Quarterly Letter, July 2019

By Ron Muhlenkamp, Founder and Jeff Muhlenkamp, Portfolio Manager

Here are the highlights of what we’re seeing so far this year:

The Federal Reserve last raised short-term interest rates in December 2018 and is now actively talking about cutting them. The futures market, in fact, is pricing in two to three cuts this year. The Fed has also stated they will end the shrinking of their balance sheet in October. They’ve undergone quite a shift in thinking over the last six months! Our concern last year was that the Fed, through the reduction of the balance sheet, would reduce dollar availability and cause asset markets to fall. The Fed’s actions this year have alleviated that concern.

Another dramatic reversal occurred in early May when the trade negotiations with China, which had appeared to be moving towards an agreement, came to a screeching halt as China had second thoughts about some of the terms of the agreement and the U.S. imposed another round of tariffs. The relationship with China was further strained a week later when the United States restricted sales of semiconductors and software to Huawei (a large Chinese tech firm that makes networking gear and low-cost cell phones). Huawei is somewhat of a national champion company in China, and cutting them off from U.S. suppliers is a mortal threat to the company. President Trump and President Xi met at the G-20 meeting in Osaka at the end of June and agreed not to take additional measures in the near term and to resume formal talks. The path forward is murkier than ever and we have no idea how or when a resolution will be achieved.

The same can also be said of Brexit (the withdrawal of the United Kingdom from the European Union). Prime Minister Theresa May has stepped down in the United Kingdom after having failed to find a way to exit the European Union that Parliament could accept. The UK is now going through the process of selecting a new Prime Minister. What that will mean for the Brexit process is unclear. Brexit concerns have not influenced the markets in a while, but the potential exists for the matter to become important again depending on the course of action the United Kingdom chooses, if they ever choose one.

On the home front, a number of U.S. economic indicators that we keep an eye on have begun to weaken, particularly in the industrial portion of the economy. The odds that we will see a slowdown similar to the one we saw in the winter of 2015 – 2016 are increasing. The stock market has not priced that in yet, but arguably the bond market has, as interest rates have fallen pretty dramatically this year with the 10-year U.S. Treasury yield falling from a high of 3.2% in October of 2018 to just over 2% today (that’s a pretty dramatic move in the bond market). It is possible, but by no means certain, that the slowdown will become a recession. Developments in this area certainly have our attention.

In summary, the Fed is no longer squeezing, there is increased uncertainty around trade and Brexit, and we see indications that the economy is slowing down. That’s what has been happening.

As we look forward, we expect uncertainty over trade and Brexit will continue. Until market participants think they can handicap the potential outcomes with some confidence, the news flow will probably affect market prices on a daily basis, so we expect some volatility. Currently market participants view the bad economic news as good for the market because they anticipate weak economic metrics will prompt the Fed to cut interest rates. If economic fundamentals continue to weaken those same participants will come to view bad economic news as bad for the markets. We already consider bad economic news as bad for the markets, which is partly the reason we have a higher-than-normal cash position. The other reason we are holding cash is we are simply not finding many investment opportunities that look interesting. As we find interesting opportunities, we will put the cash to work.

You may know that we’ve owned a gold ETF for several years now. We bought it as a hedge against central banks doing stupid things but for most of our holding period it has done very little – until recently. Gold is up about 10% in the last month.

So that’s what we’re seeing, and thinking, and doing. As always, if you’ve got questions give us a call, we’d love to talk with you.

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.

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