Download Semi Annual Letter

July, 1999
To Our Clients and Friends of Parthenon Capital Management
The initial four months at Parthenon Capital Management have been gratifying. We are
extremely pleased and grateful that so many long-time clients have joined us and are excited
about the new relationships we have established. We will work diligently to maintain the trust
you have placed in us, with a clear understanding that we must earn your trust continuously.
Rising interest rates could not stop the advancement of the stock market in the second quarter.
The S & P 500 Index rose 7.06%, including dividends, for the quarter. Reflecting the increase in
interest rates, the Lehman long-term government bond index declined by 2.50%. Since higher
interest rates adversely impact equity valuations this letter will focus on topical economic issues,
with a particular emphasis on the outlook for inflation and interest rates.
Fed Hikes Rate, Moves to Neutral Bias
On June 30, 1999 the Federal Open Market Committee voted to raise its target for the federal
funds rate by 0.25% to 5.00%. The increase followed three 0.25% reductions last fall in
response to weakness in many foreign economies. While the increase was anticipated and the
announcement included the adoption of a directive that includes no “predilection about near
term policy action,” there remains considerable uncertainty about the extent of further Fed
activity. Records show that the Fed typically has returned to a neutral bias each time it raised
rates in the past, whether it later raised rates again or not. That could mean that the Fed’s
decision to adopt a neutral bias might be less an indication of future trends than investors
thought. History provides little guidance to predicting future Fed action. In 1997 the Fed raised
rates once by 0.25%. From March 1994-February 1995 the Fed raised rates six times for a total
of 3.00%. With the stock market continuing to make new highs, a tight labor market,
a strong domestic economy and rebounding foreign economies, the risks remain for additional
tightening activity. However, our favorable outlook for inflation and the current high real federal
funds rate argue against a series of significant rate hikes. Therefore, we anticipate no more than
one or two more small increases at the most. Current bond prices and futures contracts largely
reflect such possibilities, which should minimize adverse interest rate impacts.
Strong Economic Growth Continues
The domestic economy has been accelerating at about a 4.0% real annual growth rate for
the last three years. The robust growth rate is attributable to soaring consumption and rising
productivity. The wealth impacts of the stock market gains and a near full employment economy
have pushed consumer confidence to a 30-year high. Real consumption has been growing
at about 6.0% annually, leading to a negative savings rate as calculated by the Commerce
Department. The reported household savings rate fell to minus 1.2% in May, the lowest level
since the Great Depression. Foreign economies appear to be rebounding, which will result
in some improvement in exports and less of a drag on the economy from the trade sector.
Rising domestic interest rates, including mortgage rates at a two year high, will temper
growth somewhat. However, we see real economic growth slowing only to about a 3.0% level.
The economy has now grown for over eight consecutive years and the longest economic
expansion in history should be achieved in early 2000.
Inflation Fear, Not Inflation Reality
The Fed is concerned about a labor shortage leading to rising inflation. While the unemployment
rate is near a 29-year low, labor costs have been restrained by global competition, technological
advances, mergers and cost cutting. Ironically, both job creation and layoffs are soaring.
Oil prices have nearly doubled and some other commodity prices have firmed, but productivity
gains have held unit labor cost increases to negligible levels. Pricing power in most industries
is virtually nonexistent. The world economy is improving, but probably not enough to lift
inflation materially.
The Vanishing Deficit
The economic expansion has generated many benefits. The most surprising may have been the
improvement in the federal budget. The federal budget improved from a $290 billion deficit in
fiscal 1992 to a $70 billion surplus in fiscal 1998. The surplus should reach $100 billion in fiscal
1999 with a small overage predicted even excluding the amount by which current social security
tax receipts exceed disbursements. In fact, recent predictions by the Clinton administration
show the elimination of the over $5 trillion federal debt by 2015. Long-term forecasting is
a dangerous game and we are not counting on this development. Nevertheless, the outlook
for a shift of more resources out of the government and into the private sector is a favorable
development for the bond and stock markets.
In summary we are anticipating real growth of around 3.0%, inflation of about 2.0%, a rising
budget surplus, and little additional Fed tightening. While this is a favorable economic
environment, the higher interest rates coupled with rising stock prices create a difficult
environment for equity management. However, market valuations are not homogenous
which presents some promising areas for exploration. We will remain diligent in our search.
J. McFerran Barr, II
Thomas A. Corea
Tony H. Coffey
Todd P. Lowe