Ask DWM: What Does the Fed’s Decision Last Week Mean?

FED logoThat’s a very important and good question.

Last week the Federal Reserve decided to hold rates steady. The uncertainty as to when they will raise rates has been extended to at least October and, if not then, to December or beyond. A Fed rate hike has been in the air since March when the Fed removed the word “patient” from its press release, signaling it could increase rates for the first time in nine years. Rates were reduced to zero in 2008 during the financial crisis and haven’t moved since.

This uncertainty has made markets very skittish. After a January and February when all asset classes were up, March through July was flat overall. Since the week after July 4th, the S&P 500 has alternated between weekly declines and gains for 11 consecutive weeks. China’s devaluation of the yuan in August (see the DWM blog) and the related concerns about its growth and that of emerging markets, caused a 6-7% pullback in stocks in August.

As we have pointed out previously, investors hate uncertainty. It’s interesting though. History shows us that equities typically do well during the tightening cycle (raising of rates by the Fed) and a year after the initial rate rise. (This is based on results in seven different time periods from 1983 to 2004). Hence, the uncertainty may be more disruptive to the markets than the actual tightening (raising of rates).

It’s valuable to look at the Fed’s decision and related statements in greater detail. They did acknowledge the U.S. economy is expanding at a “moderate pace” with “solid job gains and declining unemployment.” There is concern, however, about global growth. China, which has been growing at double digits, is now expected to be 6.8%. And other emerging market countries are struggling, particularly those whose income comes from oil and commodities. A decade ago, China accounted for 9% of the world GDP, now it’s 16%. Emerging markets overall now account for 57% of world GDP, up from 46% in 2004. We’re all interconnected, so lower worldwide economic growth impacts business earnings and stock valuations.

The other key factor is that inflation has failed to reach the 2% Fed target the last three years. Furthermore, the Fed doesn’t expect it to get there until 2018. What the Fed is trying to do is gradually raise rates at just the right time(s) before inflation hits 2% such that there will be a nice “soft landing” near 2% without the economy heating up and pushing inflation up too much and too quickly. At the same time, if the Fed raises rates too quickly and causes the economy to cool down, inflation could decline or even move to deflation, which we want to avoid.

Based upon the statements from the Fed officials last week and other recent data, it appears likely we may have lower worldwide economic growth and low inflation for at least a few years. Plus we will need to continue to endure the uncertainty of when the Fed will raise rates. October? December? Next year? What does all of this likely mean for investment returns?

First, nominal investment returns are likely continue to be lower than historical values. Historically, since 1970, stocks have grown at an annual rate of almost 9% while inflation has been a little more than 4% per year. Hence, there has been a 5% real return earned by risking money and investing in stocks. For the same time period, bonds returned 6%, or a 2% real return.

Mathematically, therefore, if inflation is 2%, it is very likely that a diversified all-equity portfolio might earn 7% and returns on a diversified bond portfolio might be 4%. And, if economic growth is low or stagnant, that pushes valuations down and lowers returns as well.

Nominal returns for all of us are under pressure from three sources; low inflation, slowing global growth and Fed uncertainty. We can’t control any of those. What we need to do is focus on real returns, not nominal returns. And, we need to make sure our financial planning and investment return expectations for the next few years are based on lower inflation and lower nominal returns.

We’re happy to chat about this important topic at any time. Give us a call.

Fed_lady_cartoon

Is the 4% Withdrawal “Rule” Reliable?

DiceRules of thumb can be great, except when they don’t work. Take the 4% withdrawal rate rule, for example.

This rule, developed twenty years ago, is used to forecast how much people can spend annually in retirement without running out of money. Let’s say a couple has $1,000,000 and has just retired. The rule says if they spend $40,000 (4%) from the portfolio and increase this annual withdrawal by the inflation rate, their $1 million nest egg should last for the rest of their lives.

Historically, an average annual return on a balanced allocation strategy portfolio was roughly 7% from 1970 until 2014, while annual inflation was 4%. Hence, a real return of 3%. The conditions during those four decades are different from today. The decades of the ’80s and ’90s produced average equity returns close to 20% per year. The bond bull market produced returns of almost 9% per year for the last three decades. During this time, the “rule” could have worked fairly well for some people. Today, however, there are a number of problems with this rule.

First, inflation forecasted returns and longevity have changed greatly. Inflation has been negative over the last twelve months and has averaged less than 1% per year over the last three years. Forecasted returns, of course, vary widely and no one can predict the future. A conservative estimate might be a 2% real return (3% nominal less 1% inflation, or 5% nominal less 3% inflation). Longevity is increasing. Hence, for many people, their calculations should be based on an eventual age of 100.

In an article from this past Sunday’s NYT, Professor Wade Pfau at the American College of Financial Services put it this way: “Because interest rates are so low now, while stock markets are also very highly valued, we are in unchartered waters in terms of the conditions at the start of retirement and knowing whether the 4 percent rule can work in those cases.”

Second, the 4% rule never took into account non-linear spending patterns of retirees, other goals, other retirement resources, asset allocation, taxes and stress testing the plan.

There’s a much better way to do this, though it takes more thought and time and a disciplined process. For those who value their financial future, it’s worth the effort. Here are some of the elements that you need consider:

Start with your goals. At what age do you want to achieve financial independence (freedom to retire)? What will be your likely spending patterns during retirement? What will your housing be? What will be your likely health care costs? Are there any other needs, wants or wishes you have for the future?

Retirement resources. The calculation needs to include not only the investment portfolio, but also other income sources, such as social security, pension, rental income or part-time work. The calculation also needs to review all assets, not simply the investment portfolio, and determine the amount, if any, of proceeds from the sale of those assets that could be used in the future to fund goals.

Asset allocation. Varying allocations will likely produce varying results of returns and volatility. The plan should be calculated using the appropriate allocation strategy. Returns should be calculated in two ways- historical and forecasted.

Taxes. Income taxes can have a huge impact on a plan. Allocation of investments into appropriate (taxable, qualified, Roth) accounts can make a real difference. Tax-efficiency throughout the plan is imperative.

Stress Testing. The calculations need to be done using a “stochastic” process such as Monte Carlo simulation rather than a linear one. A Monte Carlo simulation is a tool for estimating probability distributions of potential results by allowing for random variations over time. The world does not operate in a straight line and linear projections can be greatly upset (and therefore of little value) when outliers come into play. In addition, stress testing involves looking at the potential impact of negative factors in the future, including living longer, social security cuts, lower than expected investment returns, and/or large health care costs.

In short, the old 4% withdrawal rule is not a good way to predict whether or not you will fulfill the goals you have for you and your family. However, there is a process that can provide reasonable assurance and one you should expect from your wealth manager, like DWM, as part of their package of services for you. It can be a little complicated but should be customized for your particular situation. It will take some time and effort. It requires discipline and monitoring. However, if you value your financial future, it’s well worth the effort.

Get Real- Focus on Real Returns

signCould we be on our way to join the “Deflation Club?” Yes, our U.S. inflation rates continue to drop. It’s now 0.8% on an annual basis after the Consumer Price Index (CPI) declined 0.4% in December. CPI is at zero for last nine months.

For those of us who remember buying cars and getting home mortgages between 1979-1981 when inflation was 12-13%, it’s hard to comprehend. For the last thirty years, inflation has averaged about 3% per year and since 1970 about 4% per year. Hard to believe inflation is now at 1%. Yes, someone moved our cheese again.

And, it’s not just us. It’s all over the world. The Eurozone and Switzerland both recently slipped into deflation. The U.K. isn’t far off. Japan, which imposed a large sales tax increase in mid-2014, suddenly has the highest annual inflation rate in the developed world at 2.4%.

Market expectations of inflation over long periods have a huge impact on asset valuations in four major ways.

  • Price valuations. When inflation is high (think 1979-1981), buyers are willing to pay almost anything for an asset, since it appears the item is just going to keep getting much more expensive. In low inflation or deflationary periods, buyers wait because the price may be coming down and secondly, because their take home pay may be stagnant or non-existent.
  • Economic growth. The Fed has targeted 2% inflation as the rate at which the economy can grow at a sufficient level without overheating or going into recession. As we have discussed in detail in prior blogs, continued low inflation or deflation can cause low GDP growth or recession. Last week, the World Bank reduced its prediction for global growth in 2015 from 3.4% to 3%.
  • Riskless government debt rates. At the close of business last Friday, the 10-year U.S. Treasury note was 1.84% and 30-year 2.44%. The European 10-year government bonds are even lower- Germany at .45%, France at .63% and Switzerland at -.13% per year.
  • Consumer confidence. The huge drop in oil prices, caused primarily by plentiful supply, should be a real boon for families. Yet, the VIX, a measure of expected volatility called the “fear index” jumped on January 14th. Major changes and uncertainty make investors skittish.

Hence, unusually low market expectations of inflation have a huge impact on investment returns. To begin with, the risk/reward principal applies to most any investment. You need to be rewarded for the amount of risk you incur. Since U.S. treasuries are considered “risk-free”, other investments must provide the likelihood of a great return in order for an investor to risk their money. This “risk premium” is the return for the investment over treasuries.

Historically, since 1970, stocks have grown at the rate of almost 9% while inflation has been a little more than 4% per year. Hence, there has been a 5% real return obtained by risking money and investing in stocks. For the same time period, bonds returned about 6% per year, 2% more than inflation. This represents a 2% real return.

So, mathematically, if inflation is 2%, it is very possible that expected returns on a diversified equity portfolio over a long period of time might be 7% and returns on a diversified bond portfolio might be 4%. If inflation is 1%, the nominal returns might be 6% and 3% respectively. And, if low inflation or deflation persists, economic growth can stagnant which further impacts price valuations.

Of course, no one can guarantee future performance. Furthermore, there have been periods of time in the last 40 years when real returns of equities were far greater than 5% and periods where real returns were negative. From 1968-1982, the average annual equity nominal return was 6% while CPI was up 8% per year, resulting in a minus 2% real return. From 1982 to 2000, the equity return was an 18% nominal return annually and a 15% real return per year on average.

Our clients know that we have recently been modifying our DWM/MoneyGuidePro financial plans to reflect this current reality. Inflation is no longer 4.22% per year and expected returns of a balanced portfolio that historically were 7.5% are not likely when inflation is 1% a year. The focus needs to be on real returns. Depending on the allocation of the portfolio, a real return of 2%-5% over inflation for a diversified portfolio of equities, fixed income and alternatives may be a reasonable expectation in today’s investment environment.

So, our cheese actually moved two ways. Both inflation and nominal investment returns have declined. However, real returns should continue in similar historical patterns over time unless low inflation or deflation cause economic growth to stagnate or decline which could further reduce both the nominal and real returns.

Thomas Piketty’s “Capital in the Twenty-First Century”

piketty-capital-21st-centuryI’d sum it up this way: Interesting data, controversial conclusions. Regardless, it’s not often that a 600+ page economics book tops the NYT Best Seller list. However, Thomas Piketty has the right subject at the right time-inequality. It’s a hot and controversial topic for politicians here and abroad. Subtopics are the excesses of Wall Street, minimum wage, and redistribution of wealth.

There does seem to be a consensus that Piketty’s book does a great job tracking the history and status of inequality. His projections for the future and his proposals to remedy inequality, on the other hand, have delighted the left and infuriated the right.

A French born professor at the Paris School of Economics, Mr. Piketty, along with a few colleagues, have done a remarkable job tracking the concentration of wealth deep into the past. In the U.S. and Britain, he goes back to the early twentieth century. And, all the way back to the eighteenth century for France. He also illustrates the wealth of the idle rich of past generations using characters from Jane Austen’s “Pride and Prejudice” and Honore de Balzac “Pere Goriot.” I thoroughly enjoyed how Professor Piketty was able to blend centuries of tax records and history to produce a comprehensive record of the periods of low and high inequality.

Europe’s Belle Epoque and America’s Gilded Age are examples of high inequality. Unequal ownership of assets, not unequal pay, was the prime driver of income disparities. At that time, 20% of the national income went to the top 1%, another 30% to the next 9% and only 20% to the bottom 50%. Contrast that with the low inequality period from the start of WW I to the end of WW II when 7% of the national income went to the top 1%, 18%, to the next 9%, and 30% to the bottom 50%. Since the 1970’s, both wealth and income gaps have been rising to turn of the century levels. As a result, the top 1% again receive 20% of the U.S. income.

Piketty’s contention is that inequality is here to stay and will continue to grow. For him, it’s all about the rate of growth of capital versus the rate of economic growth. He assumes that wealth (aka capital or net assets) will generally grow at a rate of 4-5% greater than inflation. Wages, he contends, can only grow at a rate equal to inflation plus economic growth. In fact, since 1970, wages for most US workers have barely kept pace with inflation, while top earners’ pay has grown at double-digit annual rates. With economic growth falling and returns on capital expanding, the gap will widen, according to Piketty.

Frankly, no one knows what the future might bring. Professor Piketty seems to be simply extrapolating the last 30 years into the future. There is no hard and fast rule of capitalism that this will occur. And, history shows us that, over time, what goes up, generally comes down.

Then, Mr. Piketty really gets everyone’s juices flowing. He suggests that traditional remedies, such as education spending, worker protections, more progressive taxation, etc. may be helpful at the margins, but that inequality will worsen “no matter what economic policies are.” Hence, he suggests that major changes are needed. He proposes a global wealth tax on capital starting at .1% and increasing to 2% annually. In addition, he suggests a progressive income tax up to 80% on incomes above $500,000. These proposals are likely politically unachievable and are considered confiscatory by many.

Certainly, we Americans support equal opportunity. Redistribution of wealth is another matter. If Mr. Piketty’s objective was to spark conversation on a very important topic, he certainly has accomplished that.

Bond Bull Market May be Over- Time for Revised Strategies

Source: James O’Shaughnessy / WSJ
Graph Source: James O’Shaughnessy / WSJ

What were you doing in 1981? A mere twinkle in someone’s eye? Attending school? Working? Married? Elise and I were buying our fifth house and taking on a 15% mortgage. The rate seemed pretty decent to us. 20-year Treasury bonds were yielding 15%, businesses were paying 21% for a “prime” lending rate, and inflation was in double digits. Many people thought we were living in Jimmy Buffet’s “Banana Republic;” where inflation and interest rates would continue at record highs for decades to come.

This was not to be. We had reached a turning point in 1981, where apparent trends started to reverse. In fact, inflation and interest rates decreased steadily for the next thirty-one years. Inflation has averaged less than 1.5% over the last five years and 20-year Treasury bonds yields reached a low of 2.11% last year. Now, it appears that we have a new, permanent change of direction-rates are beginning to rise. The thirty year bond bull market seems to have ended.

Until this year, bonds have provided a great place for investors to put a good share of their money. Performance has been very good and the risk has been low. Total return, as Brett pointed out a few blogs ago, is equal to the yield (interest paid on the bond) plus the change in value of the investment. Because bond prices increase when interest rates decline, bond investors have been rewarded with both their interest income plus an increase in market value for last thirty years.

From 1/1/2000 to 12/31/12, 20-year treasury bonds produced a total return of 7.6% per year. The S&P 500 had a total return of 2.4% over the same period. It’s no surprise that investors fell in love with bonds, not only for the excellent return but also for the lower risk and volatility. However, the experience of the last three decades in bonds is unlikely to continue.

It’s a shame, particularly for older investors.

Here’s a simple example. Let’s say that you own a bond paying 4% interest that matures in 5 years. If the interest rates for similar bonds decline by 0.50%,then the value of your bond is reduced by roughly 2.5% (0.50% decline x 5 years to maturity). Hence, your total return that year would be 4% interest income less 2.5% of price reduction. Hence, a net total return of 1.5%.

So, why would someone even own fixed income investments? The simple answer is that they still serve an important role in your portfolio. Fixed income has traditionally provided diversification and low volatility and should continue to do so. When equities rise, bonds won’t keep pace. But, when equities decline, fixed income historically advances. In addition, fixed income provides superior capital preservation qualities over other asset classes, including equities.

We believe in long-term investing and are known for not making “knee jerk” reactions. However, when there are major investment turning points, as we are seeing now, it is time to review portfolios with new proactive strategies in mind. This may include reduction of the allocation to fixed income, modifications within the fixed income asset class, and other techniques. Our DWM clients have seen a number of rebalancings focused on these matters in the last few months.

If you want to hear more, mark your calendars. DWM’s annual client educational update this year will focus on proactive strategies in a rising Interest rate environment. Our Charleston/Mt Pleasant event will take place October 23rd in the afternoon and our Palatine event will take place the afternoon of October 30th. We do recognize that the topic may, for some, be important but unexciting. That said, we can promise all attendees some pleasantries at the receptions that will follow. Be sure to watch for more details soon.

Quantitative Easing: QE 4ever?

QE (2)We are all in the midst of one of the biggest global financial experiments ever conducted: Quantitative Easing. Since the world financial crisis in late 2008, the Fed and other central banks have employed this technique in an effort to stimulate the world economy. QE has certainly has had an impact. It has reduced home mortgage rates to all-time lows and helped push the stock markets to all-time highs. Yet, QE is not an elixir. QE can’t cure all the ills of a moribund world economy. Furthermore, QE could ultimately cause major damage to the U.S. and world economy.

Last week, a good friend and client suggested that an update on QE might be appropriate for our readers. Good idea DD; thanks for the suggestion.

Quantitative Easing is an unconventional monetary policy used by central banks to stimulate the economy when conventional monetary policy isn’t working. Historically, the Fed has principally stimulated the economy by lowering short-term (fed funds) rates and cooled down the economy by raising short-term rates. However, by late 2008, the Fed funds rate was as low as it could go-effectively at zero. The Fed needed another tool. QE, last used in the U.S. from 1932-1936, got the call.

QE has the same effect as printing money. The central bank buys treasury and agency bonds from commercial banks and other private institutions (using electronic transfers), thereby creating money and liquidity. The purchases raise bond prices and reduce their yields, thereby reducing long-term interest rates. Interest rates on 10 yr. U.S. Treasuries have fallen from roughly 3% to 2% since QE started. Lower treasury rates mean lower home mortgage rates, which has certainly helped the housing industry get back on its feet.

Many investors, uncomfortable with lower returns on fixed income, started loading up on stocks and riskier debt. Since the start of QE, there has been an 85% direct correlation between the amounts of money added to QE and the rise in the stock markets. During 1Q2013, the move to riskier assets intensified. The result -stocks hitting all-time highs. Furthermore, increasing stock values have been shown to affect both consumption and investment decisions, which helps the economy as well.

Other developed countries have also adopted QE to stimulate their economies. The UK started in 2009. The European Union started in 2011. And Japan, which used QE in 2001-2006, started a new round of QE last year. In total, about $10 trillion has been invested by central banks world-wide in QE programs.

There are two major concerns with QE. First, many believe that QE will ultimately cause inflation-perhaps hyperinflation. With the money supply expanding faster than the real economy, one would expect inflation to occur. This hasn’t happened yet. Fortunately, the U.S. dollar continues to be the world’s reserve currency. Hence, events in Cyprus and other parts of Europe cause investors to dump the euro for dollars. Certainly if China and/or Saudi Arabia would ever drop the dollar or dump U.S. Treasuries, we could certainly see a run on the dollar and perhaps hyperinflation. However, that scenario, if it does occur, is likely years or decades away.

The second concern of QE is the impact when it starts to unwind. At their FOMC meeting in March, the Fed signaled that it would keep its ultra-easy money policy for now. They will continue this at least as long as the unemployment rate is above 6 ½%. As it approaches this level, it is expected the Fed will taper off QE. However, Chairman Bernanke made it clear that the Fed would discontinue QE long before it would raise the fed-funds rate. And it promised to keep the fed-funds rate at current levels until 2015.

So, the net effect is that once there is a substantial improvement in the economy, QE will stop. This will likely result in higher interest rates and higher inflation- both of which could slow economic growth. As a result, some are calling for the Fed to start unwinding QE now. With the unrest in Europe and around the world currently, perhaps the impact of unwinding of QE now would be less damaging to the U.S. economy than it will be in the future.

Rest assured, DWM is following QE very carefully. This experiment has already had a huge impact on the U.S. and world economy and undoubtedly will for years to come.