Q4 2022: Commentary From ARK’s CIO

Catherine Wood, Chief Investment Officer / Portfolio Manager

January 18, 2023

Broad-based global equity indexes[1] appreciated in the fourth quarter, even as investor sentiment continued to deteriorate. Fear of the future is palpable these days, but historically crisis has created opportunities. According to the latest BofA Fund Manager Survey, cash levels are at their highest since the 9/11 crisis in 2001, and investors are overweight bonds for the first time since April 2009. In December, the Chicago Board Options Exchange (CBOE) equity put/call ratio[2] surged above 2.0,[3] the highest level on record, surpassing the ratios in both the tech and telecom bubble and the Global Financial Crisis. In hindsight, both of those times were terrific opportunities to put funds to work in highly differentiated ways. ARK believes that this time will be no different and that innovation strategies are likely to be prime beneficiaries when equity markets recover.

The US Federal Reserve (Fed) has held steady on its promise to squelch inflation by voting unanimously to increase rates. The bond market is signaling that the Fed could be making a mistake. Since March 2021, the yield curve[4] has flattened by more than 200 basis points, inverting from +159 to -84 basis points,[5] suggesting that if the Fed does not pull back on its rate increases, both real growth and inflation could surprise on the low side of expectations. At -84 basis points, this inversion is worse than at any time since the early eighties when double-digit inflation was entrenched. In our view, deflation is a more significant risk than inflation, with commodity prices and massive retail discounts during the holidays corroborating this point of view. The prices of gold, copper, and lumber––three commodities that led or flagged the rise in broad-based inflation––are down -12%, -23%, and -78% from their post-COVID closing price peaks, respectively, and are flat to down on a year-over-over basis.[6] Although previously an outlier, oil price inflation has decelerated from an increase of 99% on a year-over-year basis in early 2022 to 4%.[7] Surprisingly, even though the oil price has dropped from $130 per barrel to $70, the S&P Energy Sector ETF (XLE) is not far from its all-time high.[8] Yet, we believe energy––the strongest-performing sector since the rotation from growth to value began in late 2020––is likely to be disrupted and disintermediated by autonomous electric vehicles during the next five years.

During 2022, Fed Chairman Powell raised the Fed Funds Rate an astounding 18-fold from 0.25% to 4.50%, compared to the two-fold increase from 10% to 20% in the early eighties when Fed chairman Volcker was battling inflation that had accelerated over 15 years. Today the Fed seems to be responding to COVID- and Russia-Ukraine war-related supply shocks that surfaced in little more than 15 months. During that time, companies appear to have double- and triple-ordered goods to satisfy stronger-than-expected demand that now is diminishing. US consumer sentiment[9] remains at levels last seen during the early 1980s when the economy suffered back-to-back recessions and inflation and interest rates hit double digits. Meanwhile, the consumer savings rate has collapsed to 2.4%––near its lowest level on record[10]––which, when coupled with historically low consumer sentiment, suggests little room for solid consumption growth. In ARK’s view, unanimously the Fed is making decisions based on lagging indicators––employment and headline inflation––despite significant price deflation in the pipeline.

The combination of geopolitical forces and inventory hoarding has pushed US consumer price inflation––a lagging indicator––to 7.1% on a year-over-year basis,[11] a rate that we believe deflationary forces––good, bad, and cyclical––are beginning to unwind. Tesla’s CEO Elon Musk[12] and Doubleline’s CEO Jeff Gundlach[13] have echoed our concerns about the risk of deflation.

Innovation is a potential source of good deflation, assuming learning curves cut costs and increase productivity. Yet, we believe many companies have catered to the short-term-oriented, risk-averse shareholders and have satisfied demands for profits/dividends “now”. On balance, they have leveraged their balance sheets to buy back stock, bolster earnings, and increase dividends. In so doing, many have curtailed investments in innovation and could be ill-prepared for the potential impact of disintermediation associated with disruptive innovation. Saddled with aging products and services, they could be forced to cut prices to clear unwanted inventories and service debt, causing bad deflation.

If we are correct in our assessment that growth, inflation, or both will surprise on the low side of expectations, scarce double-digit growth opportunities should be rewarded accordingly. The adoption of new technologies typically accelerates during tumultuous times as concerned businesses and consumers change their behavior much more rapidly than otherwise would be the case. As a result, new leadership tends to surface in the equity market toward the end of a bear market. We believe the coronavirus crisis and Russia’s invasion of Ukraine have transformed the world significantly and permanently, suggesting that many innovation-driven strategies and stocks could be productive holdings during the next five to ten years.

In our view, the wall of worry bodes well for equities in the innovation space. The strongest bull markets do climb a wall of worry, a fact that those making comparisons to the tech and telecom bubble seem to forget. No wall of worry existed or tested the equity market in 1999. This time around, the wall of worry has scaled to enormous heights.

While the 2022 bear market obscured many disruptive breakthroughs, innovation continued apace thanks to artificial intelligence (AI), genomics, and space exploration, among others. ChatGPT, a version of GPT-3 tuned for conversation dialogue, already scores above the national average on SAT questions, highlighting the power of AI. In the UK, a research hospital used an advanced version of gene-editing called base-editing to cure a 12-year-old girl with leukemia who had failed dozens of therapies. SpaceX launched 61 Falcon9 rockets, reusing the last one within 21 days, compared to 356 days for the first one. In our view, companies sacrificing short-term profitability to invest heavily in innovative technologies have exponential and highly profitable long-term growth opportunities.

During the fourth quarter of 2022, ARK’s six actively managed ETFs and two indexed ETFs underperformed relative to the broad-based global equity indexes.[14]