Client Investment Letter January 2019

“The snow doesn’t give a soft white damn whom it touches.” — E.E. Cummings.

Like a blizzard that speeds across the plains stranding the unsuspecting traveler, December brought extremely tumultuous weather in the markets.  In fact, it was the worst December since 1931 for the broad U.S. equity market indices.  Thankfully, your portfolio has been bundled up in a cocoon of U.S. Treasury bonds for quite some time.  While they don’t look stylish and they can’t keep all discomfort at bay, winter clothes sure help when the snow finally starts flying and the same is true of your Treasuries.  They dampened the blow of the recent market plunge and leave us very well positioned for what is to come. We are very close to purchasing a few new companies we have been eyeing, but we will proceed with caution, making small investments at first and adding to them if conditions weaken further.

The difficult part is discerning when to discard the safety of the Treasury position and make those purchases.  On the one hand, the economy still seems to be fine, although it is clearly slowing.  Unemployment is very low at 3.9% and GDP is still growing moderately.  It seems that most of this move down has been correcting valuation excesses, although the outlook for corporate profits has been tempered in recent months.  But, as George Soros would say, markets are reflexive; sometimes a sharp market move can precipitate a change in the real economy and vice versa. Consumer confidence is beginning to tick down from a very high level and the stock market probably is contributing to this.  There is significant uncertainty about how Brexit and the trade war with China will play out.  Auto and home sales are slowing likely due to higher interest rates. The Fed appears poised to continue its tightening through raising rates (committee member forecasts estimate two more rate increases in 2019) and the reversal of quantitative easing.  Both could continue to be a headwind for markets in the near term.  Indeed, if the Fed does “take a pause,” one has to wonder if it will be too late.  Monetary policy is known to have an impact with a large time lag and making adjustments is more akin to steering an aircraft carrier than a speedboat.

One bright spot in the December squall was Dell’s purchase of the Dell Technologies Class V shares (DVMT), which you may recall were meant to track the performance of Dell’s holding of VMWare.  The deal closed on December 28th and you received $120 per share for 64% of the position.  The remaining consideration was new stock in DELL.  January also started with a bang, when Bristol-Meyers Squibb announced a cash and stock deal to acquire your Celgene for a 54% premium to the then prevailing market price.

A major question almost everyone has is, “Will there be a recession?”  We answer that with a definitive, “Yes!”  There will always be recessions; they are part of the normal business cycle.  But it is very important to draw a distinction between a run-of-the-mill recession and a financial panic-driven, deep recession like 2008.  This time around, we find the former to be much more likely.  First, the consumer, which drives about 70% of GDP, was the source of the trouble in 2008 as he was over indebted from using his house like an ATM.  This time around, we see no such excess in the consumer sector.  In addition, heading into the last recession most banks owed lenders nearly 30x their equity.  That meant small changes in asset prices could put them in peril.  This time around, leverage in the banking system has been purged to much safer levels, especially in the United States (less so in Europe).

When this recession unfolds— and we don’t know for sure if that will be 2019, 2020, or beyond – it is likely to be the corporate sector that suffers.  It has gorged on cheap debt made available thanks to the Federal Reserve’s ultra loose monetary policy from 2009 to 2017 and a relaxing of credit standards that allowed weaker companies easy access to debt.  When the recession comes, those businesses that borrowed too much will face bankruptcy or restructuring and those who loaned them money, often on unattractive terms, will lose some of their money.  This is how things are supposed to work.  We think these situations, which happen with every economic cycle, will be manageable though we have consciously high-graded your portfolio nonetheless.  None of the companies you have a core position in are dependent on the capital markets and likely to get caught out in a “debt accident.”  In fact, in a recession many of them will be in an advantageous position relative to over-indebted peers and will actually come out of it in a stronger competitive position than they had when the recession started.

The other place where debt has piled up is at the sovereign government level, particularly in the United States.  The United States is borrowing heavily in a time of plenty, which is very unusual.  The U.S. is on pace for a roughly $1 trillion deficit in 2019.  This will add to our already large debt of $21.9 trillion ($16.0 trillion netting out intragovernmental holdings like the Medicare and Social Security trust funds).  Because we can always print more money, the U.S. will never default on its debt, but there may be other consequences.  First, the value of the dollar may decline relative to other currencies.  This would help any exporters, but would make goods we import more expensive (and we import more than we export).  Second, the dollar is currently the world’s reserve currency, the de facto currency used in global trade.  If the United States is imprudent in its management of the dollar, we could lose reserve currency status as people seek more stable stores of value.  Third, we may need to increase taxes to service the debt if we don’t want to print our way out of it and this would be a drag on the economy.  Finally, high levels of debt are a headwind to economic growth as an ever-increasing proportion of our budget gets allocated to interest payments.

Unlike a corporation, governments rarely face a pre-specified day of reckoning when their debt comes due.  Rather, the markets just eventually lose confidence in them and a crisis ensues as interest rates spike and payments on newly issued debt become unaffordable.  However, the ability to predict the timing of such sovereign debt crises is virtually nil.  One merely needs to look at Japan which has more than two times as much debt as a percentage of GDP as the United States, a much more significant demographic headwind due to its aging population, and a perpetually stagnant economy.  The Japanese pay some of the lowest interest rates in the world on their debt (0% on a 10 year bond versus 2.7% for the U.S.) and the markets don’t seem to care at all and haven’t for decades.  If Japan can get away with that, you aren’t going to see us calling for a United States sovereign debt crisis anytime soon.

Market downturns like this aren’t fun even when well positioned, but they are necessary to purge excess from the system and keep capital allocated to its most productive uses.  We’ll do our best to navigate the storm and find more high-quality companies that we want to own for the long term at discount prices.  We accepted low interest rates on the large portion of your portfolio we had in short-term Treasuries so we would have the opportunity to buy bargains when the correction finally came.  It is here and we are ready to take advantage of it without having to sell the high-quality companies you already own.  Thanks for the trust you place in us and we wish you peace and prosperity in 2019.

Penn Davis McFarland, Inc.
January 2019