The United States’ economy is doing quite well in spite of the headwinds of higher energy prices and rising interest rates. Corporate earnings for the first quarter are up smartly. Unemployment has dropped to 4.5%. Industrial production is strong. The pace of activity is reflected in the current price for base commodities. Silver is at a twenty-two year high. Copper is at a high as well. We all know about the price of crude oil. Even sugar is being driven up for use in ethanol production. True, many commodities are responding to demand from China and India, but they also reflect strong demand in the US.

Short term interest rates have  moved up, but not always in harmony with long term rates. At one point long term rates were below short rates, which in the past has presaged a recession. We do not think that is the case this time, but rather an aberration.

Nonetheless, we do expect energy and higher rates to eventually be a drag on economic growth. The question we are asking ourselves is how much of that is reflected in the markets’ lackluster performance last year? In light of this uncertainty, we are being more conservative with the multiples that we are paying for stocks. Currently the best values appear to be in larger growth stocks, where high quality companies with respectable earnings growth are trading at attractive valuations.

We have recently initiated a position in Edwards Lifesciences, an exciting medical technology company that has the leading position in the market for replacement heart valves. Edwards makes and markets a line of heart valves that are favored by cardiac surgeons for their longevity, effectiveness, and ease of installation. This market alone could justify the current price of the stock, but what excites us most is the company’s pipeline of new products which includes products that can be delivered percutaneously, through an artery and up to the heart. If approved, open heart surgery for valve replacement and its attendant risks could become a thing of the past. The company currently has multiple percutaneous products in development for both valve replacement and valve repair. If one or more of these products are approved, they have the potential of rapidly expanding the market as doctors become more willing to treat patients before their health deteriorates further.

Japan Redux... 

Looking forward, China’s cyclical stocks seem to have run out of steam and may have completed their run. We view growth in consumer spending as a result of continued economic expansion to be a secular trend, and companies geared to it should do well over the long term.

Over the past 15 years, China has followed a manufacturing-led growth strategy. The country is on track to become the world’s third largest economy by the end of this decade, achieving a CAGR of 8% p.a. over the next 5 years. However, China’s policy makers are concerned that being the world’s factory, on the basis of selling cheap labor, is not a sustainable strategy in the long run: it has resulted in both a huge trade surplus and a huge increase in protectionist sentiment. In addition, there remains significant appreciation pressure on the renminbi, the terms of trade and profit margins are deteriorating, natural resources are being depleted, and the environment degraded.

In order to develop other higher value-added sources of growth, the government is now making efforts to promote home-grown technologies and the innovation capability of domestic firms, including the introduction of major tax incentives from the second half of 2006. R&D as a percent of China’s GDP is approximately 1.2% vs. the US at 2.6% and Sweden at 4.0%. The government’s goal is to see the ratio increase to 2.0% by 2010 and 2.5% or above in 2020. As a result, dependency on imported technologies should decline from the current 60% to 30% in 2020.

Of course, this is a longer term phenomenon, but may well present some interesting investment opportunities in the near future for Chinese companies with high R&D and strong or dominant market positions—exactly the types of companies we seek to invest in throughout the world.