Guild Investment Management, Inc. present a global market commentary.
We note two important themes of which investors should be aware. First is the likely future impact of the Affordable Care Act (ACA), which our contacts suggest will (1) broadly push healthcare delivery into more informal venues such as pharmacies; (2) cause the overall financial health of the system to deteriorate; (3) raise prices for those already insured; (4) lead in the longer term to reduced services for end-of-life care and procedures for elderly patients; (5) push more Americans to seek care abroad for major procedures; and (6) reduce the availability of expensive drugs and increase the use of generics.
Another important theme is that inflation looks likely to begin making a comeback. We believe that commodity prices will be increasing this year for a variety of reasons — including continued economic acceleration in the U.S. and Europe, and continued growth in China, coupled with an increase in the velocity of money as QE continues. Pressure on oil supplies may also come from geopolitical instability and the ongoing retreat of the U.S. from its role as “global policeman.”
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2. Venezuela. Venezuela is an excellent case study in the “resource curse” and instructs us in how to look at resource-heavy authoritarian regimes. Venezuela is descending into chaos as it continues down its destructive path, and other oil regimes elsewhere in the world — such as Libya, Iraq, Iran, and Nigeria — are experiencing their own forms of instability. As noted above, we see the problems of these regimes as a potential constraint on the growth of the global oil supply as producers struggle to keep pace with rising demand.
3. Google Fiber. Google announced 34 more cities being added to its “Google Fiber” project. Google Fiber currently provides internet connectivity to Provo, UT and Kansas City, giving consumers there a connection 100 times faster than the competition at comparable prices — and free slower service to anyone who wants it. Some analysts think Google is serious about building out a nationwide system. Others think it is just sending a warning shot to the controllers of the internet’s pipes, to deter them from making deals which would favor data traffic from Google’s competitors.
4. Inflation. Brazil, the world’s number one exporter of coffee and sugar, has seen rising prices in these commodities due to severe drought conditions in the country, and according to a Brazilian weather service, January and February have been the driest months in Brazil in 30 years. Some analysts say that the impact of too much rain in Indonesia is damaging that country’s large cocoa harvest, and in North America, a brutally cold winter may have damaged the wheat crop. With respect to other grains, in the U.S, farmers are expected to plant less corn in 2014 and more soybeans to take advantage of already high soybean prices. Clearly, commodity prices are telling us something about inflation moving forward. Market summary. We believe U.S. stocks will continue to move higher in 2014, thanks to healthy corporate profits, improving GDP growth, and low interest rates. While our outlook is constructive for the U.S. and Europe (and eventually for Japan), we are aware of several psychological and geopolitical trends which may create significant market volatility. The prospect of such volatility makes us bullish on gold and oil shares, especially given continued Chinese demand for both these commodities. And we still have our eyes open for overvalued stocks in the U.S. Food, energy, and precious metals prices are rising. In our opinion, the biggest surprise in 2014 and 2015 will be that inflation, not deflation will be the problem.
5. Market summary. We believe U.S. stocks will continue to move higher in 2014, thanks to healthy corporate profits, improving GDP growth, and low interest rates. While our outlook is constructive for the U.S. and Europe (and eventually for Japan), we are aware of several psychological and geopolitical trends which may create significant market volatility. The prospect of such volatility makes us bullish on gold and oil shares, especially given continued Chinese demand for both these commodities. And we still have our eyes open for overvalued stocks in the U.S. Food, energy, and precious metals prices are rising. In our opinion, the biggest surprise in 2014 and 2015 will be that inflation, not deflation will be the problem.
Two Key Themes That Are Not Widely Known
Key Theme #1:
The Affordable Care Act (ACA) is going to change healthcare delivery in the U.S. in many ways… thus far, our research indicates that most of these changes are bad for the income of doctors, hospitals, and ethical pharmaceutical companies. Most of the changes will be good for generic pharmaceutical companies and for pharmacies.
In order to prepare for the ACA, we at GIM have spoken with numerous participants in the healthcare market — doctors, hospital administrators, and healthcare consultants who work with the U.S. and other nations to implement healthcare programs.
A few key points:
(1) 40 million new people will be added to the U.S. healthcare system due to the ACA. Question: Where are the doctors to treat these 40 million people? Answer: They don’t exist, so patients will be treated by more physicians’ assistants, RNs, LVNs, and nurse assistants — and more and more healthcare delivery (such as shots and vaccinations) will take place at pharmacies. Already in California and many other states, more and more shots and vaccinations are being administered in these venues.
(2) The U.S. healthcare system is truly financially broke. When we add 40 million new people to whom healthcare will be delivered, we can expect the financial condition of the system to deteriorate further.
(3) Where will the money come from? Medicare is thought to have excess money, although it is underfunded. The requirements for those who have incomes above $200,000 per year to pay more of their own healthcare will rise. Within a few years, all who have incomes in excess of $200,000 per year will have to pay much, of their healthcare costs even if they are over 65 years of age.
(4) Our contacts predict that within a decade, a substantial percentage of all insured will be under a single-payer system, and that system will be what we now call Medicaid. The cost of private insurance is already rising, and will continue to rise for the currently insured — as it becomes obvious that offering care to 40 million previously uninsured will greatly tax U.S. finances. Care will not be as available as it has previously been to the majority of currently insured, and will cost more for the average consumer. This will force more into the Medicaid system, which will give a potentially lower quality of care than the insured currently enjoy. Over time, U.S. healthcare will come to resemble more closely the socialized medicine of western Europe and Canada.
(5) Age limitations on operations… Over the longer-term (10 years plus), operations for joint replacements and even for terminal diseases will not be available through Medicare for those over 70 years of age. This may take the form of slowness and waiting lists, or just absolute refusal because of a patient’s age. This will be necessitated
by the extremely high cost to keep people alive in the last 6 months of their lives. Countries who currently have single-payer healthcare delivery (also known as socialized medicine) do not provide resuscitation and/or major operations to those over a certain age (this varies from country to country, but the cutoff averages about 70 years).
(6) Over time, more and more middle- and upper-income Americans will go abroad for medical treatments and operations — to India, Panama, Costa Rica, and many other countries which will become destinations for operations. Long waits will develop for operations in the U.S., and costs for private medical services will remain high — so many will opt to travel abroad for medical treatments.
(7) More and more drugs will be unavailable because of government edict. Many drugs will no longer be covered — first by Medicare and Medicaid, and eventually by private insurance plans… These will be drugs for rare diseases, as well as drugs for common diseases where the government has decided that a few drug options and more generics will suffice.
This process became clearer last Friday when the Obama administration proposed new edicts in this regard. Many more edicts and regulations from top down will take place in coming years. More individuals will have some healthcare insurance, but on average, domestic U.S. care will be less available and more expensive — and often unavailable to older Americans.
Please read the following article, which documents what is happening so far with the administration’s proposals for drugs prescribed for Medicare and Medicaid patients — Plan to Limit Some Drugs in Medicare Is Criticized (New York Times, Saturday, Feb 22). Our contacts tell us to assume that this trend will continue and grow — initially in government and eventually in private health systems as well.
Our conclusion: Focus investment dollars on generic drug manufacturers and on pharmacies as healthcare delivery mechanisms.
Key Theme #2:
Deflation is not the problem ahead. Most likely the problem ahead is inflation. Deflation seems to be in the news these days, and most investors are convinced that deflation is the continuing wave of the future. Fears of continuing deflation are causing many to continue to hold onto bonds, although they performed poorly last year, and they are keeping many investors from taking positions in base metals and food commodities.
We do not believe the conventional wisdom that commodity deflation will keep prices down this year. In fact, since last fall we have been carefully monitoring the charts of many commodities — food, base metals, and precious metals. Many of you know that gold bottomed on December 30, 2013. But how many of you have noticed that coffee has skyrocketed in price, and that sugar, soybeans, corn, wheat, and cotton have risen in price?
While it is in the news a that oil, natural gas, and heating oil are up, many attribute this to the current cold weather in the U.S. and parts of western Europe, and believe that demand and prices will fall when March arrives and the weather warms up in the northern hemisphere. We think energy prices could fall temporarily, but will rise longer-term, for several reasons:
1. The U.S. is engaged in a hands-off foreign policy in international affairs, which will decrease U.S. military expenses and increase political instability in the oil-producing regions of the world. Today, crises in Venezuela, Libya, Egypt, Syria, Iraq, and other oil-producing regions are decreasing oil production, and we believe that this is likely to continue or accelerate.
2. We believe that there are many warning signs of higher commodity prices in 2014. The drought in eastern Brazil and Argentina will decrease soybean, corn, dairy, and meat production from these countries and raise prices worldwide. And further, the demand for energy and the continued and growing political instability in the oil-producing regions of the Middle East makes it unlikely that big increases in oil production are possible from OPEC. Weather for the U.S. and European growing season will be uncertain, and should it not be highly supportive, world food commodities will rise in price throughout 2014.
3. Economic growth remains durable in China. Growth is modest in emerging Asia, and it is strengthening in Europe, the U.S. and Japan. GDP growth leads to higher incomes, and higher incomes lead to increased demand for gold, other precious metals, and foods.
4. Finally, we have mentioned for some time that massive QE taking place in many countries will create the fuel for inflation once the velocity of money speeds up in those nations. It is now the time in the economic cycle for the velocity of money to pick up.
In our opinion, inflation is the theme moving ahead in the U.S. — not deflation.
We have owned gold stocks, and have recently bought corn. We will buy more commodities if — as we suspect — this theme continues to play out.
Venezuela: Oil and Chaos
“Investors are watching as Maduro finishes killing off what had been Latin America’s golden goose” Venezuela is descending into chaos.
Protesters have been killed, American diplomats expelled, a key opposition leader arrested. (The current crisis was sparked by protests against Venezuela’s extremely high levels of violent street crime, and spiraled out of control from there.) As we’ve observed before, what is happening in Venezuela is neither new nor surprising — it’s predictable based on our long observation of corrupt, resource-centered economies run by populist demagogues.
Why Bother To Look At Venezuela?
If this is the case, why do we bother to keep watching?
For one thing, Venezuela is such a perfect case study that it could serve as a concise example of the whole pattern — which is valuable to any investor who is now, or may in the future be exposed to international markets.
But also, as we noted above, we believe that political instability will be one of the key factors constraining growth in global oil production. The continued slide of Venezuela into chaos is therefore worth examining in terms of its implications for other significant oil producing nations following a similar trajectory. It’s also instructive for evaluating other resource-heavy economies struggling to escape from the trap — and deciding what signs need to appear before it’s time to buy.
It All Boils Down to Economics… and Mismanagement
Hugo Chávez, Venezuela’s recently deceased ruler, set out to buy political support by spending the country’s oil wealth. And he used it to buy support not just from the masses of Venezuela’s poor, but from like-minded rulers in neighboring countries such as Cuba and Nicaragua. Mexico’s state-run oil company, PEMEX, has had a similar history. It’s been the cash cow for the Mexican government, which has used its profits to fund Mexico’s welfare state while starving the company of any funds for maintaining and improving its infrastructure and its production capacity. With production falling, and Mexico facing the end of exports, the Mexican people finally elected a leader who might do something about it: Enrique Peña Nieto. We’re watching closely to see what he can accomplish.
The Venezuelan regime, however, has doubled down on using oil to buy support and stay in power, and the current collapse is the direct result.
Venezuela produces some 2.5 million barrels a day. 800,000 barrels are given away to Venezuelans in the form of subsidized gasoline. 300,000 barrels are given to China to repay government borrowing (the Chinese wisely contracted to get debt payments in oil rather than in Venezuelan currency). 200,000 barrels are given away to regional neighbors. Subtract all that, and Venezuela is left 1.2 million barrels a day to sell at global market prices.
Unlike a resource-rich country like Norway, which has amassed a huge sovereign wealth fund from its oil riches, Venezuela has created a situation where in the midst of plenty, it has to live hand to mouth… and can’t even afford to do that any more.
There just isn’t enough cash flow to (1) pay off Venezuela’s poor, (2) pay international debt that’s denominated in dollars, and (3) invest in crumbling oil infrastructure to stop the inevitable decline in production.
Since the regime is facing protests from the urban middle class — and the President is publically describing them as “bourgeois parasites” — it’s a safe bet where the cash will go — to number (1) above, buying off poor Venezuelans. That means default on external debt is becoming ever more likely (some Venezuelan debt is trading at 63 cents on the dollar). And it means that oil production is falling because of aging equipment and lost intellectual capital… and that will mean, eventually, the end of the whole charade, as the “goose that lays the golden eggs” is slaughtered and the oil wealth finally squandered.
The End Game for the Regime?
Unlike Mexico, the Venezuelan regime is so corrupt and dictatorial that it is going full steam into collapse. That means crushing opposition, outlawing public protests, killing protesters, shutting down dissenting media outlets, and imprisoning political enemies. But since it now has both the army and the national oil company firmly in hand, it may be able to hold on for some time, even if it defaults on its debt.
There are currently many such stories that paint a picture of contracting oil production growth — whether in Venezuela, Libya, Iraq, Iran, or Nigeria. The details differ; the overall picture is often similar. We look at the picture of global oil supply and demand, and we see two trends. One is rising instability, especially under a U.S. leadership which is explicitly not interested in being “the world’s policeman.” And the other is rising demand, as the U.S. and Europe continue to recover and Chinese growth maintains its moderating but still robust trend. The collision of these trends may shape the movement of oil prices in the coming year… with significant effects on the world economy.
Is Google Fiber Going to Eat Your Internet Service Provider?
Google has its fingers in so many technological pies that it’s hard to keep track of them — even the ones not hidden in Google X, the company’s development lab.
One of those pies is Google’s small and early-stage project to deliver high-speed internet through its own fiberoptic network. And high-speed does mean high-speed — so-called “gigabit” internet at speeds 100 times those typical of current broadband.
So far, Google Fiber has been rolled out to two cities — Provo, UT, and Kansas City. But the company recently announced that it had targeted 34 more cities across the U.S. as its next targets for expanding the network, including San Jose, CA, Portland, OR, Phoenix, AZ, and Raleigh Durham, NC.
In the announcement, Google noted the momentum building behind next-generation highspeed internet from city administrations which recognize the educational and economic significance of broadband access. With the administrators of the target cities, they’ve been discussing “what it would take to bring them Google Fiber…[working] closely with each city’s leaders on a joint planning process.”
What’s In It For the Cities?
Why are cities eager to talk to Google? The pricing plans for Google Fiber in Provo and Kansas City explain the reason.
For $120 a month, customers get gigabit internet and TV. For $70 a month, customers get gigabit internet. For zero dollars a month, customers get “standard” broadband access speeds. That is, Google is essentially offering city governments free universal broadband access for their residents, for the price of cooperating in planning the network. It seems a small price to pay, given the potential economic benefits to the city.
Reaction From Analysts
Goldman Sachs estimates that a nationwide rollout of Google Fiber could take $140 billion in capital investment. They question whether Google really wants to get involved in the relatively low-margin business of providing internet plumbing (currently, Google’s pretax profit margin is higher than that of Comcast). Skeptical analysts suggest that Google Fiber is a card that Google is playing in the ongoing “net neutrality” struggle.
Net neutrality is a voluntary principle — not a law — which says that the companies running the internet’s pipes won’t give preference to some data over other data on the basis of payment or other criteria. All the data should treated equally.
Advocates of net neutrality say that it is necessary to avoid anticompetitive practices, and think it should be written into law. Opponents of net neutrality laws think that such laws would reduce the power of service providers to maintain high quality for the data customers want the most.
Some internet service providers have disregarded net neutrality in the past, but only in marginal areas — for example, constricting the bandwidth used by peer-to-peer file-transfer protocols, which are often used for piracy.
But recently, Comcast and Netflix reached a deal which skirts the edge of net neutrality, with Netflix getting a preferential “onramp” into Comcast’s delivery system. At peak times, some 30 percent of U.S. internet traffic can come from Netflix streaming — so this deal will mean less annoyances for customers as they watch highdefinition movies.
Google is of course watching these developments very closely. It delivers its data through other people’s pipes– and it clearly doesn’t want a situation where it has to be bidding against competitors (such as Facebook and Twitter) for preferential treatment. So some analysts think Google Fiber is a shot across the bow of service providers — saying to them in essence: “If you drop net neutrality, we can just build our own pipes.” They may not be serious about doing it — they may just be sending a message.
But Maybe They’re Serious
Others believe that Google’s view is long-term enough that they could well be planning for dominance in the provision of broadband internet. One analyst writes: “It may not make a huge difference for Google or for the incumbents in the next one, two or three years, but Google is taking the long view and we think in five or more years, it could turn out to be a significant, profitable business for Google and headwind for incumbents.”
Google knows that competition — from Twitter, Facebook, and other online ad venues — will be gradually eroding their advertising business, which currently comprises the lion’s share of their revenues. Many of the plans we have heard from Google’s creative spirits will eventually be doing the heavy lifting for the company. Google Fiber, while it may or may not become a dominant force in broadband service provision, certainly gives us reason to think that Google’s leadership is not asleep at the wheel.
Higher Inflation Expectations May Start with Breakfast
Much has been reported about the recent surge in coffee prices… but sugar prices have also risen to multimonth highs due to drought conditions in Brazil, the world’s number one exporter of these commodities.
Brazilian coffee and sugar producers and analysts have been slashing their production estimates as hot, dry weather threatens 2014’s crops. According Somar Meteorologia, a Brazilian weather service, January and February have been the driest months in Brazil in 30 years.
Not Just Coffee and Sugar…and Not Just Brazilian Farmers Experiencing Challenging Weather
Some global agribusiness analysts are looking at the impact of too much rain in Indonesia as damaging that country’s large cocoa harvest, and in North America, brutally cold winter may have damaged the wheat crop. With respect to other grains, in the U.S, farmers are expected to plant less corn in 2014 and more soybeans to take advantage of already high soybean prices…which is bullish for corn.
While soybean prices may have been strong for some time, corn and wheat prices turned higher in recent weeks after prolonged declines. In fact, after a rough 2013 — in which the GSCI Agriculture Index suffered its biggest decline since 1981 at down 22 percent — the index has rebounded about 6 percent in the first two months of 2014.
Living Standards Can Not Escape Rising Food prices
Food may not make up as significant a percentage of consumers’ budgets in the developed world as it does in lesser developed countries, but the impact of rising global food prices is profound wherever one lives. This iswhy we watch food commodities closely.
Food items may only represent less than 10 percent of the consumers’ budget in the U.S., but it can be 50 percent of an Indian’s or Chinese person’s total spending. In our Guild Basic Needs IndexTM — which we publish in these letters and at www.gbni.info — food components represent 30% of the index. The GBNI index only contains, necessary, basic, essential, needs (Food, Clothing, Shelter, and Energy), and is not meant to track all spending.
In the 14 years of data collected, the basic, essential needs in our GBNI Index are up over 86 percent. This works out to an annual increase of about 4.5 percent… versus about 2.4 percent for the government’s oftenadjusted, manipulated, and managed Consumer Price Index (CPI).
The GBNI is also getting a boost from non-food items lately.
Also conspiring to send or GBNI higher lately is the recovery in real estate prices and rising energy prices. The entire commodity complex looks firmer in 2014 than it has been the past few years, which could accelerate inflationary expectations…which will have a profound effect on central bank policy, interest rates, and on global markets. Stay tuned.
U.S. stocks are near their highs, and are backing a filling as they prepare to move ahead in 2014. There are positives and negatives.
We are positive because stock valuations are not abnormally high; corporate profits are good and growing well; GDP is picking up in the U.S., Europe, and Japan; and U.S., European, and Japanese interest rates are at a reasonable level and have not risen too much, which is positive for the above stock markets.
We are aware that markets are nervous because of the decline in real estate prices in China. There are concerns that China could have a financial crisis, and there is a generalized fear of instability in oil-producing regions of the world and in the Ukraine.
China will slow its growth rate in 2014, but will still grow very rapidly for a major nation. We expect 6 to 7 percent GDP growth in China. Volatility will increase, as many are frightened by wild stories about China and fears of instability in Ukraine and in the oil-producing world. This fear will cause a flow of investment money to arrive in Europe and the U.S. from abroad.
Although we believe that markets will be volatile in 2014, we believe that the U.S., Europe, and eventually Japan will be good areas for investment. Currently we hold only the U.S. and Europe.
We are bullish on oil and gold shares, and believe they will continue to perform well for the next few months as turmoil spreads within the Middle East and Ukraine. As we write, there is an unlikely but possible Russian invasion of Ukraine to secure the ethnically Russian eastern areas of the country. We believe that demand for energy and gold will continue from China, which we believe will be the fastest-growing major economy in the world again in 2014. Food prices are rising; we are bullish on corn, and may become more bullish on other food commodities.
In the U.S., some internet growth stocks and biotechnology stocks are on an unrealistic upward trajectory, while others are more reasonably valued. We like some biotech and generic drug companies and some technology companies for investment, but we are careful to avoid bubbles. Thanks for listening. We’d love to hear from you.