Charley Grant just published the article Skies Darken for Drug Middlemen in the wsj.com on August 7, 2018. In that article, it appears that the middlemen, the pharmacy benefit managers, also known as PBMs in the industry, are doomed. CVS is one of his examples. 


I am delighted to report that CVS finally cleared the air in yesterday's earnings call. CEO Larry Merlo said that 98% of the rebates received from drug manufacturers are passed back to their clients, the health insurers and corporate payors. Yes! I recommend reading this white paper, "Making Drugs More Affordable" at their website for payors, for yourself.


For your convenience, here are the salient points which refutes some of the points in Charley Grant's article.

 1. CVS returns 98% of the rebates it  received from drug manufacturers back to its clients - health insurers and payors.
 2. Drug manufacturers are free to launch their initial drug prices at whatever levels they please, AND to increase prices whenever they desire.  And they do so with impunity. The industry's  average operating profit margin is 23%, the highest of all industries. 
 3.
 PBMs are the good guys - in 2017, CVS capped their clients' drug price increase to 0.2%, while the average listed price for drugs increased by 10%. 

Hence, CVS stock was up 4.4% yesterday, 8/8/2018. Transparency is great! 

Yes, the Sun does comes out again tomorrow!  
Photo: Lisbon's oldest quarters, the Alfama district.

Schwab: A Secular Play on Rising Rate.
We just published this article in SeekingAlpha. Please click Here, to read the full article.  4/26/2018

 Garrison Bradford & Associates.

Temasek, the sovereign wealth fund of Singapore, shares  our philosophy, which is to invest in companies with good long term growth potential.  


Click here to enjoy Temasek's March 2017 Snippets Review video

We wrote about the little known digital transformation occurring in 

Walmart in October 2017. Their Q3 2017 earnings release confirmed our outlook. 
                  Walmart Stores: Fighting Back        10.12.2017


Of Trade Wars and Fed Hikes                       7.20.2018                                                                                                            Equity markets in 2017 was characterized by low volatility and high returns but securities prices so far in 2018 have charted a more volatile course. The first market sell-off came in February, when an inflation scare sent the 10-year Treasury note yield to its highest level in four years. Stocks ended a ten-consecutive-month winning streak and dropped 12%. Since then, prices have see-sawed with considerable volatility and variability; at different times, in rolling succession and all but one of the S&P’s eleven sectors have experienced at least a 15% decline.

For the first six months of 2018, the NASDAQ index, heavily weighted with large technology companies, gained 8.8% but the S&P 500 only rose 1.7% and the Dow Jones Average fell 1.8%. The S&P Growth Stock Index was up 6%; the Value Stock Index declined 4%. Bond prices fell overall, and again there were notable differences.  Treasuries were off 0.9% but investment grade corporate bonds were down about 3%.

It is useful to understand the reasons behind this market volatility and the wide differentials in returns. The current bull market which started in March 2009 following the 2008 financial crisis is, at the time of writing, the second-longest on record. However, with the benefits of Trump’s 2017 tax cuts already factored into equity prices, additional coming Fed rate hikes well publicized, and the possibility of impending trade wars, investors are now worried and jittery. This roiled sentiment has been transferred into higher market volatility by two market mechanisms: 

1. Market churn has and will continue to be exacerbated by momentum and algorithmic trading. In this digital age, information is instantly shared, and computerized trading flows along paths of least resistance, regardless of valuations, growth outlooks or company fundamentals. It worked favorably for the investor when Trump won the November 2016 Presidential election and the world was confident that he was going to give us a tax cut. However, he has now embarked on his other promise: to make America Great Again. This vision is noble but the strategy of using trade tariffs against the second largest economy in the world, China, and the third biggest trade bloc, Europe, is flawed and simplistic.  In fact, it is outright counter-productive to the stimulative effects of the tax cuts, and depending on the magnitude of this face off, may trigger a recession. We expect continued volatility in the markets until this issue is settled.

 2. The massive fund flows into ETFs, namely Exchange Traded Funds, have driven company valuations and the market indices to the current high levels. To put things in perspective, we are not near any bubble territories. Corporate earnings have been robust due to 10 years of low interest rates, the expansion of the Federal Reserve’s balance sheet and the 2017 tax cuts. The point is that these ETFs make it easy and cost effective to own large blocks of companies at the push of a button. Yet it is precisely this same functionality which can trigger a sharp or prolonged sell off in the markets.

Investment Outlook
When formulating an investment outlook, we can follow the discipline outlined in Philip Tetlock’s book “Superforecasting: The Art and Science of Prediction”.  What do we know? And what can we reasonably extrapolate from that knowledge?

What we do know at this point is that the US economy is strong. Unemployment fell from 10.2% in 2009 to 4% in June 2018. There is a labor shortage but many job openings are unfilled due to lack of workers with relevant skills. Yet, the Small Business Optimism index is at the 6th highest level since 1973, leading to plans for increased hiring and capital spending. Courtesy, in part, of the 2017 tax cut, S&P earnings rose a phenomenal 25% in the first quarter and are estimated to grow at high-teens for the rest of the year. Business cash flows are at record levels, driven by the strong operating results, tax cuts, and the onetime event of foreign earnings repatriation. Will these economic tailwinds be countered by further interest rate hikes and a trade war between US and our major trading partners?

The Federal Reserve & Higher Interest Rates
First, let us address the much-feared phenomenon of the inverted yield curve, a good predictor of recessions in the past, and the very flat curve as of July 2018. Inverted yield curves occur when yields of the shorter notes are higher than those of the longer duration bonds. This happens when investors demand higher premiums for lending in the shorter term because a pending recession increases their credit and reinvestment risks. Also, investors prefer the safety of the longer-term bonds, and fund flows flocking into these longer duration bonds keep their yields low.

The July 2018 spreads between the 2 and 10-year yields, and the 5 and 10-year yields are much narrower than the spreads from the yield curve of July 2009. Yet, we are sanguine about this increasingly flatter yield curve because of two reasons.

      i) A comparison of the various developed countries’ government bond yields of the 2, 5 and 10-year notes in shows that the US has the highest yields. Additionally, the US and the US dollar are considered safe havens, with a bond market liquid and large enough to absorb huge investment flows. The 10-year and longer duration bond yields are particularly attractive to pension funds, insurance companies and other sovereign wealth funds because of their long-term liabilities. Hence, we think that the 10-year yield is being artificially capped low by the huge demand from these institutional investors.

    ii)  An analysis of the Federal Reserve’s current balance sheet shows that this time, it is indeed different. At no point in prior financial history has the Fed used the size of its balance sheet as a monetary policy tool. However, since the 2008 financial crisis, the Fed has been an active and large buyer of US Treasuries. Now, the Fed owns between 50% to 70% of the total outstanding amount of various US Treasuries. It is reasonable to conclude that the Fed has almost single handedly kept the 10 year and longer duration bond yields down.

Also, It is unlikely that the Fed will be a major seller of these bonds before their maturity for two reasons:

     i) The Fed is cognizant of the dampening effects of its interest rate hikes on the global economy. Already, non US companies which had issued US$ denominated Yankee bonds are feeling the double negative impact of higher interest rates and foreign exchange losses from the stronger US$. The Fed will not add fuel to the fire by selling these huge holdings in order to cushion this very same impact as they normalize interest rates. Effectively, rising interest rates reduce the spigot of cheap money for the US and the rest of the world, possibly resulting in a global economic slowdown.

     ii) Domestically, the Fed has to walk the tightrope of its responsibilities versus causing additional damage to the US Treasury in the form of higher financing costs. This is especially pertinent given that the Treasury needs to issue vast sums of debt to cover the widening budget deficits in the coming months. Premature sales may upset this balance.
 

Enter the Trade Wars
Trade wars are negative for economic growth. The full impact of trade wars can be gauged from this “equation”:

          Trade tariffs = a tax on goods => inflationary pressures => Federal Reserve to Hike interest rates higher and 
faster than planned => recession => sell off in both global bond and equity markets,

And the economic cycle continues again….                  
The IMF estimated that economic growth in 2019 will slow down marginally in China, US and Europe, but that the global GDP remains stable at 3.9%. A full-fledged trade war between the US and our major trading partners would dramatically change this forecasts for the worse. 
Further, Trade wars will also amplify the effects of President Xi Jinping’s current policies to stop corruption and to control the disproportionately large shadow banking system.

Fortunately for China, despite these policies, the Chinese GDP remains strong at 6.7% growth. Also, by gently weakening the Chinese Renminbi, China has already prepared to soften the blows from more US trade tariffs.  Given that only 19% of China’s exports goes to the US, 49% to Asia and 19% to Europe, it is reasonable to expect continued Chinese economic growth, albeit at a slower pace. Additionally, Chinese companies are already planning to relocate their manufacturing facilities to Asian countries which are free from US tariffs. And in the longer run, China’s One Belt One Road initiative lays the foundation for its future growth and economic dominance.

Europe and China have long recognized the need for cooperation. In 2014, China started its own development bank called Asian Infrastructure Investment Bank, AIIB, to rival the Washington controlled World Bank. US allies Britain, Germany, France and Italy joined China to become AIIB’s co-founders. This bond is likely to strengthen further and faster when confronted by POTUS’ dismissive, aggressive and mercurial stance.

In closing
At this point in time, we are cautiously optimistic that the US equity markets will enjoy positive momentum in the near term. However, one of the gravest dangers to the US and the world’s economic growth is POTUS’ desire for trade wars. As discussed above, when a full-fledged trade war occurs, even a benign Fed cannot keep interest rates down when faced with inflationary pressures. And historically, higher interest rates will eventually lead to higher financing costs, which leads to another recession. The only glimmer of hope against this finality is in the November mid-term elections. Can the pain points experienced by US companies be sufficient to stop the tariffs? Your guess is as good as mine.  Meanwhile, we think the best defense is to be invested in companies with good growth prospects and strong cash flows and use cash as an asset class. When market disruptions happen, cash will prove its usefulness. 


​We wish you and your family a happy and healthy summer.