Quarterly Letter, October 2019

By Ron Muhlenkamp, Founder and Jeff Muhlenkamp, Portfolio Manager

It’s been a noisy summer. Lots of political news, lots of tariff and trade war news, lots of international headlines of various sorts. Funny thing though, as we write this note during the last week of September the S&P 500 Index is within three percent of the all-time high it set in July. By that measure, it’s been a quiet summer.

If we filter out the noise, what are the important things going on today, economically, financially, and politically? Here’s what we observe:

1. The reset in trade relations between the U.S. and China is still being negotiated. Some of the tariffs announced over the last year have actually taken effect, others have been delayed. At this time, we hesitate to predict when a comprehensive agreement might be reached and are assuming the negotiations continue for the foreseeable future with the accompanying noise.

2. The renegotiation of the relationship between the United Kingdom and the European Union (EU) is ongoing. Despite a new Prime Minister (Boris Johnson) in the United Kingdom and an October 31st deadline, this doesn’t look like it will be resolved any time soon either. We are likewise loathe to predict the eventual outcome of this debate or to estimate the timeline. It seems that investors have reached a similar conclusion as news on this topic hasn’t impacted markets lately.

3. Germany is very near, or already in, a recession. Slowing growth in China is having a magnified effect on Germany—which supplies China with capital and luxury goods. As the biggest economy in the EU, a German recession could hurt a lot and increase the risks to financial markets presented by weak European banks. We don’t think we’ve seen the full impact of this yet.

4. U.S. treasury yields plunged in August, setting new lows for the 10-year and 30-year, inverting the yield curve (when short-term rates are higher than long-term rates), prompting the Federal Reserve to end their balance sheet reduction program ahead of schedule and to cut the Federal Funds Rate (short- term interest rates that they control) twice: by .25% in August and by .25% again in September. Recall that the Federal Reserve raised the Federal Funds Rate by .25% in December 2018—they have very quickly reversed themselves. An inverted yield curve has historically been the harbinger of recessions in the United States, with a lag of between 6 and 18 months. Historically, the yield curve typically inverts when the Federal Reserve raises short-term rates above long-term rates in a deliberate effort to slow the economy and contain inflation—that’s not the case this time. The Federal Reserve is not trying to fight inflation and was trying to restore short-term rates to something they consider “normal”. Long-term rates dropped below short-term rates, surprising the Fed (in our opinion). We hesitate to say “this time is different” with regard to a yield curve inversion as that is usually a dangerous statement to make, but things are a little different this time and it is at least possible that the outcome will be different as well.

5. Inflation remains low. The U.S. Consumer Price Index (CPI) shows 1.7% year-over-year inflation at its latest reading. Recall that the Federal Reserve’s goal is inflation of 2%—thus the above statement that they are not raising rates to contain inflation—inflation is actually lower than their target.

6. The industrial growth is slowing in the U.S. and globally (see German recession above). In the U.S. this looks a lot like the slowdown we saw in late 2015 – early 2016. In fact, this is the third such slowdown since the last recession—the first was in late 2011. Neither of the first two resulted in a recession. If the availability of credit drops (we’re not seeing this now) or the service side of the economy slows down as well (the signals here are mixed), we could be looking at a recession in the near future.

Looking forward, it’s not a stretch to suggest that political actors will increasingly attempt to sway voters with their actions, and market participants will factor into their forecasts the likelihood of policy change. Does that mean President Trump will look for a “win” with China timed to help him in the ’20 election? Very possibly. Has the recent weakness in Healthcare and Energy been due to the emergence of Senator Warren as the Democratic frontrunner? Also possible. What we believe is certain is that investors like us will do their best to anticipate the outcome of the election and position their portfolios accordingly.

We remain reasonably defensive in our holdings and continue to evaluate them on an individual basis—selling when full value is reached, buying what we view as undervalued. In general, we are not adding companies that we consider particularly sensitive to the economic cycle because we haven’t seen indicators of the slowdown begin to improve and frankly most “cyclical” companies aren’t priced for a recession. We’ll be patient.

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.