Executive Summary
1. Welcome to the longest expansion. The current economic expansion has crossed the threshold and become the longest in U.S. history. Investors will likely hear two responses to this milestone: one, that old age alone doesn’t doom an expansion; but two, that old expansions do begin to suffer from some common age-related diseases. The two most typical ones are inflation (which can lead to a growth-killing response from central banks) and financial excesses. We don’t see either of these as clear and present dangers. Inflation has remained more muted over the past two decades than was the case for much of U.S. history, leading many economists to rethink the old lock-step between low unemployment and high inflation. And while there are some risks rising in certain corners of financial markets, such as leveraged loans, on the whole consumers remain quite healthy financially, and overall financial conditions in the U.S. are stress free. There is no immediate sign that the usual diseases are creeping up on this old expansion just yet.
2. Risks rise in China’s financial system, but haven’t reached alarming levels yet. Close analysis shows that a relatively thin slice of China’s banks are currently challenged by poor quality assets — i.e., non-performing loans — and that the small number of banks that are in trouble are confined mostly to rural banks and credit cooperatives. The government is continuing its policy of gradually tightening regulations to control the excessive growth of risky shadow finance, while maintaining ample interbank liquidity and cushioning the effects of any bank or fund failures. At some point, China’s financial system may become an issue — one likely to have global repercussions in spite of the system’s relative isolation. But that day has not yet come. We’ll keep you apprised.
3. Drug price efforts face an uphill battle. Bipartisan drug price legislation is brewing in the Senate, but is increasingly unlikely to be proposed before the August recess. The administration has floated several proposals for executive action to address drug prices; one rule would have changed the interaction between drug makers and distribution middlemen, but the administration dropped the proposed rule changes because analysis showed they would likely lead to higher drug costs for seniors. The administration has also proposed linking Medicare reimbursements to drug prices in other developed countries, where there are drug price controls. This proposal is likely to meet stiff resistance from drug companies (who are already preparing lawsuits) and conservative lawmakers, who accuse the administration of “importing socialism.” Health care pricing in general is likely to remain a political hot potato through next year’s elections, so we believe that investors who have no mandate to hold healthcare related stocks should steer clear of the sector altogether.
4. Market summary. U.S. stock markets advanced rapidly in June, finally rising to new all-time highs. With the S&P 500 at the top of its trend channel, and several technical signals suggesting that it is overbought, a near-term correction would be normal. We will use this weakness to add exposure to our favored areas for our clients — primarily large-cap U.S. growth stocks in industries with long-term tailwinds, such as artificial intelligence, data analytics, the cloud, cybersecurity, networking, defense electronics, and financial technology.
On July 9, Mexico’s finance minister resigned, and released a stinging criticism of the Mexican administration, stating that his ministry had been forced to employ unqualified people, and that his efforts to steer an evidence-based policy “free from all extremism of the left or of the right” had been thwarted. His departure casts a darkening cloud over Mexico’s prospects in the eyes of many international investors.
We continue to like gold; we believe that inflation may begin to accelerate, technical signs are positive, and many central banks are buying. Cryptocurrencies gave a typical shellacking to overzealous speculators, as bitcoin retreated rapidly from recent highs under pressure from high-profile government attention to Facebook’s [NASDAQ:
The Longest Expansion
The economic expansion that began in 2009 has now crossed the threshold and become the longest period of economic growth in U.S. history:
Source: Goldman Sachs Global Investment Research
Of course, this milestone has led to two responses: analysts and central bank economists reminding us that “expansions don’t die of old age,” and critics responding first, that they do die of age-related diseases; and second, that there are some new global trends at work that might make this time different.
Both sides are right. There is no intrinsic reason why periods of economic expansion must end. Australia, although a very different economy from the United States in both composition and scale, has not experienced a recession since 1991. Still, as expansions age, risk factors do rise. The question then is whether we see those risk factors rising for the U.S. right now.
The first expansion killer is wage-push inflation. As expansions continue, the unemployment rate can fall to levels where wage gains heat up, create inflation, and lead central bankers to jump in and raise rates to keep inflation tame, thus ultimately causing credit to contract and tipping the economy into recession.
For a variety of reasons, this is not now occurring. Technology may be one of the main factors, helping keep inflation much more tame over the past 20 years than in previous economic cycles. In economist-speak, the “Phillips curve” has flattened — a macroeconomic measure of the relationship between unemployment and inflation. Tame wage growth and inflation, even in the face of a tight employment market, may lead to an environment where central bankers don’t need to intervene.
The second age-related illness that can afflict mature economic expansions is financial imbalance and credit stress. We discussed this above in our description of the big picture of China’s financial system. Boom times tend to generate financial excess, as low rates, psychological exuberance, and increasingly lax lending standards lead to the over-enthusiastic creation of debt.
Again, although there are distant signs of excess in some areas of the U.S. financial system — for example, in the leveraged loans increasingly favored by yield-starved pension plans — U.S. consumers remain in much more robust financial shape than in the late stages of previous expansions. Further, our favorite composite indicator, an index of more than a hundred financial stress indicators compiled by the Chicago Fed, shows so signs of stress in U.S. credit as a whole.
Finally, there are new things going on in the global environment (though we really believe the old saying that history doesn’t repeat, but it rhymes — and current events are usually not as unprecedented as they seem). The current global reassessment of the last few decades of globalization — AKA “the trade war” — is one of these. Here again, though, we continue to believe that the fallout will simply not be as catastrophic as some alarmed analysts believe. So far, the evidence suggests that trade conflicts are having a very limited effect on the U.S. economy — both in terms of consumer spending, and in terms of corporate expansion plans (that is, capex spending). If tariffs ultimately act as a tax on consumers in the nations that impose them, you could frame the current and likely future effects of tariffs as a small tax increase following a much bigger tax cut. In short, not likely to be an expansion killer.
Investment implications: The usual age-related diseases that crop up at the end of long economic expansions are not yet creating trouble for the economy of the United States. Conditions can change rapidly, of course, so we monitor a group of variables closely, including U.S. dollar strength, corporate profits, consumer and small business confidence, and overall credit conditions. For now, in spite of ongoing turmoil surrounding trade, the light is still green.
Chinese Banks: No Danger Now, But Watch Carefully
On the fringes of the Chinese financial system, signs of stress continue to appear, so far restricted to some small banks and trust companies. The central government is continuing its efforts to unwind the excesses that built up after 2009, when it initiated a massive stimulus effort to counteract the effects of the global Great Recession. As often occurs after a boom time, institutions that reached too far and made loans that were too risky find the asset side of their balance sheet getting challenged.
In China, the trouble is currently restricted to a handful of small local banks, and some overleveraged trust companies. The latter are entities in China’s shadow bank sector — they are not illegal, but they are not as tightly regulated as official banks, and offer customers higher returns. Because these trust companies’ products are often sold to consumers by official banks, however, there is a public perception that the government guarantees their safety, and would make investors whole in the event of a trust company’s collapse.
As we’ve often noted to readers, China’s basic existential dilemma is straightforward. The bargain the government has struck with the people is to generate sufficient economic growth, and in return, the people will tolerate a certain level of corruption and lack of political and civil liberties. Should the Communist Party fail to deliver that growth, they would face a restive population, and potentially, the end of their rule. (This would not be an unusual development in the broad sweep of Chinese history, which has seen long cycles of centralization followed by the collapse and fragmentation of centralizing dynasties.)
Stimulus staved off the danger of a growth collapse, but at the cost of building up potentially destabilizing leverage in the financial system. For about two or three years, the priority has been to unwind the stimulus while maintaining sufficient growth. The government has tightened regulations, forced institutions to identify and clarify their risk burdens, and restructured or unwound troubled financial firms. But they have also kept the system flush with liquidity and almost universally protected individual investors from taking losses.
Careful analysis shows that at present, relatively few institutions are in trouble. A small bank in Baotou, in inner Mongolia, was taken over by financial watchdogs in May, causing some tremors. Analysts estimate, though, that at present, only about 5% of China’s banks are under any significant stress from impaired assets. The worry, of course, is that continued economic deceleration could cause the number of such troubled institutions to spike in an unanticipated way.
Many trust products — those savings vehicles we mentioned previously that many ordinary Chinese use to earn higher interest rates than what’s available from official institutions — are based on construction, housing, and infrastructure debt. So the fear is that a significant slowdown could cause a cascade of defaults typical of financial crises that occur anywhere in the world.
The worry for the rest of the world is that even though China’s financial system is largely closed, such events would lead to a dramatic slowdown in China that would be disruptive to the rest of the global economy, and could spread financial contagion that way. It is not just China whose financial system contains debt levels that could become problematic under higher interest rates and economic recession. In spite of the new era of skepticism about global trade, the fact remains that global economies and financial systems have become much more intimately connected over the past several decades, and will remain so even if trade relationships undergo radical renegotiation.
Therefore, we continue to watch the health of China’s financial system. Although there are signs of trouble at the margin, those have yet to get anywhere near the country’s major banks.
Investment implications: The health of China’s financial system is important to monitor, but it does not seem to be a current threat for global investors.
Trump’s Executive Drug Price Efforts May Face Legal Rebuff
Partisan gridlock has made legislative progress on many issues difficult to achieve — particularly healthcare. Senate Finance Committee chair Chuck Grassley has been in negotiations with his Democratic counterpart, Ron Wyden, since early this year to advance a bipartisan bill that would address high drug prices, and although both sides say that progress is being made, it looks increasingly unlikely that draft legislation will be ready before Congress’ August recess.
The administration has made several efforts to advance policy to control healthcare prices by executive action, and so far, these have come to naught. One rule would have changed the interaction between drug makers and distribution middlemen, but the administration dropped the proposed rule changes because analysis showed they would likely lead to higher drug costs for seniors (a key demographic for both parties, since seniors get out to vote more than younger cohorts).
Another administration proposal that’s still in early testing stages would tie Medicare drug reimbursements to drug prices in other developed countries. Of course, most other developed countries have drug price controls, so the administration’s conservative critics say that this policy would amount to “importing socialism.” Drug companies are already preparing to challenge the proposal in court — even though it has not yet officially been made.
The issue is made more complex by the administration’s stated desire to repeal the Affordable Care Act (ACA). The price proposal relies on a Medicare agency created under the ACA — the Center for Medicare and Medicaid Innovation (CMMI) — and if the ACA were repealed, the proposed new rule could lose its legal footing.
Certainly, there are political currents just under the surface, with the administration anticipating election-year politics and working to steal the thunder of a traditionally Democratic issue.
Investment implications: Healthcare is still a political hot potato — particularly the biopharmaceutical industry. Investors should keep monitoring innovative companies, but if a healthcare allocation is not a necessity, we believe it’s best to avoid the sector until political headwinds abate. Those who need a healthcare allocation should consider looking in less contentious industries within or related to the healthcare sector, such as medical technology.
Market Summary
The U.S.
The U.S. stock markets advanced rapidly in June, finally rising to new all-time highs. With the S&P 500 at the top of its trend channel, and several technical signals suggesting that it is overbought, a near-term correction would be normal. In our more active strategies, we will use this weakness to add exposure to our favored areas for our clients — primarily large-cap U.S. growth stocks in industries with long-term tailwinds, such as artificial intelligence, data analytics, the cloud, cybersecurity, networking, defense electronics, and financial technology. For our dividend-focused clients, we continue to seek companies with substantial and sustainable dividends and strong track records of dividend growth and will use pullbacks as opportunities.
Mexico
Since the election of Andrés Manuel López Obrador (AMLO) to Mexico’s presidency last year, we’ve been hopeful that he would be a more pragmatic leader than some of his past might suggest. Unfortunately those hopes are becoming increasingly dim. On July 9, his finance minister, Carlos Manuel Urzúa Macías, resigned, and released a stinging criticism of the Mexican administration, stating that his ministry had been forced to employ unqualified people, and that his efforts to steer an evidence-based policy “free from all extremism of the left or of the right” had been thwarted. His specific policy disagreements with AMLO were not described, but they almost certainly involve disputes about how to handle needed reforms to the state oil company, Pemex. His departure casts a darkening cloud over Mexico’s prospects in the eyes of many international investors — including us. We have seen Latin American countries go down the populist road many times, and the final outcome is never good for investors or for citizens. Our caution on Mexico is now high.
Europe and Emerging Markets
As we’ve noted in recent letters, we see the most favorable opportunities in the United States. Europe remains mired in political strife and entrenched low-growth policy and political culture. Emerging markets have participated in the global stock market rally in 2019, but are more exposed to trade-related volatility and economic trouble than the U.S. Potential exceptions are Brazil and India; in both countries, administrations are at work to undo the effects of many decades of poor policy, corruption, and excessive state intervention in the economy. India is further along this path; Brazil is just getting started under President Jair Bolsonaro, and although he has made strong progress, we emphasize that the problems he is addressing are deep and enduring.
Gold and Cryptocurrencies
For reasons mentioned in several recent letters, we continue to like gold; we believe that inflation may begin to accelerate, technical signs are positive, and many central banks are buying.
Cryptocurrencies gave a typical shellacking to overzealous speculators, as bitcoin retreated rapidly from recent highs under pressure from high-profile government attention to Facebook’s [NASDAQ: FB] Libra digital currency initiative. Bitcoin has continued to take share from alt-coins, and now again accounts for 65% of the global digital currency market cap. Among decentralized digital currencies, bitcoin may continue to demonstrate that network effects are king here as in other areas of tech. Increasingly, we believe the trajectory of digital assets will be towards stablecoins linked to fiat currencies, and digital currencies established by central governments. A case can be made for decentralized currencies in this context, but one that will be increasingly hemmed in by governments intent on restricting such currencies’ intersection with the official financial system. To speculators, our advice is, be cautious, and stay with regulated U.S.-based exchanges.
Thanks for listening; we welcome your calls and questions.
Equities Contributor: Guild Investment Management
Source: Equities News
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