Next week will mark the 121st month of the current bull market- the longest business cycle since records began in 1854. Based on history, a recession should be starting soon. Bond rates now form an “inverse yield curve” with shorter term rates above longer term, which typically signals a downturn. Business confidence is down. However, 224,000 American jobs were created in June and equities continue to soar, rising 16-20% year to date. Is it time to party or not?

The business cycle appears to be lengthening. The current expansion, coming after the worst financial crisis since the Great Depression, has been unusually long and sluggish. Average GDP growth has been 2.3% per year, as compared to the 3.6% annual growth in the past three expansions. The workforce is aging. Big firms invest less. Productivity has slipped. And, Northwestern Economics Professor Robert Gordon continues to assert that American’s developments in information and communication technology just don’t measure up to past achievements including electricity, chemicals and pharmaceuticals, and the internal combustion engine.

However, the changing economy may now be less volatile for a number of reasons. 1/3 of American’s 20th century recessions were caused by industrial declines or oil-price plunges. Today, manufacturing is only 11% of GDP and its output requires 25% less energy than in 1999. Services are now 70% of our GDP. Furthermore, the value of the housing market is now 143% of GDP, as compared to a peak of 188%. Banks have lots of capital.

Finally, inflation has been very low, averaging 1.6% in the U.S. (and 1.1% in the euro zone) per year during the current expansion. In earlier business cycles, the economy would surge ahead, the jobs market would overheat, causing inflation to rise and leading the Federal Reserve to put on the brakes by raising interest rates. Today, it’s different. Even though the unemployment rate is at a 50 year low of 3.7%, wage growth is only 3%. As the Economist pointed out last week in “Riding High,” American workers have less bargaining power in the globalized economy and are getting a smaller percentage of company profits, keeping inflation down. The Fed recently announced that it is less concerned about rising prices and more concerned about growth slowing and, therefore, will lower interest rates at its meeting next week.

Changes in the economy to slower growth, more reliance on services and lower inflation all contribute to longer business cycles. Yet, the changing economy, particularly globalization and technology, has also produced new risks.

Manufacturing that was formerly done in the U.S. is now outsourced to global producers. These chains can be severely disrupted by a trade war. This could produce a major shock- imagine if Apple was cut-off from its suppliers in China. Also, take a look at the impact that the prolonged grounding of Boeing’s 737 MAX is having on the U.S. economy. It’s hurting suppliers, airlines, and tens of thousands of workers, while $30 billion of the MAX sit grounded. Global supply chains are extremely interconnected these days.

IT is significantly linked as well. Many businesses outsource their IT services via cloud-computing to a few giants, including Alphabet (GOOGL).  85% of Alphabet’s $100 billion annual sales comes from advertising, which in the past has been closely correlated to the business cycle. GOOGL invested $45 billion last year, 5 times more than Ford. In fact, the S&P 500 companies invested $318 billion last year, of which $220 billion was spent by ten tech companies. The big IT companies are now facing regulatory issues worldwide. What would be the worldwide impact if GOOGL, Facebook or others get their “wings” clipped?

Also, finance issues could disrupt the expansion. Although housing and banks are in decent shape, private debts remain high by historical standards, at 250% of GDP, or $50 trillion. And, if the prime lending rate continues to decline, banks’ profits and balance sheets will likely weaken.

Lastly, politics is a big risk. There are the threats of trade wars with China and physical war with Iran. The big tax cut that pushed markets up in 2017 could now produce lower year over year earnings for companies. On Monday, July 22nd, Congressional leaders and White House negotiators reached a deal to increase federal spending and raise the government’s borrowing limit. This would raise spending by $320 billion, at a time when the annual deficit is already nearing $1 trillion, despite the continuing expansion.

Conclusion: Changes in the economy have produced reasons why business cycles are longer, yet more sluggish. Those changes have also added new risks for a continuing expansion and bull market. No one can predict the future. Focus on what you can control: Make sure your risk level is appropriate for your risk profile. Make sure your portfolio is prepared for the next downturn. And, yes, stay invested.

Ask DWM: What is an Inverted Yield Curve and What Does it Mean to Me?



Great question. Historically, an “inverted yield curve” has been a signal that recession was on the way. As with so many things these days, though, the old “rule of thumb” may not apply. Here’s why:

yield curve is a graph showing interest rates paid by bonds. The chart is set up with the horizontal axis representing the borrowing period (or “time”) and the vertical axis representing the payments (or “yield”).   We all would typically expect that loans over a longer period time would have a higher interest. That’s “normal.”  For example, if a 30 year mortgage rate is 4%, a 15 year mortgage rate might be at 3.25%.   A one year Certificate of Deposit might earn 1% or less and a 5 year C.D. might be 2%. The situation is referred to as a “normal” or “positive” yield curve in that interest rates are higher as the borrowing period gets longer and the curve slopes upward, see below:



However, rates don’t always work that way. At the end of last week, the three-month Treasury bills’ yield 2.46% was higher than the yield (2.44%) for 10-year treasuries. This situation technically produced an inverted yield curve, since a shorter period had a higher rate. This also happened three months ago. Historically, “curve inversions” have tended to precede major economic slowdowns by about a year.



Inverted yield curves are unusual because they indicate lenders (or investors) are willing to earn less interest on longer loans. This is most likely to happen when the economy is perceived to be slowing down and faces a meaningful risk of recession. Historically, curve inversions have occurred about a year before the each of past seven recessions in the last five decades, though a recession doesn’t necessarily occur every time we see a yield curve inversion.

The U.S. economy has slowed already from the average growth rate of 2018; mainly as a result of the 35-day government shutdown and reaction to the Federal Reserve’s (“Fed”) reports of slower growth and a moratorium on interest rate hikes. Some economists feel the economy may slow even more due to the tax-cut stimulus being only a one year spike, headwinds from trade tensions with China, political uncertainties and global polarization and fragmentation.

However, other factors point to strong economic growth. We do have a solid labor market which drives consumption. Average monthly job creation is well above what might have been expected this late in the business cycle. Further, more workers have been attracted back into the labor force and wage growth has been 3%; a rate in excess of inflation. Business investment should rise and government spending is higher.

In short, an inverted yield curve is not a perfect predictor of recessions. A different portion of the yield curve inverted three months ago in December and the markets in early 2019 have rebounded sharply as fears subsided. Also, many economists believe the drop in 10-year Treasury yields is due to non-U.S. economic headwinds, like Brexit as well as the unwinding of the Fed’s balance sheet after Quantitative Easing. They believe it’s not because of serious weakening of U.S. economic fundamentals.

The current inverted yield curve may or may not be the bellwether of a coming recession. These days, there is not a simple cause and effect relationship between an inverted yield curve and recession. More likely will be the resolution or non-resolution of uncertainties such as Brexit, trade tensions, political matters and global peace. Stay tuned and stay invested for the long-term.

The Mighty Dollar

With tax cuts and tax returns on everyone’s minds, we think it is a good time to look closely at our favorite currency!  We might call it “dough”, “bread” or “cheddar”, we have “bean”-counters to keep track of it and we use simple, gastronomic valuations, like the Big Mac Index, to compare it to its peers.  Thinking about the US dollar and its’ value might just make you hungry!   The dollars’ worth is determined by the foreign exchange market, but investors and economists alike are always looking for ways to value the currencies and look for explanations or even monetary conspiracies, to explain currency fluctuations.

In 1986, The Economist came out with the Big Mac Index as a simple way to discuss exchange rates and purchasing-power parity (PPP), which compares the amount of currency needed to buy the same item in different countries, in this case a Big Mac. The Wall Street Journal came up with their own modernized version of this same idea with their Latte Index, which compares the price of a Starbucks tall latte in cities around the world.  For example, in New York City, the WSJ reporter could buy a tall latte at Starbucks for $3.45.  Other WSJ reporters would need to spend $5.76 in Zurich, $4.22 in Shanghai, $3.40 in Berlin (almost the same as the U.S.), $2.84 in London and $1.53 in Cairo.  These simple comparisons of the price of a good that is available in many countries can be an indicator of whether foreign currencies are over-valued or under-valued relative to the US dollar.

There are some criticisms of these simple tools.  Costs of these products can depend on local wages or rents, which are generally more expensive in richer countries and can add to the cost of the product.  The price for a Starbucks Latte can even fluctuate amongst American cities or specific locations, like airports, which may have higher rents.  And adjusting these indices for GDP will change the data and perhaps improve their accuracy.  Some also have pointed to the ingredients in these particular items as causing value differences.  McDonald’s, for example, must use strictly British beef in the U.K.  Starbucks can be a little more consistent, as coffee beans are not generally grown in most of the countries they operate in, so the imported price is pretty standard.


What these indices don’t tell us about the currency market is why fluctuations occur.  For example, why has the U.S. dollar hit a recent three-year low?  According to an article in yesterday’s WSJ, one simple explanation for a weakened dollar is that “the economies in the rest of the world are finally growing again, so their currencies are strengthening. The U.S. economy isn’t improving as fast—because it was stronger to start with—so the dollar’s falling.”  The Chinese yuan has gained 3.8% so far in January after gaining 6.7% in 2017, which has the officials at the People’s Bank of China concerned about their exports.  President Trump and the U.S. have been critical of any Chinese central bank policies that would devalue the Chinese currency and cheapen goods coming into the U.S.  This trade friction complicates China’s management of their currency, particularly as they attempt to make the yuan a more market-driven currency.

Adding to the currency gap with China and the drop in US currency values overall were comments made last week by the U.S. Treasury Secretary signaling Administration support for a weaker U.S. dollar as being “good for trade.”   Such overt comments are traditionally avoided by the Treasury Department, but may spotlight the Administration goals to reduce the trade deficit and allow currencies to float freely.  President Trump reiterated his stance on trade imbalances in his State of the Union address, pledging to “fix bad trade deals” and that he expects trade deals to be “fair” and “reciprocal”.  Another factor that may weaken the dollar is the belief that 2018 will bring a tightening of monetary policy by the international banks.  Some banks, like the Bank of Canada and Bank of England, have already raised rates.

A weaker dollar makes U.S. goods cheaper to foreign markets, but there is a risk of undermining confidence in an array of U.S. assets, like the U.S. Treasury market.  As the WSJ article explained, as the new tax law expands the federal budget deficit, the government will look to sell the debt to foreign investors.  Those investors may demand higher rates to compensate for the risks of a weaker currency and those costs could fall onto the U.S. taxpayers.

So, we should think about our American dollar today and perhaps look at our paychecks or tax returns to see what has changed.  At DWM, we are always careful to think about each and every one of your dollars – the ones you invest, the ones you save, the ones you spend and the ones you pay in tax.  Using the simple Big Mac or Starbucks Latte indices might help us remember all the factors that go into the value of a dollar around the world.  For me, I certainly prefer to imagine buying a tall latte in Zurich over a Big Mac!



Ready for a quick quiz?


Two-thirds of the world can’t pass this financial literacy test.  Can you?  You don’t need a calculator, just 3-5 minutes of time.


Risk Diversification: Suppose you have some money to invest.  Is it safer to put your money into one business, piece of real estate or investment or to put your money into multiple businesses or investments?

a)One business, piece of real estate or investment

b)Multiple businesses, pieces of real estate or investments


Inflation:  Suppose over the next 10 years, the cost of things you buy including housing, food, taxes and health care and all others double.  If your income also doubles, will you be able to buy less than you can buy today, the same as you can buy today, or more than you can buy today?


b)The same


Mathematics: Suppose you need to borrow $100 for one year.  Which is the lower amount to pay back: $105 or $100 plus 3% interest?


b)$100 plus 3% interest

Compound Interest:  Suppose you put money into a bank and the bank agreed to pay 3% interest per year to your account.  Will the bank add more money to your account in the second year than the first year, or will it add the same amount of money for both years?

a)The same


Compound Interest II:  Now suppose you have $100 to invest in a (very aggressive) bank who will pay you 5% interest per year.  How much money will you have in your account in 5 years if you do not remove any of the principal or earned interest from the account?

a)Exactly $125

b)More than $125

c)Less than $125


Pretty simple, right.  The answer is b for all.  We’re sure our regular DWM blog readers got them all right.

Across the world, however, the 150,000 people who took the test didn’t do so well.  Two-thirds of them answered at least 2 of the 5 questions incorrectly.  The survey pointed out some key findings.  Norway has the greatest share of financially literate people worldwide.  Canada, the UK, the Netherlands and Germany also finished in the top 10. The U.S. didn’t.

downloadIn the Emerging Market countries, like China, India, Brazil and Russia, the young people, ages 15 to 35 were the most financially literate.  Apparently the kids in Shanghai “knocked the cover off the ball” (just like George Springer of the Astros).

So, what’s the takeaway? Financial literacy for Americans could use improvement.  In addition, as we pointed out in our blog two weeks ago highlighting Nobel Prize winner Richard Thaler, people, even if they are financially literate, can make systematically irrational decisions.  This means you may need a financial coach and advocate.  That’s what we are for our DWM clients.  Whether it’s professional investment management, financial decisions and planning, income tax planning, insurance and estate planning matters, we provide our financial literacy, rational analysis and proactive solutions and suggestions.  It’s our expertise and our passion.  At DWM, this is how we hit home runs!

Big Macs and Donald Trump

Big Macs are becoming a real bargain everywhere in the world… except for the United States. This is because most emerging market currencies have taken a big hit since the election of Donald Trump, whereas, the dollar is as strong as it has been in almost 20 years. Not only has Trump raised expectations of an increased strength of the dollar, but many foreign countries have had problems of their own as well, leaving emerging markets lagging behind.  The Turkish Lira, for example, is one of the worst performing currencies so far this year due to terrorist bombings, economic slowdowns, and a central bank reluctant to raise interest rates to defend the currency (The Economist, Big Mac Index of Global Currencies). Emerging market struggles paired with a surging US dollar has led the Lira to be undervalued by 45.7% according to the Big Max Index.

You may be asking yourself “what on Earth is the ‘Big Mac Index?’” At least that’s what I asked myself the first time I heard it. You may be surprised to hear the Big Mac index is exactly what it sounds like: the cost comparison of a McDonalds Big Mac burger from one country to another. It is a fun, educational, and interesting way to learn how the world is valuing cost of goods on a country by country basis. The Big Mac index is built on the idea of purchase-power parity, meaning in the long run currencies will converge and rates should move towards equalization of an identical basket of goods & services.

In the United States a Big Mac costs $5.06 versus 10.75 Lira, or $2.75, in Turkey. The Mexican peso is even more undervalued at 55.9% versus the US dollar, meaning, a Big Mac only costs $2.23 in Mexico as of January 15th, 2017. The Big Mac index allows us to take complicated subjects, such as international commerce, and make it relatable and understandable.

One drawback of the Big Mac index is it does not take account of labor costs. Of course, a Big Mac will cost less in a country like Mexico because workers earn lower wages than workers in the US. So, in a slightly more sophisticated version of the Big Mac index, labor is included. This typically devalues the US Dollar (USD) compared to other countries around the world because our income is higher. For example, in the traditional Big Mac index, the Chinese yuan is 44% undervalued to the greenback, but after labor adjustments, it is only 7% undervalued. When this adjustment of labor cost is made, it makes it nearly impossible for the USD to trade at a premium against the Euro. This is because Europeans have a higher cost of living and lower incomes than Americans (The Economist, Big Mac Index of Global Currencies). Typically, the Euro trades around a 25% premium against the USD according to the Big Mac index. However, since the election of Donald Trump, even with the labor cost adjustment, the Big Mac index currently finds the Euro UNDERVALUED to the dollar. The US dollar is so strong, it is currently trading at a 14 year high in trade-weighted terms.

 A strong dollar may sound great, but it has many disadvantages. In the United States specifically, a strengthening USD can lead to a widening trade deficit with decreased exports and increased imports. This has a negative result on domestic businesses that operate in foreign countries as well as anyone servicing debts tied to the US dollar. President Trump has publically stated he feels international commerce is rigged against the United States. Whether he is right or wrong, as the trade deficit grows, so does the likelihood of him imposing tariffs on imports from China and Mexico in hopes of bringing balance to trade. If we put a tax on imports, it will lead to something called “protectionism,” or the practice of shielding the United States’ domestic industries from foreign competition. Some feel this is a strong policy because it will keep businesses in the United States and, according to Trump, will prevent us from being taken advantage of. However, it is fairly accepted in macroeconomics that protectionism is a poor/outdated policy because corporate globalization has led to international supply networks that promote convergence and integration throughout the world. Simply put, the countries that are the best at developing goods, develop them, and other countries benefit from the best products at the lowest prices. When something like protectionism takes place, it disintegrates these networks and adversely affects trade-dependent states and the domestic country itself (in this case the United States). The import tax will ultimately drive up prices for domestic consumers who would otherwise benefit from world prices that are significantly lower. This will lead to an increase in trade of intermediate goods and inward investing into value chain niches.

The reason the Big Mac index is so interesting is because it can explain a complex subject like macroeconomics with something as simple as the cost of a hamburger. By knowing the price of a Big Mac on a country by country basis, we are able to understand a significant amount about the world economy and the repercussions the US will face based on the actions we take moving forward.

The Big Mac index is telling us one thing for certain: the US dollar is abnormally strong, which makes the near future uncertain. It is important to have a well-diversified portfolio with an appropriate asset allocation and a competent, experienced fiduciary like DWM to help guide you through times like this. 

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.


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.