QUARTERLY LETTER

Published Third Quarter 1988
Muhlenkamp Memorandum 5

The U.S. economy continues to hum along nicely. Consumer spending is moderating a bit, but is offset by strong exports. The fall in the dollar since 1985 has helped limit imports and boost exports, which is why we continue to think the trade deficit will fix itself. An improving trend in the trade deficit is now apparent; the strengthening dollar reflects this.

In terms of the Federal budget deficit, nothing is being done and probably nothing will be done until after November. Even then, we may not do much. The electorate has narrowed the political choices to those who have made the fewest promises to change things. If you adopt the thermostat theory of elections (we only get up to change things when we're uncomfortable), it implies things won't change much because the public is comfortable.

Wall Street's mood has shifted from fears of depression after the October crash to current fears of a near boom and inflation. We are sure that some individuals have realized these fears (such as those investors who sold last October, either because they were on margin or panicked). But, in the aggregate, the public and the economy have treated the crash as a non-event.

Charlie Smith's accompanying article on the drought highlights some of the reasons why increased prices in some parts of the economy do not necessarily result in economy-wide inflation. Those who now fear inflation are looking at the pieces, not the whole picture.

Don't get me wrong, the drought is a negative and creates inflationary pressures. Higher employment is a positive, but also creates inflationary pressures. Historically high interest rates are a positive for savers and a negative for borrowers and create disinflationary pressures. It is normal for some parts of the economy to improve while others suffer setbacks; that's the strength of a diverse economy.

If the response of the Fed to the above is to create more money, we will have higher inflation. There are; however, no current signs that it is doing so. Historically, once elections are out of the way, Washington is more likely to slow the economy than to stimulate it. We therefore look for inflation to remain in the 4-5% range. If so, interest rates should come down, making bonds attractive. Further improvement in the trade and/or budget deficits (which would strengthen the dollar) would help bonds as well. At these levels, the average common stock is fairly priced, and individual stocks should reflect the current results of the underlying companies. Our emphasis will remain on those companies and industries that are doing well in the mixed economy of 1988.

Read our quarterly newsletter, Muhlenkamp Memorandum, for more by Ron Muhlenkamp.