QUARTERLY LETTER

Published Second Quarter 1989
Muhlenkamp Memorandum 8

The first quarter of 1989 witnessed a continuation of trends discussed in previous memos. GNP growth is moderating, but grudgingly, so the markets and the Fed have pushed up short-term interest rates one more time. T-Bill rates have now been pushed from 6% to 9% in one year. The purpose of this push is to slow the economy (economists trained in Keynesian theories believe a too strong economy is inherently inflationary), and it seems to be working.

Various measures of GNP show increasing signs that the economy is slowing down. Because hikes in short-term interest rates are viewed as beneficial in controlling inflation, long-term rates have moved up only modestly (about 1/2 of 1%) during this time. We now have an "inverted" yield curve; short-term rates are higher than long-term rates. Because yield curve inversions often precede recessions and periods of stock market decline, this has excited a lot of people. These people are flocking to buy certificates of deposit paying 9% for a year or two, just as they did when rates were 15% in 1981 and 10% in 1984.

If 9% rates are so attractive, why not buy bonds paying 9% for 20 or 30 years instead of a year or two? The only reason not to is if you expect inflation (and therefore interest rates) to go considerably higher. Since we have concluded that monetarist and "classically' trained economists have a better record at predicting inflation than Keynesians, and since money growth has been 6% or less for over two years, we don't see much risk of significantly higher inflation any time soon. At the risk of saying, "This time is different," we note that this time the Fed started slowing money growth early, in anticipation of inflation rather than in reaction to it. In fact, the Fed began squeezing before the election, which is almost unprecedented.

The recent stability in both long-term interest rates and the dollar indicates that the markets (meaning the majority of people with their money on the line) are reaching similar conclusions. The current risk in bonds is that the Fed will have to raise rates still higher to satisfy the Keynesians, or to respond to higher short-term inflation as reflected in the Consumer or Producer Price Indices. Most of the current discussion is whether rates have peaked, are peaking or are about to peak.

The risk of recession remains. Fed tightening preceded each of the U.S. recessions since W.W. II (although not all Fed tightenings resulted in recession). A recession is certainly more likely when the Fed is trying to slow the economy rather than speed it up, but is by no means guaranteed.

In general, recessions are bad for corporate earnings and therefore bad for stock prices. Since most stocks are now fairly priced in relation to inflation and interest rates, earnings surprises are likely to be reflected rapidly in stock prices.

So what are the options? The economy may continue stronger than desired and the Fed will push rates higher. Good for earnings, bad for bonds. The economy may fall into recession. Bad for earnings, good for bonds. The economy may "muddle through" in a slow growth mode. OK for earnings, good for both bonds and stocks. A drought or other crisis (war or budget fiasco) is always a risk.

What to avoid? Stocks or bonds of companies with weak balance sheets. A continued squeeze by the Fed to raise interest rates and slow the economy will put greater pressure on business than we have seen at any time since 1981-82. This is not a time to borrow money. This is not a time to own high-yield or "junk" bonds. This is not a time to bet on fledgling companies or venture capital.

This is a time to select companies with strong balance sheets and good earnings who can weather any storm, to set prices at which these companies are compelling values, and to be prepared to buy their stocks-or their bonds when the cumulated evidence indicates that a turn in inflation and interest rates is probable. We are doing just that.

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