Quarterly Letter, July 2018

By Ron Muhlenkamp and Jeff Muhlenkamp, Portfolio Managers

Allow us to summarize what we’re seeing so far this year. The U.S. economy is doing well, with 1st quarter Gross Domestic Product (GDP) growth coming in at 2%, unemployment in May was a low 3.8%, and inflation was 2.8%. The interest rate on 2-year U.S. Treasury notes at the end of June was roughly 2.5%, 10-year U.S. Treasury notes yield almost 2.9%, and the average 30-year fixed mortgage rate in the county is 4.4%. As of June 30, 2018 the S&P 500 Total Return Index is up 2.65% since the beginning of the year. The Federal Reserve continues to raise short-term interest rates and continues to reduce their balance sheet as they said they would. Internationally, the dollar is up about 5% against a basket of foreign currencies year to date. The stock markets of a number of emerging markets have sold off with Turkey down 32%, Brazil down 20%, and China down 20% as examples. The European Central Bank (ECB) continues to pursue their policy of negative interest rates and asset purchases, though they have reduced the amount of assets they purchase each month and have reiterated their intention to end the program by the end of 2018. The Bank of Japan (BOJ) continues to pursue its policy of low interest rates and asset purchases as well. Italy has elected a populist government which raises the prospect of policy conflict with the rest of the European Union and disagreements over immigration are threatening the German coalition government led by Angela Merkel.

What do we make of all this?

First, we still don’t like bonds with a duration of longer than three to four years as they are mispriced relative to inflation (historically the 10-year treasury yield would be roughly 3% above inflation, which would make a 5.5% – 6% yield “normal” with today’s inflation). Second, while it is appropriate and necessary (necessary because abnormally low interest rates are killing savers, pensions chief among them) for the Fed to raise interest rates and try to get them back to something approaching the historical norm, we foresee two challenges: the easy money policies of Europe and Japan are keeping our long-term interest rates low, hindering our efforts; and a decade of cheap money has gotten baked into a lot of business plans. Higher cost money will be a problem and no one (neither the Fed nor us) can know exactly what interest rate will start to cause serious problems. So while the Fed intends to return rates to normal without disrupting either the markets or the economy, they may be unable to pull off such a feat.

Third, higher inflation would put the Fed on the horns of a dilemma: should they stick with the slow pace of rate increases and risk still higher inflation and all the problems that would bring or should they raise rates faster and risk slowing the economy in a bid to keep inflation at a reasonable level? Market participants are alert to this dilemma and paying very close attention to inflation data.

Fourth, the tax law changes passed at the end of 2017 plus regulatory changes are having a beneficial effect on the economy. The economic indicators we monitor all look pretty good with few signs of trouble to be seen. Corporate earnings were strong in the first quarter with sales growth of 8% and earnings growth of 22%.

Fifth, Europe and emerging markets are the most likely sources of external economic shocks. Europe because of the political turmoil, emerging markets because many of them borrowed heavily in dollars when dollars were cheap and will find it difficult to repay the loans now that dollars are more expensive.

We’ve been saying all year that we expected economic growth and earnings to increase but that higher interest rates should cause price-to-earnings ratios (P/E) to decline. Both of those things are happening, roughly offsetting each other so far resulting in only modest changes to stock prices and a small decline in bond prices. 

That’s what we see at a high level. Economically things are pretty good but there are a number of things that could upset the economy or the markets and we’re keeping an eye out for them. We continue to spend most of our time looking for investment opportunities and managing our current investments. We are comfortable carrying a bit of cash given the tug of war between the economic strength and monetary tightening but we are equally comfortable putting money to work when we find what we believe is an attractive investment.

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.

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).

Price-to-Earnings Ratio (P/E) is the current price of a stock divided by the (trailing) 12 months earnings per share.

S&P 500 Index is a widely recognized, unmanaged index of common stock prices. The S&P 500 Index is weighted by market value and its performance is thought to be representative of the stock market as a whole. You cannot invest directly in an index.