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The question that I get asked most often is “Is there still a recovery?” It would seem the answer is a decided “no.” Europe’s finances got worse over the past several months, especially among the “Club Med” countries. For Greece, they became  precarious. French banks, which hold particularly large quantities of Greek bonds, curtailed lending in self preservation, reviving  memories of the roiling markets in 2007 and 2008. At the time, U.S. banks sharply cut back lending as they realized the value of the collateral, on their balance sheets and in their Special Investment Vehicles, much of which was mortgages, was fictional.

As anxiety rose through the spring, investors quite understandably sold assets that they suddenly perceived as risky, and again ran for the safety of the U.S. dollar. Indeed, in spite of a dramatic increase in supply, the demand for safe-haven investments caused U.S. Treasury bond yields to drop by 18%, from 3.9% on April 8 to 3.2% on June 14, 2010 (Charts 1 & 2).  

GLOBAL MARKETS FACED A LACK OF CONFIDENCE

Of course, the confusion over strategy and tactics among European leaders did not bolster confidence. Adding to the anxiety was the markets’ reaction to China’s leadership sensibly deciding to reign in real estate speculation. Predictably, the Shanghai Composite promptly fell 20.6% after that April 14 decision.

Global markets had a lot to digest, with shrinking credit and the great marginal buyer—China—deliberately slowing its growth. Anyone questioning global recovery certainly had a point.

EUROPEAN LIQUIDITY ISSUES RESULTED IN INCREASED SHORT-TERM BORROWING COSTS

Markets cheered when the European leaders announced on February 11 their readiness to help Greece through its liquidity crunch, reminding investors how the Fed so vigorously moved to restore markets in 2008. It was the same playbook. But the confidence evaporated in mid-April as the extent of Greece’s liquidity problems became apparent. Greece’s problems were telegraphed across the globe by the higher cost of short-term borrowing. Sensing trouble, the London Interbank Borrowing Rate (LIBOR) crept up after mid-March and then rose sharply after mid-April as banks again questioned the real value of collateral (Chart 3).

 

FALLING EUROPEAN INVESTOR CONFIDENCE WAS COMPOUNDED BY INCREASED LIBOR RATES

A higher LIBOR equates to lower profits and growth—toxic to investor confidence. European equities went on to fall 17.4% between April 15 and May 25. Only German exporters benefited from everyone else’s pain as the weakened Euro spurred demand for globally important big-ticket German exports. And, of course, after the oil spill in the Gulf on April 20, BP took over television screens and headlines. Investors focused on the future price and supply of oil—the essential commodity—fearing that the shut down of Gulf supply would drive prices higher. To everyone’s relief it did not.

POSITIVE INDICATORS IN THE U.S. MUTE EUROPEAN WEAKNESS

Investors now had major, adverse events to digest and calibrate on top of looming changes in financial regulation and inevitable higher taxes next year. Would these slow global recovery or actually derail it?  “Double dip” again came back into our language. Ben Bernanke tried to calm anxiety in testimony before the House Commerce Committee on June 9, when he stated “Although the recent fall in equity prices and weaker economic prospects in Europe will leave some imprint on the U.S. economy, offsetting factors include declines in interest rates on Treasury bonds and home mortgages as well as lower prices for oil and some other globally traded commodities. The Federal Reserve will remain highly attentive to developments abroad and to their potential effects on the U.S. economy.”

FOUR KEY SIGNALS SHOW RECOVERY IS STILL GAINING GROUND

• Strong earnings. First, as a backdrop, first quarter earnings were nothing short of terrific, topping analysts’ expectations and often surprising investors by the degree the actual results beat the estimates. Indeed, with 94% of the S&P 500 reported as of this writing, 82% beat analysts’ consensus first quarter earnings estimates and 66% beat the estimates for sales. Indeed leading, high quality global capital goods companies are telling investors that their order books are expanding. The same story is coming from semiconductor makers. Overall factory orders have increased by nearly 20% since March 2009, coinciding with higher future earnings estimates (Chart 4).
  

• Low oil prices. Second, oil prices, in spite of the BP debacle, are down 11% from their April 6 peak. This is a sizeable price cut for the world, but also as sign that traders are doubtful about future demand.
  
• Americans are working more. In spite of the angst of the May employment report and the confusion over including census tabulators, Americans are working longer hours and more of them are doing so, a classic recovery sign.
  
  As the economist Robert Barbera recently noted, “In 2005-2006 [the recent peak period in economic activity] the workweek averaged 30.7 hours. In each of the past three months, the workweek has climbed one-tenth of an hour, rising from 30.2 hours to 30.5 hours. At this pace, a 30.7 average workweek will be in place in July. Gains in headcount, thereafter, would likely be the primary source for companies in need of expanded hours” (Chart 5).
  

• Inflation remains muted. There is no sign of rising inflation in the near term, suggesting the global expansion can gather force without facing immediately higher costs. Indeed, aggravated by Europe’s weakness, disinflation—perhaps even deflation—appears to be the more acute concern.

INVESTORS AND VOTERS ARE HOLDING GOVERNMENTS ACCOUNTABLE

Our outlook at the start of summer is for a pause in the rate of recovery, but not a halt. The worst appears to be over in Europe as governments face up to bloated budgets and announce budget cuts. This in no way suggests that changing long-held, flaccid fiscal habits will be either smooth, certain or swift. Equally, we should remind ourselves that markets and voters (in most countries) are truly powerful. Bond market vigilantes have been imposing fiscal discipline on reckless governments (Chart 6).

As Ed Yardeni, pointed out, “… deficit-financed Socialism doesn’t work.” Indeed, Ed goes on to suggest, voter vigilantes just might impose regime change or perhaps agenda change on Washington come November. We have noted that the earnings recovery has been strong and is forecast to continue. In fact, current estimates have advanced from $86.88 on the S&P 500 this year, to $95.57 next year and $109.28 in 2012.

These estimates will inevitably change, and likely to a somewhat lower gain. But the direction is clear and credible based on the many signs of recovery at hand.

If the earnings recovery continues, equities will look inexpensive, especially against long-term averages. The growth in earnings estimates has been worldwide: U.S. +17%, Europe +16%, Asia (ex Japan) +12%, China +15%, India +20%, Latin America +16%, Canada +12%.*

*2010/2011 earnings estimates; MSCI indices via Bloomberg.

OUR LONGER TERM OUTLOOK REMAINS POSITIVE

It is easy to succumb to the widespread bad news. However, experience with many past crises suggests to us that the eventual impact, both the physical and financial, will be less than feared. We shall see.

Our longer-term outlook has therefore not changed. In our view, the likely path, once the crises pass, is for the resumption of recovery growth—albeit at a somewhat slower pace. Fiscal cuts in among European governments struggling to close deficits, the unavoidable impact of the BP oil spill upon the economies along the Gulf coast and the apparent on-going preference of Americans to save more of their incomes, together, will slow the rate of recovery growth.

In response, we have adjusted portfolios to reduce risk by taking some profit selectively among emerging market exposures. We are also continuing to be cautious with respect to companies wholly reliant on U.S. consumers, while shifting toward securities with more generous income.

In fixed income, we are focused upon preserving the value of bond exposures in portfolios. We see bonds—both municipal and taxable issues—holding value and, of course, providing valuable income. We do not expect to see gains, which would imply further declines in interest rates. But at some point bonds’ market values will likely become vulnerable to accelerating inflation, but that seems a distant threat today.

These are tactical moves only, as our long-term view anticipates a sustained recovery.

Mackin Pulsifer
Vice Chairman and Chief Investment Officer
June 17, 2010

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FIXED INCOME PERSPECTIVE

Managing Through a Low Yield, More Volatile Environment

MARKET UNCERTAINTY CONTINUES TO DRIVE DEMAND FOR FIXED INCOME INVESTMENTS

There has been much news in the headlines causing fixed income markets to react:  the sovereign debt crisis in Europe, the oil spill in the Gulf, uncertainty over the Fed’s time frame for raising interest rates, and deteriorating state and local credit fundamentals.

Market uncertainty tends to cause investors to seek safe-haven investments and reprice assets they perceive are risky. The markets have therefore experienced unprecedented demand for fixed income investments as investors have been unsettled by the influx of both positive and negative economic signals. In fact, May 2010 marks the 17th consecutive month of positive net new cash flow (sales minus redemptions, plus exchanges) into bond mutual funds. These inflows significantly dwarfed the inflows into equity funds, illustrating a continued risk-aversion trend that began as a result of the credit crisis (Chart 7). 

  

MUNICIPAL BONDS: MANAGING VOLATILITY WHILE SEEKING INCREMENTAL TAX-FREE YIELD 

Our view is that fiscal stress will likely be a part of the municipal landscape for the foreseeable future. Our existing portfolio structure reflects a defensive approach, with a focus on:

• High-grade credit quality
• Issuer diversification
• A reduction of in-state concentrations (greater geographic distribution)
• Essential service revenue bonds with dedicated and predictable revenue streams 
• Issuers and regions with strong balance sheets and well-funded pension liabilities

During periods of uncertainty and volatility often comes opportunity. In this environment, we have been looking to add incremental yield in the short- to intermediate-term portion of the municipal bond yield curve—maturities between four and seven years where the slope of the curve remains steep. We have also been finding what we believe to be attractive yields on higher coupon callable bonds, known as “kicker bonds.” Additionally, we have been purchasing government-backed, single-family housing authority issues in an effort to enhance portfolio yield.

INVESTMENT GRADE CORPORATE BONDS: INCREASING DIVERSIFICATION AND AFTER-TAX INCOME

The recent flight to quality increased investor appetite for less risky investments such as Treasury bills, resulting in lower prices and increased yields for corporate bonds. In fact, on an after-tax basis, over the past several months, short-term corporate bonds have at times yielded more than comparable short-term municipal bonds. 

Corporate fundamentals have improved as a virtue of dramatic cost reductions and the ability to refinance outstanding debt. Given this backdrop, we continue to pursue opportunities within this sector, and for clients with a higher risk tolerance, there may be opportunity in high yield corporate bonds.
 
Strategic Asset Allocation: Adjustments Reflect Our Expectation of Continued Market Volatility

WE SEE U.S. LARGE CAPS LEADING AMONG DEVELOPING COUNTRIES

Equities

• We reduced our overall equity allocation to 57.5% with the expectation that markets will remain volatile during the summer months.
• International large cap stocks were reduced as we limited exposure to areas potentially affected by the credit situation and fiscal adjustments underway in Europe.
• We are favoring U.S. large cap and, to some extent, U.S. small cap, which we believe have stronger growth potential than companies of foreign developed markets.
• We continue to maintain a 10% allocation to emerging markets with an emphasis on Asia.

Fixed Income

• Our fixed income allocation remains underweight at 30% due to the continued credit and interest rate risk in the sector.
• Similar to equities, we have limited our exposures to areas impacted by the European credit concerns. 
• We raised our investment grade corporate bond allocation to 7.5% to increase diversification and strengthen return opportunities within fixed income portfolios.
• We are also selectively adding to high yield corporate bonds in portfolios that have more risk tolerance, to take advantage of attractive valuations as a result of the recent market volatility.

Cash

• We continue to recommend maintaining modest cash balances to dampen overall portfolio volatility and to provide liquidity to take advantage of future investment opportunities.

     
*As of June 15, 2010. The tactical recommendations provided by the Fiduciary Trust Asset Allocation Committee are short-term asset allocation strategies based on a 12-month forward view. They are expressed relative to the long-term strategic models to demonstrate the committee’s biases based on the macroeconomic and financial market outlook. Our clients’ portfolios are individually tailored, and allocations are customized based on each individual client situation. Portfolio holdings and investment strategies may vary depending on factors such as market and economic conditions.

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FIDUCIARY TRUST FORUM

PANEL MEMBERS

Gail E. Cohen
Vice Chairman and General Trust Counsel

Elisa Shevlin Rizzo
Managing Director, Trust Counsel

Craig S. Richards, CPA/PFS, CFP
Managing Director and Director of Tax Services

PERSPECTIVE ON GIFTING

TIMELY STRATEGIES FOR GIFTING TO GRANDCHILDREN

With higher taxes legislated to take effect next year, 2010 may prove to be a very advantageous year for transferring wealth to grandchildren. Our Fiduciary Trust Forum discusses several timely, tax-friendly gifting ideas.

Q: With the expectation that taxes are going up, is there anything grandparents should be doing today to minimize tax on gifting?

Gail: The year 2010 is a great time to make gifts. The top Federal gift tax rate for 2010 is 35%, a historically low rate. What’s more, this is the first year since 1976 that there is no Generation Skipping Transfer (GST) tax. The GST tax is a separate federal tax imposed in addition to the federal gift tax that is levied on transfers that skip a generation, such as a gift from a grandparent to a grandchild.

Let me explain. Under current law, the first $1 million in gifts made—called the lifetime exemption—is free from federal gift tax and GST tax. Any gifts over the lifetime exemption, however, are subject to taxation. In 2011, both the federal gift and GST tax rates are scheduled to rise to a maximum of 55%, making gifts to grandchildren very expensive. So making gifts now—under today’s favorable tax law—can translate into significant savings.
 
Q: What will next year’s higher taxes mean to a gifting strategy?

Elisa: Let’s assume grandparents want to transfer $1 million after tax to a grandchild and they have already used their lifetime exemption. To make that gift in 2010 they will be taxed with a 35% gift tax and 0% GST tax. That translates into a $1.35 million cost for the $1 million after-tax gift.

The picture changes dramatically if they wait until 2011. The federal gift tax goes up to 55% and the GST tax is reinstated at 55%. Additionally, the GST tax is further subject to the gift tax. With all of these taxes applied, the grandparents would need to spend over $2.4 million for that same $1 million after-tax gift—that’s more than $1 million in additional taxes just for waiting until next year! 

Gail: I’d add that before making any gifts that might be subject to GST tax, it’s important to understand that there is still a chance that Congress will retroactively apply that tax to 2010. However, the later we get in the year, the less likely it seems that they will be able to do so. Also, grandparents should check their state’s gift tax laws, as a handful of states impose their own gift taxes.

Q:  How is it different if a grandparent waits until death to pass property to a grandchild?

Gail:  Assuming the death occurs in 2011 or after, the tax consequences will be even worse. In the same scenario, if a grandparent waits until death to make a $1 million after-tax gift, it would cost them over $3.4 million, after paying both estate and GST taxes.

Craig: And, given the lapse in the GST tax, another smart strategy to consider may be disclaiming inheritances in 2010. This means that if an individual inherits something this year from their parents’ estate, they may make a disclaimer, and pass this inheritance directly through to their own children, free of both estate and GST taxes. You can’t achieve the same result in 2011.

Another benefit right now is the low capital gains rate. Since the grandchild assumes the grandparent’s original cost basis for the gifted stock in 2010, no matter if it’s given during lifetime or at death, if the grandchild decides to sell this year, gains are subject to today’s 15% capital gains rate, vs. the 20% rate slated for next year. Keep in mind that if the grandparent dies in 2010, their estate will have the benefit of a $1.3 million modified carry over basis adjustment.

Q: What other options, if any, do grandparents have for making      
tax-free gifts?

Elisa: I’d highly recommend taking advantage of the annual exclusion each year. The use of the annual exclusion is a simple and straightforward way to maximize lifetime transfers to grandchildren and other recipients. The annual exclusion permits individuals to make tax-free gifts—up to $13,000 per year is allowed—to any number of individuals. Married grandparents can make a tax election known as a ‘split gift,’ allowing them together to gift $26,000 per year to a grandchild.

Q: What about gifting stock?

Gail: It’s very common for grandparents to gift stock. The stock’s market value is determined upon transfer, and the gift tax is assessed on that amount. Often, donors will gift stock they believe is undervalued, so that the gift tax is assessed on a lower amount and future growth takes place in the child’s account and not in the grandparents’ estate.

I’d suggest though, that gifting cash is a better strategy and gifting stock is appropriate only if three conditions are met: 1. the grandparents do not have cash on hand; 2. they are averse to paying capital gains tax; 3. they expect the stock will be held by the grandchild long term.

If these conditions do not exist, in most cases it can be better for grandparents to gift cash. If the grandparents sell the stock and pays the capital gains themselves, the grandchild is alleviated from what would be a built-in tax liability on the stock gift. And, the capital gains taxes paid by the grandparents further reduce the value of their estate for estate tax purposes.

Q: What can grandparents can do in terms of paying for a grandchild’s education or other expenses?

Craig: There is also a tax break for medical and educational expenses which allows an individual to pay for another person’s current medical or tuition expenses on a gift tax-free basis, as long as payments are made directly to the provider. For example, an individual may make direct payments for a grandchild’s physicians’ bills, prescription medications, health insurance and the like.

Likewise, an individual might elect to pay for a grandchild’s educational expenses by making tuition payments directly to the qualified educational organization-be it nursery school, private school, college or other qualified institution. This exclusion does not count against an individual’s lifetime federal gift tax exemption, so it is a wonderful tool for individuals who wish to assist with specific expenses.

Elisa: A 529 Plan is a tax-advantaged investment account designed to encourage savings for higher education costs. In most states, contributions are income tax deductible and earnings may also be free from state income tax. Moreover, a donor may front-load up to five years worth of their annual exclusion gifts. That means at today’s gift tax exclusion of $13,000 per year, each grandparent could gift $65,000 now, free of gift tax, as long as they don’t’ make another gift to the same grandchild in the following four years.

Q: Many grandparents establish trusts for their grandchildren. How does this approach compare to outright gifting?

Elisa: Despite their simplicity, outright gifts are not appropriate in all instances. Gifts to trusts can be preferable for a variety of reasons, including greater flexibility, control and asset protection. 

For most donors, it is important to ensure that any trust created for a grandchild or a group of grandchildren will qualify for the $13,000 annual gift tax exclusion.

Q: Are there particular trust structures that are more advantageous?

Gail: It depends upon what the goal is. There are several ways to do this. Crummey Trusts, for example, can be attractive because the trust can be established for a group of beneficiaries and it can continue for as long as the trust instrument specifies.

Elisa: 2503(b) and 2503(c) Trusts can also be great options. Like a Crummey Trust, grandparents can contribute $13,000 per trust each year, tax-free. However, unlike Crummey Trusts, which can be purely discretionary, the beneficiary of a 2503(b) Trust or a 2503(c) Trust does have certain rights to income and/or principal.

There are pros and cons to the different approaches but, overall, these kinds of trusts may be attractive to individuals who are concerned with a grandchild’s right to receive trust principal at a certain age and who want to create separate trusts for individual beneficiaries.

Gail: One more trust strategy I’d like to mention is the Dynasty Trust. A Dynasty Trust can benefit children and grandchildren and can continue indefinitely. They are intended to shelter the GST exclusion, so for 2010 they would therefore have questionable utility if the GST tax remains at zero. But as the GST tax is reinstated in 2011 and beyond, Dynasty Trusts can offer a valuable multi-generational solution. 

Q: Are there non-trust options that could also work to help     
minimize taxes?

Craig: A Uniform Gift to Minors Act (UGMA) account and Uniform Transfer to Minors Act (UTMA) account are non-trust options that can be used to make annual exclusion gifts and to minimize taxes paid on earnings. The gifted funds belong to the minor, but are controlled by a custodian until the child reaches adulthood, usually age 18 or 21, depending on the state. There are no contribution limitations, and the first $950 of investment income is tax-free, the next $950 is taxed at the child’s rate and anything above that amount is taxed at the parent’s rate.

Gail: We’ve covered several great gifting options, and I’d like to close by adding that gifting plans are tailored to each individual’s specific needs and circumstances. We encourage all clients to speak with their tax and estate planning professionals who can help consider these options in the context of their overall estate plan and objectives.

This communication is intended to provide general information. The information and opinions stated are as of June 9, 2010 unless otherwise indicated, and do not represent a complete analysis of every material fact concerning any industry, security or investment. 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 advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether information in this newsletter may be appropriate for you. 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 or written 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 or matter addressed herein.

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