June 2019 Newsletter
Over the last few months, the markets have been primarily focused on three major topics: The Fed and interest rates, the trade war with China and global growth. Interest rate policy from the Federal Reserve and the trade war have definitely been the main drivers of market action.
As long term investors, we will always have an appropriate allocation to stocks for each of our clients. After all, there is no better investment to help our clients achieve financial independence than stocks, especially dividend paying stocks. Valuations within reason, positive (but lower) earnings growth, and a growing (but slowing) economy with low unemployment are just some of the reasons to be optimistic.
We would also count the general levels of skepticism in the marketplace as a reason for optimism, believe it or not.
Consider the results from this recent Bank of America/Merrill Lynch Global Fund Manager Survey:
- Largest jump in cash since 2011 debt ceiling crisis
- Lowest allocation of stocks to bonds since May 2009
- Record decline in global growth expectations
We just do not see the high levels of euphoria we saw leading up to the last two significant declines in stocks.
However, the market’s continued addiction to very low interest rates and Fed policy is somewhat troubling. Global Central banks are in control of the markets. Within the last year or so, every time the markets have sold off, the Federal Reserve has stemmed the declines by promising more rate cuts or at least just keeping rates low. Debt levels are soaring everywhere.
Take a look at what happened in Europe this week. ECB head Mario Draghi once again promised more monetary stimulus; the markets there (and in the US) soared. But why? Monetary stimulus hasn’t worked there for almost 10 years! The 10-year German bond is a NEGATIVE .35%! Is that the sign of a healthy economy? In the US, our 10-year Treasury is close to going under 2%. The Greek 10-year bond is now yielding 2.5%; this for a country that was on the verge of defaulting just a few years ago.
Who would loan money to Greece for 10 years for a paltry 2.5%? Well, there also seems to be just a tremendous amount of cash in the marketplace that has to be invested. Even at these extremely low yields bonds are being bought and there are record amounts of money going into areas like private equity.
So where does this leave us? Well, if interest rates stay very low it is possible that stocks could continue to move higher. If all debtors can continue to kick the can down the road on their ever-increasing obligations, or at the least service their growing debts at very low interest rates, equity markets may continue to rise. But what happens if the Fed loses control of the bond market? What happens if rates rise on their own? We saw how the market reacted to potentially higher rates in the 4th quarter of 2018---They threw a tantrum.
Again, we are long term investors, not market timers. Our intent is to build long-term strategies that will help our clients achieve whatever goals they have. The fact is, we don’t know the answers to some of these questions that are raised, but nor does anyone else! But we take comfort in that a well-diversified, and well-thought balanced investment plan will get our clients through whatever it is we face in the markets.
And again, we are expressing our general views here, but everything we do is specific to each client. We aren’t too worried about these concerns for our clients that are years away from retirement. But we are very mindful for those clients who have either just recently retired or are within approximately a few years of retirement.
Growing Bond Market
Over the years as interest rates across the globe have remained low, there has been an unprecedented rise in the issuance of debt (i.e., bonds) by both companies and governments. For example, the US deficit is likely going to pass $1 trillion this year, while in 2018, corporate debt rose to over $15 trillion. This staggering growth in the sheer amount of bonds has led to a “drift” in how they are classified.
Recently, Morningstar changed how it categorizes its bond funds in an attempt to try to more accurately describe the fund’s holdings. One of the prime areas that it is focused on, for example, is within the sector of “intermediate bond funds.” In the past, this has been a very broad category that allowed for many funds to hold various types of bonds, but the category became so inclusive, it didn’t necessarily allow for an “apples to apples” comparison between different bond funds.
Morningstar has now split this category into two: 1) plain “vanilla” core funds and 2) core-plus funds, which tend to invest more than 5% of their portfolios in high yield debt. This should be helpful for all investors in determining risk levels in bond funds. Nowadays, many bond funds may be stretching for yield by holding things like leveraged loans, junk bonds, derivatives, swaps, amongst other items. This shift by Morningstar should help investors with their due diligence on bond funds.
Lower Rates = Refinance?
As interest rates have declined, a growing discussion topic among certain clients is whether to refinance their mortgages. In some cases, the fall in rates may dictate that a re-fi be considered. The common claim in the industry is that rates need to be at least 50 basis points below the borrower’s current mortgage rate to make it worthwhile.
However, it is important to understand what the savings will be over time versus how much in immediate dollars will need to be paid out in closing costs. In other words, paying out thousands in closing costs “today” may not be recouped from the savings over the years.
Similarly, it is also imperative to forecast the time factor of how long until your mortgage is paid off; that is, refinancing at a lower rate may bring lower monthly payments, but extending the number of years on the mortgage may ultimately result in a larger amount of interest being paid over time.
We’ve recently helped a few clients with this decision. In one case, we felt that it made sense for a particular client to refinance considering all the variables just described. However, in a different scenario for another client, we felt that the client’s bank was overestimating the financial benefit to our client; we suggested NOT to refinance.
In this case, the client had a traditional first mortgage at a very favorable interest rate and a HELOC at a less-than-favorable rate; the bank proposed combining the two loans into one. Our opinion was that after factoring in all costs and “giving up” the superior rate on the first mortgage, refinancing now was not the optimal strategy for this client.
Fiduciary Rule, Broker Rule, now Regulation Best Interest…Which is it, What is it?
For quite some time, regulators and market lobbyists have been engrossed in the debate about creating a rule that would require those who give financial advice to act in the best interest of the client. One would think this is a fairly straightforward concept. However, years of lobbying, years of missed deadlines, and numerous iterations at the state and federal level (i.e., The Securities Exchange Commission “SEC”) would indicate otherwise.
Previously, a “Fiduciary Rule” was introduced which would ensure that all advisors would have to put the client’s interest above their own. All conflicts of interest and sources of compensation would have to be disclosed. However, this law was struck down in 2018 and new guidelines were brought forward and numerous “watered-down” versions were put forth.
Recently, however, the SEC has passed a rule called Regulation Best Interest which is intended to give investors more information about brokers’ complex pay incentives. Brokers--those who sell products and offer more specific recommendations on which they are paid-- typically have had a lower bar of disclosures than “advisors,” but many argue that this new rule doesn’t do as much as it should to raise the standards.
The description of this new “regulation” is over 750 pages long! 750 pages to explain policies or procedures that we think can be explained in about 3 paragraphs. We think it’s very unlikely that consumers will be able to understand this new rule; it’s even complicated to us!
In our view, it is really simple: All financial advisors should be able to demonstrate that they put their clients’ best interests first; they should be transparent with how they are compensated, and they should disclose any conflicts of interest. It’s not about a fee vs. commission argument! It’s about disclosure and transparency and committing to being a true fiduciary to clients.
All the best,