Happy New Year! This year’s Collegiate Football National Championship on January 9th featured two of the best teams in the nation, the University of Alabama Crimson Tide and the Clemson University Tigers, matched up to decide which school could claim the coveted title. After a hard-fought battle, we now know it was a great match-up, thrilling to the end. What made it a good, competitive football game was the skill possessed by both teams to play a robust balanced offense. What was also important was the ability to play solid defense against both the run and pass - efficiently, effectively, and consistently. I use this analogy because it is my belief that a good football team resembles prudent portfolio management - the ability to play a balanced offense with diversification, with the objective to move the portfolio forward, and just as important, the proficiency to play solid defense during the inevitable market downward cycles, both with an investment methodology that is consistent, effective and efficient.
In this Kickoff Newsletter we will discuss the state of our global markets as we enter 2017, as well as, the perceived opportunities and potential areas of concern to investors. We inaugurate our new President-Elect, Donald J. Trump, on January 2oth, and we will explore in some detail what this new administration might mean for investors.
As we enter 2017, consumer confidence has hit a 15 year high[i]. We have witnessed higher equity prices, commodity prices moving higher[ii], rising interest rates and a stronger U.S. dollar. Investors are cautiously optimistic for modest U.S. and international growth presumably based on a Republican Presidential Administration, coupled with a majority Republican House and Senate that may mean a roll back of regulation and fiscal expansion through spending and tax cuts[iii]. Prior to the election, U.S. growth was warming and showed improvement from the first part of 2016 as estimates for future growth had increased. Since the election, equities have moved forward and yields have increased likely due to the pro-growth inflationary Trump policies that are being proposed[iv]. Apparently, instead of reacting slowly to the anticipated changes in fiscal policy that are expected by the new administration, U.S. equities have reacted as if the changes have already taken place, even though they face tough debate in Congress before they’ll be enacted[v]. The Federal Reserve has begun to raise rates and is expected to increase bond yields only gradually, while other major central banks around the world are continuing to ease rates in a pro-growth posture[vi]. The contrarian would point out that the political uncertainties surrounding a Trump Administration, as well as around the world, and the potential for increased inflation could cause volatility to spike[vii].
Most investors have heard that when bond yields rise, prices decline, and conversely, when bond yields decline, prices increase. We have certainly witnessed bond yields increase a bit since election day as evidenced by the rise in 30 year mortgages and the 10-year Treasury bond[viii]. In the past three decades, interest rates have declined due to many factors affecting inflationary pressures: aging demographics, global growth, technology, central bank policies promoting low rates, and the globalization of trade, labor and supply chains. Now we see a reversal, or possibly a pause, of some of these factors that are forcing bond yields higher such as tighter labor markets, wage growth, higher commodity and oil prices, and the new administration’s proposed policies that may increase inflationary pressures[ix]. Keep in mind we have been in a period of low interest rates and below average inflation for many years due to the policy of our Federal Reserve to keep our economy moving. This monetary intervention, which purported to keep us out of recession following the financial crisis of 2008, may also have contributed to falling commodity prices, low wage inflation and the slow economic growth, so some normalization and increase in inflation and interest rates may actually be healthy for our economy[x].
The bond market may be pricing in a change in fiscal policy due to the anticipated increase in infrastructure spending and lower taxes that are supported by the incoming president-elect, which may increase the U.S. budget deficit in the short-term while attempting to boost U.S. gross domestic product. Higher output and larger budget deficits are factors that could be a recipe for inflation to rise[xi]. Additionally, the bond market may be leery of protectionist policies that may arise from renegotiating the North American Free Trade Agreement or implementing tariffs, as these may move prices higher, and thus bond yields higher. Trade deals traditionally take time and may not have an immediate impact on growth, but protectionist tariffs will impact prices on imported goods, which would have a negative impact on growth initially[xii]. On the monetary side, Janet Yellen’s term at the Federal Reserve, which has been characterized as a dovish policy stance, is set to expire in February 2018. The bond market’s uncertainty with who the new President-Elect might choose to lead the Fed is an unknown at this point so the bond market may be pricing in a more hawkish Fed Chief with designs on raising interest rates[xiii]. However, fiscal expansion over time may replace monetary stimulus, as it is perceived now, as the primary driver of economic growth[xiv].
Although the new administration’s proposed policies of deregulation, lower corporate and individual taxes, and infraructure stimulus spending may be perceived as a positive boost for riskier assets like equities, bonds could continue to be vital for portfolios for a number of reasons that may not be fully priced-in at present[xv]. Possible risks to economic growth that could hurt equities and drive more money into bonds include the uncertainty that the new administration’s fiscal and monetary policy will not work as intended, or as quickly as expected. Additionally, there is risk that a trade war may be triggered and thus could harm growth, or that the new administration’s immigration policy may be too restrictive and thus stimies growth. Pension funds, endowments and insurance companies in the U.S. and throughout the world buy U.S. denominated bonds to fullfil their asset allocation and to support funding future obligations and this is likely to continue as in the past thus driving demand for bonds[xvi]. Geopolitical potential economic concerns, such as low or negative interest rates in Japan and the Europe or growing global debt levels, may cause increased demand for U.S. bonds[xvii], as could potential unforeseen events, such as acts of terriorism, natural disasters and major market declines, all which would more than likely serve to boost bond buying[xviii].
Politically & Economically
Donald J. Trump will become the 45th President of the United States with a Republican administration that will initially have majorities in both the House and Senate that may aid in enacting his economic agenda. He could enact his economic agenda through the budget reconciliation process, which requires only a majority approval in the Senate for tax and spending changes, not a 60 vote filibuster proof majority[xix]. Presidential inaugural years have historically had the highest frequency of negative returns in the stock market of presidents’ four-year terms since 1948; however, these returns are still positive more often than negative[xx]. We explored some of the potential areas of concern in the global markets section of this letter while discussing the economy and markets, so we will concentrate in this section on the potential positive aspects of the President-Elect’s proposed agenda.
An estimated $500 billion to $1 trillion in infrastructure spending has been proposed on roads, bridges, airports, tunnels, seaports, water treatment, sewer systems, electric grids and the “Wall,” which could provide stimulus and jobs for the economy[xxi]. The Trump Administration plans to triple Immigration and Customs Enforcement (ICE) agents, reform and enforce immigration laws, and end catch-and-release and funding for sanctuary cities in an effort to thwart illegal immigration and restore legal immigration as the main route to entry and participation into the United States. Legal immigration is vital to our growing economy; in fact, the U.S. Census Bureau estimates that 65% of our population growth in future decades is projected to come from immigration. Without immigration, the U.S. could experience population stagnation or decline as currently experienced in Japan and Europe[xxii]. Conceding the fact that illegal immigrants can increase economic growth by spending and producing as workers, illegal immigration can also be harmful to a society by increasing competition for low-skilled jobs and thus decreasing overall wages, as well as, adding to state and federal expenditures extended for social services, education, incarceration and health care by non-citizens/non-documented workers who often do not pay all the required taxes that citizens are required to pay[xxiii].
Proposed increases in defense spending by the new administration may be expected to aid manufacturing and technology companies in the defense and aerospace industry as the military re-tools its air, land and sea capabilities and readiness. Excessive “red tape”, as identified by the new Trump administration, in the areas of energy, environment and financial regulations, may be removed from many industries with the expectation of reducing costs, boosting productivity and creating jobs. Specifically, mentioned by Trump thus far has been a pull out of the Paris climate deal, reversing regulations that hurt fracking and coal mining, an overhaul of the Dodd-Frank financial regulations enacted in 2010[xxiv], and all illegal and overreaching executive orders[xxv]. Obviously, there will be pushback on many of these items, but the financial and energy sectors of our economy are expected to benefit[xxvi].
Lower tax rates for corporations of 15% could replace the 35% highest marginal rate currently levied on corporations. The new proposed tax rates on businesses could extend to sole propriatorships, S-corporations, LLCs, and partnerships. The incoming administration expects corporate tax cuts to be stimulative by allowing companies to hire more employees, expand operations, upgrade equiptment, increase research and development, and raise wages[xxvii]. Additionally, the proposed one-time tax of 10% for corporations to repatriate the estimated $2 plus trillion of U.S. corporate earnings trapped overseas is expected to seduce companies to bring cash back to the U.S.[xxviii]. Individual tax cuts would serve to put more money in consumers’ pockets, including the proposal to make child care expenses fully deductible, and is expected to strengthen economic growth[xxix]. The area of corporate and individual tax reform appears to be a bi-partisan issue - U.S. corporate tax rates are among the highest in the world and corporate and individual tax cuts are expected by many to be stimulative to the economy over the long-term.
Trade is an area that Donald Trump campaigned on vigorously during the campaign, and a president has considerable power to renegotiate current trade deals, so we expect changes are forthcoming. Specifically, the new administration has mentioned renegotiating NAFTA, nixing the Trans-Pacific Partnership (TPP), and negotiating fairer U.S. trade deals with Mexico and China in an effort to put American interests first, including jobs[xxx].
Lastly, but maybe the most important of all Trump campaign promises, is the pledge to repeal and replace the Affordable Care Act (ACA or ObamaCare). Healthcare comprises 1/6 of the U.S. economy, so getting this reform right could be highly stimulative and beneficial for our country. Since 20 plus million Americans have health care under the ACA, it is unlikely that these recipients will simply be cancelled. More likely, new reforms will scale back regulation and reduce subsidies to insurance companies going forward while grandfathering current ACA beneficiairies with coverage[xxxi]. We may also see the private heath insurance market expand across state lines, as consumers demand more insurance company choices, affordable coverage, and an expanded network of providers.
Timeless Investment Principles
Market declines are inevitable and do not last forever. We expect higher long-term returns on stocks than we do from cash and bonds, and for that, we also expect greater volatility based on historical data. Over the past 115 years, market declines of 10% occur about once every 115 days[xxxii]. The last time we experienced a pullback in the U.S. stock market of this magnitude (10% or greater) was in January 2016[xxxiii]. The average length of a 10% correction is about four months[xxxiv] before prices begin to return to previous levels. Market declines of 15-20% occur on average every 2-4 years[xxxv] during the prior 115 years. Declines can sometimes cause imprudent behavior by filling and consuming investors with dread and panic. History has shown that stock market declines are a normal part of the investment cycle. Market declines have varied in intensity and frequency, but the market has always recovered from declines. Although past results don’t guarantee future results, remembering that downturns have been temporary in the past may help quell your fears[xxxvi].
Short-term market timing does not work. Short term market timing is the elusive “holy grail” or “fountain of youth” of investing—something you want very much, but that is very hard or impossible to get or achieve. If anyone could do it consistently—sell right before something goes down, and buy right back before it goes back up—the rewards would be great, but typically investors end up with sub-par performance due to the extreme difficulty with getting the short term timing (day trading) wrong[xxxvii]. Although the Holy Grail/Fountain of Youth most likely does not exist, the benefits of a long-term disciplined investment plan are compelling, but the generally higher returns associated with investing in stocks over the long-term is dependent on sticking with your investment plan through both good and bad times in the markets.
The importance of diversification. After studying the most brilliant and successful minds in the investment field over the past 28 years—both past and present—the one vital and common lesson learned is that diversification through asset allocation works to mitigate volatility over the long-term by diversifying into separate asset classes with varying correlation to one another. We were taught as youngsters by our parents and grandparents “don’t put all your eggs in one basket” which is a straight forward translation to allocate your investment funds into different asset classes within your portfolio. The idea is that they all don’t go up or down at the same time. While this may not be the case on a day-to-day basis, a mix of different types of assets provides a smoother and more stable ride for your portfolio over the long-term[xxxviii]. Broad diversification requires patience based on three key attributes; a diversified portfolio won’t beat the large-cap equity market every year, it will contain investments that each perform differently each year and you cannot bail out of the positions that are temporarily down, and lastly, the value of a broad diversification is manifested over time frames of 15 to 20 years[xxxix]. Investment disciplines do not work all the time in every economic environment. In fact, in a recent Bloomberg News article, it was argued that asset allocation in 2015 had one of the worst results in nearly 80 years with most major asset classes finishing the year with tepid results, with no asset class offering superior relative returns to lift the overall diversified asset allocation portfolio return[xl].
The key to a sustainable and inflation adjusted retirement income stream is managing the risk of outliving your assets (longevity risk) alongside of managing volatility (market risk). Equities have greater long-term total return than bonds but with greater volatility[xli]. An increase in the amount of equities within a portfolio can potentially decrease longevity risk, but at the same time increase volatility risk. Volatility risk may also adversely affect the longevity of a portfolio during the distribution phase depending on the sequence of market returns and the percentage withdrawn each year[xlii]. Conversely, when we reduce volatility risk by reducing equity exposure, we are prone to increase the longevity risk of the portfolio, thereby increasing the likelihood of running out of money. The balancing act between these two risks have been even tougher with the lower bond yields we have experienced for several years. At Leshnak Wealth, we believe the selection of investment equity positions within a portfolio that may best mitigate volatility while potentially alleviating the longevity risk over the long-term can be characterized by the following five historical traits when comparing to peer investment alternatives[xliii]:
· Lower expense ratio.
· Lower downside capture of negative market moves.
· Payment of consistent increasing dividends.
· Higher risk-adjusted return.
· Lower volatility as measured by standard deviation.
Our LW Gameplan
Our LW Portfolio Models are not immune to declines in global markets as we experienced recently on Brexit Friday in June 2016 or in the oil price drop scare of January 2016; or from the larger market declines we experienced after the 2008 sub-prime mortgage crisis or after the terrorist attacks of 9/11. We do not have a crystal ball nor do any of the market analysts and forecasters. Our belief is that our LW Portfolio Model construction has positioned us for potential resilience in any environment and has also positioned us to possibly take advantage of market mispricing. Although we constantly monitor our investment methodology we rarely see a need to change course after or during market declines. However, we are constantly reviewing our individual investment positions, and asset allocation decisions for potential enhancement.
“If we are facing in the right direction, all we have to do is keep on walking”.
–Ancient Buddish Proverb
Our Leshnak Wealth Portfolio Models are globally diversified and strategically constructed, with a tactical component. We have a bias toward value which prescribes a requirement for dividend yield from our investment positions. In simple terms, we have investment positions in eight asset classes: domestic equities, foreign developed stocks, foreign emerging market equities, domestic bonds, foreign bonds, cash equivalents, alternatives (commodities, infrastructure & natural resources) and real estate.
How much of each asset class (if any) we hold in the aforementioned asset classes is based on your unique risk tolerance, financial resources and personal goals and objectives. Moreover, we have a portion of each portfolio that is tactical and flexible. This allows the manager to move assets into the sector(s) that best fit current market conditions based on their methodology. Our portfolio construction has two other vital components—we want dividends from each position so no matter what the market is doing day to day, we still have a dividend coming into the portfolio for income or to reinvest. Lastly, we overweight value versus growth in our allocation models which we believe puts us in the position of the “turtle”, in the proverbial tortoise verses the hare scenario, over the long-term with equities.
As your financial fiduciary, the Leshnak Wealth Team cares deeply about your financial well-being, and will monitor for rebalancing opportunities that may add value to your portfolio, or to be defensive as conditions might warrant. As always, please call with questions or if you wish to discuss your specific portfolio in greater detail.
–Bob Leshnak, January 10, 2017
[i] “Key Points”; Blackrock Investment Institute Weekly Commentary, January 3, 2017.
[ii] “Key Points”; Blackrock Investment Institute Weekly Commentary, January 3, 2017.
[iii] Davidson, Kate. “Fed Minutes to Offer Insight on Central Bankers’ Outlook for 2017”; The Wall Street Journal, 1/6/2017.
[iv] “Making American Reflate Again”; PIMCO Global Update, December 2016.
[v] “What Could Go Right in 2017”; Legg Mason Annual Outlook, December 2016.
[vi] Maxey, Daisy. “The Outlook for the Markets and Economy in 2017”; The Wall Street Journal, 12/11/2016.
[vii] Maxey, Daisy. “The Outlook for the Markets and Economy in 2017”; The Wall Street Journal, 12/11/2016.
[viii] Federal Reserve, Thomson Reuters Datastream Dec 2016.
[ix] “Fidelity’s Persective on Rising Interest Rates”; Fidelity Leadership Series, December 2016.
[x] Kelly, David Dr. “The Investment Outlook for 2017 – Economic Warning and Political Warmings”; J.P. Morgan Market Insights, December 2016.
[xi] Spence, Darrell. “Trump’s Presidential Win May Not Be Bad for the Economy”; American Funds Investment Insights, November 2016.
[xii] Spence, Darrell. “Trump’s Presidential Win May Not Be Bad for the Economy”; American Funds Investment Insights, November 2016.
[xiii] “Reports of the Bond Market’s Death Have Been Greatly Exaggerated: Post-Post-Crisis Era to Continue”; American Funds Investment Insights, November 2016.
[xiv] “Global Investment Outlook 2017”; Blackrock Investment Institute, December 2016.
[xv] “Reports of the Bond Market’s Death Have Been Greatly Exaggerated: Post-Post-Crisis Era to Continue”; American Funds Investment Insights, November 2016.
[xvi] “Reports of the Bond Market’s Death Have Been Greatly Exaggerated: Post-Post-Crisis Era to Continue”; American Funds Investment Insights, November 2016.
[xvii] “2017: How Poilcy and Politics Shape the Global Outlook”; Lord Abbett Economic Insights, November 14, 2016.
[xviii] “Reports of the Bond Market’s Death Have Been Greatly Exaggerated: Post-Post-Crisis Era to Continue”; American Funds Investment Insights, November 2016.
[xix] Miller, Matt. “Five Ways President-Elect Trump Could Move Markets”; American Funds Capital Ideas, 11/9/2016.
[xx] “The Unabridged History of Postwar Elections and Stocks”; Fisher Investments Market Minder, 10/12/2016.
[xxi] Miller, Matt. “Five Ways President-Elect Trump Could Move Markets”; American Funds Capital Ideas, 11/9/2016.
[xxii] “Reports of the Bond Market’s Death Have Been Greatly Exaggerated: Post-Post-Crisis Era to Continue”; American Funds Investment Insights, November 2016.
[xxiii] Davis, Bob. “The Thorny Economics of Illegal Immigration”; Wall Street Journal, 2/9/2016.
[xxiv] Miller, Matt. “Five Ways President-Elect Trump Could Move Markets”; American Funds Capital Ideas, 11/9/2016.
[xxv] Green, Bryon. “Trump’s Campaign Promises: What are the Investment Implications?”; Green Investment Management Market Update, 12/14/2016.
[xxvi] [xxvi] Kelly, David Dr. “The Investment Outlook for 2017 – Economic Warning and Political Warmings”; J.P. Morgan Market Insights, December 2016.
[xxvii] Green, Bryon. “Trump’s Campaign Promises: What are the Investment Implications?”; Green Investment Management Market Update, 12/14/2016.
[xxviii] Miller, Matt. “Five Ways President-Elect Trump Could Move Markets”; American Funds Capital Ideas, 11/9/2016.
[xxix] Green, Bryon. “Trump’s Campaign Promises: What are the Investment Implications?”; Green Investment Management Market Update, 12/14/2016.
[xxx] Miller, Matt. “Five Ways President-Elect Trump Could Move Markets”; American Funds Capital Ideas, 11/9/2016.
[xxxi] Miller, Matt. “Five Ways President-Elect Trump Could Move Markets”; American Funds Capital Ideas, 11/9/2016.
[xxxii] “Keys to Prevailing Through Stock Market Declines”; American Funds Investor Resource: A Guide to Market Fluctuations; Aug. 2015; americanfunds.com
[xxxiii] “Keys to Prevailing Through Stock Market Declines”; American Funds Investor Resource: A Guide to Market Fluctuations; Aug. 2015; americanfunds.com
[xxxiv] “Keys to Prevailing Through Stock Market Declines”; American Funds Investor Resource: A Guide to Market Fluctuations; Aug. 2015; americanfunds.com
[xxxv] “Declines Have Become Common and Temporary Occurrences”; American Funds Client Conversations; Jan. 2016
[xxxvi] “Keys to Prevailing Through Stock Market Declines”; American Funds Investor Resource: A Guide to Market Fluctuations; Aug. 2015; americanfunds.com
[xxxvii] Vanguard Principles for Investing Success; 2014, pages 29-32; vanguard.com
[xxxviii] Vanguard Principles for Investing Success; 2014, pages 8-16; vanguard.com
[xxxix] Israel, Craig L. “The Secret to Portfolio Performance Consistency”; Financial Planning, 7/12/2016.
[xl] “The Year that Stocks, Bonds and Cash Failed to Thrive”, Investment News, January 4, 2016.
[xli] “Key Steps to Retirement Success: How to Seek Greater Wealth and Downside Resilience”; American Funds Select Active Advantage, July 2015.
[xlii] Zolt, David, M. “Retirement Planning by Targeting Safe Withdrawal Rates”; Journal of Financial Planning, October 2014.
[xliii] “Key Steps to Retirement Success: How to Seek Greater Wealth and Downside Resilience”; American Funds Select Active Advantage, July 2015.
The investment decisions are those of Robert M. Leshnak, Jr., CLU, ChFC, CFP®, MS, EA as of 1/10/2017 and are subject to change. The information contained herein is only intended for Leshnak Wealth clients invested in the Leshnak Wealth Portfolio Models. No forecasts or recommendations are guaranteed. The technical data utilized as part of the investment decisions does not guarantee future positive results. Performance, especially for short periods of time, should not be the sole factor in making investment decisions. The information contained herein does not constitute client specific investment advice or take into account a specific client’s particular investment objectives, strategies, tax status, resources, or investment time horizon. No investment strategy such as asset allocation, diversification, tactically overweighting sectors, or utilizing fundamental and technical analysis can always assure a profit, nor always protect against a loss. The information presented is not intended to be a substitute for specific individualized tax, legal, or financial planning advice. The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time. Investing involves risks in regards to all of the investment products mentioned in this commentary, including the potential loss of principal. International investing involves additional risks including risks associated to foreign currency, limited liquidity, government regulation, and the possibility of substantial volatility due to adverse political, economic, and other developments. The two main risks associated with fixed income investing are interest rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the insurer of the bond will not be able to make principal and interest payments. Investments in commodities may entail significant risks and can be significantly affected by events such as variations in the commodities markets, weather, disease, embargoes, international, political, and economic developments, the success of exploration projects, tax and other government regulations, as well as other factors. Indexes are unmanaged and investors are not able to invest directly into any index. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.