January 2008: A Good Year, A Difficult Year
“That-was-the-year-that-was” summaries abound today in the media; we leave punditry to the pundits. For investors, it’s important to note that although 2007 was a rocky twelve months, a strategically balanced, well diversified portfolio yielded a reasonable return while experiencing a bit less than market benchmark risk (volatility).
But the backdrop is shifting. As economic historian Peter Bernstein suggests, investors worldwide have been reassessing investment risk, their willingness to assume it, and, as he writes, “… in the minds of investors, the essence of risk itself has been fundamentally transformed. Risk today depends upon the consequences of what somebody else will do… Risk management means protecting oneself from the adverse and unexpected decisions others may make, and in the process making better decisions than they do.” Easily said of course; the practical task for individual investors is in the implementation within the evolving, increasingly integrated, developed and developing economies of our world.
In the context of our four-region global economic and investment model (i.e., U.S., Eurozone, Japan, and China-India) the persistent question today is how dependent, or convergent, have these regions become as a result of the globalization process, and what are the risks to the other component regions of this new free market equation if the U.S. should not be able to evade recession.
The "R" Word: Can Recession in the U.S. be Avoided?
Today’s investment market malaise is not so much driven by the world’s basic free market economic outlook as it is by disarray in the credit markets. Financial market stress is evident to all, but global economic growth, particularly in Europe, Asia, and the developing countries, continues apace, albeit more slowly. “Headline” inflation currently attracts media attention, but core inflation rates (which excludes energy and food price changes) worldwide remain benign. Inflation expectations are a bit less optimistic than a year ago.
Although not without potentially unfavorable consequences later, the scene seems to be set for yet another round of central bank short term interest rate cuts and continued reflationary policy moves and pronouncements. This could temporarily fortify equity investors while the credit markets continue to sort through the sub-prime loan and securitized debt mess. Given time, and without some ill-conceived “we-must-be-seen-to-be-doing-something” political intervention, the culpable financial service institutions will continue to take their hits, those responsible will be mustered out and at shareholders’ expense defend themselves in court, but most institutions will emerge leaner and ready to compete once again.
With the credit market adjustment process already underway, the question remains: while roughly 25% of the U.S. economy (i.e., financial services and housing) is under a cloud, can the goods and services producing sectors, as well as the consumer, sustain overall combined U.S. GDP growth in 2008? If Chairman Bernanke and our central bank (FED) cannot ease current banking sector strains, then recession will probably be unavoidable. Job creation, unemployment, labor productivity, and consumer spending will be key indicators to watch. At a minimum, the U.S. economy faces a few quarters of sub-par growth, but with the FED maintaining its reflationary stance, a flat growth pattern in the first half of this year, rather than a full-fledged recession, is a more likely outcome.
Portfolio Strategy Implications
The big shift in the structure of our worldwide investment markets today is the domination in the portfolio management profession by computerized securities and asset class pricing and trading models, and their lack of focus on essential relevant economic fundamentals. These complex algorithms have been created by today’s contemporary portfolio managers (average age 36 years). Particularly in the hedge fund world, (which accounts for roughly 40% of daily U.S. stock market trading volume) these models pay much more attention to investment market cash flows than a given company’s, or industry sector’s, outlook.
In this short-term-oriented investment market setting, it seems prudent at the moment to allow client portfolio equity concentrations in U.S. larger companies (with a tilt toward growth) to build relative to small companies (down 16% in price from last summer’s peak). The international equity portfolio segment will remain more weighted toward large companies with roughly 15-20% of this allocation in emerging (now termed “developing”) country positions. For your information, our current emerging market exposure is just under 10% of total equities. As most clients are aware, in our portfolio rebalancing decisions during the quarter just ended, prompted by the run up in price experienced by the Ivy Global Natural Resources Fund, we trimmed the natural resource asset class from 10% to 8% of equities.
U.S. corporate earnings reports for the fourth quarter 2007 will make for dismal reading, as will, no doubt, the first few quarters of this year. However, isolating out the financial services and housing sectors, one could end up with respectable underlying operating earnings for the bulk of the non-finance, manufacturing, and services groups, and possibly, subsequently a strong post write-off rebound in financial services company profits in the latter part of 2008.
In the "Keep Your Eye On..." Department
The geopolitical situation, it goes without repeating, continues to be precarious. Almost daily we are reminded of this by new developments accompanied by predictions of dire consequences ahead. We do not for a moment wish to minimize the need for attention to these issues as they arise. However, as one of Dr. Pangloss’s sidekicks in Voltaire’s Candide was rumored to have said in an aside while on the battlefield witnessing the massacre of thousands by Bulgarian muskets and bayonets, “if this be the best of all possible worlds, then how should we regard Lou Dobbs’ pronouncements of impending doom and collapse, or worse, the pernicious effects of globalization?”
Dobbs has found his market and a raft of enraptured followers (he possibly will run for President as an “Independent”). But consider what has transpired in the geopolitical sphere during the past 6-8 months:
1. After 35 years of virtually no diplomatic exchanges, the U.S. and Iran are talking informally at a number of levels. Iran’s economy is faltering, the country’s younger generation is in despair, civil strife barely restrained, and its ruling class, publicly arguing amongst themselves, badly misjudged our military reaction to the results of the 2006 U.S. election.
2. The Saudis (i.e., Sunnis) are fearful of their northern border Shiite neighbors, and rethinking their support for al Qaeda. In the fall of last year, and just announced again this week, the Saudi government has executed military purchase agreements with U.S. suppliers worth nearly $50 billion; pacts unthinkable if the political stars were out of alignment and the two countries’ interests not moving closer together.
3. The Egyptians (also Sunnis) have evidenced great concern about the rise and political impact of the emerging Shiite insurgent forces’ continued encroachment in Lebanon and Palestine.
4. Tony Blair, (now dividing his time between J.P. Morgan’s Board and his diplomatic chores) and we know not whom else, have been working behind the scenes to affect an Israeli-Palestinian arrangement. Unless there had already been some handshake understanding, the Annapolis Conference would not have been possible, nor would Bush have been tempted to risk his Middle East “exploratory” trip.
5. Kaddafi’s Libya is slowly being reintegrated into the Western world’s commercial channels and diplomatic networks.
6. North Korea (through the mechanism of the so-called “5 Party Talks”) seems to be moving toward its own form of diplomatic rehabilitation. Of course, this is not a new story, but at least until the Beijing Olympics, China will wish to keep the lid on this one.
Although one should remain skeptical about the interaction of so many moving parts, last year at this time none of this would have seemed possible. Certainly al Qaeda has not been reduced to the role of a video production company, as some have alleged, but there is evidence that an increasing number of moderates in the Islamic community are losing patience with extremist means and goals. The Benazir Bhutto assassination may have been a trip wire finally illustrating to modern Islamic moderates how far the pendulum has swung. Is there a paradox emerging here, a disconnect between the media’s take and the reality of a more closely knit economic world in which the practical forces of the information revolution and free-trade effectively counter the insurgents’ objectives? Stay tuned; don’t misplace your remote; leave it on the coffee table.
A Planning Note: The Prospect of Higher Ordinary Income and Capital Gains Tax Rates
If, as all the polls indicate, the voters above all else wish for a change in political leadership at the Federal level, then it seems certain investors need to be prepared to share a substantially greater proportion of their future market returns with the tax collector. The indications are that the “Bush tax cuts” will, at a minimum, be allowed to expire. Top marginal ordinary income tax rates in 2009 could move up as high as 45% (from 35% today) and long term capital gains rates to 30% (from 15%). Consider the post-election tax math. If in your personal taxable investment account, you had the temerity to invest after-tax ordinary income in equities, pay tax on any long term capital gains earned along the way, and leave the result in your taxable estate, ultimately in the years ahead the IRS could lay claim to nearly all your initial and accumulated investment.
Lest we forget, under current law (suspended by the Bush cuts), the dividend tax rate is due to revert to 39.6% in 2011. Thus the post-2008 Congressional majority will promote a proposed 30% long term capital gains rate as a “tax reduction.” The alternative minimum tax (AMT) will probably remain in place for those earning roughly more than $200,000. Even if the incumbent party should retain the White House, it’s difficult to see how increases of this nature could be resisted in the current and probable post-election political line-up. The consensus seems to be that the Federal estate tax schedule will not be abolished, but that the individual lifetime exemption will be raised to $3.5 million ($7 million for a married couple).
This commitment to raise income taxes identifies our politicians as the only group of public officials on the planet currently intending to increase personal income taxes. Virtually all European, and particularly the emerging Eastern European, governments have embraced tax reduction politically as the path to improved economic growth. What is it they know of which we are unaware? Most state legislatures have also spent their treasuries into deficit and will no doubt escalate tax collections to cover the added budgeted commitments of the past few years.
(Financial Planning Note: All this elevates for consideration in the months ahead, evaluating Roth IRA conversions and other strategies for our financial planning clients with significant retirement plan assets (relative to total net worth) to optimize and maximize future net estate transfer values to their heirs. More on this topic in future months.)
Final Comments
There are a few improvements in client services we are planning to implement in the coming months, all to be overseen by Julie Zimmerman, who joined the firm in November as our new Client Service Manager. These include trade confirmations, monthly custodian statements, and our portfolio and accounting reports by email (if desired), and an improved, more interactive website including a personal password-protected portal enabling clients (and/or their CPAs, if authorized) to access account data at their own convenience. An individual document storage, digital “lock box” will also be a feature of this new website. Shortly, you will be receiving a survey questionnaire, the feedback from which will indicate other assistance or improvements we might be able to provide you in the future.
As always, we welcome your questions, comments, and suggestions.
Sincerely,
James L. Joslin
Chairman, CEO