Investors are also starting to slowly realize that monetary policy may have reached a ‘point of diminishing returns’ with interest rates so low that any changes are not impacting economic decisions.  Very few companies we’ve heard from cite the ‘cost of capital’ as the factor holding them back from larger spending plans.  As a result, many investors are now counting on some forms of ‘fiscal stimulus’ by the major economies to supplement zero interest rate policy to restart global economic growth.   But is anyone paying attention to global debt levels?  Global debt has passed US$250 trillion but its impact is diminishing.  We now need at least 4-5 units of debt for each unit of GDP growth.  But China’s debt has already increased from US$3.5 trillion in 2005 to US$42 trillion today, representing over 3x GDP. This has been the fastest debt accumulation ever, by-passing Japan’s debt spree of the ‘80s.  Troubled banks in China are struggling to raise funds as concerns over the health of the financial system grow and confidence in state-led bailouts falters.  China’s banking system is facing its greatest challenge in nearly 20 years after years of runaway growth and mounting bad debt levels, which have topped 40% of loans at some small lenders.  The government has had to intervene in the operations of three local banks this year and partial bailouts at two more lenders.  Despite those efforts, many banks are facing deteriorating funding conditions.  Troubled banks have been able to secure only 20-40% of the funds they have sought to raise in the interbank market for negotiable certificates of deposit, a vital source of funding for many smaller lenders.  China’s central bank warned this week that about 13% of lenders in the country, or 586 institutions, presented a “high risk”.

China is therefore probably not going to supply the fuel to turn things around this time, after having rescued global capitalism three times in the past decade.  But if not China, then who else has the ability to step in and fill this spending void?  Not the U.S. as their debt has also sky-rocketed in the past decade to record levels and there are clear political hurdles to any massive infrastructure spending plans.  The Euro zone (and Germany in particular) have more room on their fiscal budgets to increase spending, but they have also consistently avoided running large fiscal deficits in the past and seem unlikely to change that behavior.  Moreover, with the Brexit risk still hanging over the continent, an aggressive spending plan seems highly unlikely.  The bottom line is that economic growth is likely going to remain subdued for at least the next few years.   This however might be the ‘Goldilocks’ scenario that stock investors are looking for since this ‘below trend’ growth would keep inflation and interest rates low.  However, this tepid economic growth would make it difficult to achieve any corporate earnings growth, so the real question becomes; can stock valuations continue to rise to keep the bull market intact?   If not, then the longest stock market expansion on record could soon come to an unpleasant, if not overdue, ending!

In our Hedge Fund, we continue to have short positions on some U.S. indices against long positions in the ‘value sectors of the market.  We also have short positions in a group of stocks where we see extremely extended valuations and/or business models that just don’t generate any cash.  Current names on this list include Uber, Tesla, Netflix and Shopify.  While the ‘Amazon experience’ has inured investors to the idea that companies can generate continued losses and still see their stocks soar, that acceptance had to be supported by significant revenue growth which, in turn, gave investors some comfort that profitability would inevitably come.  But, as investors in the ‘cannabis sector’ in Canada have found out this year, those operating losses lead the stocks to get harshly punished if not accompanied by the stellar revenue growth.   Companies such as Netflix, Uber and Tesla all continue to generate negative cash flows and their need to continue to invest in growth means continued massive negative free cash flow that has to be funded by increasing debt levels and/or equity dilution.  They are all now facing competition in their new industries from companies that have stronger balance sheets.   Something has to give and we expect that it will be the stock price.  We have already seen a sharp pullback in Netflix this year as HBO, Warner, Disney Plus and Amazon Prime have all entered the video streaming market with new content.   For Uber, the business model makes no sense.   As an ‘app’ company it has lots of value but as an operating company that has to pay drivers in a more competitive market, we don’t see a path to profitability.   In terms of Tesla, by the time they finally start to generate some free cash flow (i.e. 2023) we expect that they will be seeing more serious competition from electric vehicles from all of the major auto companies.  Positive ‘tweets’ from founder/CEO Elon Musk will need to be replaced by real profitability on a fully-accounted basis in order for the stock to sustain a market capitalization that is 20% higher than General Motors, despite the fact that GM profitably produces more cars in a week than Tesla does in a year!

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