European Update: Secession, Tax Evasion, Downgrades, Bailouts

fee-only financial planners, investment managementThe Eurozone continues to struggle. Slow growth, lots of debt and millions of unhappy people. I thought it might be informative and interesting to look at recent anecdotal evidence from four countries. 

Secession is in the air in Spain. Catalonia, the Basque country and other regions are ready to become autonomous nations. The primary issue is… (drum roll)… money. These northern areas don’t want their tax dollars funding poorer regions in southern Spain. Catalonia, the home to Barcelona and millions of Catalans with their own language and culture, held elections Sunday. The results were inconclusive. The pro-independence parties won a majority of seats in Parliament, yet, Catalan President Mas, who has supported independence but also further austerity programs, saw his party lose some power. According to the Wall Street Journal on Monday, Catalans want independence and they don’t want austerity. Sounds like a group of teenagers to me.

Tax evasion has been rampant in Italy, Greece and some other countries for decades. It is estimated that Italy’s underground economy, excluding criminal ones such as drug rings, accounts for $350 billion per year. This is roughly 18% of the GDP. Taxes on that income, estimated at $150 billion, never make it to Rome. Roughly 50% of Italians report an annual income below $25,000, yet hundreds of thousands of these folks have large boats, luxury cars or helicopters. Now, the Italian government is fighting back. They are distributing a “tax-cheat self-test.” This allows people to gauge whether their declared income is in line with what they spend annually. The Italian tax authorities hope people will use this self-assessment tool to voluntarily file correctly in the future. In addition, the government is sponsoring TV ads comparing tax evaders to various animal, fish, wood and intestinal parasites. Two questions: Is it any surprise that Italy has troubles balancing its budget? And, do you think the self-test or calling someone a “tapeworm” in Italian will change their behavior?

France received a bond downgrade last week. Moody’s stripped it of its AAA rating; citing France’s sustained loss of competitiveness, deteriorating economic prospects and its large financial exposure to peripheral Europe. The Economist noted last week, in a special report on France, that the business climate has worsened. French employers pay 30% of labor costs to fund social security. No fewer than 34 laws and regulations start to apply once an enterprise reaches 50 employees. It’s not surprising that researchers are finding that a significant number of French companies have exactly 49 employees. There is now a 75% top income tax rate, unemployment is 10% and over 25% of the young are jobless. Is it any wonder that so many entrepreneurs are leaving the country and/or sending their children somewhere else in the world for a brighter future?

Greece received a bailout on Tuesday. European finance ministers eased the terms on emergency aid for Greece. In fact, Bloomberg reported that the ministers declared that after three years of false starts that “Europe has found the formula for nursing the debt-stricken country back to health.” The ministers cut rates on bailout loans, suspended interest payments for ten years and gave Greece more time to repay the loans. Quite a formula. Greece will get the December loan installment of $45 billion despite the fact that its economy continues to shrink. It is good to see they will make it through 2012 as part of the euro. January will be the next test. Greece needs $12 billion. They will get it only if the EU, ECB and IMF certify that they have implemented a tax reform by that time. Perhaps they can get the Italian tax self-test and the tape worm commercials translated into Greek.

Core and Satellite Investing

From The Charleston Mercury, November 15, 2012

Let’s face it. We probably will have at least a few more years of slow growth along with world and investment environment uncertainty. Seems to me you have three choices: sit in cash (and make almost no return while inflation erodes your purchasing power), stay in your current asset allocation of stocks and bonds (and hope your portfolio doesn’t get hit like it did in 2008), or consider a core and satellite portfolio (designed to participate when the market goes up and protect your assets when the market goes down.)

Try to visualize your total portfolio as a car tire, viewed from the side. The rim and everything within is the core; the tire itself is the “satellite” portion. The core is composed of traditional equity and fixed segments seeking to provide higher expected returns with lower risk in a cost-efficient manner. The satellite portion is composed of investments that do not correlate with the traditional markets. The satellite seeks to provide solid returns and provide diversification and downside protection for the overall portfolio.

The core investments are in low-cost, tax efficient passive mutual funds and ETFs. Research, primarily the Efficient Markets Hypothesis, has shown that active management cannot consistently add value through security selection and market timing in efficient (traditional) markets. For the five years ended December 31, 2011, roughly 75% of actively managed mutual funds underperformed their benchmarks. There are three reasons for this: higher fees (operating expense ratios), more transaction costs, and more tax ramifications. Of these, the fees are the biggest culprit. Actively managed funds cost about one percent per year more than passive funds. That one percent shortfall ultimately results in underperformance and costs investors lots of money.

Therefore, a passive strategy in the core portfolio of traditional investments produces, on average, better returns.

On, the other hand, active management, can be more appropriate in inefficient markets. One good example is liquid alternatives. These publicly traded securities are non-correlated to the stock markets, are easily redeemable and may follow hedge-fund like strategies. The liquid alternatives should be considered for the satellite portion of the portfolio. These funds are specially designed to participate in up markets and protect in down markets. They have been shown to be particularly valuable in limiting losses during bear markets.

Consider a core and satellite portfolio, with passive investments in the core and actively managed liquid alternatives in the satellite. You get diversification, lower volatility and a portfolio designed to protect your assets and grow them. Something we all need in these uncertain times.

Les Detterbeck is one of a small number of investment professionals in the country who has attained CPA, CFP®, and CFA designations. His firm, DWM Financial Group, Inc., a fee-only Registered Investment Adviser, has offices in Charleston/Mt.Pleasant and Chicago. Les may be contacted at (843)-577-2463 or les@dwmgmt.com

China: World’s Number Two Also Faces Major Issues

fee-only financial planning, world-wide economy

The U.S. is the not the only major power trying to find solutions. China is too.

No, they are not grappling with taxes, budgets and deficits as in the U.S. Rather, China must deal with economic reform, environmental problems and political change. They need to shift from an economy built on exports and heavy internal infrastructure investments towards a more sustainable emphasis on domestic spending. In addition, the hyper growth development model has led to widespread environmental degradation. Lastly, most of the 1.3 billion people in China want political change. The Communist party and its 80 million members control, according to the New York Times, the economy, the courts, the news media, the military, educational institutions, civic life and the day-to-day affairs of citizens. And roughly 400 top party Central Committee leaders control the Communist party. Wealth is concentrated where the power is and corruption is rampant. And, we think we have problems.

The Communist Party Congress has been meeting in Beijing since last Thursday. Current leader Hu Jintao outlined his party’s policies that first day. It was a major event. He has been in office ten years and this was only his second such public address.  He called for broader economic and political reform. China’s economic progress in the last decade has been phenomenal, increasing GDP four fold. Yet, even Mr. Hu admitted that China’s development is “unbalanced, uncoordinated and unsustainable.”

Regarding political change, Mr. Hu said last week that “we will never copy a Western political system.” Four years ago, as the U.S. and Europe dealt with the financial crisis, China boasted of the triumph of its model of authoritarian politics which “produced strong, sustainable economic growth.”

Recently, there have been worldwide concerns that Chinese economic growth has been slowing; from a 14% real increase in 2007 down to 7.5% in 2012. However, September and October were stronger, primarily based on major increases in exports and new infrastructure projects, particularly railways. Barron’s reported Saturday that “the doomsday scenarios of hard landings are far-fetched.” Even so, the days of double digit economic growth for China seem to be over. Mr. Hu indicated that he thought economic growth over the next decade will be roughly 7% per year. This pace would likely put China’s economic machine ahead of the U.S. by 2020.

We’re all connected worldwide these days. The fragile recovery and potential fiscal cliff in the U.S. and the continuing problems in the Eurozone are key issues for China in the future. In March, Xi Jinping will take over from retiring President Hu. We’ll be watching closely as the new government deals with its economic, environmental and political issues. Let’s hope China and the U.S. both solve their major issues successfully.

Election 2012: Some Certainty, Lots of Uncertainty

fee-only financial planner, stress-test financial planningYes, the 18 month, $6 Billion 2012 Election is over. Many of us probably feel like four-year-old Abigael Evans who spoke for millions on youtube when she sobbed, “I’m tired of Bronco Bamma and Mitt Romney.” 

Yes, Abigael, it’s over and we have some certainty.

First, we need election reform. How about replacing the Electoral College with a popular vote? This way, the contest won’t focus on ten swing states. Every one of our votes would count equally. Of course, it was nice in IL and SC to be exempt from most of the brutal campaign ads from both parties. Next, we need to reduce the money in politics. $6 billion was spent on the federal 2012 elections. Did it really make a difference? Considering that almost all of the ads were negative and frankly insulted our intelligence, did this process help in solving the nation’s problems and educating voters or merely add to the polarization between Americans?

Political campaigns have become like a nuclear arms race. Each politician tries to out-raise and outspend his opponent.  As a result, Lawrence Lessig in Republic Lost: How Money Corrupts Congress has calculated that politicians spend ½ to 2/3 of their time raising money. This detracts from their time and focus on their job and obligation to their constituents.  It also clouds their judgment on important issues- adding to Washington gridlock, the lack of attention to and resolution of major issues, and the growth of government. In addition, the system has created a marvelous career path for current and former officeholders who can become lobbyists when they leave office and make the really big bucks. We need to fight the corrupting influence of money in politics. You might look at www.rootstrikers.org to see how one organization is doing this. Since incumbents are not likely to change the system, Mr.  Lessig proposes that a constitutional convention may be needed to make the changes necessary.

Finally, regarding election reform, we need a better way to vote. Why do voters have to wait hours seated on school bleachers while poll workers struggle with one computer to verify voters. Or worse yet, stand out in the rain due to long lines. C’mon man!  This is America, the greatest country in the world and home to Apple, Google and Microsoft, among others. Why can’t one of our current day Steve Jobs find a better way for Americans to vote safely and securely using the internet?

Yes, there is certainty to the cast in Washington: President Obama in the White House, the Republicans controlling the House and the Democrats with a small advantage in the Senate. We don’t expect a repeal of Obamacare in January.  Nor, do we expect to see a massive deregulation push coming from the White House. In short, there is unlikely to be a sea change in American economic policy.

However, there is still considerable uncertainty. The fiscal cliff is coming in 53 days. Can Congress and the President make a Grand Bargain or will they kick the can down the road with gimmicks? With our U.S. economy growing but still fragile, can we afford a 5% drop in GDP if the fiscal cliff is not avoided? In addition, of course, we have Europe’s worsening problems, China’s slowdown and world hot spots that could erupt. Lots of uncertainty.

The stock markets showed their initial reaction yesterday, with many equity indices down 2% or more. Expect more volatility. Our clients needn’t worry- they have an investment portfolio that is designed to participate in up markets and protect in down markets.

Now that there is some certainty, let’s hope business leaders start making decisions to increase production and hire more people. And, most importantly, let’s hope the politicians and all of us put aside differences and find the common ground that unites us- to move our great country forward.