Thoughts on the Closed End Fund Market

We have been investing in closed end funds for our clients for more than a decade.  Over that time, we have developed an extensive knowledge of the unique nature of that market and the intricacies of how closed end funds operate for investors.  Since March of 2009, we have applied this knowledge in managing the Essential Absolute Return strategy with excellent results until the last twelve months.  

In the early days of this strategy, we invested primarily in corporate action situations that were low risk and which provided relatively steady and predictable returns.  Many of those corporate actions were a direct fallout of the 2008 financial crisis.  As the effects of that crisis faded, so did the number of opportunities of this type.  

More recently, we have focused on convergence trading.  We believe the closed end fund market is structurally inefficient which gives rise to temporary mis-pricing of assets, relative to their “normal” value.  We try to buy mis-priced funds, and then wait for the pricing to return to average or normal levels.  These types of opportunities tend to give rise to more volatile return streams (both positive and negative) and, because we never know when markets will return to normal pricing, the timing of such returns is uncertain.  However, because of the leverage inherent in most fixed income-oriented closed end funds, our clients earn a high current income stream which serves to mitigate somewhat the risk of price declines.  

Over the past twelve months, closed end fund discounts have widened to levels not seen since the financial crisis of 2008.  Yet, there has been no crisis, no significant widening of spreads (except in a few emerging markets where we have limited exposure), and no dramatic changes in the levels of short or long term interest rates.  There have, however, been periods of market uncertainty caused by concerns about the US Federal Reserve raising interest rates, a potential Greek default or exit from the Eurozone and China’s boom and bust A share market.  These events had relatively little impact on our holdings’ underlying net asset values.  Yet discounts continue to widen.  

This time period has left us wondering if something has fundamentally changed in the closed end fund market.  There have been a few developments: (1) the market for new closed end funds is quite muted and new funds that are being brought to market have more innovative structures designed to limit discounts; (2) the number of institutional investors has grown to the point where pure corporate action arbitrage opportunities are now rare; (3) fixed income exchange traded funds continue to gain popularity, potentially distracting investor interest away from closed end funds; and (4) investors have been hearing for years that the end of bond bull market is upon us and they need to prepare for rapidly rising rates.  

The first two factors should actually bring more rational pricing to the closed end fund market, not less.  The last two factors may actually be depressing the demand for closed end funds among retail investors, making a return to rational pricing more difficult.  We believe the fourth factor — fear about the impact of rising rates — is likely the biggest contributor.  For many reasons, we believe this fear is overblown.  

Over the course of the past year, we have continued to selectively add to positions in closed end funds that meet our investment criteria, only to see discounts on these funds widen further.  And we have allocated additional client (and personal) assets to this strategy, believing that the opportunities now present are extraordinary.  We hear the same story from our fellow institutional investors in closed end funds.  Here is a chart recently published by RiverNorth, a well-known manager in the closed end fund space.  

Taxable Bond Funds: 30-day Moving Average Discount June.1997-June.2015

Source: Morningstar, Inc. 

Source: Morningstar, Inc. 

As you can see, discounts have only been at this level immediately prior to the last two recessions.  In 2000, discounts quickly recovered, even before the recession fully kicked in.  In 2008, the financial crisis wreaked temporary havoc with all financial assets before a strong recovery kicked in.  We believe this time period is more likely to be like the early 2000s but there is of course no assurance that it will turn out that way.  

We are exercising patience in waiting for prices to return to more normal levels with the comfort of knowing that we are able to buy the assets of closed end funds at 10-15% discounts off the prices available directly or through open end mutual funds or exchange traded funds. 

July 30, 2015                                            Essential Investment Partners, LLC

Thoughts on the Current Outlook -- July, 2015

Three Key Thoughts:

  1. Fed dials back its optimism about US economy; 2+% is the new norm

  2. China's stock market volatility complicates market reformers' job

  3. Greece is the word 

Last quarter, we talked about our expectation that the US economy would grow in the 2-2.5% range for 2015, a result very similar to the previous three years.  Now that we have seen much more data on the first quarter and some preliminary figures for the second quarter, the Federal Reserve has dialed its consensus forecasts down into this range as well.  And the discussions about interest rate hikes are more about the Fed wanting to get off of zero so that it has room to maneuver if the economy weakens.  This is a very different viewpoint than one which had been concerned about strong growth and inflation. 

You might wonder why we spend any time thinking about the aggregate growth of the US economy.  After all, gyrations in that growth rate show very little correlation to stock market returns.  We care because stock prices are tied quite closely to corporate earnings and aggregate corporate earnings growth is tied to the nominal growth (not adjusted for inflation) in the economy.  Stock prices can rise for either of two reasons: (1) growth in corporate earnings; or (2) an expansion in the multiple (the price/earnings ratio) that investors are willing to pay for future earnings.  At this point in the market cycle, those multiples have already expanded significantly so further gains are very dependent on earnings growth.

There are other underlying reasons why we expect the economy to grow slowly over the next several years.  In aggregate, the economy can only produce more by a combination of  increases in the labor force and increases in productivity.  The Bureau of Labor Statistics projects that the US labor force will grow by about 0.5% over the next 7 years.  With the exception of a short period in the early 2000s, productivity has increased about 1.5% annually over the long term.  Adding these together, we get about 2% real (after inflation) growth as the new benchmark.  If we add 2% inflation, then we can expect about 4% in corporate profit growth, certainly not a very exciting number.  

With the US stock market trading at a price/earnings ratio of about 17, investors are paying a relatively high price for pretty slow growth.  So what is a good corporate executive to do?  Predictably, corporations have been raising dividends and buying back stock.  While stock buybacks boost reported earnings per share (because the share count is lower), they do nothing to grow the underlying business.  Bottom line: we expect modest returns on US stocks.

Outside the US, we are more optimistic about stocks as earnings growth is picking up in many places and prices are much more reasonable.  However, the major non US economies all have their issues.  

In China, financial regulators are getting a lesson in what can go wrong when markets are opened up without all of the proper regulatory controls in place.  The China A share market soared for more than a year and now is suffering a severe correction.  Day to day volatility is through the roof and regulators are scrambling to put in place proper margin account controls and other initiatives to stabilize the markets.  Ironically, this stock market volatility was caused by the rush of domestic investors speculating on A shares, betting that prices would go higher once non US investors are fully allowed in.  This game was bound to end poorly and it is a distraction from the government’s long term efforts to open China’s capital markets to the outside world.  We view these developments as growing pains and, as in the past, China will learn, adapt and move forward. 

Japan continues to make progress, albeit slowly, in creating sustainable economic growth and a moderate level of inflation.  If we look at Japan with the same lens we examined US growth potential above, it is easy to see how difficult their challenge is.  Japan’s demographics are poor (rapidly aging and low birth rate) and they do not encourage immigration so their labor force is not growing.  Addressing these issues is one part of Prime Minister Abe’s “third arrow” of comprehensive labor and corporate governance reforms.  

In Europe, Greece is the word, for now anyway.  Having stolen the limelight from the rest of Europe (which seemed on the road to a respectable recovery), Greece now seems to be playing the part of your erratic drunk uncle at the family party.  His behavior gets increasingly bizarre up to the point at which he is ushered out the door by the largest family members.  It seems to us that the only reasons the Europeans continue to negotiate are: (1) to prevent other weak members (Portugal, Spain, Italy and France) from trying to renegotiate their own debts; and (2) to prevent Greece from leaving the Eurozone and providing an opening for a competing rescue with geopolitical implications (think Russia).  If the Europeans could dispatch Greece in isolation, they would have long since done so.  It is just not that simple and the entire episode raises questions about the wisdom of the currency union for weaker members.  So we must be mindful of the broader risks and how they are managed.  

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international stock markets where growth is emerging.   In addition, we are under-weighted in fixed income as yields generally are not attractive except in closed end funds where discounts to net asset value have widened to very attractive levels.  We continue to add to carefully selected hedged strategies as a way of controlling portfolio risk.  

July 8, 2015                   © Essential Investment Partners, LLC               All Rights Reserved

Social Security -- The Perplexing Retirement Asset

With thousands of baby boomers reaching retirement age each day, tens of millions of people will be signing up to receive their Social Security benefits over the coming few years.  Until President Reagan worked out a deal with Congress to raise the retirement age gradually, many of us expected that Social Security would be bankrupt long before we reached retirement age.  The good news is that the system is solvent for at least another decade but it will need another, perhaps similar, fix to keep full benefits going through retirement for boomers and gen Xers.

What many don't know, however, is that maximizing your Social Security benefits takes some planning.  Most know that delaying benefits until age 66 (so called Full Retirement Age for most boomers) is good and delaying until age 70 is even better.  While that is generally true, the situation can get quite complex and confusing for two earner couples, divorced individuals, couples with substantial age differences and even those couples who have uneven employment records.  

As more of our clients are approaching their full retirement age, we decided to dig deeper into this subject and, quite honestly, we were surprised by what we found.  While the simple rules of thumb do apply, they may not maximize benefits, depending on the specific situation.  And, not surprisingly, the helpful folks at the Social Security Administration may not be able to provide you the best answers.  Perhaps more importantly, they likely won't know if you are asking the wrong questions for your situation.  

In addition to lots of reading on this topic, we have purchased software that allows us to help clients determine the optimal claiming strategy for their specific situations.  You might think: how much difference can this make?  The answer is: quite a lot. For example, one change to the simple "defer until 70" strategy for a two career couple could net them an incremental $50k in benefits!

This is the type of service we provide to our wealth management clients as part of helping them live the best life possible with the resources they have available.  

 

A few thoughts about mutual fund share classes

The US Supreme Court weighed in Monday of this week on an arcane area of the mutual fund world: whether 401(k) plan sponsors have a continuing obligation to search for the lowest cost share class options for their participants.  Leaving aside the details of that case, investors might be wondering whether similar logic might be applied to mutual funds selected by their investment advisers.  

Here at Essential Investment Partners, we are fiduciaries for our clients so we are required to put their best interests first, always. In the context of selecting share classes, that means we pick the share class we believe makes the most economic sense for our clients.  

The math involved is usually pretty straightforward.  Typically (though not always), the difference in the annual cost of a fund's "investor" class and its "institutional" share class is 0.25%.  On the flip side, our clients typically pay a $25 fee to buy an institutional share class and there is no upfront fee to buy the investor class.  So the question is: what is the breakeven point?  If we assume a one year holding period, the answer is $10,000 (10,000 X 0.25% = $25).

This is the rule of thumb we use in selecting share classes for client portfolios.  If the purchase is for more than $10,000 and we expect to hold the fund for at least a year, then we buy the institutional share class, if it is available.  (Not all fund companies offer institutional share classes and some that do have very high minimums that our clients might not be able to meet.)

This is just one of the elements we consider when making investment decisions for our clients.  And, there may well be circumstances when an approach other than our rule of thumb for share class choice is appropriate.

Back to the US Supreme Court case for a moment.  This is likely to turn into an "inside baseball" case before it is done because of the complexity of how fees are shared in 401(k) plans.  That is a subject for another day.  However, we are happy that the Court took up a case that is likely to shed light on the importance of the costs of retirement investing.  And, most importantly, how we should be putting plan participants' long term interests first.  

 

Thoughts on the Current Outlook -- April, 2015

The US economy grew by 2.3% in 2012, 2.2% in 2013 and 2.4% in 2014, despite a number of volatile quarterly reports.  We expect a similar result in 2015.  In fact, 2015 is shaping up in some ways very much like 2014: an unexpectedly poor first quarter, resulting from temporary factors, followed by a bounce back to somewhat stronger growth.  The net result is slow but surprisingly consistent growth.  

This time, the special factors have been the east coast weather (again!), the west coast port labor dispute and a sharp reduction in energy projects.  In the last few weeks, we have seen expectations for first quarter growth get marked down quickly. Optimism for a second half rebound remains high, however.  

The Federal Reserve seems to have become cheerleader-in-chief for the economy.   Perhaps it isn’t too surprising that they would “talk their book,” hoping their optimism becomes contagious, allowing a move off of zero interest rates.  Unfortunately, their track record in the last several years is consistent: too much optimism, which must be tempered significantly as reality sets in.  Bond investors now believe the Fed will be slower to raise rates than the Fed members themselves believe.  We agree.  

While the economy will likely do better later this year, three factors will likely keep inflation low and growth slow:  (1) the large decline in oil prices will keep headline inflation low and producer prices stable, offsetting modest wage pressures; (2) gains in the value of the dollar relative to almost all other major currencies make imports cheaper and exports more expensive, leading to lower domestic growth; (3) reduced capital expenditures and losses in high paying employment in the energy sector will be reflected in economic reports over the balance of 2015.  Over the longer term, we believe that very slow growth in the labor force, combined with small productivity gains, will constrain our growth to less than 3%.  

Over the next few weeks, we will get another read on the magnitude of the impact of the stronger dollar and lower oil prices on corporate earnings.  In aggregate, earnings are likely to decline modestly.  For now, investors are giving companies a pass on the earnings hit from the stronger dollar and are expecting that oil prices will gradually recover.  And so far, consumers haven’t been spending their oil bonuses – they have been saving them instead.  Put all these factors together and US stock valuations remain disturbingly high, relative to earnings.  

Despite all of this talk about slow US growth, we are still doing much better than Europe and Japan.  Looking back, the dollar strength compared to the Euro and the Yen makes perfect sense.  Higher rates, stronger growth, low inflation: what’s not to like?  The question is: where do we head from here?  We believe that as the European and Japanese economies recover, the gap between the respective growth rates will decline and the currencies will be more stable.  However, fixed income investors will continue to be drawn to US bonds as our rates are still more attractive than those available in Europe and Japan.  We expect this will keep a lid on US longer term rates and the dollar in a positive trend.  

Europe finally seems to be turning a corner, even while dealing with the Greek challenge and uncertainty in Ukraine.  With the European Central Bank’s quantitative easing program well underway, we expect interest rates there to stay low until the major economies show sustained growth and some inflation is evident.  These green shoots have been welcomed by the equity markets, which have rallied sharply.  Unfortunately for US dollar investors, a portion of those gains have been erased by currency losses.  

In Japan, the third arrow of Abenomics – important economic and labor reforms – are beginning to take hold.  Corporate governance reform, increased equity investments by pension plans, greater employer/employee flexibility and growing wages are a few of the more visible signs that genuine change is afoot.  Serious problems remain, however, including a very rapidly aging workforce, an aversion to immigration and low productivity growth, all of which work to limit the potential growth of the Japanese economy.  

Finally, China continues on its unique path toward greater free market reform, broader social safety nets and crackdowns on political dissent and “corruption.”  In the west, we have a hard time understanding how capitalism can flourish in the absence of political and personal freedom.  Meanwhile, given the miraculous growth of the Chinese economy over the last 30 years, the Chinese wonder why we don’t think their model is better than ours!  

We expect China to continue its move toward a sustainable 4-5% growth rate, suitable for a mature but healthy economy.  And they have accelerated the pace of capital market reforms, including a more freely traded currency, more flexible exchange rate and relaxed constraints on trading in the domestic equity (A share) and Hong Kong equity markets.  Longer term, this greater economic openness is quite positive for the entire region.

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international stock markets where growth is emerging.   In addition, we are under-weighted in fixed income as yields generally are not attractive.  We continue to add to carefully selected hedged strategies as we believe valuations of US stocks and bonds are high. 

April 15, 2015

© Essential Investment Partners, LLC               All Rights Reserved

 

2015 Investment Outlook

And everyone thought the Fed would be the main story in 2014…

In mid-2013, the Federal Reserve sent ripples across world financial markets when it hinted that it would begin “tapering” its bond purchase program soon.  As it turns out, the Fed did wind down its bond buying program over the course of 2014 with virtually no apparent impact on the markets.  Why no impact?  The Fed’s buying was readily replaced by other investors, looking to put money to work in a strong currency at higher yields than most other high quality sovereign debt.  In fact, despite the Fed’s withdrawal from the bond market, yields on long term US government debt marched steadily lower over the course of 2014. 

This leads to two related questions: why is the dollar so strong and why are competing yields so low?  The US economy is now the leading growth engine among developed economies.  With growth at roughly 3% annually, the US economy is running circles around Japan and Europe, both of which face serious economic issues.  So, against these two other major currencies, the dollar should be strong.  

Japan is trying to boost itself out of a two decade malaise with its Abenomics agenda.  However, a sales tax hike, enacted effective April 1 of last year to try to keep the program on a balanced fiscal footing, slowed the economy much more than anticipated.  Prime Minister Abe decided to call elections in order to reaffirm support for his three arrow program.  As we have said previously, the third arrow – genuine reform in labor markets and related policies – will be exceptionally difficult to execute but they are critical to the success of the program.  

Europe, meanwhile, seems destined to take up the mantle of the world’s chief bureaucrat – all talk and no action.  Nearly two years after ECB chief Mario Draghi promised “whatever it takes” to stimulate the economy, they are still in the same spot:  no growth, no inflation and no stimulus.  The question now is which route do they take next:  backsliding into recession, renewed break up talk as peripheral countries tire of austerity or actual monetary stimulus designed to reignite growth.  The only progress Draghi has made so far is weakening the Euro, which will help Germany, Europe’s biggest exporter. 

…but oil pushes itself onto the main stage…

Behind all of the cheering about America nearing energy self-sufficiency, there was a subplot building that few foresaw in its scale: the impending collision of expanding supply and flat demand.  While not wildly out of whack, excess global supply was enough to bring about a sudden and rapid decline in crude prices.  Then, in late November, OPEC added more downward pressure by deciding to maintain production at its current level.  There is much speculation about their motivation – to maintain market share, to wipe out recent higher cost-based producers, to keep income up for their weaker countries are among the possibilities – but whatever the correct answer is, the world now has excess oil.  And the price has been in free fall.  

First order winners and losers in this period of much lower oil prices are easy to spot.  Consumers in oil-importing countries (US, China, Japan and Europe principally) now have more income at their disposal than previously.  Meanwhile, the big oil exporting countries (OPEC, Russia, Norway, Canada) will see significant declines in oil revenue as fixed price contracts mature and spot prices take over.  

For world financial markets, the cross currents are many.  An even stronger dollar reverberates through emerging market economies somewhat indiscriminately, knocking down debt and equity values.  Inflation, already considered too low in many developed countries, will now be even lower.  Capital spending plans for energy projects are put on hold, along with the employment growth that came with those projects.  And high yield debt comes under fire because so much was issued to newer, less financially strong energy companies.  

…and the ending to this story has yet to be written…

Where oil prices may go from here in the short term is anyone’s guess.  Longer term, we expect the supply/demand imbalance to be resolved in favor of prices significantly higher than the current market (around $50/barrel at this writing).  However, more important are the implications of low oil prices in the near term.  We believe these are:

  • Higher financial market volatility as oil prices fluctuate and winners and losers are sorted out 
  • A boost to consumers in oil importing countries in the form of direct cash benefits in those countries with significant automobile use and in the form of stable or lower prices for transported goods and services for those without as much automobile use
  • Short and medium term interest rates are likely to stay lower for longer than previously expected as reported inflation drops precipitously.  For the US, we expect the Fed to stay on hold and stimulus programs in Japan to continue and to get started in earnest in Europe
  • More potential geopolitical instability as oil exporting countries assess the impact of lower oil prices on their domestic economies and decide whether and how to act in their own best interests.  Russia seems like the biggest wild card, having recently shown little regard for others’ interests in Ukraine and routinely threatened supply disruptions for political gain
  • Second order effects such as high yield bond defaults, employment cutbacks in energy and  retrenchment in capital spending plans will begin to take hold over the course of 2015 if prices stay at current levels

…but in the near term, we should use volatility to our advantage.

Here in the US, we believe the net short term effects will be positive as the benefit to consumers far outweighs the damage done to the energy sector of the economy.  And, this stronger growth should come with little or no inflation.  However, if oil prices stay low for long, we will begin to see the negative impacts on employment and capital spending.  Outside the US, the effects will be highly variable, even among oil importing countries.  

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international markets where valuations are much more reasonable.  Internationally, we believe active managers can use the recent volatility to their investors’ advantage.   We continue to be underweight in fixed income as the yields available do not compensate investors adequately for the risks assumed.    

January 14, 2015
© Essential Investment Partners, LLC               All Rights Reserved

 

Thoughts on the Current Outlook -- October, 2014

A few comments about risk…

At a point in time when many people think US stocks are very overvalued and even more believe that bond prices are in a bubble, we thought it made sense to talk a bit about risks we see.  But first a little background.  Howard Marks, Chairman of Oaktree, a highly-regarded investment firm, has written eloquently and extensively on the subject of risk.  He sets the stage this way:  “Here’s the essential conundrum: investing requires us to decide how to position a portfolio for future developments, but the future isn’t knowable.”

But even though we can’t know the future, we can still develop a plan to deal with possible outcomes in a logical way.  Indeed, we, like most investors, view the investing world as a series of possible outcomes each with its own probability of occurring.  Because each outcome only has a probability, we have no way of knowing in advance what will actually occur.  Back to Mr. Marks: “Risk means more things can happen than will happen…Many things would have happened in each case in the past, and the fact that only one did understates the variability that existed…Even though many things can happen, only one will.”

Rather than trying to predict the exact course of events, it is our job to try to tip the scales in our favor, i.e., make informed judgments about investments that are likely to succeed based on the events we believe are most likely to occur. Of course, we will almost always be wrong about the specific events (unless we are just lucky) but if we correctly choose those investments with more upside than downside, we and our clients should fare well over time.  Mr. Marks refers to this process as finding “asymmetries” – where the upside far exceeds the downside.  

Are bonds now riskier than stocks?

Applying this thinking to the current environment, we can readily see good and bad asymmetries in the bond world.  The very low yields on sovereign debt throughout the developed world can’t fall much further but those rates could certainly rise dramatically, if growth and inflation were to be ignited.  This is particularly true in continental Europe and Japan where we believe the downside risk to bond prices is much greater than the upside – the bad kind of asymmetry. 

Further amplifying this risk, the Japanese and European central banks are firmly in stimulus mode.  Japan is much further along and the jury is still out on whether they will be able to jumpstart the economy.  So far they have succeeded in weakening the yen dramatically and spurring sporadic growth.  While a weaker yen might boost reported inflation, it could be counterproductive if rising import prices dampen economic growth.  In Europe, the central bank is just beginning its quantitative easing program and the only result so far is a significant drop in the common currency.  Due to limitations unique to the Eurozone situation, this program will have a tougher time succeeding.  In addition, it has a big near term challenge in overcoming the negative effects of the sanctions against Russia on the Eurozone economy.  Bottom line, both central banks are working hard to boost their economies and, if they are successful, rates will rise significantly.  For these economies, we believe the answer is yes, bonds are much riskier than stocks.  

Here in the US, the Federal Reserve is near the end of its bond purchase program and will likely begin raising short term rates sometime next year.  Unless we get some spark of inflation, however, we expect those rate increases to be relatively modest.  With energy prices recently declining and wage pressures non-existent, reported inflation is likely to be benign. So we think a large increase in US rates is unlikely but a modestly higher range of rates, particularly for short and medium term debt, seems like a quite reasonable outcome.  However, we can buy fixed income closed end funds at very high discounts to net asset values (reflecting investors’ belief that a large increase in rates or spreads is around the corner) which we believe provides our clients a good asymmetry.  In addition, high yield and floating rate loans provide good yields relative to inflation and higher quality bonds.  For the US market, we don’t think carefully selected bond investments are riskier than stocks.  

Stocks aren’t cheap either

Among US stocks, we have thought small caps were overvalued for a long time.  We were wrong in 2013 but have been proven correct so far in 2014 as small caps have drastically underperformed large caps.  However, even among large cap companies, we are finding it difficult to find high quality companies trading at reasonable values.  One particular concern of ours is that many very good, but slow-growing, companies are trading at very high multiples on earnings.  Typically, these stocks would be safe havens in difficult markets – that may not prove to be true if the market decides to mark these multiples down to more reasonable levels.  

To some extent, stocks are levitating based on a lack of alternatives (many perceive a higher risk in bonds) and a general skepticism that the bull market cannot last much longer.  How long this will go on and how it will be resolved only time will tell.  For now, we are paying very close attention to individual stock values, relative to the earnings growth expected.   

Outside the US, valuations are much less challenged so we added significantly to international stock fund positions earlier this year.  This proved premature this quarter as the dollar strengthened dramatically and international stocks, with the exception of a few markets, slumped.  However, leaving China aside, prospects for better economic growth are good in the coming year and this should provide a positive environment for stocks.  

In China, the gradual growth slowdown continues, making it hard for investors to handicap the stock market.  As a result, valuations remain low.  We believe China is heading for mid-single digit GDP growth with a greater share of its economy comprised of consumer spending.  What we find hard to discern is how the dichotomy between the government’s more market-oriented economic policies and crack down on political freedoms will play out.  

Finally, we continue to increase positions in hedged investments which provide some exposure to equity and debt markets but with lower market exposure.  Fortunately, more successful hedge fund managers are bringing their strategies to mutual fund form, providing us access to a much broader array of managers and strategies than ever before.

October 8, 2014                   

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Thoughts on the Current Outlook -- July, 2014

Volatility in Surprising Places

With two major bear markets in stocks within the last 15 years seared into investors’ memories, we have come to expect high volatility in stock prices.  Conversely, we tend to view the US economy as a lumbering giant, moving slowly but constantly forward, with only something as large as the Great Recession able to throw off its trajectory.  

Lately, we have seen volatility in the stock market decline rather dramatically.  Actually, this is pretty typical of a sustained run of positive returns like we have had since the middle of 2011 and we also saw in the mid 2000s.  However, we have seen the opposite in reported GDP over the past year.  The quarterly numbers have bounced around a lot (+4.1%, +2.6%, -2.9% and +3% estimated for the last four quarters).  If we just look at the year over year increase though, we find that GDP has grown at less than 2%.  

This raises a couple of questions.  Is 2% as good as it gets, now that the economy seems to be hitting its stride in this long recovery?  Does 2% growth really support the kind of rally we have had in stocks?

We believe there are a number of structural reasons why this 2% level of growth may be closer to the economy’s new growth potential, down roughly a third from the 3% we became accustomed to for several decades.  Productivity growth has slowed for at least two reasons: (1) chronic underinvestment in business capital equipment in the post-Great Recession period and (2) changes to the size and composition of the labor force occasioned by demographic shifts.  While productivity will be boosted somewhat by advances in mobile technology, these other factors will likely offset that boost, holding our growth back.

There is both good news and bad associated with lower potential GDP growth.  The good news is that we need fewer new jobs to sustain employment at a relatively high level (we are seeing this play out in the rather quick drop in the unemployment rate over the last 18 months).  The bad news is that we could be much closer to triggering a bout of renewed inflation from wage pressures than the Federal Reserve currently believes.  And, on a cyclical basis, we are getting close to a point on capacity utilization that typically results in inflation pressures.  

From an investment perspective, this result is by no means terrible.  Growth at this new potential with renewed wage inflation will mean higher nominal GDP growth.  Corporate profits and stocks can likely grow at that nominal rate.   Interest rates on bonds will drift up to at a more normal spread to long term inflation expectations (elimination of Fed buying will let rates seek this natural level).  Overall, we should expect returns to be lower than those of the last three years, when both stocks and bonds did quite well.  

Returning to the second question of stock prices relative to growth prospects, we view US small cap stock valuations as very stretched and US large cap stocks as fully valued.  As we look at individual companies, we often see valuations that reflect a great deal of optimism about  earnings growth when the reality is that earnings will likely grow slowly.  It takes a great deal of searching to find growing companies at reasonable prices.  We are much more positive about the prospects for non US stocks as growth is beginning to accelerate and prices are lower.

Global Growth Takes a Positive Turn

Globally, we see economic growth trending more positively with renewed contributions from Japan and Europe offsetting lower growth in China and many other emerging markets.  In Japan, the long-awaited, third and critical arrow of Abenomics will soon be announced.  It will be interesting to see how bold Mr. Abe will be in his proposals for labor market reform and, if he is bold, whether the Japanese people will continue to support him.  Please see the previous blog post on this website to read our publication about Japan entitled Big Change in the World’s Third Largest Economy? 

Continental Europe is still struggling to emerge from recession.  The process is slow and central bank stimulus continues to expand.  Without a strong central force for fiscal stimulus, the European Central Bank’s monetary stimulus is the only game in town.  The ECB is still fighting off the effects of fiscal austerity plans put in place across southern Europe several years ago.  Those economies are now bouncing back after severe recessions.  On the other hand, the UK, which retained control of its own currency and fiscal matters, has recovered well from recession and is now looking at monetary restraint to make sure inflation doesn’t become an issue.  

China continues to forge ahead on its economic and market reforms at the same time it seems to be going in reverse politically.  Numerous incremental changes have been made in the financial markets that all point to a more market-oriented approach to economic policy.  A series of important domestic policy initiatives have been announced that will allow more individual economic freedom.  However, censorship is as strong as ever and China is flexing its military and political muscle on regional territory issues, including most surprisingly Hong Kong.  

Cautiously Overweight US Stocks, Aggressively Overweight Non US Stocks

In most portfolios, we hold the maximum weight permitted in international stocks, particularly smaller company stocks, as we believe valuations are more compelling and better growth lies ahead.  We have increased our weightings in hedged equity and continue to be underweight in fixed income, with a relatively defensive stance within those holdings.   

July 9, 2014                   

© Essential Investment Partners, LLC

All Rights Reserved

Big Change in the World's Third Largest Economy?

We recently had the opportunity to spend 11 days in Japan, our first trip to a country that boasts the world's third largest economy.  Honestly, we weren't sure what to expect because Japan has spent much of the last 20 years wrestling with recessions and deflation.  And, if a two decade hangover from the 1980's party wasn't enough, the country is also recovering from a devastating tsunami that has shifted their entire energy policy away from nuclear energy.

Viewed from this side of the Pacific, the launch of Abenomics 18 months ago is having a positive impact on economic growth and inflation.  But the history of Japan's government stimulus programs over the past 20 years is littered with failures.  So the question is: is it really different this time?

Certainly, in structure, scale and scope, Abenomics is much greater than prior efforts.  The three "arrows" -- fiscal stimulus (deficit spending), monetary stimulus (quantitative easing) and structural reforms to boost competitiveness -- are designed to be mutually reinforcing (a Japanese folk tale says that three arrows held together cannot be broken).  The first two were readily implemented and are producing results.  The third is very much a work in progress, requiring both legislative action and great deal of change to Japanese work life.  

So what did we observe in our brief trip?  First, we were consistently struck by the great deal of pride each person we encountered took in their work.  As we settled into our first taxi ride -- with an extraordinarily polite, uniformed driver and an immaculate vehicle -- we could only imagine the horror of a Tokyo native who hails a cab for the first time in New York or Chicago.  This pride was evident everywhere we went and in every service provider we encountered.  So refreshing and so different than the US!

Second, we sensed real optimism about the direction of the economy.  Having family in Michigan, we have seen the impact of pervasive economic devastation first hand.  We sensed none of that in the three cities we visited.  On the contrary, the people we encountered were upbeat, welcoming and focused on their work.  

Our visit came on the heals of the consumption tax increase from 5 to 8% that took effect on April 1.  Japan's retail sales reports for March and April showed the impact (a big pull forward increase and then a large decrease).  However, we found retailers to be sanguine about the changes, even if they were acutely aware of its short term impact.  We came away thinking that Prime Minister Abe must have done an excellent job of communicating his policies.  People understood and seemed to accept the tax increase as part of a bigger plan.  

So what was negative?  You have to look beneath the surface to find it.  First, unemployment is very low and many people are employed in ways we would not conceive of here.  At department store elevators, we encountered three elevator ushers, assisting shoppers to the next available car, when we wouldn’t even have one here.  In our eleven days, I can’t remember ever having to wait to be assisted – there was always some one ready, willing and able to help.  (Mind you, we scrupulously avoided the queues at the most popular outlets – the first “street” queue we encountered was for Garrett’s Popcorn.  Those of you from Chicago will instantly remember the Garrett’s lines on Michigan Avenue – the same situation exists at Garrett’s near Harajuku in Tokyo.)

Second, the lack of immigration is painfully obvious.  The elevator ushers, the hotel bell persons (many female) and the cab drivers were all Japanese.  The corollary is that the workforce is not growing, either by birth rate or by immigration, and this will work to limit the growth in the economy.  It also implies that while unemployment is low, many workers are performing far below their potential.   As part of his structural reforms, Mr. Abe wants to encourage greater female participation in the labor force.  However, that would at best provide a one time boost to the work force, likely in the service sector.  

Finally, with the first two arrows of Abenomics firmly in place, the government is showing some success in creating economic growth and inflation.  However, the third arrow – labor market reform is critical for several reasons.  First, with little slack in the current labor force, even modest raises in wages could easily ignite a labor cost-driven inflation cycle that would be difficult to contain.  Worst case, Abenomics could give rise to a stagflation situation – high inflation and low growth.  Second, for the labor market to be more productive, employers need to be free to hire and fire.  Third, to have sustained growth in the labor market (and, by extension, the overall economy), some immigration will be required, as the domestic population simply isn’t growing on its own.  And boosting it with female participation won’t be sufficient.

With difficult structural reforms ahead, Mr. Abe has his work cut out for him to establish a long term platform for growth.  Our observation was that people are optimistic about positive change. Whether Mr. Abe will have the will to propose sweeping labor and immigration reforms is an open question. Assuming he does, then we will see whether the people will continue to be supportive of him and his policies.  Only time will tell.  

 

 

 

 

Thoughts on the Current Outlook – April, 2014

The Weather Strikes Back!

It seems a bit ironic that we used a weather analogy as the framework for our 2014 outlook because the weather itself was the biggest economic story in the first quarter. East of the Mississippi, from Minneapolis to Washington DC, record cold and snow were served up repeatedly.

Against this frigid backdrop, retail sales slowed, car sales stalled and hiring took a hit. About the only thing contributing positively to a growing economy was the big increase in consumption of natural gas for heating! We don’t have a preliminary read on GDP for the first quarter yet but we expect it will be significantly slower than the fourth quarter’s 2.6%.

The weather-induced slowdown in the economy had another surprising effect: the bond market did better than stocks in the first quarter. By the end of 2013, bonds were all but given up for dead with most predicting that interest rate rises were imminent and a bond bear market was about to start. And, conversely, conventional wisdom was that stronger economic growth would help stocks. As is usually the case when a trend is so universally expected, something else happened.

The bond market seems full of surprises these days. Even with new Fed Chair Yellen signaling that interest rate hikes are likely to begin next year, longer term bond yields have barely budged. To be fair, intermediate term rates moved up and mortgage rates continue to creep up. But, the worst performing part of the bond market in 2013 – long term municipal bonds – were the star of 2014’s first quarter.

But Change Is in the Air

Despite all of the uncertainty created by the weather, there is one thing that is certain: the weather will change. And, with it, we expect that economic activity will resume at a respectable pace. Respectable is the key word here. There are many factors that will keep the economy from accelerating too quickly.

First, we believe the snapback in housing is now over and the future gains in home prices will be driven by longer term supply and demand dynamics. While those dynamics are favorable, double digit price gains are likely behind us and more consistent, inflation plus 1-2% gains are more realistic.

The employment picture is still solid, if unexciting. Except in a few, high-skill, high-demand fields, there is still a great deal of slack in the labor markets, meaning income growth will be restrained and wage-driven inflation will be non-existent.

Finally, consumers continue to be financially conservative, taking on little debt and using their credit cards sparingly. This is one of the positive legacies of the Great Recession. But it also constrains growth in our economy.

More Excitement Elsewhere

Ukraine is in focus as the world ponders Russia’s next steps after its annexation of Crimea and troop build-up on Ukraine’s eastern border. We have long expected Russia to use its energy influence and the war-weariness of the US to expand its regional influence. We believe that the markets are Putin’s biggest adversary – the ruble has plummeted and, if oil prices follow, his ambitions will be diminished.

The more important European financial story is its emergence, albeit very slowly, from recession. The peripheral economies still have a long way to come before they can claim recovery. Indeed, central bankers are concerned that inflation remains too low, with talk of more stimulus creating news. Discussions about a possible break-up of the common currency, all the rage just a couple of years ago, are all but dead.

India, the world’s largest democracy is about to embark on its largest election (800 million prospective voters) ever. At stake is a renewed focus on the economy, which has struggled to post decent growth of late. India is in great need of more forceful economic leadership but we remain skeptical whether this election will provide it.

In China, concern has shifted to the magnitude of the debt build-up over the last few years, even as growth has slowed. From a very big picture perspective, this combination of factors is very similar to the US situation in the mid 2000s. As we know, that did not end well. However, there are many, many differences between how China and the US are able to manage these circumstances. We expect the Chinese to accept much lower economic growth as they shift toward a more sustainable growth model. And, they will use their unique “market-oriented” approach to gradually introduce freer float in the currency and more risk of default into the debt markets.

Finally, in Japan, Abenomics has accomplished its first task of shifting psychology away from deflation to modest growth and inflation. Salary growth, a critical element of the shift, is showing signs of taking hold. An increase in the consumption tax is just now going into effect so the next several months will be critical in seeing how this impacts the economy.

The Bottom Line

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international markets where valuations are more reasonable. We have reduced our dedicated Asia investments but have increased the weightings in international small company stocks, expecting these strategies to perform well in a better economic environment. We continue to be underweight and defensive in fixed income, favoring flexible strategies that can adjust to changes in market expectations about the future course of interest rates.

April 9, 2014              © Essential Investment Partners, LLC

2014 Investment Outlook

Sun Breaks Through the Clouds

One lasting legacy of the Great Recession is our pre-occupation with concerns about new crises that will lead to a reprise of that terrible period. 2013 was chock full of crises that were supposed to derail us. We started off with the fiscal cliff (sooo 2012…) which gave rise to surprisingly positive new tax laws. Then came the sequester, the chemical weapons crisis in Syria, the debt ceiling showdown and the government shutdown. Let’s not forget China’s growth slowdown and the launch of Obamacare. And lurking in the background was the imminent demise of the Eurozone and the common currency! All of these bogey men turned out to be not so scary and the US stock market not only shrugged them off but surged to new all time highs.

The biggest surprises of the year turned out to be Fed “taper talk” – first came the too-early discussion of it by Chairman Bernanke in May and June. While shocking the bond market, equity markets barely flinched. And then there was the big “nevermind” in September and the bond market rallied while the stock market just kept plugging along. Finally, the Fed closed out the year with a modest start to tapering its asset purchases, setting the stage for the new Chair to implement it. How ironic that the one entity trying to prop up markets gets the credit for creating the most volatility!

As we look forward to 2014, there aren’t even any faux crises on the horizon to be worried about. Even Congress, the best at creating crises out of thin air, decided to patch up their budget differences before the holidays, leaving no real fiscal accidents waiting to happen in 2014. It is amazing how forthcoming elections can focus the mind!

Of course there are lingering concerns in Europe, Japan, China and other emerging markets. But after six years of prospective crises, we find ourselves a bit uncomfortable with a moderately sunny outlook.

How Sunny Is It?

Let’s not get too excited. While the outlook is improving, it is hardly perfect. Here in the US, the employment picture continues to show resilience as the jobs reports have shown consistent, if uninspiring, strength. Stock market gains and home price increases have restored consumers’ net worth to pre-2008 levels, while debt service costs have dropped to a very low percentage of income. We are seeing this positive backdrop show up in solid gains in retail sales and strength in automobile sales. Housing continues to recover but a sharp back up in rates could well slow that recovery.

We expect that this consistent growth path will lead the Federal Reserve to wind down its bond purchase program in 2014. This will likely be coupled with repeated statements about holding short term rates low. That long term interest rates have stayed as low as they have might be a bit surprising. We think this is a function of low and contained inflation. Without labor cost pressures, we expect inflation to stay low for some time to come. The ten year Treasury bond yield was in a range of 2.50-3.0% for the second half of 2013. Over the course of 2014, we expect that range to move up to 3-3.5%.

But we also expect volatility in rates to be the norm as markets try to figure out how the Fed moves away from its bond purchases. It is certainly possible that long term rates could move up much farther and faster than anyone expects, tanking the bond, stock and real estate markets all at the same time.

Still Cloudier to the East

In Europe, we are now past the German elections so we would hope to see continued progress toward solidifying a Eurozone bank regulator. Austerity and, more importantly, labor and tax reforms in southern Europe are finally beginning to have an impact on those economies. But we are hardly out of the woods. While the recession has technically ended, growth is very anemic and there is a real risk of backsliding into another recession.

Much further east, Japan’s Abenomics program is having the desired short term impact: modest growth and inflation. However, big challenges lie ahead. For progress to be sustained, fundamental changes need to take place in the labor market. Companies need the flexibility to hire and fire according to market needs, rather than providing lifelong employment. And workers need to be rewarded for increased productivity so that sustained growth in wages can take hold. Finally, there is an enormous demographic problem building which will likely require new approaches to immigration and labor rules. Progress on these difficult structural issues is by no means assured.

And Just Plain Hazy in China

Meanwhile, China, the bigger growth engine of Asia, has completed its leadership transition and the Third Plenum. Billed in advance as reforms comparable in importance to those of the late 1970s, the high level plans that came out of the Plenum are important evolutionary steps. Whether they turn out to be revolutionary will depend on the implementation. Loosening of the one child policy, changes in land rights for farmers, reform of the household registration system and a definitive statement that market forces should guide resource allocation are just some of the key provisions of this new plan.

While we view these changes as quite positive, they will take some time to play out. In the meantime, China is still burdened by an economy too-dependent on fixed investment, financial and labor imbalances and strong state-owned enterprises. Perhaps most important for long term investors, China’s new leaders understand the problems they face and have crafted a plan to deal with them.

Other major emerging markets face issues unique to their own situations. One common thread is high inflation and low growth, a combination not likely to inspire investors’ confidence for some time. Relatively cheap stock prices in these markets reflect these poor fundamentals.

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international markets where valuations are more reasonable. We continue to be underweight and defensive in fixed income, favoring flexible strategies that can adjust to new dynamics.

January 6, 2014                                                       Copyright, Essential Investment Partners, LLC

Thoughts on the Current Outlook – October, 2013

All of the buzz in the financial markets since May has been about the Federal Reserve and the rise in interest rates in the wake of the expected “tapering” of their bond purchase program.  But in fact the real “rising” story has been stocks.  Hurdling a wall of worry that included higher interest rates, possible use of force in Syria and an impasse over the federal budget and debt ceiling, stocks have shot up this year.  For the year to date, US stocks have gained nearly 20%. 

Not to be outdone by the US, developed international markets also rallied strongly, gaining more than 16%.  However, emerging markets continued their lagging behavior as concerns about less Fed stimulus led investors to withdraw investments from emerging markets bonds and stocks.  Those economies with high inflation and slowing growth (think Brazil, India and Turkey) were particularly hard hit.

A hallmark of Federal Reserve policy under Ben Bernanke has been open communication, making sure the markets know well in advance what the Fed is planning to do.  This policy stood in stark contrast to the Alan Greenspan era when the former chair would go to great pains to ensure that whatever he said was indecipherable.  The Bernanke approach was closely followed until the September meeting when the Fed surprised the markets by announcing a deferral of the tapering plans that the Chairman had carefully laid out in the preceding months.  While not stated, we believe that the delay was less about economic data than a hedge against the impact of the impasse over the continuing resolution (CR) to fund government spending and the debt ceiling.

Negotiations over the CR and debt limit are noticeably more difficult this time around as the poisonous atmosphere in Washington has only grown worse with mid-term elections looming.  Adding drama, if not substance, to the debate is the launch of the open enrollment period that kicks off Obamacare.  At this writing, the government is in shutdown mode which we expect to continue until a longer term debt ceiling and full year CR are ironed out.  We view all of this as political theater, with the resolution unlikely to have a lasting effect on the path of the economy.

 
The biggest impact, we believe, is that the Fed will sit tight until the show is over and then begin scaling back its bond purchase program.  We believe the US economy is likely to continue growing at a below long term average rate (2-3%), but sustainably growing nonetheless.


With no structural changes happening, Europe remains in neutral, not going backward or forward.  China is now well through its power transition and policymakers are clearly focused on the key issues of excess credit creation and conversion to a domestic oriented economy.  Recent data from China has been more encouraging but we expect growth to be choppy. 

US interest rates are settling into a new trading range reflecting low inflation, modest economic growth and little or no Fed buying.  One thing clear from the Fed’s September announcements is that short-term interest rates are likely to stay low for at least two more years, particularly since inflation is well below the Fed’s stated 2% target.


Absent an external inflation shock, we expect inflation to stay low because of the slack in the labor market.  The unemployment rate will keep falling from a combination of lower participation and steady employment growth.  There has been much debate about whether the drop in the labor force participation rate is due to discouraged workers dropping out or baby boomers retiring.  No one really knows how much each factor contributes but it is clear that new college grads are still having a hard time finding jobs. And the baby boomers are the first generation with two wage earners retiring, sometimes simultaneously.  The debate about the cause is less important than the fact that the lower participation rate will keep the economy on a slow growth, low inflation path.

This kind of path should be good for stocks and that has certainly been the case this year.  We think US stocks are on the expensive side right now and need a breather to allow earnings growth to catch up.  International stocks had been cheaper but they too have rallied strongly of late.  While we remain overweight stocks and underweight bonds, we are trying to keep a modest cash reserve that we can deploy if we see a significant pullback. 

Within our general underweight in bonds, we believe there will be opportunities for reasonable total returns if we remain nimble.  However, the general trend for rates will be up, toward a more normal long term structure, so minimizing interest rate risk remains a paramount consideration.

October 4, 2013                        © Essential Investment Partners, LLC   

Explaining the Unexplainable: US Strategy toward Syria

We have been baffled by the Obama Administration’s statements and actions over the last month in dealing with the Syrian chemical weapons situation.  George Friedman, founder of Stratfor, a foreign affairs consultancy, penned an excellent article which we highly recommend.  It lays out in simple terms why we are so conflicted and unable to articulate a clear path forward. 

http://www.realclearworld.com/articles/2013/09/17/ideology_trumps_american_strategy_in_syria_105448.html

Thoughts on the Current Outlook – July, 2013

In last quarter’s Thoughts on the Current Outlook, we spent a great deal of time talking about the price risk in bonds.  Our view was that the US economy was gradually improving and that this would lead the Federal Reserve to cut back (and ultimately eliminate) its bond purchase program. This cutback would result in bond yields rising and prices falling as the Fed would no longer be the principal buyer.  We expected this adjustment to be gradual as a stronger, self-reinforcing recovery was by no means assured. 

Well, we were wrong about all the gradual stuff.  Bond investors, a notoriously impatient bunch, made the adjustment shockingly fast.  In May, the Fed hinted that it was considering reducing its bond buying and rates jumped about 4/10 percent.  In June, Fed Chairman Bernanke outlined a very specific timeframe for bond buying cutbacks, conditioned on continued improvement in the economy, and bond investors promptly ignored the conditional and pushed rates up again as much. 

Finally, the June report on non-farm payrolls, released on July 5th, was a solidly positive report and bond yields rose sharply yet again as investors became convinced that the end of Fed bond buying was a done deal.  From the lows in April, the 10 year Treasury yield rose nearly 1.1 percent. 

Normally, this type of rapid increase would cause stocks to fall as investors mark down future earnings with a higher discount rate.  Wrong again.  With just a two day hiccup, stocks resumed the 2013 rally.  However, emerging market stocks were hit hard on worries about negative currency flows, adding to already prevalent concerns about slowing growth and high inflation. 

The good news is that the US economy does appear to be doing somewhat better, if we look past the second quarter in which GDP growth will likely have been pretty anemic (think 1-1.5%).  The employment picture is positive even though many of the jobs being added are low-paying, part-time or both.  Consumers and small businesses are more confident than they have been since 2008 and consumers are even expanding their use of credit. 

With changes in future Fed policy now squarely on the table, we hope that stocks and bonds begin trading on more fundamental factors like future earnings prospects, economic growth and inflation expectations, rather than being artificially altered by Fed stimulus. Now that interest rates have moved so far so fast, we think that selected areas of fixed income show attractive value.  In particular, high yield corporate bonds are now trading at somewhat wide spreads to US Treasuries, even though default rates are still trending down (as one would expect if the economy is doing better). 

US stocks have streaked ahead of the rest of the world so we are being cautious in investing new cash here.  Outside the US, valuations are far more reasonable but there are reasons for concern.  In China, the new regime is working hard to rein in the shadow banking system that has created much more credit than is healthy.  While very necessary, their efforts run the risk of slowing China’s economy – the world’s second largest -- sharply. 

Other emerging markets have been hit hard by falling stock, bond and currency prices.  While the proximate cause of these quick declines is the knock-on effects of changes in US monetary policy, each major emerging market suffers from its own set of unique challenges with the common themes of slower growth and higher inflation.

Europe has shifted out of crisis and into chronic problem mode.  There are a few bright spots on the horizon, but these tend to be of the “less bad” news variety.  But recoveries are made out of “less bad” gradually changing over to good.  We expect the road ahead to continue to be bumpy, with many setbacks along the way, as the Eurozone puts in place the structural reforms needed. 

With all of these headwinds, non US stocks are now significantly cheaper so we have begun selectively adding to international investments for the first time in a long time.  Over the next few years, we expect the US to lead a global recovery which should be good for stocks around the world. 

Bond investors need to become nimble, after thirty years in which being a sedentary bond investor was the best strategy.  Within our general underweight in bonds, we believe there will be opportunities for reasonable total returns as current coupons compensate for inflation and periodic emotional reactions – like what we have just experienced -- drive prices to bargain levels. 

July 10, 2013                        © Essential Investment Partners

Fed Riles the Markets

In our “Thoughts on the Current Outlook” dated April 9 of this year, we said:

We aren’t suggesting that you rush to sell all of your bonds immediately because we don’t expect this rise in rates to occur suddenly.  But we are actively reducing the duration risk in client portfolios as we think this rise could happen as rates return to “normal” levels.  This normalization of rates comes with some good news though:  interest rates are likely to rise as the economy continues to recover and approaches its long term growth rate. 

Higher growth will give rise to two conditions leading to higher rates.  First, the Federal Reserve will likely back off of its program for purchasing bonds, which we believe has artificially suppressed bond yields.  Second, better growth typically means a return of inflation as incomes rise, demand rises and prices respond. 

Events of last week jumbled the order we had anticipated.  Prior to last week, the Federal Reserve had only hinted at considering “tapering” their purchases of US Treasury bonds and mortgage bonds if the economy continued to improve.  Last week, in conjunction with the Fed’s regular meeting, Federal Reserve Chairman Bernanke laid out a relatively specific plan for tapering their purchases later this year and stopping them next year, effectively anticipating that the economy will continue to improve, or at least that is how the markets’ interpreted his comments. 

The markets’ reaction to this change in Fed intentions was violent.  Interest rates spiked, bond prices tumbled and stocks followed suit.  To give you a sense of the magnitude of the move in interest rates, the yield on the 10 year US Treasury bond was 1.64% on May 1, 2.16% at the end of May and it closed Friday at 2.51%.  We had expected that this rate might move into the range of 2.75 to 3.00% over the next year.  Instead, we got about three fourths of the move in just a few weeks. 

Markets don’t like surprises, particularly from the Fed, so bond and stock prices dropped swiftly.  And the downward moves in prices of closed end bond funds have been particularly stunning.  However, there is a silver lining.  This negative investor sentiment presents a great buying opportunity in our opinion.  Over the last few days, we have been selling open end bond funds and buying closed end funds at prices we view as exceptionally attractive.  We also expect to add to stocks as well, although those corrections have been more selective and we will be more cautious in our buys. 

We will be publishing our new investment outlook in early July.  It will have a much more complete discussion of the issues that the new Federal Reserve stance has created.  These issues extend well beyond our shores as the impact of the world’s largest economy changing its monetary policy has large ripple effects.

Thoughts on Current Outlook – April, 2013

There’s always a rally in bonds – either prices or yields are going up!

Do you find bond math confusing and counterintuitive? If so, you are in the vast majority! Fortunately, for the last 31 years, buying bonds and just hanging on was a good thing to do. But that long, pleasant ride may soon be over.

Most of us know that as rates fall, bond prices rise and conversely that prices fall when rates rise. From their current low level, there isn’t much room for rates to fall but there is unlimited room to rise. This is enough to warrant concern about the future of bond prices.

However, there is another major risk that bond investors face today that many non-professionals haven’t recognized. We will spare you the math but as bond coupon rates fall, bonds’ price sensitivity to interest rate changes rises. With rates now so low, price sensitivity to interest rate changes is exceptionally high.

At the current level of rates on US Treasury securities, the duration (a measure of interest rate sensitivity) on a 10 year Treasury bond is now about 9 and the duration of a 30 year bond is over 20. This means that if market interest rates rise by 1%, a ten year Treasury note would lose about 9% of its market value and a 30 year bond would lose about 20% of its market value.

If interest rates on 30 year Treasury bonds rise from the current rate of about 3% to over 5%, those bonds could lose about 40% of their market value. While a 2% rise in interest rates doesn’t seem unreasonable, the accompanying loss of value would be about the same as stocks suffered during the crisis of 2008!

We aren’t suggesting that you rush to sell all of your bonds immediately because we don’t expect this rise in rates to occur suddenly. But we are actively reducing the duration risk in client portfolios as we think this rise could happen as rates return to “normal” levels. This normalization of rates comes with some good news though: interest rates are likely to rise as the economy continues to recover and approaches its long term growth rate.

Better growth ahead for the US

Higher growth will give rise to two conditions leading to higher rates. First, the Federal Reserve will likely back off of its program for purchasing bonds, which we believe has artificially suppressed bond yields. Second, better growth typically means a return of inflation as incomes rise, demand rises and prices respond.

So what will give rise to this better growth? Four major trends that we have been talking about for nearly a year now continue to gain prominence: substantial progress toward energy independence, recovery in residential real estate, dramatic productivity enhancements resulting from mobile capabilities and the emergence of the echo boom generation as the driving force in the economy.

Interestingly, it seems the economy (and the markets) have begun to ignore the machinations in Washington, so long as they aren’t destructive. We cruised right into the sequestration-related spending cuts without so much as a hiccup (yet, anyway) as the markets seemed to decide that if this is the only way we can get spending cuts, so be it. The effect of these cuts and higher taxes may slow down GDP growth in the second quarter but we expect this effect to be temporary. The conversations now appear to have shifted to longer term entitlement reform, also a positive.

Didn’t think your bank deposit could be taken to recapitalize your bank?        Guess again!

Across the pond, things are not so rosy. Cypriots are up in arms about the plan to tax bank deposits as a way of funding part of the bail out their banks need. While the whole of Cyprus’ banking system isn’t meaningful in the context of the size of Europe, this plan sets a dangerous precedent. And, we think it works against the idea of a unified banking regulation and deposit insurance which is critical to a better functioning Eurozone.

Meanwhile, the rest of southern Europe is left to wonder: are we next? It is little surprise that markets in Italy, Spain and even France have not taken kindly to the Cyprian plan even while the bureaucrats that worked out the plan are saying it was a one-off. Given the inconsistencies, skeptics abound. We are somewhat puzzled about what will come next as politics may continue to get in the way of progress. Italy is having trouble forming a new government, the Socialists in France are struggling and elections in Germany are not far off.

Right now, we have the pledge of the European Central Bank to provide liquidity needed to support markets but very little progress has been made toward the structural reforms needed to keep the Eurozone alive indefinitely. We expected this road to be bumpy but the Cyprian plan is a new, large pothole. Meanwhile, the Eurozone recession drags on.

Emerging markets chart their own path while US and Japanese stocks soar

Both the Dow Jones Industrial Average and the S&P 500 stock index reached new historical highs in the first quarter. In the aggregate, we don’t believe US stocks are significantly overpriced. However, our bottom-up work on stocks tells us that it is much harder to find bargains.

Even while the US and Japanese stock markets rallied strongly in the first quarter on the heels of central bank actions, emerging market stocks were declining. Investors became concerned about whether the recent history of strong growth would revive, in the face of continued inflation. The combination of slower growth and inflation does not give investors confidence.

For the next few years, we expect stocks will be a better place to be than bonds, given the risks in current bond prices outlined above. However, if interest rates rise too quickly, stocks could tumble along with bonds as investors place less value on future earnings when rates are higher. We don’t think this is likely but are acutely aware of the risk.

Finally, we continue to like the prospects for high quality companies with worldwide sources of revenue growth. We remain cautious about European stocks as their recession continues. And we are reducing exposure to interest rate risk in the bond portion of client portfolios and adding to long/short strategies in both stocks and bonds.

April 8, 2013                               © Essential Investment Partners

Income and Estate Taxes – A Surprising Bit of Certainty

At a time when it seems that politicians here and abroad are contributing to the uncertainty of the world economy, the US Congress recently delivered a bit of certainty in two very important aspects of our financial lives.  It took two old line Senators – McConnell and (now Vice President) Biden – to hammer out a deal in the waning hours of 2012.  The final deal allowed both sides to claim victory – higher taxes on upper income taxpayers for the Democrats and permanently lower rates in all other brackets for the Republicans. 

Remember the phase-ins and phase-outs and constantly changing brackets of the 2000s?  Gone.  In the end, the lower tax rates initially established under President George W. Bush were made permanent for all but the highest income earners.  In addition, no major deductions or exemptions were modified and that pesky alternative minimum tax fix (that Congress has been doing annually for who knows how long) is now permanently fixed by indexing it to inflation. 

Congress also drastically reduced the applicability of the estate tax by making permanent the estate/gift tax exemption at $5,250,000, also indexed for inflation. Portability (sharing of the exemption between husband and wife) has been made permanent.  The quid pro quo?   A higher estate tax rate of 40%.  

This all seems too good to be true, right?  Well, if you make more than $200,000 (single) or $250,000 (married), your 2013 income tax calculation is about to get a lot more complicated.  We aren’t going to try to explain all of the nuances here but let’s summarize by saying that there are three new ways that your taxes will go up. 

First, the 3.8% Medicare surtax will apply to net investment income to the extent the $200,000/$250,000 threshold income is exceeded.  Second, at incomes above $250,000/$300,000 personal exemptions and itemized deductions begin to phase out.  Finally, at incomes over $400,000/$450,000, a new higher income tax rate of 39.6% applies and the capital gains rate increases from 15% to 20% (in addition to the Medicare surtax).  

Behind each of the these general ways that taxes may rise is a somewhat complicated formula – best left to your tax accountant. 

Stepping back from the details, it seems pretty likely that those with high incomes and estates exceeding $10.5 million will look to shift income-producing assets out of their estates by way of gifts below the gift tax exclusion amount.  The secondary benefit is that the income from those assets could be taxed at substantially lower rates in the hands of a lower tax bracket recipient.  

Our advice – seek the counsel of your tax accountant and estate attorney early in 2013 – as asset and income shifting might be an important part of a smart estate and income tax strategy.  The sooner you look at your options, the more effective they will be in 2013 and future years.

Good News from Essential

2012 turned out to be a very good year – our clients experienced strong absolute returns and we were blessed by the expansion of our client roster.  We closed 2012 at just over $100 million in assets under management and plan to continue to grow in a measured way that puts client service first and foremost.  

Speaking of continued growth, we are pleased to announce that Mark Asaro, CFA,  has been promoted to Portfolio Manager.  Mark has done an excellent job in all aspects of our investment research – he and Jon Zeschin now co-manage all client portfolios. 

In addition, we have named Marce Webster to the position of Client Service Director.  Marce is the consummate client service professional, making sure that all aspects of our clients’ interactions with us and their custodians run smoothly.  

A great deal of the credit for our clients’ investment success goes to Mark and Marce – they are always ready to do whatever is needed for our clients.

2013 Investment Outlook

Success in 2012 seemed to be mostly about staying the course: not reacting to each bit of news out of Europe or China or, heaven help us, the fiscal cliff negotiations. We should have expected our politicians to copy their European counterparts by doing the absolute minimum at the last possible moment to avert a crisis and deferring bigger decisions until later. This exercise in procrastination did achieve two important things, however: (1) the new tax law made the income and estate tax rates permanent, providing some certainty about tax policy and (2) by deferring any action on spending cuts, they delayed the economic impact of the cuts to a later date, making a recession much less likely.

We had been concerned that higher income taxes and the expiration of the payroll tax holiday, combined with spending cuts, could be an immediate 1.5-2% hit to our economy. This could easily have thrown us into a mild recession. While the hit from the tax hikes (mostly the expiration of the payroll tax holiday) will be about 1%, we are pretty confident now that spending cuts will get pushed into the future. And, some of the short term impact of the tax hike will be mitigated by lower gasoline prices. Bottom line, intransigence may prove to be just what we needed to avoid recession – isn’t it incredible how Washington can work this magic!

We should caution that we are by no means out of the woods. When you govern by brinksmanship, there is always the risk of a major self-inflicted wound (like the 2011 debt ceiling debacle). So we will be watching the spending and debt ceiling debates closely. But for now, we believe that “absolute minimum at the last possible moment” is the governing philosophy.

So what of our burgeoning deficit, insufficient revenues and unrealistic social promises? They are left to another day. We can only hope that these words from the preamble to the report of the National Commission on Fiscal Responsibility and Reform (Simpson Bowles) prove prophetic: “We believe that far from penalizing their leaders for making the tough choices, Americans will punish politicians for backing down – and well they should.”

For nearly four years now, we have been talking about the legacies of the Great Recession: high unemployment, consumer savings and debt payoffs, reduced bank lending and the housing drag.

Chronically high unemployment is certainly still with us. Even though the “headline” rate is 7.8%, down a long way from the peak, much of this has been accomplished by a drop in the labor participation rate. This participation rate – currently at 63.6% – is near a 30 year low. Recently, the Federal Reserve has set its monetary policy targets based on achieving a 6.5% jobless rate, an interesting target given that there is little evidence that the aggressive Fed policies have spurred job growth to date.

Speaking of the Fed, its low interest rate policies have helped consumers deal with their debt issues. So far, most of the progress has been made on debt service costs (now near historical lows, as a percentage of income) rather than principal reduction (about halfway back to the long term average, also as a percentage of income). Because consumers have limited the growth in debt very sharply even while incomes have expanded, we expect slow but steady progress.

Almost left for dead by many, real estate has staged an unexpectedly strong turnaround. In particular, demand for multi-family housing is very robust and prices reflect that dynamic. Single family housing inventory is now only five months, well below long term average of seven. Most importantly, residential real estate is no longer the financial and psychological drag it once was.

Finally, banks are coping with greater capital requirements and huge regulatory burdens, not to mention very low interest rates. So lending isn’t a big priority now and, honestly, demand for loans isn’t high either. Consumers don’t want to take on a lot of debt and larger companies have more cash than they have had in a very long time. Instead, fee income has taken precedence. Recently, we had a major bank charge a client $40 for returning a wire that was sent to them in error. To us, that showed just how far banks are searching for new fees to charge. Get used to it!

Except for high unemployment, we believe the other legacies of the Great Recession will fade as new trends replace them. We see four long term trends emerging that will drive our economy forward in the next few years. These are: (1) substantial progress toward energy independence; (2) rebound of the residential real estate market; (3) dramatic productivity improvements resulting from mobile capabilities; and (4) the emergence of the echo boom generation (boomers’ children) as the driving force in the economy, reinforcing all three of the other trends. So while Washington dithers, there are trends in the real economy that will drive growth, which is the best prescription of all for reducing the deficit.

Mired in recessions, severe in the south and moderate in the north, Europe is largely in a holding pattern, as the Eurozone slowly debates the type of new structures needed for closer unity. In the meantime, the European Central Bank has clearly stated its intent to do “whatever it takes” to keep the Euro in place. Knowing that the Eurozone is about promoting prosperity while preserving peace, Germany will ultimately provide the leadership needed but only once it believes the correct structures have been established. How long this will take is anyone’s guess. So the weaker economies are left to struggle with austerity while the stronger economies likely begin to recover from a mild recession.

China continues to be the big question mark in Asia. How will the new leadership team stimulate the economy? How will it deal with excess debt accumulated in the real estate sector? Will it become more territorial militarily as it looks to secure energy resources? These and hundreds of other questions are waiting to be answered as the once-a-decade transition of power continues through March.

One thing is clear, however. China and its emerging Asia neighbors will continue to grow much faster than the developed world. But how that translates into future investment returns remains to be seen. Already, spreads on emerging market sovereign debt have plummeted to historic lows. And, Asian stocks posted a strong 2012. That said, we believe that there is opportunity in the uncertainty surrounding China and will look for ways to take advantage of that for our clients.

Caution is warranted on fixed income investments. Even a moderate recovery in global growth will pressure prices. Combining that pressure with excess supply (particularly once the Fed stops buying) will cause rates to rise. From these levels, the loss to principal from higher rates could be substantial. We don’t expect a sudden move but we could look back a year from now to find Treasury and corporate bond rates at a meaningfully higher level.

Among stocks, we still like the prospects for large multinational companies with diversified revenue streams, particularly those with substantial emerging market exposure.  And, with the continued uncertainties we face in the US, we continue to like a mix of absolute return oriented strategies (such as long short debt and equity) combined with shorter term fixed income investments.

January 8, 2013                                           © Essential Investment Partners, LLC

Thoughts on the Current Outlook – October, 2012

Bloomberg News reported today that the presidential campaigns, on their paths to spending $1 billion apiece, are on target to spend about $5 million per electoral vote in the battleground states. Since Colorado is one of these lucky states, our local economy has been bolstered by all of the advertising spending, even if it makes watching television unpleasant. And, the University of Denver just hosted the first of three Presidential debates, another economic boost both short- and long-term. Despite these local positives, we can’t help but think that the massive resources that go into our elections could be so much better spent on more productive pursuits.

Speaking of productive pursuits, the Federal Reserve really wants us all to invest in stocks and bonds. So much so, that it made two important announcements in early September: it expects to hold short term interest rates very low (near zero) until 2015 and, if that wasn’t enough, it will embark on a new round of “quantitative easing” some have dubbed QEternity. (In this context, quantitative easing is Fed-speak for increasing the size of its balance sheet by buying US Treasury or mortgage bonds.)

Importantly, the Fed announced that QEternity will stay in place until there is a meaningful reduction in the unemployment rate, so long as inflation is contained. The experience of the last few years tells us that lowering interest rates isn’t the cure for our economy or unemployment this time around. If it were, our economy would be screaming by now and the unemployment rate would have dropped precipitously. Instead, over the last couple of years, the rate has dropped mostly as a result of people leaving the work force and growth in the economy could best be described as anemic.

Complicating matters for the Fed, the most recent report – likely the most influential pre-election report – showed a meaningful drop in the unemployment rate (to 7.8%) even while the workforce expanded. Some of the underlying components of the report were positive (earnings, length of work week) but others were still very troubling (unchanged broad unemployment rate, large growth in part-time workers, loss of manufacturing jobs). We won’t know until well after the election whether this report was a precursor of more positive change or a statistical fluke.

Meanwhile, corporations are sitting on record amounts of cash and consumers continue to pay down the debts they accumulated over the last 20 years. So the economy putters along at 1-2% growth; not in recession but oh so close that any misstep could put us there.

What kind of misstep? Well, the “fiscal cliff” that we are screaming toward on January 1 is the number one candidate. (As a reminder, the cliff is a combination of tax increases and spending cuts that would come into being if Congress does what it is best at: nothing.) Many believe that the cliff is so steep and so well known that surely the politicians will do something to avoid it. We wish we could be so confident – having kicked can after can down the road and showing no propensity for compromise, we think counting on a solution before a crisis ensues is naïve.

After a weak first debate performance by the President, it appears that the presidential race has tightened up. Perhaps as important is what happens in the Senate races as control of that chamber is up in the air. With so much action required on federal tax and spending policies in the coming months, this election will shape the prospects for compromise. Much more so than normal, the resulting policy changes (or lack thereof) will directly affect the short term course for the economy, consumer confidence and employment.

Despite all of this political talk, we see four long term trends emerging here that we believe will ultimately lift us out of the shadow of the Great Recession. These are: (1) substantial progress toward energy independence; (2) stabilization of the residential real estate market; (3) dramatic productivity improvements resulting from mobile capabilities; and (4) the emergence of the echo boom generation as the driving force in the economy, reinforcing all three of the other trends. In the short term, political and policy news may make it harder to see the strength of these positive trends. However, we believe they will continue to move to the forefront regardless of the political environment.

Across both the Atlantic and Pacific Oceans, the trends which have been in place for the last two years stay in place. Europe, still struggling with the debt problems of its southern members, finds itself squarely in recession. Recessions in the south are quite severe, the result of austerity programs designed to reign in debt growth. In the north, the recession is much milder.

China continues its long transition from an export and infrastructure economy to a domestic consumption economy. The transition away from exports has been pushed along by slow demand from their trading partners elsewhere in the world. As a result, growth has slowed to a mid-single digit rate and stock prices have drifted down to early 2009 levels. This economic transition is further complicated by the political leadership transition that is also taking place.

We believe the biggest risk the financial markets face is an acceleration of the slowdowns across all three major economies – the US, China and Europe. As we have said, the fiscal cliff would likely be the chief short term culprit here at home. In China, policy inaction resulting from the political transition could result in growth slowing dramatically. Ironically, Europe, which has been the source of most concern for the past few years, seems to be more on track than the US and China. This is largely due to the European Central Bank’s vow to do “whatever it takes” to hold the Euro together, even as the southern countries’ austerity plans continue.

Of course, we need to keep in mind that unexpected geopolitical events could change the course of world economies abruptly. In the Middle East, Iran remains a wild card, moving toward nuclear capabilities even while the impact of economic sanctions is now reaching the streets. Expansion of the civil war in Syria to Turkey or other neighboring states (even if inadvertent) runs the risk of igniting conflict across larger powers in the region. And in Asia, a longstanding dispute over a tiny set of islands has spawned economic conflict between China and Japan at a time when neither economy can afford it.

While Europe continues on its bumpy road, we have significantly underweighted investments exposed to that region. However, our dedicated exposure to Asian equities remains in place as we believe the rise in consumer incomes and growth of a large middle class will continue. Among US stocks, we continue to focus on companies that can continue to deliver strong returns on equity and consistent earnings growth. Technology and health care are two areas where we find companies with an attractive combination of revenue growth, strong profitability and reasonable stock prices.

Finally, we continue to avoid US Treasury bonds on which yields are suppressed by demand from the Federal Reserve. At the current level of yields, the risk to principal, once rates begin to rise, is astonishingly high. Quality corporate and municipal bonds still trade at attractive levels, relative to inflation, so our fixed income investments are focused in these areas.

October 8, 2012                           © Essential Investment Partners, LLC