Second Half Challenges
One of the most challenging aspects of managing portfolios is to process the endless information flow and determine what impact it will have, if any, on the markets. Some information, while interesting to read about, has virtually no impact on the future direction of stock and bond prices. Other information may not have an immediate impact, but it may be impactful in the future. This, delayed-impact information encompasses the vast majority of information that surfaces on a daily basis.
Case in point – Having gone to business school in Michigan, or that state up north as Woody Hayes would say, I have always been fond of Detroit. When I was born in 1959, Detroit was very near the top of the economic ladder, sporting one of the highest levels of per capita GDP in the entire country.
Essentially, Detroit’s politicians have made financial promises over the last several decades that it can no longer keep. Does this historic collapse of one of our greatest cities mean anything to the future of our economy or country? Cities throughout America are wrestling with the issue of underfunded pension obligations. Given our aging population, over time, other cities may face similar financial difficulties that Detroit now confronts.
From an overall economic perspective, recent statistics show a domestic economy that is growing around 1%, well below what is required to meaningfully improve employment and personal income, two engines of a healthy, expanding economy. Meanwhile, government spending, national debt, and taxes are increasing much faster. As we have witnessed the last five years, during the weakest post-war recovery on record, we simply cannot have both an expanding government and rapid economic growth in the private sector.
One of the bright spots in this persistently weak economy has been the recovery in housing. Yet, below the surface, there are disconcerting trends here as well. First of all, the number of first-time home buyers is well below historic averages, while the percentage of younger people living with their parents has climbed well above the norm. Neither of these trends bodes well for the sustainability of the housing recovery.
Another seemingly bright spot has been corporate earnings. But again, a look below the surface reveals fundamental weakness. In the most recent second quarter, corporate earnings grew modestly, despite flattish top-line revenues. Profits were driven by margin expansion, as corporations were able to reduce expenses, squeeze suppliers, and improve productivity. While the stock market has rallied reflecting higher earnings and strong cash flow, there is a limit to how long this can continue in the absence of acceleration in the overall economy.
Over the next several months political battles will be fought over immigration, tax reform, gun control, implementation of the Affordable Care Act, entitlement reform, Internet privacy and electronic communication, raising the federal debt limit, and the overall level of government spending. At the same time there is a growing battle being waged over states’ rights and an expansive and intrusive federal government. At the very least, all these issues are delayed-impact events. Some will affect the markets in the short term, but all of them will over time. And in this sense, if we do not shrink the federal government, reduce our national debt, and free up the entrepreneurial spirit of corporate America, the economy will not accelerate from its very slow growth rate. It simply will not happen.
With this as a backdrop, we are a bit cautious for the remainder of the year, especially after the relatively strong rally in stocks through the end of July. Stock selection will be critical going forward. For companies to buck the slow growth trend they will have to continue to drive productivity and new product innovation, while developing strategic partnerships to outcompete their rivals. In this difficult environment, average companies may survive, but only the best managed ones will thrive.
At the heart of our stock selection process, we will focus on identifying companies that have sustainable competitive advantages over their peer group in these areas: Cost control, technology, financial strength, cash flow, strategic vision, consistency and deliverability of earnings, and overall executive leadership. Unless the overall economy accelerates, the list of companies that hold these sustainable competitive advantages is likely to shrink, making gains in the overall stock market harder to achieve.