The campaigns are finally over and the results are in. In the game of political gridlock (or compromise), Washington will field the same players for another two years at least.
Fiscal Cliff in Focus
Investors woke up Wednesday morning, November 7, and with the election behind them, lined up their sights on the impending fiscal cliff. They didn’t like what they saw.[1] Stocks fell by over 2%, while US government bond yields plunged more than 10 basis points (0.10%), both indicating fear of economic problems ahead.
To review, the fiscal cliff is the outgrowth of a deal negotiated in mid-2011 as a condition for increasing the US national debt ceiling at the time. The cliff entails substantial automatic cuts in government spending starting in 2013. Coupled with the scheduled year-end expiration of both the Bush tax cuts and the more recent 2% payroll tax reduction, it’s a fiscal double-whammy – spending cuts and higher taxes, both imposed on a weak and possibly fragile economic recovery. Absent action by Congress and the President, the fiscal cliff occurs by default.
Prognosticating what’s next is difficult. The easiest prediction: the fiscal cliff in its present form is not likely to happen in January 2013. At a minimum, Congress can postpone its implementation – say, six months, while the parties seek to craft the so-called “grand bargain.” It’s also possible that a compromise can be reached in the lame-duck session that follows the election, but we view a kick-the-can action as more probable. A somewhat less certain prediction, but still more likely than not in our view, is that a bargain will be struck in 2013. The most difficult prediction of all – what shape the compromise takes – we’ll address below.
Call me a cockeyed optimist, but despite the rhetoric and campaign-related antagonism, I believe the parties well remember their disastrous performance in the debt ceiling crisis of 2011 and will do everything possible to avoid a repeat. They understand that a failure to achieve something substantive in 2013 could easily result in a market and economic debacle.
The Grand Bargain
What might a grand bargain look like? First, it will have to contain elements that allow each faction to claim a victory of sorts. President Obama will need to show that the top 1% is paying more. The Republicans, in turn, will need to cite their own tax victory. One idea, floated during the debates, would be to cap tax deductions well below the level that top earners have been accustomed to. (Note that this has the political appeal of not repealing any specific deduction, while drastically curbing deductions in aggregate.) In exchange, the Bush tax rates might be held steady. Democrats can claim they’ve closed tax loopholes for the rich, while Republicans will argue they’ve beaten back growth-retarding higher marginal tax rates. Probably the payroll tax reduction is allowed to expire on the argument that it really was intended as a temporary measure.
A bolder compromise would also change the way investment income is (or is not) taxed. Examples include limiting the tax exemption of municipal bonds and the tax deferral benefits of whole life insurance. Even the tax-deferred nature of qualified retirement plans (e.g., IRA, 401k) could be on the table. The opposition by affected interests would be fierce, but such changes can’t be ruled out, especially if some meaningful concessions are gained in return. Much as we’d mourn the passing of these hallowed tax benefits, we would also be very impressed by a Washington that could enact such changes.
The next component would be to put Social Security on a sounder actuarial footing. A fix here is relatively straightforward and politically manageable – some combination of extending the eligible retirement age (reflecting today’s longer life expectancies) and broadening the wage base to which the Social Security payroll tax applies.
That still leaves the really big one, the really important one, the really hard one – tackling Medicare. Left unchecked, Medicare will swallow the federal budget whole in relatively short order. Unfortunately, we doubt that meaningful Medicare reform will occur in 2013. However, if a grand bargain is struck that markets view as, (1) a serious first step towards fiscal sanity, and, (2) balanced with respect to its impact on economic growth, we believe that markets could react positively and grant Washington more time to get its arms around Medicare.
Investment Implications
The path to compromise will be filled with sharp twists and turns, so expect market volatility in response to alternating bouts of optimism and pessimism. In our experience, pessimism is the more natural emotion, but optimism is better rewarded over time. Investment plans, soundly crafted in less turbulent times, should prevail, much as we may be tempted to run for cover.
Higher taxes on investment earnings arguably could depress equity prices, but consider the paucity of alternatives. Bond yields are at historic lows, cash pays about zero, and even the government admits to inflation of 2%-3% annually. Retail investors have been net sellers of equity mutual funds for the past three years, often a contrary (in this case, bullish) indicator for stocks. On the other hand, we’ve had a massive rally from the March 2009 lows, so there is plenty of room for profit taking, perhaps already previewed in Apple’s 21% decline from its peak six weeks ago.
The best advice we have is this: remember your time horizon and don’t overreact to headlines.
With President Obama’s reelection, it seems likely that Fed Chair Bernanke (or his ideological equivalent) will be appointed to a new term in 2014. Hence, short-term interest rates will likely stay near rock bottom for the foreseeable future. Still, the upside for bonds is very limited at this point, even if major downside is not yet on the horizon. At this point, high quality bonds serve largely to dampen portfolio volatility (a critical function, to be sure), but do little else given their paltry yields. Consequently, investors should not expect rising bond prices to substantially cushion the next major stock market decline. (See my earlier blog post: Why the Next Bear Market May Be Even Less Pleasant than the Last). Now if we (or anyone else) knew just when that was going to occur, we wouldn’t have to work for a living.
Rather than reaching too far out on the risk spectrum for yield or return, it’s far wiser for investors to reduce their return expectations, at least temporarily, and adjust accordingly. (For more, see: On Financial Repression and Rate of Return Expectations.) Effective portfolio diversification today should also consider asset classes and investment strategies that go beyond the conventional stock/bond balanced mix. We’re continually working on this.
Year-End Tax Planning
Finally, get used to the reality that almost every worker will be paying higher taxes, and those with high earnings and/or substantial assets will probably pay a lot more. (With the passage of Proposition 30, top earners in California are already looking at a 3% rise in marginal tax rates, to 12.3%, retroactive to 1/1/2012.) High earners also need to consider the real possibility that the bulk of their mortgage interest, state income tax, and charitable gift deductions will be disallowed under a deductions cap. Tack on the 3.8% Obamacare tax on investment income for higher earners, throw in up to a 2.9% hike in the payroll tax, and, well, you get the picture.
In the short run, higher taxes will almost certainly reduce after-tax incomes. In the longer run, the hope is that well designed tax and budget reform will put the economy on a higher growth trajectory, such that pre-tax and after-tax incomes both rise. By far the most plausible path out of our budget morass is improved rates of economic growth. It’s just possible.
If (a very big if) a compromise takes the form presented above, affected taxpayers should accelerate income into 2012 where possible. The prospect of higher capital gains tax rates means net capital gains harvesting in 2012 will make sense for some, but we don’t advise upending long-term holdings for this purpose. If deductions are capped in 2013, it could also make sense to accelerate deductions such as planned charitable gifts and state income taxes into 2012. This is one of those curious situations where it could make sense to accelerate both income and deductions into the current year, though it’s a much tougher call on the deductions side.
Stay tuned.
[1] We note that this reaction is not unlike what occurred after Labor Day 2008. Recall that Fannie Mae and Freddie Mac were widely regarded as being on the ropes through the summer, but it wasn’t until Wall Street got back to work in early September that the wheels came off the bus. In less than a week, Fannie and Freddie were wards of the state. Nothing really changed on Labor Day, other than investors’ capacity for focusing on the problem. Likewise, nothing really changed on Election Day 2012. Of course, we hope (and expect) that the next several months will not largely resemble the horrific six months that followed Labor Day 2008.
Like Pavlov’s famous dog, the markets now seem conditioned to lurch upward every time Fed Chairman Ben Bernanke rings his easy money bell. (A similar story could be written about the European Central Bank and its chairman, Mario Draghi.) I find this persistently disturbing, like a recurring bad dream waiting to become a reality.
Big Ben has printed roughly two trillion dollars in the last four years and, in an experiment without precedent, has used them to buy financial assets – mostly US Treasurys and mortgages. The polite term for all this money creation is “Quantitative Easing,” or QE for short. In the process, the Fed has driven short-term US interest rates to near zero, and through its “Operation Twist” (which sounds vaguely like the title of a late 1950s madcap movie that might have starred Fred MacMurray) has managed to push even the longest term rates below 3%. (As an aside, the Fed effectively purchased 60% of all net Treasury issuance in 2011. Remind you of any southern European countries?)
With Bernanke’s latest announcement of QE3, we learned that the Fed will print another $500 billion annually, potentially indefinitely. Additionally, Operation Twist will remain in full force, and short-term interest rates will be kept near zero for at least another three years.
The thinking seems to go, if we can just print some more money, everything will be hunky dory, or at least a little less grim. In essence, the theory says that by printing money, we can print wealth, too. If 2 trillion is good, why not print 20 trillion? More formally, the Fed argues that these very low interest rates have helped the economy to the tune of 2 million extra jobs. How, you ask? A couple of ways, apparently.
First, low interest rates have reduced borrowers’ interest expense, leaving them more money to invest in job-producing activities, and perhaps also stimulating the moribund housing industry. And second, low interest rates have pushed the stock market higher, creating a so-called “wealth effect” whereby the owners of the appreciated stocks are thought to be a bit looser with their purse strings. At the margin, their extra spending stimulates the economy and also translates into more jobs. Count me among the skeptical.
Surely the Fed’s policies have also engendered a reverse wealth effect. Just ask any retiree trying to live off the interest from their bonds and CDs. We estimate that annual interest income from a typical bond portfolio has dropped by perhaps 40% in the last four years and will continue its descent as the proceeds from maturing bonds are reinvested at today’s minuscule interest rates.
The typical south Florida retiree is less worried about hurricanes than the government’s wholesale plundering of a kind of social contract – one that said that if you worked hard for decades and were thrifty enough to accumulate, say, $1 million, you could comfortably live out your retirement years on the interest from your bank CDs. 5% interest would get you $50K per year. Now it’s maybe 15K. And shrinking.
How anyone could think that more money printing will help us now, given that interest rates are already scraping their lower bound, is beyond me. Our college economics texts called this the “liquidity trap,” cleverly described as pushing on a string.
As for the Fed policy that seeks to create a wealth effect, we might restate it this way. If the Fed can keep interest rates low enough, long enough, bonds and CDs become so unattractive that stocks look good by comparison. Desperate for income (even the S&P 500’s 2% dividend yield looks good by comparison) and at least a theoretical possibility of a decent total return, investors will say a prayer and throw cash at the stock market. In the process, many could easily be building portfolios that are riskier than they can actually tolerate over time.
I have a strong visceral negative reaction to the idea that the government is printing money to drive the stock market higher. Yet the Fed openly acknowledges such a policy (see Bernanke’s August 2012 speech at Jackson Hole) and even trumpets the rising stock market as one of its triumphs.
Lest I give the wrong impression, no one should blame Ben Bernanke for today’s problems. I have considerable sympathy for Bernanke. We’ve asked him to dance the tango solo. The real changes needed today must come from the House, Senate and Executive branch in Washington. With his dancing partner missing in action, our nation turns its lonely eyes to Ben, and he does what he can, printing more money on the off-chance it might do just a little good.
Yes, low interest rates have pushed up the stock market. But here’s another take worth considering. Maybe all this money printing is driving cash into anything that might protect one from debasement of the currency. That includes not just stocks, but also gold, commodities, real estate and anything else that can’t be created with the stroke of a pen. In other words, printing money is inflationary after all. It’s just that today’s inflation expresses itself more in the price of assets, rather than goods and services. The other inflation – consumer price inflation – probably lurks somewhere down the road, on top of a multi-trillion dollar pile of dry tinder. Read more
The last two US bear markets – 2000-2002 and 2007-2009 – saw the stock market lose about half its value in each instance. Investors with balanced portfolios – some mix of equities and fixed-income – fared much better than those invested mostly or entirely in stocks, for two reasons, one obvious and the other less so.
The no-brainer benefit of having a balanced portfolio in a bear market is simply that the bond portion dilutes the overall exposure to a declining stock market. The second and less obvious benefit falls into what we might term the modern portfolio theory (MPT) basket. MPT basically says that overall portfolio risk is reduced when we combine asset classes whose returns move at least somewhat out of sync with one another. In the two bear markets cited, while stocks fell, bonds turned in positive returns, and in general there is good reason to expect this outcome.
In an economic slowdown, corporate earnings expectations drop, and stocks follow. At the same time, business loan demand subsides with receding growth prospects, leading to lower interest rates. Recall that the price of existing bonds rises when the available rate on new bonds falls. So in this instance, we have the holy grail of MPT: negative correlation between stock and bond returns, leading to more stable returns of the portfolio as a whole.
The question now is whether balanced portfolios should expect MPT benefits when the next bear market rolls around. On this score, the outlook is not promising. Consider that the 10-year US Treasury note yielded about 6% at the outset of the 2000-2002 bear market, falling all the way to about 3.6% by the end of the period. By the time the 2007-2009 downturn commenced, the 10-year yield had risen back to about 4.5%. When the US stock market bottomed in early 2009, the yield plateaued around 3%.
In the second case, bond yields started lower and their decline, not surprisingly, was less pronounced. Consequently, as seen in the accompanying chart, bonds did less well in cushioning the impact of the 2007-2009 bear market than they did in 2000-2002.
Today the 10-year Treasury yields rests at 1.6%. The scope for further reductions in this rate – in other words, the likelihood that good bond performance will meaningfully offset the damage done by the next bear market – is greatly diminished.
This is a sobering observation, to be sure, but better to be thinking about it now than in the aftermath of the next bear market, whenever that may be. One conclusion is clear. Effective portfolio diversification today must incorporate asset classes and investment strategies that go well beyond the conventional stock/bond balanced mix.
The arithmetic of today’s minuscule interest rates — what some investors have called “financial repression” — leads to some far-reaching conclusions and unpleasant implications.
In the good old days (i.e., the historical averages since 1926), intermediate US government bonds earned about 2.5% real (i.e., above inflation), while stocks earned about 7% real. Today, the market expects a real return on 10-year Treasurys of roughly negative 0.5% (as derived from the current yield on Treasury Inflation-Protected Securities, aka TIPS).
Assume for the moment that stocks continue to outperform bonds by 4.5% as they have in the past. This implies an expected real return on stocks of only 4%, instead of the 7% that most financial plans blithely assume. It also means that a 60-40 balanced portfolio might only have an expected real return of about 2.5%. This is a rather astounding result: to have the same real return expectation today that a 100% government bond portfolio would have carried in the past, one might have to allocate more than half the portfolio to stocks. And, of course, we’re only talking expectations, not guarantees, since actual stock market performance often varies substantially from expectations, even over long holding periods.
The investment implication is clear: central banks’ negative real interest rate policy significantly worsens the risk-return tradeoff for everyone. Investors are faced with a lousy choice: take more risk to maintain one’s return expectations, or reduce return expectations to maintain one’s risk exposure (or some combination of the two).
The retirement planning implications are equally unappealing. If investors take on more risk, they introduce more uncertainty into portfolio performance and, by extension, retirement spending. Conversely, if investors accept lower return expectations, they must also be willing to defer retirement and/or reduce spending in retirement. Read more
Money market funds, long the parking place of choice for cash balances, now face two existential challenges. The first is the Fed’s policy of maintaining near-zero interest rates at the short end of the yield curve. When market yields are less than the cost of running a fund, the fund sponsor must eat the difference. Operating even the largest scale money funds costs about 0.20% of assets annually.
With 3-month Treasury bills yielding a mere 0.08%, a fund investing only in T-bills is costing the sponsoring fund company at least 0.13% per year, assuming the fund pays 0.01%, the default yield for many funds these days. (Apparently, paying 0.01% is considered more cosmetically acceptable than paying zero. At 0.01%, your money doubles in about 7,000 years.) Funds investing in bank and corporate obligations may be able to eke out a gross yield that barely exceeds fund expenses, but who would want to own such a low-yielding vehicle? Fewer and fewer, it seems. In the past three years, investors have pulled nearly $1.5 trillion from US money funds, or almost 40% of assets. Numerous fund sponsors have exited the business altogether.
The second threat is regulatory and can be traced back to the September 2008 depths of the financial crisis. The Lehman Brothers bankruptcy caused the Reserve Primary Fund (the oldest money fund and among the largest) to lose about 1.3 cents per share overnight and thereby “break the buck,” i.e., lose its hallowed $1.00 share price. To stem the panic that ensued, the US Treasury temporarily guaranteed all money market funds. New regulations put in place in 2010 forced funds to maintain even higher quality portfolios than before, but the fundamental vulnerability of money funds remained, namely, the risk that bad investments could cause a run on a fund.
The idea of a constant $1.00 share price has been a convenient fiction since the advent of money funds in the early 1970s. In reality, money fund share prices fluctuate daily, but as long as they remain above 0.995, applicable rules permit the fund to round its share price to $1.00 and transact shares at that price, giving the illusion of a risk-free investment. The SEC recently proposed that money funds report and transact at their true share price, be it 0.9984 or 1.0015 or whatever. From a policy standpoint, this is a reasonable proposal, but it would also remove the money funds’ last vestige of cash equivalency, with dire consequences for the money fund business, in our view. When one dollar in is no longer a certain dollar out, the game changes.
The money fund industry rightly argues that most bank assets aren’t nearly as safe or liquid as money fund portfolios. Yet FDIC insurance effectively guarantees a constant $1.00 value on the bank deposit, plus interest, up to $250,000 per depositor. But this misses the key point, which is that the banks have a big, powerful lobby and an even more powerful constituency (depositors) for whom FDIC deposit insurance is sacrosanct. Arguably, the government (and the taxpayer) should not be on the hook for bad decisions by bankers or money fund managers. This is a case where the money funds might win a fairness battle, but will likely lose the political war.
