Quarterly Letter, July 2017

By Ron Muhlenkamp and Jeff Muhlenkamp, Portfolio Managers

As June comes to a close, we find that most of the things we talked about in March haven’t changed much. Starting at the international level, both the European and Japanese Central banks continue to buy bonds (Japan also buys equities) in order to manage interest rates and support their economies. The European Central Bank hinted during a speech in late June that it may be appropriate to think about ending their program, but the Bank of Japan isn’t even discussing ending theirs. We’ll have to see how things develop. French elections, which had the potential to be disruptive, turned out to be a non-event. We’ll see what Macron does now that he’s in power. He may manage to make some changes that will free up the French economy and get it moving again.

International trade has not been disrupted by a U.S./China trade war which some feared based on statements made by President Trump. Chinese economic growth continues to meet their government-set goals of about 6.5% and the renminbi has been fairly stable against the dollar. Interestingly, the organization that governs what countries are included in global stock indices decided in mid-June to start including Chinese shares in the global index (MSCI EAFE Index*) for the first time. Lastly, the war in Syria hasn’t created any economic problems either.

Domestically, the economy continues to grow at about 2% when adjusted for inflation. Inflation remains below 2%, aided by declining oil prices which have dropped from about $50 per barrel at the start of the year to close to $40 per barrel currently. Unemployment remains low but wages haven’t grown much. The Federal Reserve raised the Federal Funds rate (short-term interest rate they charge banks that sets short-term rates in the U.S.) by another .25% to 1.25% as expected and they detailed how they intend to reduce the size of their balance sheet in the near future, but not when they would start. While short-term interest rates have risen, long term-interest rates have not.

In the March newsletter and again during our May webcast (both of which can be located on our website www.muhlenkamp.com) we told you that small business optimism had improved immensely postelection—it remains at high levels even though neither the promised health care revamp nor tax cuts have yet come out of Washington. First quarter earnings in the aggregate were good, with both revenues and earnings coming in higher than the prior quarter. On the negative side, we are seeing enormous disruption in the retail sector as consumers change how they shop, creating a few big winners and many big losers. A year ago we saw increased bankruptcies in energy companies, now it’s happening to retailers. We are also seeing an increase in credit defaults by consumers—mostly with auto loans but a little bit with credit cards too.

The U.S. stock market, in aggregate, is expensive relative to its own history and margin debt (money borrowed from brokers to buy stocks, using the stocks themselves as collateral) is once again setting new highs.

That’s what we are seeing. Here’s what we think:
• We expect slow economic growth in the U.S. to continue in the short term while recognizing we can’t see very far down the road. The signs we are seeing in the credit markets are not immediately disconcerting, but will become a concern if they get worse. Increased business optimism hasn’t resulted in increased capital investment by companies—we’re watching for signs of that too.
• We think assets in general (bonds and stocks) have been supported in part by central bank asset purchases. That era may be coming to an end as the Federal Reserve begins to shrink its balance sheet. This makes us cautious and we’ll be paying close attention to the plans of the foreign central banks we’ve talked about as well as the implementation of the Fed’s plans.

Here’s what we are doing:
• We continue to sell assets that have done well for us and reached what we consider full value and invest in undervalued companies when we find them. We are comfortable holding cash when we can’t immediately find undervalued companies.
• We don’t own any bonds as they remain overpriced relative to inflation.
• We are slowly reducing our holdings of companies that are most exposed to the cyclical aspects of the domestic economy.

Until next quarter…

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.

*MSCI EAFE Index is a stock market index that represents the equity market performance of large and mid-cap securities outside the U.S. and Canada. The EAFE acronym indicates that the location of the 21 developed markets are within Europe, Australasia, and the Far East.