Ron Muhlenkamp Memorandum: Third Quarter
The same three topics that we’ve been talking about for almost a year continue to drive the markets: Europe, China, and the United States—with the current emphasis on Europe for debt and equity markets, and China for commodity markets. Let’s review what’s taking place.
Spain is now in the European spotlight. Spain has officially requested external assistance of up to 100 billion euros in recapitalizing its banks. The European Community has promised support for the Spanish banks, but the details have not been worked out. Announcements made in the wake of the European Summit last week generated hope that Europe was getting its arms around the problems and prompted a nice rally in the markets on June 29, but were very light on details. How the Spanish banks are bailed out matters at least as much as the fact that they are bailed out. The Spanish government does not want to become another Ireland, (sunk by the liabilities of its banks), and is thus reluctant to cosign the loans for its banks. Meanwhile, the Spanish government is diligently trying to get government spending under control in the face of a serious recession and high unemployment. Simultaneously, it is trying to reassure lenders that it will repay its debts, (and hence should be able to continue to borrow at reasonable rates), while trying to avoid angering the voters so much the incumbents get thrown out of office. (Videos of burning tire barricades across Spanish highways indicate at least some Spanish voters are not pleased with what their government is doing.) The Spanish government is walking a tightrope; the balance is getting harder to maintain with every step. Note: Spanish 10-year bond yields, which dropped meaningfully after the European Summit, are back above 7%, a price Spain will find difficult to pay.
Earlier this spring, Greece provided an object lesson in how hard it is to satisfy both lenders and voters. Voter dissatisfaction with the terms of the second bailout will force the Greek government to re-open negotiations with lenders over its terms. We’ll see where that goes, but it places Greek problems back on the table only a few months after market participants thought they were done worrying about Greece for a couple of years.
Italy has moved out of the headlines. The yield on its 10-year bonds has dropped below 6% to roughly 5.75% after the European Summit, and is now back above 6 percent. Italy has not resolved its long-term problems.
How has the recent European drama affected the markets? The European equity market sold off pretty hard from March through June, while “safe havens” boomed. German 2-year bond yields went negative as investors moved their money to places where they were sure it would be returned. In the U.S., Treasury yields declined for the same reason German yields did, while the equity market gave back much of its gains for the year. Of particular note, the January-March rally in financial stocks almost completely reversed itself from April to June. We expect developments in Europe—primarily Spain and Spanish banks—to continue to influence the bond and equity markets at least through the summer. (June 29 is a prime example of how news from Europe is driving U.S. equity markets.)
We believe Europe has not solved any of its problems and note that forecasts of countries departing the Eurozone are increasing. For example, Finland recently stated it would rather leave the Eurozone than pay other countries’ debts. We’re not trying to predict how Europe’s problems will be solved; we just know they aren’t solved yet. (And it seems Europe is able to accomplish little during the July-August vacation season.)
China is gradually cutting interest rates and relaxing restrictions on its banks in an effort to manage economic growth. On June 7, the Chinese Central Bank lowered the official interest rate at which loans are made. This provides Chinese banks a bit more leeway to deviate from the official rate for both loans and deposits. Allowing Chinese banks more room to set the price of money is a positive development, but it will take time to make a difference, as will the lower interest rate. In the meantime, a slowing rate of growth is hitting Chinese heavy industry particularly hard; Chinese demand for raw materials is dropping. Evidence of this can be seen in the 16% drop in copper prices from April to June; the rapid drop in steel prices over the same timeframe; and, perhaps, even in the 24% drop in crude oil prices from April to June.
Some market commentators expect China to pursue a stimulus program similar to its 2008 stimulus. We suspect if it stimulates its economy in the near future, it will not look like the last one. The Chinese government has stated it wants to encourage consumer spending, not build more highways and bridges. In sum, the Chinese economy is growing more slowly. The Chinese Central Bank has taken its foot off the brake and started to push on the gas, but the Chinese economy isn’t responding yet.
In the United States, economic indicators are softer as we move into the summer. So far, the equity market hasn’t expressed the recession fear that hit late last summer, but nothing in the numbers rules out a reemergence of that concern. There is no more clarity around tax rates, government spending, and regulations than there was a year ago—with the sole exception of health care. On June 28, the Supreme Court ruled the Patient Protection and Affordable Care Act constitutional, removing one source of uncertainty for that industry. The popular press now focuses on the “fiscal cliff” or “taxmageddon” that is anticipated to hit on January 1, 2013 as tax cuts expire and government spending cuts take effect. It seems neither political party is willing to make a significant move pre-election, but waiting until after the election leaves precious little time to do anything meaningful. We don’t expect much change in the economy for the remainder of the year. And we don’t expect to get much clarity on the direction of taxes, spending, and regulation until after the election.
In the U.S., gasoline prices, which hit nearly $4.00 per gallon in the spring, have pulled back to about $3.50 per gallon and are expected to go lower; that’s good news. Cheap natural gas has prompted electricity producers to shift from coal to natural gas much faster than anyone anticipated, pushing coal prices and electricity prices down. Cheaper energy is probably the biggest positive force in the U.S. economy today. Hopefully, we won’t kill it.
Overall, on the negative side, European debt and banking problems, slowing Chinese growth, and U.S. fiscal challenges keep us cautious. On the positive side, dramatic shifts in energy production and use in the U.S. provide us some very interesting investment opportunities. We expect the summer and fall to remain volatile as Europe continues working through its problems and the U.S. political debate heats up in advance of the elections.
The comments made by Ron Muhlenkamp in this commentary are opinions and are not intended to be investment advice or a forecast of future events.
Questions and Responses
At our investment seminar on May 3, 2012, Ron Muhlenkamp and his Investment Analysts presented The Market Drivers—Europe, China, and U.S.Politics: Recent Changes and Impacts to an audience of clients, shareholders, and prospective investors. Afterwards, Ron and his Investment Analysts entertained questions from the audience. The following are responses to these and to some other questions that have recently surfaced. A video archive of the presentation is available on our website at www.muhlenkamp.com.
About the U.S. Economy…
Inflation has been added to the checklist of things you routinely monitor. If inflation does increase, how will it change the portfolio? What will you do differently?
Those of you who have been listening to us for awhile know that we haven’t feared inflation for the last three years because much of the money the Federal Reserve (Fed) printed was to offset a collapse in the velocity (turnover) of money. Whereas a lot of people feared inflation three years ago because they saw the money supply jump, we told you then that printing money was necessary because the velocity of money collapsed. (Gary Shilling, among others, points out that the Fed doesn’t really print money; the Fed puts money in the banks—it’s when they start lending it that you get the creation of the money.) One of the triggers that tell us the velocity of money is picking up is an increase in commercial and industrial loans. In recent months this has occurred, so inflation is now on our red flag list.
For us, inflation eats into the purchasing power of our “income” and our assets. (As consumers, most people think of inflation in terms of price increases. As investors, we think of inflation not as prices moving up—but as the value of money shrinking.) Today, we can’t protect our purchasing power against 2% or 3% inflation with cash or even long-term Treasuries. We believe by investing in companies that have strong balance sheets and free cash flows that we are better able to protect the purchasing power of my (and your) assets. Such companies, however, must also be able to adjust for changes in the inflation rate.
If we have a gradual rise in inflation—if it moves up at a rate that corporations can respond to based on sufficient demand—corporations can, in fact, offset inflation. But there are two qualifiers: It has to be gradual and businesses have to see enough demand in the economy to offset it. Remember: Inflation normally drives up interest rates, which would normally drive down P/Es (price-to-earnings ratios). But if your earnings are growing faster than your P/E is going down, your stock price goes up. (Obviously, if your earnings aren’t growing faster, as your P/E goes down, your stock price goes down.)
To learn more about how we price the markets, refer to Ron’s essay, Why the Market Went Down.
Do you trust the numbers you’re getting on inflation? I’ve heard it’s understated, or they’ve changed how they calculate it… those kinds of things. How do you know what the inflation rate is?
All of those things are true, but they’ve been true for a long time. We prefer numbers that are consistent in their derivation, versus ones that have been changed every couple of years to be “accurate.“
Frankly, we don’t know any number that you can take at face value without checking to see whether or not it makes sense. So the answer to your question is, “Yes, we trust the numbers, but we always verify.”
Do you think employment numbers will improve soon?
The most recent employment numbers stated 80,000 jobs were added in June; the expectation was for 120,000. Here’s what we think is happening:
The U.S. economy continues to grow at a modest pace, but 2% growth does not get unemployment down. Because the economy is currently growing about as fast as productivity is growing, businesses don’t need to hire additional people or open new plants. The longer we have slow growth, the longer we have high unemployment.
Also, we think the mindset in Washington discourages businesses from growing and hiring. We believe increasing taxes, increasing regulations, and the increasing cost of health insurance make it difficult for employers to hire. So we think employment is going to be slow to come back. We don’t think the U.S. economy will really get into gear until after the elections in November because, frankly, as an employer, I don’t know what the rules are. Going forward, we think other employers are reluctant to hire for the same reason(s).
What’s the general consensus on the consumer—are people spending or saving?
Back in 1992, the personal savings rate (of disposable income) was at 7%-8 percent. From 1992-2006, it went from 8% to 1 percent. In the fourth quarter of 2008, personal savings went from 1% back up to 5%-6 percent. Pretty much for all of ’09 to date, the public has kept its savings at about a 4%-6% rate. Similarly, after the 1990 recession, people began to rebuild their balance sheets. You might remember that economists referred to that period as a “half-speed recovery.” The same applies to today.
What’s encouraging is that even though our economy is not back to where we want it to be, credit card delinquencies are back at low levels. People are paying their credit cards down—so the American public is doing what I think it needs to do. (In contrast, you’re hearing a lot of negative news about foreclosures. Foreclosure on a house or a mortgage tends to be a one- or two-year process. Credit card defaults are processed quicker than mortgage defaults and foreclosures.) Incidentally, this is what typically happens during a recession—people work a little harder, spend a little less, and save a little more. After a while, they build up their balance sheets and gradually resume spending as they become comfortable with their savings. That’s why we think, to a large extent, recessions are self-correcting.
About U.S. Politics…
What do you see happening with those states that made promises they cannot keep?
Some states and municipalities are making strides at getting spending under control; many others are not. There’s a beautiful experiment in economics and politics going on within states all across this country. If you compare Illinois to Wisconsin, Texas to California… Whether the politicians and voters pay attention to those experiments, remains to be seen. This will be a gradual process.
What are your thoughts about the upcoming election?
We think it’s about making a choice between continuing down the path to a Euopean-style welfare state or a return to a greater reliance on free markets and private enterprise. We think that’s the choice we’re making this year, and we’re seeing discussions among our neighbors on economics and politics to an extent we never did before.
Come November, whatever the public decides, that’s the way we’re going to go. After November, we’ll look at the circumstances and determine where we can protect and grow your assets.
About the Markets…
You have mentioned that dividends are now worth watching. Please elaborate on the increasing role dividends may be playing in your thinking.
Right now, the Fed not only has its thumb on the scale—it has its whole arm on the scale—holding interest rates below where they should be. Low interest rates are limiting the incomes of retirees and the returns on pension funds. The Fed is trying to help the people who borrow and spend, but, it’s squeezing the people who have saved and are trying to live off their income. As a result, you can’t get reasonable income from Treasury bonds, so investors go to the next source which is corporate bonds—and there’s not a whole lot there. And so, in that search for income, the choice of vehicles is being narrowed to where we think some investors would benefit from stock dividends. For example, we have owned telephone companies with a 6% dividend yield partly because the yield was better than what we could get on a Treasury or corporate bond.
In this investment environment, we want to own companies with strong free cash flows that tend to come back to us either in the form of dividends, or by the companies buying in their own stock. The long and short of it is there aren’t good alternatives today for the people who are looking for income. As a result, we think stock dividends have become more important than they have been in the last 30 years.
NOTE: Currently stock dividends are taxed at 15%, but that may change very soon.
Is this a good time to be investing in commodities, and what are your thoughts on using Exchange Traded Products (ETPs) to get this exposure?
Commodities are subject to the same forces of supply and demand present in other parts of the economy. Every commodity has its own set of different economic and perceptual variables, so it’s tough to generalize a response. For instance, U.S. natural gas has been in abundant supply, due to healthy production levels and increased storage left over from last winter. Producers are slowing their rate of new well/drilling activity, while the demand side of the picture is improving as a result of a very hot summer (so far), and electric utilities switching from coal. Petroleum is a bit different. Increased U.S. production, combined with certain OPEC countries increasing their production, is coming onto a market that is experiencing declining demand growth (influenced by both China and Europe). The shift in the supply/demand balance would argue for lower prices ahead for petroleum. Two commodities in the energy sector are experiencing different fundamentals.
In agricultural products, weather often drives price. The price of corn has increased meaningfully recently on the back of very dry weather in critical growing regions. This affects the price of cattle, but not as directly as one might expect. As feed becomes more expensive, cattle are sent to slaughter which has the effect of lowering prices for a time.
In addition, commodities have benefited from the Federal Reserve’s (and other central banks’) efforts to stimulate the economy through monetary easing. This has caused certain investors to seek “hard assets” as a protection against potential price inflation. Should the fear of inflation subside, commodities that benefited from this concern would be at risk.
As far as how to invest, Exchange Traded Products provide a convenient way to get exposure. Yet, we explicitly caution against Exchange Traded Notes (ETNs) that are linked to a particular commodity. Such products do not represent an underlying ownership interest in the commodity, but are an unsecured, debt-like instrument of a financial institution (often a European bank). Be sure to understand what is owned in the ETP and whether there are guarantors that sit between you and the commodity you intend to own. This is one area where we say, “Convenience is usually expensive. Ignorance is deadly.”
One Family’s Perspective on the U.S. Federal Budget: 2012 Perspective Ron Muhlenkamp
When people set out to discuss the federal budget, they often get glassy-eyed after the first few $100 billion. We have all seen graphic examples of the sums involved, such as the stacks of dollar bills rising to the moon and beyond. Designed to help us understand the magnitude of federal finance, these “visual aids” are often as overwhelming as the raw numbers and don’t really help at all.
In 1988 I wrote an essay that attempted to make the U.S. federal budget easier to understand by breaking the numbers down on a per household basis. That worked out pretty well, so I updated the numbers in 1992, 2002, 2006, and 2010. Given the attention federal spending is currently receiving in the press and popular discourse, it’s probably time to visit the topic again. To eliminate the effects of inflation from the discussion, I have converted all the nominal dollar amounts to 2010 equivalent dollars in the following figures.
Let’s start with the big picture and work our way smaller. Figure 1 shows U.S. Gross Domestic Product (GDP), along with Federal Government Outlays, Revenues, and Deficit (or surplus) on a per household basis:
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Source: Fiscal year 2012 Historical Tables Budget of the U.S. Government
Looking at GDP per household (left axis) you can see a pretty steady movement higher, interrupted by significant drops during the 2001 and 2007 recessions. After the 2001 recession, it took until about 2004 for us to reach the prior high. We haven’t yet regained the 2007 level. In 2007, GDP per household (in 2010 dollars) was $127,219; in 2011, it was $123,335. In nominal terms, we have surpassed the old highs. GDP per household in 2007 was $120,920; in 2011, it was $127,180. Adjusting for inflation, however, reveals a different picture.
Looking at the total Federal Outlays (right axis), you can see they were fairly stable in the vicinity of $23,000 per household from 1991 through 2001, and steadily increased until it stood at $25,000 per household in 2006 where it leveled off for about two years. In 2009, Federal Outlays leaped to $30,000 per household; that amount has come down a little bit since then, but not much.
Looking at Federal Revenues, you see them increasing a bit faster than GDP from 1991 to about 2000 and declining from 2000 to 2003, likely due to the 2001 recession. As GDP grew once again, they increased during 2003 to 2007, and then moved down again as the recession hit in 2007. I find it interesting that Federal Revenues per household were about the same in 2011 as in 1991, although GDP per household was about 20% higher in 2011 than in 1991.
Finally, you can look at the plot of the Federal Deficit which steadily declined from 1991 to 2000—actually turned into a surplus from 1997-2001—jumped in 2003 and, again, in 2009.
Summarizing where we stood in 2011, the Gross Domestic Product of the country was just over $123,000 per household, while Federal Outlays were about $29,000 per household, roughly 23% of GDP. Of the $29,000 per household that the government spent in 2011, taxes and other revenues only covered $18,800; the remaining $10,200 per household was borrowed.
With that as a backdrop, let’s dig a little deeper into where the federal government is spending our money. In Figure 2 we’ve graphed Federal Outlays by category from 1991 to 2011 on a per household basis, and adjusted them to 2010 dollars; (right axis).
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Source: Fiscal year 2012 Historical Tables Budget of the U.S. Government
In order to keep the plot from being too crowded, we did not include any category that was less than 3½% of Federal Outlays in 2011. (Note: Education, 2.8% of 2011 outlays, was the largest budget area that didn’t make the cut.)
We’ve included GDP per household again for reference. You’ll notice that Interest on the Federal Debt is the only one that has significantly declined in the last twenty years, decreasing from $3,200 per household in 1991 to $2,000 per household in 2011. This is mostly the result of declining interest rates. (The budget surpluses from 1997-2001 brought the debt down a bit, but not a lot.) Since 2009, interest payments have started moving up. The amount we spend on Veterans Benefits is about $1,000 per household in 2011. Let’s drop those two categories and look at the top five Federal Outlays; refer to Figure 3.)
Once again, in Figure 3, we’ve included GDP per household for reference:
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Source: Fiscal year 2012 Historical Tables Budget of the U.S. Government
In 1991, Defense was the largest single Federal Outlay at about $4,700 per household in 2010 dollars. This amount declined to about $3,600 per household during the drawdown after the Gulf War and rapidly increased after September 11, 2001. (Remember the decline in Federal Outlays from 1991 to 2001 we discussed earlier? It looks like a decline in Defense spending was a big piece of that.)
Social Security has moved from the number two position to number one, now accounting for over $6,000 per household in federal spending. It was increasing at about the rate of GDP until 2008, and has increased rapidly in the last two years.
Income Security—general retirement and disability insurance, unemployment compensation, housing assistance, food and nutrition assistance, and federal employee retirement and disability—has gone from about $3,000 per household from 1991 through 2001 to $5,000 per household in 2011. You would expect a piece of this to be sensitive to economic cycles (e.g. unemployment and food stamps), look at the increase during the 2001 recession. The jump from 2007 to 2010 is huge, reflecting the extension of unemployment benefits, some of the homeowner’s assistance programs, and food stamps. This category is starting to come down a bit as employment improves.
Medicare has been on a pretty steady march upwards, doubling from just under $2,000 per household in 1991 to just over $4,000 per household in 2011.
Health, which includes health care services, health research and training, and consumer and occupational health, has more than doubled from 1991 to 2011, costing each household about $3,100 in 2011. (Note: Medicaid outlays in 2011 were 89% of the Health category, so “Health” is mostly Medicaid).
Overall, this plot highlights that of the top five spending categories two, Defense and Income Security, are at cyclical highs. We can expect them to come down if employment increases and the wars end. The remaining three, Health (Medicaid), Medicare, and Social Security, have steadily increased over the last twenty years. If they continue to increase at the same rate, they will dominate Federal Outlays.
I find this approach to the Federal Budget makes the numbers real to me. In 2011, the federal government spent $29,000 on behalf of my family—$13,000 (45%) of which was spent on Social Security, Medicare, and Health. The federal government collected $18,800 in revenues and borrowed the remaining $10,200. There have been times in my life where I borrowed 35% of what I spent, like the government is doing now, but I couldn’t do that forever. So I found ways to earn more and spend less and get my budget into better shape.
Figures 2 and 3 show me the big expenses that dictate where we have to go looking for big savings, explaining why every politician who is serious about reducing the deficit talks about Social Security, Medicare, and Medicaid. Those two figures also show me which parts of current Federal Outlays are cyclical and will come down—unless we fail to reduce unemployment or remain in a permanent state of war.
The Appendix contains the raw data used in creating these figures, so you can look at the data yourself. Sources are also listed, so you can double check the data or dive deeper. Historical data from the 2012 Federal Budget contains a wealth of information about where we have spent our federal dollars in the past, where we are spending them today, and projections for the next few years.
Appendix: U.S. GDP, U.S. Federal Spending raw data, in millions of dollars