First Quarter 2013 PerspectiveApril 2013
Nothing Is Stopping This Recovery
So much has taken place since we last wrote in December—and so much has not. Despite unending hyperbole by pundits and politicians, the world did not fall off a cliff on January 1. The American political system worked. There was compromise, and no one left the debate pleased. What did occur was a Congressional recognition that was backed by a wide majority vote to raise revenue. The increased revenue is a step toward reversing the nation’s long-term precarious finances.
TWO COMPROMISES DOWN, ONE TO GO
What did not occur was any decision on spending. March 1 has now passed, and the self-disciplining sequester arrangement put in place in August 2011—with crossed Congressional fingers that it would not ever be invoked—is now in force. Most observers agree that its provisions will have little evident impact for several months. But by mid-summer the mandated spending cuts will be visible, surely inconvenient, and some will be painful. Their potential impact will also be unacceptable, as the US economy has finally begun to produce durable growth after the 2007-2009 recession.
On February 15 the Congressional Budget Office noted,
“If the current laws that govern federal taxes and spending do not change, the budget deficit will shrink this year to $845 billion, or 5.3 percent of gross domestic product (GDP), its smallest size since 2008. In CBO’s baseline projections, deficits continue to shrink over the next few years, falling to 2.4 percent of GDP by 2015.”1
Although true, this may come at considerable cost to Americans’ wealth as the recovery slows, perhaps into recession. Both higher revenues and lower spending are the unavoidable prerequisites to sustaining the nation’s financial strength. With two compromises down—the August 2, 2011 compromise that permitted the debt ceiling to rise and the January 2, 2013 compromise that raised taxes—whether there is compromise leading to an acceptable round of spending cuts to replace the now in-force sequestration remains to be seen. Our view is that this third episode in the saga will end as these two have, with a meaningful compromise.
THE RECOVERY—AND MARKET RETURNS—MARCHED ON
While this political drama played out, financial markets were assessing the odds of global recovery continuing. Investors have been pleased. In the US, the S&P 500 rose 23% between August 2, 2011—the date that President Obama signed the law that started the clock toward material deficit reduction—and today.
It is our view that the ebb and flow of this often bitter debate over curbing the growth of US debt and the appropriate levels of taxes and spending will continue from episode to episode. We expect these discussions will be characterized by hyperbole and brinksmanship, but end in meaningful compromise. So far we have not been disappointed. After all, all of the House and 35 senators know that Election Day 2014 is approaching. It seems unlikely that voters will reward representatives who have obstructed job growth and recovery. The equity markets have cheered this volatile progress, but not without periods of doubt, one of which took the S&P 500 down 10% before the market recovery resumed (CHART 1).
STRONG MARKET ADVANCES, DESPITE WEAKER EARNINGS GROWTH
Remarkably, this strong equity advance took place while earnings growth was weakening from +7.63% in the fourth quarter of 2011 to a forecast -1.55% in the first quarter of 2013. This earnings decline makes the survival of the market advance noteworthy (CHART 2).
Ben Bernanke and his fellow central bankers have investors’ confidence that the Fed’s money spigot will stay open, ensuring cheap credit until joblessness is significantly lower. The heady year-over-year increases in earnings forecasts for the back half of this year will have to be validated by results or there may be trouble ahead.
POSITIVE FUNDAMENTALS SUPPORT EARNINGS ACCELERATION
There is a lot of good fundamental data to suggest that the forecasts for increases in earnings growth are likely to be reasonably accurate. For one, consumers are increasingly optimistic as monthly net job growth continues uninterrupted and housing improves. A national measure of builders’ expectations demonstrates that the rapidly improving outlook for housing correlates with consumers’ improving sentiment (CHART 3).
GLOBAL GROWTH IS GAINING MOMENTUM
The supporting story is global. China is regaining its economic momentum suggested by the acceleration in the growth of imports. In fact, the latest data shows imports rising +28.8% year-over-year, a sharp increase from the +5.2% average over the past 12 months.
In Japan, the new but returning Prime Minister, Shinzõ Abe, feels he has a mandate to conquer deflation and the nation’s seemingly permanent malaise, and is expected to adopt the post-2008 playbooks followed by central bankers across the globe. After all, the Bank of Japan invented quantitative easing following the bursting of Japan’s real estate bubble in 1991, and has deployed various versions ever since with little result. Printing yen to buy Japanese Treasury Bills—the recent practice of the Bank of Japan—is hardly stimulus; it is swapping cash for cash. The incoming Bank of Japan Governor, Haruhiko Kuroda, is highly respected, having run the Asian Development Bank since 2005, and is an outspoken advocate of reversing ongoing deflation. But we have been here before and been disappointed. As in Europe, structural change of Japan’s ossified economic system must occur before growth can meaningfully accelerate. Let us hope. The third-largest economy could help lift growth in the rest of the world if its leaders adopt well-understood and tested growth policies. We shall see if the 48% rise in the Nikkei from early June is just another false dawn.
Lastly, Europe at times appears drawn to farce with the Italian election results now on center stage. But the unfolding events are deadly serious if one considers the frayed patience of the massive numbers of unemployed. So far, markets believe that compromises and growth policies will be crafted. One gauge is the difference in the interest rate banks charge to borrow from each other that reflects the risk of lending to commercial banks, versus the cost of borrowing risk-free from the European Central Bank. The spread narrows when the risk of default is considered to be decreasing, which has been the trend since the first quarter of 2012 (CHART 4).
IT IS NOT TIME TO WORRY ABOUT INFLATION—YET
Inflation remains a threat that we take very seriously. Can central banks effectively drain the vast amount of liquidity they have placed in banks’ hands since 2008? Will this money bypass productive, long-term investment to find its way into ephemeral, wasteful consumption? Asset price bubbles have already emerged and are inevitable, but they do not represent widespread inflation. For example, Iowa farmland prices have risen +20%, +28% and +22% in each of the past three years.2 Asset class bubbles are, however, in stark contrast to the overall US Consumer Price Index, which has averaged just +0.2% over the past 36 months.3
Gold, another often-cited barometer of inflation, also has not been signaling inflation’s return. The mean consensus estimate of the 26 analysts surveyed by Bloomberg is that the price for gold will rise by just $49 by the second quarter of 2014. Gold is influenced by many factors and the outlook for inflation is just one, the prospect for currencies another.
Competitive currency devaluation, never, of course, officially acknowledged, is the rule of the day. The yen has fallen -20% since July; the euro by -8%; and the pound by -8% since late December. The Brazilian real has declined by -13% from a year ago but has been stable since July. Beggar-Thy-Neighbor policies only work for a while, but in the short term, stimulating exports is undeniably helpful as long as there is ongoing growth to encourage demand.
Although the US is importing deflation, bonds are starting to express the opposite story of increasing inflation. The breakeven rate on the 10-year Treasury bond has crept up from +2.18% in early March 2012 to +2.58% today.4 Bond prices themselves have reflected this wariness by weakening in recent months. Perhaps the much discussed ‘Great Rotation’ of funds flowing from bonds into equities and other asset classes is underway, but the data does not yet confirm this is so. At least for the time being, the Fed’s assurance about low inflation appears correct.
THE US REMAINS THE BEST HOUSE ON THE GLOBAL BLOCK
With spring 2013 arriving, so again are the economic “green shoots” that were so much discussed yet never truly materialized in early 2009 at the depth of the recession. This time their roots are deeper in a fertile mix of widespread evidence of growth, albeit still sluggish, and global coordinated central bank support. We have increased portfolio allocations to equities in recent months and remained cautious on bonds. Carefully selected, shorter-duration bonds should mitigate the ever-present volatility among equities, but we expect their contribution to total return will be muted. With the US remaining the best house on the global block in our view, our equity allocations tactically favor staying at home. Even with this current US tilt, there are many leading global non-US companies that remain core exposures in accounts. Dividends have always been an important contributor to long-term return, and dividend-paying stocks, especially those with strong records of regular increases, remain our emphasis.
Not all is perfect, and the big risks of conflict in the Gulf, snapped patience from double-digit unemployment across southern Europe or a misreading of China’s re-adoption of growth policies could upset the recovery. At least for the next several quarters, a non-inflationary global expansion appears the likely path. Markets climb walls of worry and there is indeed always plenty to worry about. However, for now, barring the risks noted above appearing and as long as corporate earnings keep validating businesses’ expansion, equity prices can move higher.
1. Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2013 to 2023, 2/15/13.
2. Federal Reserve of Chicago.
3. US Dept. of Commerce, Bureau of Economic Analysis.
4. Bloomberg. US breakeven inflation rates are calculated by subtracting the real yield of the inflation linked maturity curve from the yield of the closest nominal Treasury maturity.
STRATEGIC ASSET ALLOCATION
Economic Momentum Presents Opportunity for Equities
OUR TACTICAL SHIFT TOWARD EQUITIES REFLECTS FEWER UNCERTAINTIES AND POSITIVE ECONOMIC SIGNALS
- We have increased our equity allocation recommendation to meet our long-term strategic target given positive economic momentum and reduced political and policy uncertainties.
- Our bias is toward US firms because we believe the US is further along in repairing itself from the damages of the Great Recession.
- We continue to emphasize dividend-paying stocks for their ability to better withstand volatility and provide income.
- Our fixed income allocation recommendation remains underweight and unchanged due to the persistent low rate environment.
- While we believe rates will remain depressed for some time, we are preparing portfolios for eventual rate increases by avoiding longer-dated bonds.
- Our allocation recommendation toward corporate bonds remains overweight; however, we are taking a very selective approach due to higher valuations.
- We have redeployed cash into equities, reducing our cash recommendation to no more than 5% of a portfolio.
FIDUCIARY TRUST FORUM
Is It Still a Good Idea to Make Lifetime Gifts?
The new tax law passed on January 2, 2013 provides certainty in the estate and gift tax landscape for the first time in more than a decade. With a long-term tax law now in place, our Fiduciary Trust Forum members discuss the benefits of making lifetime gifts in 2013 and beyond.
Q. How have federal estate and gift taxes been affected by the new tax law?
Ronnie: The amount that can be passed tax-free to beneficiaries—either with lifetime gifts or through a will at death—is set at $5.25 million for 2013, avoiding the drastic decrease to $1 million that was scheduled. This exemption amount will continue to increase at the rate of inflation in future years. The maximum tax rate for amounts transferred above the exemption limit was raised from 35% to 40%, but is still significantly lower than the 55% maximum rate that was scheduled to take effect.
Gail: The fact that we now have certainty about the estate, gift and generation skipping transfer taxes where there has been none for so long is one of the best results of the action Congress took in January. While there is of course no guarantee against future changes to the tax laws, today’s law offers much more stability than in years past. And, given the default rates that were scheduled had Congress not acted as well as the various tax options being deliberated by lawmakers, the outcome from a transfer tax perspective is very positive in our view.
Q. Given the higher exemption amount, do you still recommend lifetime gifting for families?
Ronnie: Gifts are the bedrock of estate planning, and we believe clients who made gifts last year made a good decision. Because we are living longer lives, gifts often help beneficiaries when they need it most. Many estates pass to children at a time when they themselves are retiring, whereas lifetime gifts may help in paying for family living, housing and education expenses. Another advantage of gifts is that they may allow children to become familiar with the investment process along the way, enabling them to better handle a later inheritance.
Gail: There are also several valid economic reasons to make lifetime gifts versus waiting to pass assets to beneficiaries through a will. For one, allowing investment growth to take place in the hands of beneficiaries is often very advantageous from a tax standpoint. With today’s maximum 40% estate tax on assets transferred above the exemption, removing any future appreciation from the estate early can mean significant potential tax savings for heirs down the road.
Ronnie: We often recommend making gifts in trust. Trusts offer asset protection benefits, allow assets to pass to multiple generations tax free, and may provide an opportunity to leverage gifts by allowing the donor to pay the trust’s income tax.
Q. How can making gifts help reduce estate taxes at the state level?
Gail: The impact of state estate and inheritance taxes can often be overlooked because not every state imposes them. However, more than 20 states including New York, New Jersey, Connecticut, Maine and Rhode Island levy a state estate tax or inheritance tax on top of the federal estate tax, and these taxes can be as high as 16% in some states. Furthermore, many of these states have much lower estate tax exemption amounts. For example, the exemption in New York is $1 million. Therefore residents who die in 2013 with a $5.25 million estate will pay no federal estate taxes, but their estates will be subject to $420,800 in New York state estate tax.
Ronnie: The good news is that making lifetime gifts can usually reduce or eliminate state estate taxes. Most states impose an estate tax only on property owned at death. Thus, property transferred out of the estate during life in the form of a gift can avoid state estate tax entirely.1 Also, since no state other than Connecticut imposes a gift tax, the transfer will generally not incur state level gift tax.
Q. With tax laws finally settled, what can be done to make the most of today’s transfer tax environment?
Ronnie: If couples believe they will have more than $10.5 million in their estate, several strategies should immediately be considered to reduce the value of the estate for estate tax purposes. For example, we commonly use Grantor Retained Annuity Trusts as part of an estate plan to help families transfer asset appreciation to beneficiaries tax free. We also recommend that families take advantage of the $14,000 annual tax-free gift allowance, meaning individuals can gift up to $14,000 per year to as many beneficiaries as they would like without reducing their transfer tax exemption amount.
Gail: Gift tax returns are required to be filed by the donor by April 15 of the year following the gift. If family members have already made lifetime gifts up to the exemption limit, they should consider topping off that gift every year since the limit is adjusted upward for inflation annually. For example, if a family member gifted the $5.12 million individual tax-free limit for last year, he or she can add another $130,000 tax free to that gift to meet this year’s $5.25 exemption, and so on for future years.
Q. How can families best structure gifts to grandchildren under the new law?
Gail: The Generation Skipping Transfer tax exemption has also been set at $5.25 million for 2013. We often recommend family members use their GST tax exemption to establish Delaware dynasty trusts that can last in perpetuity, ensuring that distributions to grandchildren and other remote descendants are not subject to any transfer taxes in the future.
Ronnie: It is important to note that unlike gift and estate tax, the GST tax exemption must be used by each spouse during his or her lifetime or death. It cannot be transferred over to the surviving spouse.
Q. What is the first step families should take today?
Gail: With more certainty regarding the law, this is a great time for families to step back and take a look at all of their assets, how they are held and who will receive them at death. This review should involve not only wills and trusts, but also other documents that may govern the disposition of substantial amounts of property at death. These include pension, IRA and life insurance beneficiary designations, real property deeds and the title of investment and bank accounts.
Ronnie: Regardless of the financial and non-financial benefits of lifetime gifts, we always stress that individuals need to take care of themselves first, and make sure their assets will support their needs through the rest of their own lives. The uncertainty of taxes in 2012 provided an opportunity for families to think and talk about gift and estate planning and understand their financial position with regard to making gifts. Whether or not they changed their plans, that exercise was important, and the conversations should continue in 2013.
We invite you to meet with us to review your estate plan and to discuss planning opportunities specific to your family’s needs.
1. Some states, including New Jersey, impose a claw-back period in which gifts made within a certain time period of death may be subject to state estate or inheritance tax.
This communication is intended solely to provide general information. The information and opinions stated are as of March 8, 2013, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.
Vice Chairman and
Chief Investment Officer
Vice Chairman and
General Trust Counsel
Managing Director and
Fiduciary Trust's new capabilities brochure provides you with a comprehensive overview of our breadth and depth of wealth management services, our investment management philosophy and approach, and our firm's history and heritage.
Please complete the form below, and we will be happy to mail you a copy.