First Quarter 2014 PerspectiveMarch 2014
STILL A BULL MARKET, DESPITE TURBULENCE
The trends that guided our market views for the past several years continued since we last wrote in early December. US stocks are up nearly +3% from November and world equities, excluding the US, are up +0.6%, with, of course, wide variation across markets. The emerging markets, however, fell -4.8%. Treasury 10-year bond prices rose as yields fell from a post-recession high of 3% on December 31, 2013 to 2.6% as of this writing. Gold rose +13.6% from a mid-December low.1
These price moves send mixed signals about the future. That equities rose to new post-recession highs after a two-week -5.7% mid-January correction suggests there is confidence the global expansion will continue.
But now the fast-moving realpolitik events in the Crimea are presenting the West and NATO with bad, costly choices: accept the de facto seizure of Crimea or risk civil war and further Russian military intervention in the Ukraine. After a one-day -2% drop on February 28, European equities made up the decline and have gone to a fraction below the pre-February 28 high. The Russian market was not as calm, falling -14.5% with only a modest rebound when the Kremlin dialed back its rhetoric and aggression.
At this writing it is too soon to judge the longer-term impact on markets, except to observe that investors are best served by taking a measured view and not reacting to the crisis. The threat to vital Russian gas exports to Europe, much of these passing through the Ukraine, and the impact on world wheat prices are the ‘known unknowns’ that will likely stoke anxiety for months to come.
CONFIDENCE IN ONGOING GLOBAL EXPANSION, DESPITE A SOFT PATCH
The bad weather across the eastern US plausibly impacted analysts’ estimated 2014 earnings and revived anxiety that US GDP growth was not going to accelerate from its dismal 1.9% 2013 rate. We are not convinced that this soft economic patch is anything more than a pause in the laborious expansion from the early 2009 global recession low. Fed Chairman Yellen concisely summarized the improving outlook in testimony to the Senate Banking and House Financial Affairs committees in February:
"Among the major components of GDP, household and business spending, growth stepped up during the second half of last year. Early in 2013, growth in consumer spending was restrained by changes in fiscal policy. As this restraint abated during the second half of the year, household spending accelerated, supported by job gains and by rising home values and equity prices. Similarly, growth in business investment started off slowly last year but then picked up during the second half, reflecting improving sales prospects, greater confidence, and still-favorable financing conditions. In contrast, the recovery in the housing sector slowed in the wake of last year’s increase in mortgage rates."
CAPITAL SPENDING AND CONSUMER CONFIDENCE ARE INCREASING
We are also impressed by recent reports of a pickup in businesses’ capital spending and consumers’ confidence. Twitches in measures of consumers’ outlook are important thermometers for what likely lies ahead.
The University of Michigan’s widely-followed monthly survey of consumers’ confidence ticked up by +11% from an October low through February, in spite of the weather (CHART 1). The just-released report for January by the Institute of Supply Management shows manufacturing continuing to expand, as are new orders and backlogs. To argue that equity markets are rising on unfounded hope is challenged by this data. Spring, and likely better weather, is also at hand.
SALES AND EARNINGS GROWTH ARE ACCELERATING
At the end of the day, companies must produce favorable results, be it unit sales, earnings per share, rising book value or expanding cash flows to justify the prices investors pay. The regular drum beat of quarterly earnings reports is the reality check, and so far the upward march of equity prices rests on pretty solid actual and forecast year-over-year growth of sales revenues and earnings (CHART 2). That sales growth is forecast to accelerate each quarter this year supports our confidence that the US economy will continue on its upward recovery path.
VALUATIONS: NOT ESPECIALLY HIGH AND NOT UNREASONABLY LOW
And lastly, valuations. US equities are now trading at 17.3x trailing earnings, one multiple point above the 60-year average of 16.3x. This current level, however, does not seem especially hot, as 29.9x was in June 1999 at the frenzied peak just before the dot-com blow off, nor unreasonably low, as when extreme disbelief in the future gripped investors’ views in March 1980 when stocks traded at 7.2x. Obviously that disbelief was very costly.
For those who truly enjoy diving deep into the never-ending valuation conundrum, CHART 3 shows 15 measures commonly used to help inform investors if equities are expensive or cheap.
If averages mean anything and inflation remains at its current subdued rate and earnings rise to levels that validate investors’ expectations, stocks can indeed trade at somewhat higher valuations. How much higher is the great question, but the direction is supported by the evidence at hand.
EMERGING MARKETS: THE GAP BETWEEN THE TOP AND BOTTOM PERFORMERS IS WIDENING
The days of watching a broad index of emerging markets steadily rise is over. The gap between the top and bottom performers over the past year through February 2014 is indeed huge, as a cursory glance at CHART 4 shows.
IS THE SUCCESS OF THE US TO BLAME FOR EMERGING MARKETS’ WOES?
Why have investors recently treated these markets so differently than US or European equities? Why is their performance now so varied and volatile? One often-cited reason is that commodity prices are falling and no longer supporting many natural-resource rich emerging market economies. The Dow Jones UBS Commodity Index has fallen -30% from its April 2011 high. The most informative explanation we have found, however, appears more powerful, pointing out that the US has cut its current account deficit in half, from 5.89% of GDP in September 2006 to 2.36% today (CHART 5).
The impact of this swing is that there are fewer dollars circulating through the global system available to finance world trade, be that trade in oil, Maseratis, or any other traded good or service. This effective contraction in the supply of the world’s most important currency has starkly revealed the weak finances of a number of emerging economies. These nations now face the tough policy choices of increasing debt to finance trade and budget deficits, raising interest rates to suppress domestic demand, devaluing the currency to stimulate exports, or in the extreme, defaulting on debt. GaveKal pointed out the strong link of weakening equity markets to improving US current deficits. Their message is that success in the US may be sowing the seeds of the next recession. This is likely a ways off, but this first signal appears to be at hand.
WE REMAIN FOCUSED ON THE US
Our response is to concentrate investment assets in the US and be confident that the business prospects for non-US equities we may place in portfolios are insulated from the weaknesses that are appearing, especially in some emerging economies. As long as Fed policy is to continue to add liquidity and maintain interest rates near current historically low levels, we expect equity prices to continue to rise. But, our success is indeed many nations’ growing burden. Stay tuned.
Vice Chairman and Chief Investment Officer
STRATEGIC ASSET ALLOCATION: WE CONTINUE TO OVERWEIGHT EQUITIES, FAVORING DEVELOPED OVER DEVELOPING MARKETS
- Our overweight bias toward US equities continues as valuations appear reasonable to us against the backdrop of positive sales and earnings growth and investor confidence that the US economy will continue on its upward recovery path.
- While our international positions remain slightly underweight, our views are more positive as Europe is no longer declining and optimism appears to be rising.
- We are maintaining a neutral position in emerging markets as valuations and opportunities remain attractive in some markets; however our view is cautious and we are taking a very selective investment approach across regions and individual holdings.
- We continue to be tactically underweight, but view fixed income exposure as necessary within a multi-asset class portfolio to help mitigate volatility.
- We feel that bonds, in particular Treasuries, hold more risk than potential reward, especially after their strong performance year-to-date.
- Municipal bonds generally seem fully valued; however particular issues remain attractive in the context of today’s higher-tax environment.
- We are recommending that portfolios remain fully invested, with cash positions at no more than 5%.
FIDUCIARY TRUST FORUM: KEEPING THE PEACE BETWEEN TRUST BENEFICIARIES
Trust beneficiaries with differing financial needs often face an inherent conflict of interest regarding the investment management goals of their trust. This conflict has been exacerbated over the past five years by the persistent low-yield environment, which has reduced the level of traditional income that trust portfolios have been able to generate. Our Fiduciary Trust Forum members discuss how beneficiaries’ competing goals may be addressed by exercising the ‘power to adjust’ distributions between income and principal.
Q. Why are many beneficiaries facing conflicts of interest over the investment management goals of their trusts?
Gail: The investment goals of a trust can have a significant impact on all beneficiaries. Many trusts are structured so that current income beneficiaries receive the income generated from a trust, and the remainder beneficiaries ultimately receive the principal and any capital appreciation at the end of the trust’s term.
This structure often creates an inherent conflict of interest among beneficiaries since income beneficiaries typically have expectations for generous current income, which, in more normal times, could be secured with a heavier weighting of higher income-producing investments such as bonds. Remainder beneficiaries often have expectations for maximum asset appreciation through a high allocation to growth securities, regardless of the income they generate.
These conflicts can be aggravated by the terms of the trust or family dynamics. For example, we have experienced situations where the income beneficiary and the remainder beneficiaries were not related and had not formed strong relationships with one another. In one case, a step-parent was the income beneficiary and step-children were the remainder beneficiaries. The step-parent wished for the trust to be invested to maximize income, with little regard for the growth of capital. The step-children, on the other hand, preferred the trust to be invested for growth at the expense of current income. Trustees have a fiduciary duty to balance these competing interests.
Q. How has the low interest rate environment intensified this issue?
Ron: The income available from bonds has been considerably below historical levels since the credit crisis began in 2008. For instance, in the decade preceding the credit crisis, a 2-Year Treasury bond yielded approximately 4.0% and a 10-Year Treasury bond yielded 4.8% on average. Even with the slight rise in rates since 2013, both the 2-Year and 10-Year Treasury bond yields still stand considerably below their historical averages, at about 0.3% and 2.7% today. It has therefore been very difficult for trusts to generate the same level of income that beneficiaries have been accustomed to receiving prior to this dramatic decline in rates.
Q. Can the ‘income versus growth’ conflict be resolved?
Gail: There is a solution available under the current trust law that can help trustees better manage this ‘income versus growth’ conflict. Trustees in most states have the ability to exercise a discretionary ‘power to adjust’ the distribution between principal and income to provide income beneficiaries with an appropriate level of income, while preserving and growing the principal for the remainder beneficiaries. The income needs of the income beneficiaries are met because their distributions represent a combination of income, principal and capital gains, rather than income alone.
Ron: This approach can be a win-win for both parties. It allows the trust to be managed with a much greater degree of flexibility to invest for the highest overall returns without the need to produce a certain amount of income. Trustees can take advantage of the full range of investment opportunities available in today’s market while still fulfilling their fiduciary duty to balance the interests of both the income and remainder beneficiaries.
Q. How can the ‘power to adjust’ trust distributions between principal and income benefit beneficiaries?
Mackin: Since the current law allows trustees to distribute principal to meet beneficiaries’ cash needs, a trust portfolio can be invested for growth. In the current low-rate climate this means constructing a portfolio that is primarily equity. Over time as the trust principal grows, so will the amount that a trustee may distribute within the rules of each state and prudent investment practice.
As an example, consider a $10 million trust with a balanced asset allocation of 50% equities and 50% fixed income. The current income beneficiary is the surviving spouse; the remainder beneficiaries are her children. Our expectation from this 50/50 allocation would be that the portfolio would have an annual income yield of 2.6% on average and appreciate on average at 4.4%. Eight years later, after taxes and any fees were paid, the spouse would have received a total of $2.2 million in income. The trust’s value at the end of the eight-year term would have been $11.9 million, which would ultimately be passed to the children.
Consider the outcome if that same trust had instead been invested for growth, with 80% of its assets allocated to equities and 20% to fixed income. The income yield expectation would be less, just 2.2%, but the appreciation expectation would be much higher, 7.2% annually, on average. The trustee can use the ‘power to adjust’ to reclassify a portion of the principal as income, so the annual distribution totals 3% of the value of the trust for example, even if only 2.2% was technically derived from investment income. The expected outcome is significantly better for both parties: eight years later, the income beneficiary would have received $2.7 million, $500,000 more than with a 50/50 portfolio, and the trust’s market value would have grown to $13.2 million, providing $1.3 million more for the children than in the other scenario.
Using the ‘power to adjust’ has allowed what were once competing interests to be aligned, since both the current and remainder beneficiaries can meet their goals with a growth-oriented portfolio.
Fiduciary Trust Company International and subsidiaries (doing business as Fiduciary Trust International), and Fiduciary Trust Company of Canada are part of the Franklin Templeton Investments family of companies.
This communication is intended solely to provide general information. The information and opinions stated are as of March 1, 2014, 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 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.
IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction of matter addressed herein.
Vice Chairman and
Chief Investment Officer
FIDUCIARY TRUST FORUM
and General Trust Counsel
Executive Vice President and
Director of Fixed Income Strategies
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