Quarterly Letter, October 2018

By Ron Muhlenkamp and Jeff Muhlenkamp, Portfolio Managers

At the end of the third quarter the U.S. economy is by most indicators in good shape. Real (inflation adjusted) GDP growth the first two quarters averaged 3% and forecasts are for the full year to come in at about 3%. Small business and consumer sentiment indicators are at high levels. Unemployment is quite low and most credit metrics are looking fine. Companies are bringing overseas cash back home and are, in general, doing three things with it: investing in their business, sharing it with employees, and sharing it with owners (the mix varying a bit by company). If you are looking for reasons to be optimistic the domestic economy provides plenty of them.

There are also some reasons to worry (there always are). Domestically, the worries center on inflation (which is approaching 3%) and rising short-term interest rates. Long-term interest rates haven’t really done much all year, which is somewhat surprising given good economic growth and 3% inflation. Rising short-term interest rates are being driven by the Federal Reserve which kept the Federal Funds Rate near zero from 2009 until 2015 and is now steadily raising that rate to get back to what they consider “normal.” There are two problems with this: no one is quite sure what “normal” is anymore (more precisely, the interest rate that neither spurs nor retards economic growth—a neutral rate) and there is the distinct possibility that some businesses have become accustomed to very low interest rates and will not survive in a higher rate environment. So the Fed is feeling its way along, slowly raising the Federal Funds Rate and reducing the assets they hold, hoping they don’t disrupt economic growth. Higher inflation will put the Federal Reserve on the horns of a dilemma, which is why it is a worry. The Federal Reserve has a target of 2% inflation, which we are now above. At some inflation level the Fed will feel compelled to raise rates more rapidly to fight inflation which would increase the odds of slowing the economy and would be negative for asset markets. So it is entirely possible that, despite their best intentions, the Federal Reserve’s monetary policy either creates problems in an economy dependent on cheap credit, or spurs higher inflation first, then chokes the economy to curb the inflation they stoked. Currently we have 3% real economic growth and 3% inflation—so far so good.

Internationally, we find more reasons for worry than reasons for optimism. First, the strong dollar is creating problems for countries that borrowed a lot of dollars. This has exacerbated existing problems in a number of countries and we’ve seen their currencies plummet, most notably Argentina and Turkey. The potential exists for them to default on their dollar denominated loans which would impair the banks and others that lent them the money. At the extreme, those defaults could ripple through the international banking system and create a wider problem. That’s not what we expect to happen, but we are watching for the early warning signs that something like that is occurring.

Second, on a global basis, monetary policy continues to move back towards normal as central banks end their extraordinary policies. You may recall that the central banks of the U.S., Europe, and Japan all dropped interest rates to essentially zero and implemented asset buying programs in order to spur economic growth and generate inflation. The U.S. Federal Reserve was the first to start moving back towards normal by ending their asset purchase program in 2014, raising short-term rates beginning in 2015, and reducing their assets beginning in 2017. The European Central Bank (ECB) is the second major central bank to move back towards normal. The ECB has announced it will end its asset purchase program in December 2018 and will look to begin raising rates perhaps in mid to late 2019. We think this will allow interest rates in Europe to rise which will reduce upward pressure on the dollar and create downward pressure on U.S. long-term interest rates. This is a big step towards tighter money on a global basis.

We think the loose central bank policies inflated pretty much all asset prices around the world. Additionally, all kinds of borrowers have taken advantage of the abundance of cheap money—countries, companies, and individuals. We expect the withdrawal of that monetary support to exert downward pressure on asset prices and are concerned that some of those borrowers will not be able to support the debt they took on. It’s a big shift and it will take time to unfold and time for the problems to become manifest, but we are four years into it with another big move coming. We think the plunging currencies of Turkey and Argentina are first of the problems that will unfold in this tighter monetary environment.

The above is really a reiteration of what we’ve been saying all year. A strong U.S. economy boosted by changes in the tax code and reduced regulations is a positive force in the markets. The shift from a very loose monetary environment to something less loose is a negative. We said at the beginning of the year that these two drivers (strong U.S. economy & the tightening of the money supply) would shape the markets in a fashion we couldn’t predict.

In March, President Trump injected a wild card as he seeks to restructure the trading relationships between the U.S. and other countries. In general, the pattern seems to be for the U.S. to unilaterally levy tariffs on imports until we convince the other party to sit down and seriously bargain. Some countries came to the table after the first round of tariffs: Korea and Japan. Others came right back at us with their own tariff schemes for a round or two then sat down: Mexico, Canada, and the European Union. We have yet to get China to the bargaining table after what is, by my count, four rounds of tariffs and counter-tariffs. So far, the markets haven’t reacted much to this activity, but the potential remains for global trade (and by extension global growth) to be significantly affected. So we’ve added “Trade” to our worry list and we’re incorporating it in our thinking. We’ll keep you posted.

So far this year, we’ve done more selling than buying and are holding a bit more cash than we were at the start of the year. This activity has been bottom up driven: a number of our holdings met our sell criteria and so were reduced or sold and the number of buying opportunities has been low. We are comfortable holding a little more cash given the change in the monetary environment and will put that cash to work when we find a lucrative opportunity.

The comments made in this commentary are opinions and are not intended to be investment advice or a forecast of future events.

Refer to the SMA All-Cap Value Fact Sheet for the Top 20 Holdings and performance data as of the most recent quarter-end.

Central Bank is the entity responsible for overseeing the monetary system for a nation (or group of nations). The central banking system in the U.S. is known as the Federal Reserve (commonly referred to “the Fed”), composed of twelve regional Federal Reserve Banks located in major cities throughout the country. The main tasks of the Fed are to supervise and regulate banks, implement monetary policy by buying and selling U.S. Treasury bonds, and steer interest rates.

Federal Funds Rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. It is the interest rate banks charge each other for loans.

Gross Domestic Product (GDP) is the total market value of all goods and services produced within a country in a given period of time (usually a calendar year).

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