Letter - October 2013





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Here We Go Again

In the past couple of years, it seems that when it is time to write our quarterly letter we are confronted with some sort of crisis, which makes it nearly impossible to look ahead with clarity. Well, here we go again.

Today, investors are facing a political stalemate in Washington over passing a budget, pitting the Republican controlled House of Representatives against the Democratic White House and Senate. As a result, the government has been partially shut down for lack of funding. The House wants something in return for passing the budget. That’s called compromise. The Democrats say absolutely not. By the time you receive this letter, the issue may well be resolved. Meanwhile, for the time being, the shutdown focuses on non-essential services and the man in the street is largely unaffected. While Wall Street is not happy, so far it has reacted with merely a shrug.

A more serious showdown is due for later in the month. On or about the 17th of October, Washington will be unable to borrow additional money as it hits the statutory limit on its authority to borrow. Unless a divided Washington comes together (and so far it has not), the federal government will be unable to pay its bills.

Lacking a compromise to raise the debt limit, the US could well be forced to default on its outstanding debt. It would be unable to pay interest or retire maturing US Treasury securities. This would be a big deal. Although not rated AAA by all three rating agencies, Treasury securities are considered the safest and most liquid securities in the world. As the global reserve currency, these securities are held by foreign central banks. China is notable as the largest foreign holder. Default would conceivably result in frantic selling of Treasuries and a sharp rise in interest rates. This in turn could push the economy back into recession. The stock market would decline. Wall Street would most definitely not shrug it off.

We will not pass judgment on the issues that divide Republicans and Democrats. Suffice it to say that the country is sharply divided. Reflecting this, there is little appetite for compromise in Washington.

As we head into the fourth quarter, investors are confronted with the unknowable. Here we go again. We will just have to get used to it.

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So, where does the economy stand assuming Washington figures a way out of its fix?

The good: After the rally from the lows of last November, stocks have become much more fairly priced. Recently, there have been a number of highly successful initial public offerings, which suggests sentiment is buoyant. There has been a whiff of détente between Washington and Tehran, which could have enormous implications for the price of oil.

The bad: The economy is growing very modestly. Employment is fragile with many of the new jobs created being in low paying lodging and restaurant industries. Housing continues strong but the rate of growth has hesitated recently due to higher mortgage rates. Meanwhile, the Fed continues full steam ahead with quantitative easing (easy money, artificially low interest rates).

Recently, corporate earnings have grown, largely due to cost cutting and companies buying back their own stock (fewer shares outstanding means higher earnings per share). This has driven stocks higher. However, by now, many companies have exhausted their ability to cut expenses much further. What business and the stock market need now is for GDP growth to accelerate thereby driving corporate revenue and earnings higher.

Currently, inflation adjusted GDP is growing at about 1%, which is too low to drive anything, let alone corporate revenue. If Washington cannot resolve the budget and debt ceiling impasse in a timely manner, the economy will likely sink back into recession. That would be very bad for the stock market.

Our read of market sentiment is that players are somewhat complacent. A year ago, we faced the budget sequester; two years ago we faced the debt limit debate; five years ago we faced a market meltdown and banking crisis yet we got through them. “We’re all old hands now; we’ll get through this too.”

Well, hold on to your hats (and stocks), folks. Here we go again!

Tom Herzig


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