Quarterly Letter, April 2019

By Ron Muhlenkamp, Founder and Jeff Muhlenkamp, Portfolio Manager

A couple of noteworthy changes have occurred in the first quarter of 2019:

First, the Federal Reserve has reconsidered their program of interest rate increases and balance sheet reductions. They now intend to hold short-term rates steady in 2019 and end their balance sheet reduction program in October 2019. Last year, we wrote extensively about the risk to asset prices we saw in the Federal Reserve’s asset reduction program and, we believe, the market started reacting to that program in October 2018. We are not at all surprised that the stock market rebounded when the Federal Reserve announced the change in their thinking.

Second, the U.S. Treasury yield curve inverted in late March 2019. A “yield curve inversion” occurs when short-term interest rates are higher than long-term interest rates. In this case the 3-month Treasury yield was higher than the 10-year Treasury yield. As we’ve mentioned before, conventional wisdom considers this a sign of an impending recession, with the recession following the inversion by anywhere from 6 months to 2 years. As a result of the inversion, stock prices didn’t move too much, but bond prices did: the yield on the 10-year Treasury went from 2.6% to 2.4% in two weeks—a sharp move in the bond market. Even with the recent drop in interest rates short-term rates have remained above the rate of inflation, a benefit to savers and pension funds and increasingly a rare set of circumstances when looked at from a global perspective.

Looking at the domestic economy, economists expect 2.4% real GDP growth in the U.S. this year and 1.9% real GDP growth next year. That’s significantly slower than the 2.9% GDP growth we saw in 2018. On balance, the economic data we are seeing is consistent with slower growth than last year. We are not seeing signs of an imminent recession. One bright spot is the housing market where we are seeing better than expected sales numbers as the spring selling season begins. Inflation remains subdued between 1.5% and 2%. We don’t currently see a reason for inflation to increase meaningfully.

Globally, economic growth is weak in China and virtually non-existent in Europe. The Chinese government is actively trying to manage its growth slowdown and, so far, appears to be successful—keeping growth in a range that they consider acceptable. Europe isn’t faring as well. As a result of weak economic numbers the European Central Bank (ECB), which ended its asset buying program in December, is talking about restarting the program to support growth. The “Brexit” debacle in Great Britain isn’t helping matters. After two years of negotiations, the British Government still has no clear idea what they want the split from the European Union (EU) to look like. The British parliament has voted on eight separate concepts, and rejected them all. The deadline for “Brexit” has been extended from March 29, 2019 to April 12, 2019. We expect it will be extended several more times as the debacle drags on. Also, on the international front, the U.S. and China continue to negotiate over trade and we expect something to get worked out this year. Neither “Brexit” nor the trade negotiations with China appear to move the stock market any more—we believe our views to be widely held.

In summary, the U.S. economy appears to be slowing this year, but perhaps not as much as we thought four months ago. The threat to asset markets posed by the Federal Reserve’s shrinking balance sheet is receding, and disruption due to tariffs or Brexit is also less likely. Slowing global growth remains a concern and we’ll be watching what happens in China pretty closely. The inversion of the yield curve is also a cautionary sign. During the last quarter we’ve invested some of our cash in good companies at prices we found attractive. We will continue to do so.

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.