without power in San Diego and nearby areas.  The list goes on….

It’s easy to imagine things are better elsewhere, but that’s not always the case.  Japan has efficient bullet trains but they are part of a system that is now over 50 years old.  Germany has good roads, but they are largely in the former East Germany, which received a massive infrastructure investment immediately after reunification.  With increased austerity over the last decade however, large parts of western Germany’s infrastructure, most famously the autobahn, are in poor shape. 

Government has a big role to play in improving infrastructure, as many of the critical elements of said infrastructure are public goods, such as roads and bridges.  Over time it has also become public policy to promote access to private infrastructure, such as the electrical grid or broadband communications.  Since government does not operate on the profit motive, but tends to try to satisfy the most voters, problems of various sorts have repeatedly cropped up in infrastructure development, often related to waste.  “Roads to Nowhere” are a recurrent theme, particularly in remote places such as Alaska or West Virginia, while truly critical facilities deteriorate.  Despite the heavy involvement of the government, however, private entities are very frequently included in infrastructure development and management, and many innovative solutions for our infrastructure problems today are coming from the private sector.  For example, US freight railroads, almost completely in private hands, are in excellent shape.

What Could Be Done

We would not be surprised to see increased infrastructure spending, regardless of who becomes the next president.  Likely, they will be motivated by a combination of factors to favor projects which have large numbers of jobs associated with them and, as always, are at least in part efforts to reward political allies.  Fair enough, but that doesn’t mean these have to be “make work” projects, as there are plenty of real needs.  And it’s important to remember that infrastructure jobs on average pay about 30% more than other jobs for non-college graduates.  That’s good for consumer spending.

In terms of guiding the spending, the decision makers should keep in mind that the technological revolution affecting so much else in our lives is also already having an impact on infrastructure.  The use of electronic tolls is a now widespread example.  A very intriguing area is the combination of the sharing economy and autonomous vehicles.  Though not even in existence 10 years ago, Uber and Lyft have now become major providers of transportation and pose noteworthy threats to existing systems.  Over the same timeframe most major automobile manufacturers have begun development of driverless cars.  If the two concepts are combined, it is possible that at some point in the not distant future one will be able to contact Uber on a smartphone and have a driverless vehicle show up to take one almost anywhere.  At the point that driverless cars are the majority of vehicles on the road, automobile density may safely rise without sacrificing speed.  The attractive combination of price, convenience, and safety may cause demand for mass transit to decline. 

Another new technology which conceivably could have some impact on infrastructure is the use of drones.  While the days of people flying in a drone are far off in the future (if ever), there are some ways that the devices could be useful sooner.  The most plausible scenario we have heard of is driverless delivery trucks equipped with drones to take the package from the curb to the doorstep. 

Other technologies that show promise for the future include photovoltaic cells.  Their increasing efficiency and wider adoption will reduce the stress on the existing grid.  The need for clean water here in California, as well as other parts of the world, is being met not only with new desalination technologies but also through cheaper purification techniques to recycle waste water, which require vast amounts of electricity.  Photovoltaics could provide some of this necessary power.

Despite these examples, it is likely that much of the infrastructure of the future may not differ dramatically from what we have now.  Newer or repaired versions will simply restore the functionality of the original system.  Some simple solutions, like carpool lanes, can substantially add to capacity.  Continued application of new technology, such as better rail and air traffic control software, or smart utility meters, can also effectively add capacity without the need to build.  Once in place, the renovated and new infrastructure would likely help eliminate or reduce inefficiencies in the economy and improve quality of life (for example by reducing traffic jams, minimizing blackouts, and ameliorating the impact of droughts). 

It is important to realize that as computer power and computer connectivity are likely to play a part in making the most of our infrastructure, computer networking itself is now a significant part of the infrastructure.  Minimal government intervention is necessary here.  Purely profit-seeking companies in highly competitive industries are building out data centers and fiber networks as well as developing next-generation wireless technology to increase capacity of the cellular and Wi-Fi networks in densely populated areas.  These efforts will ultimately lead to the extreme interconnectivity of the Internet of Things. 

Of course, despite the positive economic impact, finding the money for infrastructure investments has always been an issue.  Government spending on infrastructure would increase the deficit, at least temporarily.  A prime source of money for many projects is the Federal Highway Trust Fund, funded by Federal gasoline taxes.  However, such taxes haven’t increased since 1993 (they are levied on a cents-per-gallon basis with no inflation indexing) even though inflation has risen 65% in the interim.  Furthermore, with more fuel efficient automobiles on the road today, the tax revenue per mile driven (per mile of wear and tear on the roads) has gone down.  This rate should be adjusted.

There are also the possible negative effects of some of these changes to be considered.  Truck drivers of all sorts constitute approximately one percent of the work force with substantial organized labor representation.  Resistance to driverless trucks could easily be quite strong.  So we don’t mean to imply that accomplishing the rebuilding and rethinking of our infrastructure would be easy, but it would be desirable.  

Investment Implications

Massive spending on infrastructure in general likely would have significant macro level implications.  In keeping with the GDP equation mentioned at the outset, any meaningful increase in government spending will increase overall economic activity noticeably.  If done right, all the building would tend to lower unemployment and increase secondary spending.

If overall GDP growth was in the 3% range instead of 2%, this would be positive for earnings for all kinds of companies.  A meaningful infrastructure spending program would increase economic growth.  The resulting rising wages would be good for the consumer sector and rising interest rates would be good for many financials.  Many sectors would be positively impacted, and our allocation to equities would probably increase from what is appropriate to the current slow-but-steady growth environment.

Various industries and subindustries could participate if the ball got rolling on an infrastructure rebuild.  Among other areas, firms in the water and power industries would benefit.  Utilities which supplement existing electricity generation efforts with “peak power” at times of high demand are intriguing.  In the water area, makers of equipment for water treatment and filtration, as well as the companies that buy and use that equipment (utilities, for example) would likely reap the benefits of an infrastructure reboot.

As mentioned, companies providing digital infrastructure, whether it be fiber optic service to homes or “cloud” storage of data, remain interesting.  In traditional infrastructure improvement, maintenance, and build out, there are companies involved at various points in the process.  These would include engineering firms which are designing and overseeing large construction and renovation projects, equipment manufacturers, materials (aggregate, cement etc.) suppliers, and even those creating components in buildings (such as systems for security, heating/air conditioning, and electricity control).  Even in the energy sector — not usually considered a part of infrastructure per se — there are noteworthy opportunities in oil pipeline firms. 

Market Update

Until the end of June, the stock market traded within a fairly narrow range for most of the second quarter.  Investors had been encouraged by continued moderate economic growth and a mild acceleration of inflation.  Oil prices have been continuing to recover from the low levels reached earlier in the year, and, while U.S. job creation in May appeared weak, the overall employment picture has remained relatively bright throughout the year overall.  The Federal Reserve elected to take no action on raising interest rates at its June Open Market Committee meeting.

Then, a “Brexit” vote in favor of the United Kingdom leaving the European Union took investors by surprise and stocks tumbled in response.  The potential for restrictions on free trade, immigration, and travel raises questions about the future rate of economic growth for both the U.K. and the rest of Europe.  There may be indirect effects on U.S. economic growth as well.  Some initial guesses are that the Brexit could lower U.S. GDP growth by 0.2% per year.  An ensuing flight to the perceived safe haven of bonds caused interest rates to drop to near-cyclical lows.

In spite of near-term market volatility, our own view is that the economic environment in the U.S. is good enough for equity investors to earn moderately positive returns.  Political turmoil in Europe warrants close monitoring, but at this point we do not think it will derail our economy.  Valuation levels are slightly on the high side, but not enough to be in speculative territory.  Our focus continues to be on finding companies that are generating growth in revenue and cash flow, rather than relying on expense cuts to drive profit growth.

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