Wednesday, June 25, 2014

Don’t Look Back… …Something Might Be Gaining On You – Satchel Paige.

If you’re a regular reader of these pages then you know that we harbor a fondness for most things baseball. The game is at once purely American and thoroughly idiosyncratic. It’s a game of inches and it’s a game of wits. A contradictory pass-time: games have no time limit yet speed is highly rewarded. It is a treasure trove of wit and wisdom, too, that at once illuminates both the game and life. Small wonder that it can also provide guidance to students of the markets, as well.

U.S. markets continue to blithely skip along, oblivious to a multitude of gremlins on their trail. Punk GDP metrics, signs of a re-awakening of inflation, contradictory employment numbers, chaos in health care markets, frightening portents in Syria and Iraq, stalled de-leveraging of American households’ balance sheets and so on and so on.

As of this writing, most professionals are waiting, with some trepidation, to hear about one of the bigger gremlins: first quarter U.S. Gross Domestic Product (GDP) growth. Markets have been in full Bull mode for well over a year now, based at least in part on the assumption that the U.S. economy is finally shrugging off the funk it's been in since the end of the “Great Recession” over 5 years ago. GDP growth has been below its long term trend ever since then.

Because so many people are interested in this number every quarter, the Commerce Dept. actually does this calculation 3 times. A flash estimate is produced once the first 2 months of a quarter are “in the can.” After the quarter is completed a full quarter estimate is then calculated. Finally, once all the numbers are in, a final report of the annual rate at which GDP grew in a quarter is published.

The flash estimate for Q1, 2014 came in last month at a rather anemic +0.1%. The chill winter weather that brutalized much of the industrial heartland and the trucking and rail lines that traverse it got most of the blame for the number being on the light side. It is tough to get to work when your car is snowed in, frozen solid or your bus doesn't show up in the morning so most economists looking over Commerce's shoulder expected this figure to be lower than even the modest recent trend.

Eyebrows shot up like Roman candles when the full quarter estimate came out at a -1.0%. Cold weather was again blamed for turning down the thermostat  on the economy. But there were other factors at work, it seems. Investment, one of the 4 main components of GDP, and the most critical one for job creation, was looking very “molasses in January”-like, too. Since most investing these days, be it in stocks and bonds or plant and equipment, happens inside of computer spreadsheets and networks, the weather is not as huge a factor as it is in consumption (people can't get to the mall) or export (goods can't get to shipping terminals). Health care services spending also took a surprising dip. This not a great portent for either the benighted Affordable Care Act or for the final Q1 GDP growth rate.

We could be in for a lower “real” number than either of those estimates, perhaps as low as    -2.0%. Many strategists are assuming that there will be a robust snap-back from what they think is an entirely weather-related phenomenon. We'll see. Consensus expectations for 3%+ growth this year will need to be adjusted downward in a major way if Q2 does not show a big reversal. A lower GDP rate ultimately means that companies' competition for their share of the business pie gets tougher because there is less growth to go around.

What else might be gaining on the markets? Inflation, for one. Our main takeaway from the most recent Fed Open Market Committee meeting is that “Core Inflation” may, in their view, be starting to heat up. This Core Inflation measure is what the Fed uses to guide them in fulfilling their mandate to promote price stability; it removes energy and food prices because of their volatility. Now, when we do our budget every month, food and energy are pretty big factors in figuring if there will be “any month left over when the money runs out.” According to the Fed's math, inflation has been in check for several years, even though most everything that people spend money on costs more.

Should price inflation by the Fed's measure heat up, then we're all in for some tough decisions. The Fed, too. They'd like to keep borrowing rates at the rock bottom levels they've engineered. But higher inflation could force them to raise those rates, which would translate into an increase in the cost of capital. Typically, that's not good for stock prices. However, some believe this could ultimately be a good thing, since the rate structure we have now is artificially imposed and is grossly distorting capital investment policies. If forced to decide, we'd join the latter camp.

On the world front, fractiousness in Eastern Europe and turmoil in Iraq and Syria could be bringing an end to the relative stability we've experienced in oil prices. If we've heard it once we've heard it a thousand times: oil price increases act on the economy much like a tax increase. Please, don't let our peeps in Washington, D.C. know that: judging by their behavior, they think tax increases are a good thing.

Perhaps the biggest something that might be gaining on us is the national debt. It has now surpassed the nation's GDP and it is growing at a faster rate. Should the rate of interest that the Federal government pays to carry this level of debt increase, it alone could blow out our government's already dysfunctional budgeting capabilities.

So, there are plenty of “somethings” that might be gaining on us. Moreover, left to themselves, the capital markets are the best mechanism we have for discounting what may  lie ahead and allocating resources accordingly. Almost by definition, markets don't look back, they look forward. Normally, a rising market is telling us that all of the somethings we talk about and fret over are already known, already “built in” and that something better is coming along. And, normally, we can't ever quite completely believe it. That's why we always return to our core belief in Special Situation investing. Government meddling, foreign intrigues, even “Black Swans” come and go. But there are always Special Situations, companies discovering new needs that people want to satisfy and devising new ways of making things or doing things to satisfy them. Dozens, if not hundreds, of such companies. They don't all succeed but they all go their own way. They don't look back. They don't have time to.

PS Bonus Satchell Paige quote: “My pitching philosophy is very simple; you gotta keep the ball off the fat part of the bat.” Can the Federal Reserve keep our economy off of the fat part of inflation's bat yet keep the ball over the plate? Sounds like a tough job for a rookie pitcher like Janet Yellen.

R. Russell Last, CFA
Walrus Partners, President

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