July 2016 Commentary

There have been more than a few economists and economic commentators alike that talk about the economy being in a state of “new normal.” There are a few areas of concern, which I will highlight in a moment, but on the whole we see this new state as a great opportunity. The rules of the game are changing, and each manager, young and old, are having to learn them as they are written.

Now for the areas of concern. The majority of the economic and market instability can be broken down into three general categories – the US, the European Union (“EU”) (still including the UK), and China/Japan. Starting with the US, as we mentioned in our monthly newsletter, we are in the midst of another earnings season, and it has been a relatively strong one thus far with big names like Apple, Alphabet (parent company to Google), and Amazon all posting earnings that came in well over the expectations of Wall Street. On the other hand, there were also some significant soft spots coming from companies like Ford and McDonalds who both reported much lower than expected US sales, and as a result, lowered guidance going forward.

Averaging out some big beats with some big misses, we arrive at the “relatively strong” I emphasized above. The reason for this is that we should now be asking, “What do these lukewarm earnings say about the market as we head into the second half of 2016?” I will posit two cases that both explain our current situation, and shed some light on how we will position the portfolio going into the second half of this year. The first case is there are certain businesses who through this unstable bull market have continued to streamline their processes and improved various aspects of their models, products, services, etc., and have been able to capitalize on the selective strength of consumer spending. Despite our most recent GDP data coming in much lower than expected, the largest contributor (by a very large margin) was consumer spending, however, this most recent earnings season is a great example that this spending has in fact been selective. The second case is less optimistic with beats being the product of lowered C-suite guidance from the end of last year and the first half of this year, the struggling economic data from the first half of this year, and a considerable amount of uncertainty leading up to the Brexit vote resulting in lower expectations from Wall Street analysts. These two cases lend us to position defensively, especially at current asset prices, to maximize downside protection in the event of a correction, but also to allow us to take selective long positions in companies we still see significant upside. Turning to another area of concern within the US, the growing debt problem. Since 2008, our federal debt, as a portion of GDP, has skyrocketed from around 60% to over 100%. This is an extremely concerning trend, and one which I will spend more time on in next month’s letter highlighting similarities between the situation here and what has been going on in Japan, so stay tuned.

Moving East to the EU, and to extend the metaphor, the post Brexit world has very much been a tale of two regions. The UK has been largely in a state of economic standstill with things like automotive and housing purchases grinding to a halt. Yet, one positive sign has been the FTSE 100 (the 100 largest companies on the London stock exchange) has seen a tremendous rally since the Brexit vote over a month ago. Across the channel, a few formerly weak parts of the EU are now showing some early signs of economic growth. In Spain, June retail sales made a strong surge and handily beat expectations. In Italy, both business and consumer confidence saw upticks for June, which could indicate the emergency monetary measures the Italian government is trying to orchestrate with the help of the European Central Bank (“ECB”) have been somewhat successful. While it is still way too early to make definitive proclamations about the effects of Brexit, it appears at the one-month mark, on net, it has been more harmful to the UK than to the remainder of the EU.

The final points of concern I will highlight this month are Japan and China. While China was widely discussed at the beginning of this year, it has taken a back seat to its neighbor, Japan, in recent months. This has resulted in China suffering in silence, as the economic woes that were reported a few months ago have not abated. While it appeared in the first quarter of this year that China’s economy had begun to strengthen again, as reflected in the increased value of the Yuan over the dollar, the second quarter had other plans as the Yuan gave up all of the gains it had made and then some. Things worsen when you turn to the state of the Chinese consumer. Over the past few months we have sustained a trend of year-over-year (“YoY”) disposable income growth lagging behind YoY GDP growth. The ramifications of this being, as disposable income growth continues to slow, consumer spending growth will be capped and will also slow. This slowdown in consumer spending, a component of GDP, will have a feedback effect into the slowdown of GDP – further increasing its rate of decline. I contrast with China’s lack of coverage; Japan has been the center of attention in recent months leading up to the recent Bank of Japan (“BoJ”) meeting. On first read, the monetary policy decisions that came out of that meeting were not as dramatic as most would have hoped, but in next month’s letter I will spend more time giving the background of Japan’s current situation.


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