Renewed U.S. industrial policy supports our view that in the current market cycle (and perhaps for several years after), “real economy” stocks should outperform the growth stocks that dominated the 2010s. We like real economy equities that offer high free cash flow and dividend yields (and companies improving shareholder returns, for example through dividend growth).

Among energy transition stocks, we favor manufacturers of clean energy technology over site developers and utilities, as we’ll explain. We also like investing in energy transition infrastructure, such as battery storage projects. Among corporate recipients of CHIPS Act benefits, we prefer semiconductor companies that have close ties to the US military. Military spending, currently at a secular low relative to gross domestic product (GDP), may rise in the years ahead.

Part 1: Grim consequences: The path to industrial policy today

Hyper-globalization’s impact on the American worker

Policymakers and economists understood from the start that globalization would lead to some job loss and economic hardship for certain communities. However, they thought economic gains would far outweigh losses and the bigger pie would compensate those affected, through worker retraining and other types of redistribution.

The overall efficiency of the global economy did improve – and the U.S. consumer benefited spectacularly. By one estimate, for every U.S. manufacturing job lost due to soaring trade with China in the 2000s, the U.S. consumer gained about $100,000, or $200 billion in total.²

However, there were two practical problems with the way globalization unfolded. The first problem was that globalization did not happen gradually and its effects were not absorbed smoothly. In the 1970s and 1980s, manufacturing job losses due to globalization (and automation) were steady. Even in the 1990s when globalization’s pace was accelerating, factory payrolls held up. But in the 2000s, after China joined the World Trade Organization, globalization accelerated rapidly. The camel’s back broke, and manufacturing payrolls fell off a cliff.

A total of 5.7 million factory jobs were lost from 2000 to 2010 – nearly 10 times more than during the previous 30 years, from 1970 to 2000. Redistribution and worker retraining can be effective if change is slow and predictable, but in the event of a shock like this there is only so much worker support systems can do.³

Workers, especially men, had a hard time adjusting to the shock of massive manufacturing job losses. Social, health and economic pathologies have bloomed as a consequence.⁴

The share of working-age men not in the labor force rose from 5.7% at the start of the 1980s to 11.4% as of 2022. But the pain wasn’t smoothly distributed. It was concentrated in the eastern heartland, states east of the Mississippi River from Mississippi to Michigan (excluding the Atlantic coast). That region’s mortality rates soared above the coasts’ and the western heartland’s.⁵

Had globalization not occurred as an abrupt shock but progressed more steadily and predictably, it is safe to say that less of these pathologies would have emerged.

How outsourcing opened national security vulnerabilities

Globalization’s impact on national security also didn’t exactly go according to plan. Its architects assumed that after the Soviet Union collapsed, the global economy would reap a “peace dividend” indefinitely. And so it largely did, in the decades after the fall of the Berlin Wall in 1989.

But war, and the threat of it, eventually reemerged. Russia annexed Crimea in 2014, then invaded Ukraine in 2022. China in 2021 tested a hypersonic missile system capable of evading U.S. defenses.⁶ Governments started to question globalization through a national security lens. More specifically, governments in the advanced economies began to realize GDPs based primarily on services are a vulnerability.

Emmanuel Todd, an influential French historian and sociologist, recently wrote, “Western power, measured on the basis of GDP, is fictitious.”⁷ We think that is an overstatement, but helpfully provocative. While the U.S.’s GDP may outstrip China’s and Russia’s, it has a low non-services share of GDP and fewer military personnel.

The aforementioned U.S. social and health pathologies also create a national security vulnerability. A 2020 Pentagon study found that more than three-quarters of Americans aged 18–24 were medically unfit for military service. Obesity was the most widespread health problem.⁸

Part 2: How industrial policy can succeed

What is industrial policy? The case of the U.S. interstate highway system

Industrial policy can be defined as “an effort by a government to change the sectoral structure of production toward sectors it believes offer greater prospects for accelerated growth [or for national security reasons] than would be generated by a typical process of evolution according to comparative advantage.”⁹ In other words, it is an intervention by the government to go against market forces.

Recent policy initiatives are intended to reduce the services share in GDP and raise the nation’s industrial capacity. Politically, there is now a bipartisan consensus that this is a necessity.¹⁰

The history of U.S. industrial policy includes numerous examples of failure. The Synthetic Fuels Corporation, set up in 1980, failed spectacularly in reducing dependence on foreign sources of oil. But done right, industrial policy can create profound change that reinforces itself over time.

The largest and one of the most successful examples in U.S. history is the Federal-Aid Highway Act, passed in 1956 to build the interstate highway system. It was designed to connect cities and towns, lift productivity and, as today, improve national security. Mindful of the Cold War, the network of highways would allow military resources to be rapidly mobilized.

The government played a huge upfront role. By the early 1960s, U.S. public spending on highways totaled 1.8% of GDP. But as more drivers took to the road in the late 1960s and 1970s, the Highway Trust Fund, set up to maintain the roads, grew. The fund derives its revenue from gasoline and diesel fuel sales taxes. Over time, its balance started to rise. By the 1980s, public spending on highways fell to around 1% of GDP, financed entirely by the system’s own revenues from the public.

The fund’s surplus eventually eroded after the 2008 financial crisis. People were driving less (fewer tolls collected) and cars’ fuel efficiency improved (generating less in gas taxes). Highway maintenance costs kept rising. Since 2008, the Treasury Department has plugged the fund’s shortfalls with fiscal transfers.

Whatever its later financial troubles, the government, playing a heavy hand upfront, set off a system that became self-financing with its own internal source of demand. And still today, the interstate highway system is profoundly important to U.S. transportation infrastructure: While accounting for only 1% of all road mileage, it accounts for 24% of all vehicle miles driven in rural America.¹¹

The U.S. government is attempting to do something similar today when it comes to decarbonizing the economy, but rather than relying entirely on public financing, it aims to provide a set of carrots that stimulate private sector investment.

The Inflation Reduction Act: Carrots for Players in the Energy Transition

The Inflation Reduction Act is a misnomer: IRA is an energy bill. It, and CHIPS, are designed to use public funds to stimulate private capital investment, using subsidies and tax credits. These enticements to private-sector partners taper off, and then fully phase out once renewables are cost-competitive without government support, and emissions targets (reducing electricity sector emissions by 75% by 2032¹² ) are met.

IRA tax credits and subsidies are designed to push down the cost of renewable energy production and, in turn, a competitive power market should push down consumer energy prices over time, spurring a faster adoption of renewables.¹³ Economies of scale and technology learning curves have already resulted in sharp declines in the cost of wind and solar power. By 2030, Bloomberg New Energy Finance (NEF) projects that the cost of generating wind and solar power will be well below average wholesale power prices as a result of the IRA investment/production tax credits, which are expected to drive net costs (for solar) to just $15 to $25 MWh (chart below).¹⁴ If that’s the case, then there should be substantial continued investment in wind and solar generation, constrained only by the speed with which additions can be integrated into the grid.¹⁵

The increased expected cost competitiveness of renewables resulting from the IRA already appears to be accelerating private-sector capital spending commitments. In the subsequent eight months since legislators signed the bill into law in August 2022, companies announced more than $150 billion in private capital investment for U.S. utility-scale clean energy projects and manufacturing facilities – surpassing total investment in these projects commissioned from 2017–2021.¹⁶

How can industrial policy potentially impact investors? Changing profitability expectations

We think the energy transition that the IRA seeks to catalyze is likely to play out more visibly at the company level, as its incentives take hold and change profitability expectations.

The IRA offers manufacturers tax credits.¹⁷ That’s in part why the largest profit margin increases are likely to accrue to manufacturers. Single-stock analysts at J.P. Morgan Research are starting to incorporate these tax credits into their modeling of financial statements. Their initial conclusion: Expect big effects. They expect that by 2025, the IRA can double the profit margin for a representative renewables technology manufacturer versus the no-IRA baseline.¹⁸

Higher expected profitability is likely to drive up capex as firms begin to see more clearly their likely returns from newly expanded production. The end result: expanded renewables generation capacity relative to the pre-IRA baseline. Bloomberg NEF estimates that by 2030, there will be about 88,000 MW of additional utility-scale solar and wind capacity as a result of the IRA. That’s roughly the capacity of the Texas electrical grid in 2020.¹⁹

Project developers, however, may not experience spectacular profit gains. The IRA’s incentives for developers seek to remedy the geographic inequalities that grew during hyper-globalization. Under the IRA, project developers are entitled to multiple “stackable” investment tax credits, if their energy production is sited in a low-income area and/or an “energy community”²⁰ – that is, in the eastern heartland areas where shuttered coal and brownfield sites stand to benefit.

Another reason manufacturers’ profit margins are likely to increase more than developers’ is that under the IRA, even some of the developer credits will likely accrue more to manufacturers because of the market structure for critical components. For developers to receive the “domestic content” credit, for example, they need to purchase components from U.S. manufacturers of renewables technology, and there are relatively few of them today. Being highly sought after can give these manufacturers a new premium in pricing power that they may pass on to their customers, likely eroding the tax credit for developers – at least until domestic manufacturing capacity expands.²¹

The potential macroeconomic effects of renewed U.S. industrial policy

We do not expect large effects on trend GDP growth over the next decade. These laws’ economic multipliers are expected to be mostly low. The IRA’s intent is to reduce greenhouse gas emissions, and to the extent this is achieved, it will be a non-GDP benefit for U.S. residents and the global population.

Nor is the CHIPS Act meant to raise GDP. The United States is a high-cost destination for semiconductor chip production. (An executive from Taiwanese chip maker TSMC has said in an earnings call that production in the United States costs four times more than in Taiwan.²²) It is highly inefficient to reshore the industry, especially considering semiconductor chips are among the most easily transportable goods in the global supply chain. Yet CHIPS may increase domestic semiconductor-chip security, serving as a hedge against any future supply disruptions – a benefit, but not to GDP.

For these reasons, we wouldn’t be surprised if the economic multipliers from the IRA and the CHIPS Act were close to zero. To be sure, these bills may shift the composition of investment demand, away from housing toward manufacturing (which could be problematic, given the chronic U.S. housing shortage).

On the other hand, the third new law, the Infrastructure Investment and Jobs Act of 2021, is expected to boost GDP through traditional productivity effects. But the addition is too small to meaningfully accelerate trend growth.²³

New laws are expected to have little effect on long-run inflation expectations, but may spur more short-run variability

These three new laws aren’t likely to change long-run expected inflation, which is anchored by monetary policy and the effect it has on the labor market (as the fastest pace of rate hikes in 40 years has reminded us). The laws may well change short-run inflation variability, however, by increasing resource nationalism globally; barriers may create unexpected pressure on commodity prices in the years ahead.

To see what that looks like, consider the inflation shock the pandemic brought about. Remarkably, it didn’t alter long-term inflation expectations, yet it created tremendous short-run variability (chart below). The energy transition may cause similar inflation dynamics in the future, although likely not as dramatic (COVID hit suddenly, while the energy transition will spread over years and decades).²⁴

Nevertheless, a more variable inflation outlook may mean the Treasury market’s current pricing of inflation risk premia is too low.²⁵

Conclusion: Investment implications

Renewed industrial policy supports our expectation that the current market cycle is likely to be a “real economy” cycle, after the “growth cycle” of a decade ago. Within this real economy thesis, we like equities that can potentially offer high free cash flow and dividend yields, including those companies shifting their focus toward shareholder returns (e.g., dividend and buyback growth). When it comes to the energy transition specifically, we favor the manufacturers of clean energy technology over both the developers and the utilities. (Many of the IRA’s subsidies for developers will likely accrue more to domestic manufacturers.)

When it comes to energy-transition commodities, we note that China currently dominates the supply chains for many critical minerals related to renewables, leading the world in production of aluminum refining and smelting (67% of global capacity), lithium and cobalt refining (80% and 66%, respectively) and graphite production and refining (about 80%) – along with many other critical minerals.²⁶ We also note that while the IRA offers U.S. consumers a tax credit for buying an electric vehicle, half the credit disappears if vehicles do not meet the requirements for critical minerals to be extracted, processed and/or recycled in North America, or in a country with which the United States has a free trade agreement.²⁷

In light of this, exposure to commodities necessary for the transition to renewables may offer attractive investment returns less correlated to a typical portfolio of stocks and bonds. Another favorable way of gaining exposure to the energy transition outside of stocks and bonds would be direct exposure to energy-transition infrastructure projects. Two attractive examples are battery storage and recycling.

When it comes to the CHIPS Act’s implications, we prefer U.S.-domiciled foundries and integrated device makers (IDMs) that have close ties to the U.S. military—in other words, investments in technologies that have so-called “dual use” capabilities. Military spending is currently secularly low relative to GDP, and we think there is a good chance it may rise in the years ahead, given how the Ukraine War is rapidly depleting NATO stockpiles,²⁸ and the rising U.S.-China military tensions in the South China Sea.