Client Investment Letter June 2018

“In his blue gardens men and girls came and went like moths among the whisperings and the champagne and the stars.” – F. Scott Fitzgerald, The Great Gatsby

Summer heat has descended upon us and so, for many, it is time to head to the beach or mountains and curl up with a good work of fiction.  One of the classics is The Great Gatsby, and this year as we ponder the state of the economy and markets, we all might want to think what a book of times long past can tell us about the present.

One parallel is obvious.  In 1922, the same year as the parties in West Egg, a Republican Congress passed the Fordney-McCumber Tariff.  It turned out to be the first shot in a global trade war that escalated dramatically.  Our trading partners countered with tariffs of their own over the following several years.  We responded with the more widely known Smoot-Hawley Tariff Act in 1930, and our trading partners raised additional tariffs of their own in turn.  The tit-for-tat tariffs are widely believed to have contributed to the length and severity of the Great Depression, though they generally aren’t thought to have caused it.

Donald Trump seems to have fired a warning shot across the bow with tariffs of his own.  Will they prove to be a brilliant negotiating tactic or an epic miscalculation on the way to another costly trade war?  It is hard to know, but there is some reason for optimism.  First, the experience of the 1920s isn’t lost on many people.  It seems unlikely that Congress, which could easily revoke Trump’s ability to enact tariffs, will continue to go along with them and risk true damage to the global economy.  Second, many companies today are multinational.  They will dodge tariffs as best they can by moving production around, just as companies like Harley-Davidson have already announced.  Finally, we do think that there have been some abuses by certain of our trading partners; China, for example, has been stealing U.S. intellectual property for years.  Our past efforts to thwart the problem haven’t worked, so perhaps a different tack will?  So put us in the concerned but hopeful camp when it comes to a trade war.  And here too, perhaps, the example from the 1920s can be useful.  While the trade war began in 1922, it didn’t really impact the economy until the 1930s.  It seems to us there is still plenty of time to avoid a trade war-driven economic calamity.

But aside from the direct comparisons between the two time periods, there is perhaps a broader metaphor for the markets in Gatsby as well.  Those men and women in the blue gardens looking for partners to dance with represent capital trying to find investment opportunities.  During the light of day most party goers can distinguish pretty clearly the guests that they deem worthy of their attention. However, once the lights are dimmed and shadow is cast over the parquet floor, perceptions sometimes change.  In the markets this shadow is liquidity which makes people think things are always as easy to sell as they are to buy and cheap capital is widely available and will remain so.  As long as liquidity is flush, drenching the guests in darkness, an otherwise homely dance partner can sometimes seem attractive.  Next, throw in the Federal Reserve, which acts as a bartender serving up glasses of champagne and mixed drinks in the form of low interest rates.  The low rates change people’s perception about what good returns are. They make them more likely to reach for riskier assets that seem like a good relative bet instead of offering good absolute returns given the risk involved.  Finally, the band can be thought to be the economy in general, setting the tone of the entire party.  It’s been playing a vigorous tune for us recently, with GDP growth accelerating to north of 2% for four quarters in a row for the first time in several years and better growth expected ahead on the back of corporate tax cuts. Unemployment is hitting new lows of 3.8% for this cycle while inflation is finally picking up to the Fed’s 2% target.  As long as the economic beat remains lively, many investors are sure to remain out on the dance floor looking for investments.

So where does all this leave us at the party? Well, we’re reaching for water and sitting beside the dance floor continuing to make sober assessments of the investment opportunities we see.  We do still see good bargains pass by from time to time and, when we see them, we pounce. As the party has worn on, however, we have noticed less and less truly attractive opportunities that we think would stand up to the scrutiny of daylight. With our highest cash position in years (invested primarily in short term U.S. Treasuries which pay about 2.3% for a 12 month bill), our dance card has room for plenty of new partners.

Meanwhile, other party guests have been finding your holdings attractive.  This quarter, Bayer finally closed its deal for Monsanto paying $128 in cash per share after a two-year saga.  The stock started the year around $117 on fears that regulators wouldn’t approve the deal.  A full scale bidding war is in progress for 21st Century Fox.  You will recall that Disney had originally planned to acquire certain assets of Fox for Disney stock worth about $30 per share.  The remaining Fox assets were to be spun out in a stub we thought would be worth at least $10 per share.  Comcast had made a bid during the lead up to the Disney deal, but the Fox board had rebuffed it on anti-trust concerns and a lack of adequate protections against them.  However, when the AT&T and Time Warner merger was approved by the courts with no conditions in June, Comcast was emboldened and made a new bid of $35 in cash for the same assets.  Disney quickly countered with a $38 per share cash-and-stock bid.  More rounds are expected in the coming weeks.  Finally, Michael Dell seems poised to find a way to close the 41% gap between Dell Technology Class V shares and the VMware shares underneath them. Dell has agreed to acquire Class V shares for $109 per share in cash or new Dell Technologies shares.  This represents a 30% premium to where Class V shares were trading before the deal was announced and effectively splits the discount between Class V shareholders who take the cash and Dell (including some Class V shareholders who become Dell owners).

While the drama surrounding the aforementioned merger situations is exciting, we still believe the overarching factor that will impact the market most in the near future is the pace and amount of continued Federal Reserve tightening.  It is interesting that we haven’t seen a new market high in five months, while the Fed continues apace having implemented its seventh rate hike this cycle in June.  Is the gravity of higher rates beginning to assert itself on all asset prices?  Volatility has also resumed in domestic markets and returned with a vengeance in emerging markets where a strong dollar is upsetting the apple cart due to high dollar-denominated debt loads which get harder for emerging market debtors to pay back as the dollar strengthens.  The Fed has to achieve the difficult balancing act of undoing quantitative easing and raising rates high enough to have some tools available during the next economic downturn, but not removing accommodation so fast that they cause the downturn.  With the Fed expected to hike rates at least a couple more times this year, we believe caution remains warranted which is why we are keeping plenty of cash available.

When the lights come on, the buzz wears off, and the guests all start to depart, we believe we are well prepared to identify new opportunities to add to your portfolio just as others are realizing they weren’t discerning enough with their choices.  Meanwhile, we remain confident that the high quality companies you own will still look just as good in the sunlight as they do in the shadows.  Thanks for the trust you place in us and we wish you a summer full of fun and fiction.

Penn Davis McFarland, Inc.
June 2018