Cathie Wood: The Big Risk Is Deflation, Not Inflation

The big risk ahead over the next five years is deflation, not inflation, and it will benefit investments in innovation strategies, according to Cathie Wood, founder and CEO of Ark Invest.

Innovator companies, whose share prices have tumbled 30% to 35% from their heights earlier this year, are likely to return 25% to 30% in each of the next five years from their current levels, Wood predicted.

“In terms of the recent behavior of value stocks, especially those we believe are in harm’s way, compared to the severe draw down of innovation stocks, I like the set-up very much,” Wood said.

While the current situation is reminiscent of the run-up in prices from 2006 to 2008, the bond market is signaling that may not be the case, Wood said.

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Instead of 10-year Treasury yields rising significantly as they did during the 2008 financial crisis, the bond market “has settled down” following a sharply higher move in yields earlier in the year on inflation fears and the potential impact of higher taxes on capital gains, she said.

Wood offered her views on potential market winners and losers in a period of deflation in her monthly webcast for May.

Good Deflation

Treasury yields are not moving higher because the bond market is now seeing three sources of deflation, according to Wood.

First, bond market investors see what Wood called “good deflation” coming from innovation that spurs an economic boom.

Wood cited several examples of good deflation she expects from innovation strategies.

Advances in DNA sequencing can lead to lower health care costs, Wood said, impacting prices in 20% of the economy, potentially bringing deflation to the health care sector, where costs have risen steadily over time. “For every cumulative doubling in the number of whole human genome sequences … health care costs decline 40%,” she said.

“We are only in the early days of cumulative doubling” of DNA sequencing, she added, with continuous improvements and cost savings ahead.

Advances in battery pack capabilities are another example of good deflation, Wood said. “For every cumulative doubling of capacity in battery packs for electric vehicles, costs drop 28%,” she said.

Wood foresees potential deflation from a decline in artificial intelligence (AI) training costs, which she said are expected to drop between 37% and 50% a year. “Artificial intelligence is going to permeate every sector, every industry, every company.”

Bad Deflation

The good deflation from innovator strategies will spur the “bad deflation” from the creative destruction of companies that fail to innovate, Wood said.

“Roughly 50% of the S&P 500 is at risk by this creative destruction,” Wood said. “Those companies spent the last 20 years catering to short-term investors, who wanted their profits and they wanted them now, companies that were leveraging up to buy back shares and not investing enough in innovation.”

These companies did not take seriously the threat innovation posed to their businesses, she said.

The potential commercialization of electric vehicles was seen as being a decade away in 2014 when Ark Investment was launched, Woods recalled. At the time, however, she viewed it as already underway.

“Now we see auto manufacturers are scrambling and I would even say scrambling for dear life,” Woods said.

As demand for autonomous electric vehicles takes up, it will “put a big dent in oil demand,” she added

The two sectors that have done best this year—energy stocks and financials—will see big impacts from creative destruction, according to Wood.

In the financial services sector, growth in assets held in digital wallets is moving a pace that is “faster than anyone could have believed,” Wood said.

China showed the way with WeChat Pay and now Alipay, Wood said. In the past five years, however, Venmo and Square’s Cash App have been moving so quickly that their user bases have rapidly scaled up to a level higher than JPMorgan’s customer base, she noted.

“The digital wallet evolution or revolution has gone viral,” Wood said. “So financial services buyers beware.”

Commodity Prices

The third source of deflation will come from falling commodity prices that will take place as early as the end of this year, maybe next year, Wood said.

“We believe that there is a lot of double and triple ordering taking place right now,” she said. “I think supply chain management systems are getting better so maybe it won’t be as bad as it has been historically.”

Wood expects inventories to build to a level well above demand sometime next year and that the unwinding of them will cause an unwinding of commodity prices.

She cited the soaring “break-out” all-time high in the price of copper from its 15-year trading range as an example that commodity prices that are vulnerable to a correction.

Wood acknowledged her investing strategy based on future deflation comes with risks.

“If we are wrong … then we will be perhaps uniquely wrong,” Wood said.

Even so, the reward can be greater.

“At these times, if you do take a stand differentiated from the crowd—for a good reason and not just to be a contrarian—the payoffs can be enormous,” she noted. “We do think the bull market has broadened out and we look forward to innovation rejoining the party once again.”

In April, Ark Innovation Fund invested $246 million in Coinbase shares when the company went public on the Nasdaq. At the same time, Ark sold some of its Tesla stock, even after Wood said in March that she thought Tesla shares could hit $3,000 by 2025.

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Tags: Ark Invest, Bitcoin, Cathie Wood, Coinbase, Commodities, copper, Cryptocurrency, deflation, electric vehicles, Inflation, Tesla

Japan’s $1.6 trillion Government Pension Investment Fund (GPIF) is looking for ways to divine the benefits of investing in alternative assets, but without some of the drawbacks that come with them, such as liquidity issues and high fees.

And replicating alts’ performance using traditional exchange-traded funds (ETFs) is one method that seems to have piqued the pension giant’s interest.

The pension fund recently released a report that it commissioned from Nomura Research Institute that investigated replicating alternative assets using exchange-traded assets. The report said that while there are “several drawbacks” that come with investing in alts, replication “could help to mitigate” those shortcomings.

The GPIF said it is allocating to alternatives in order to get better risk-adjusted returns because they “offer different risk/return profiles than public equity and traditional fixed income and tend to be uncorrelated or even anti-correlated with public markets during short-term bouts of volatility.”

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The drawbacks of alts, as cited by the report, are that they are “highly idiosyncratic” as a function of the investment strategy and the specifics of the assets involved, and that capital allocated to alts often sits around doing nothing for long periods of time before being invested.

“To successfully invest in alts, pension funds have to scale up their exposure over numerous years while managing risk, evaluating performance, and refining their ability to select investment opportunities,” the report said. “Additionally, pension funds heavily allocated to alts, like certain European/US ones with double-digit alt allocations, have to address the issue of ensuring sufficient liquidity to fund pension benefit outflows.”

The report’s three main areas of focus were: alternatives replication techniques that use traditional/exchange-traded assets; management fees and performance evaluation methods; and basics of alternatives performance data and indexes.

Nomura constructed a replicating portfolio by re-weighting a public equity index to mimic a private equity market index’s attributes, such as its size weights and sector weights. Its implementation method included investing in periodic installments, similar to dollar-cost averaging, and evaluating the performance based on things such as returns and the Sharpe ratio. The institute used a 2018 paper titled “A Bottom-Up Approach to the Risk-Adjusted Performance of the Buyout Fund Market” by Jean-François L’Her as a reference on how to construct index-weight replicating portfolios.

The researchers found that their replicating portfolio’s simulated performance “roughly coincided” with a private equity index’s long-term performance, and that one of the benefits of replication is the ability to rapidly scale up exposure without worrying about illiquidity. The report added that replicator products could be used to deploy capital waiting on a capital call.

The report also said that while private equity fees “look high at first blush,” it found that they are reasonable and not necessarily as high as other asset classes’—at least relative to returns. However, it did note some of the issues investors have with private equity fees, such as charging flat management fee rates regardless of how many assets are under management and charging performance fees even on beta.

Research for the paper included interviews with outside experts, who said that some of the practical drawbacks of replication include inconsistent performance and insufficient precision of replicating high alpha funds’ performance. The report concluded that continued efforts, including research, to improve replication techniques’ accuracy are well-advised.