Q4 Perspective: Positive Signs Exist Despite Heightened Concerns about European GrowthDecember 2011
After this summer’s July 7 high, the equity market had a white knuckle 17% drop through the next 22 sessions. Market volume reached almost two billion shares on August 8. It felt as if the culmination of the “known unknowns”—the possibility of a renewed U.S. recession, a European bank funding crisis and a hard landing by the Chinese economy—trumped what we did know and what we could calibrate with a reasoned perspective.
And so it was. However, while prices were volatile in the extreme, the actual additional decline after August 8 in the face of seemingly endless “bad” news was only 1.8% to a low on October 3 (CHART 1).
Volatility and European Debt Concerns Drove Investors to Treasuries
Amid the equity turmoil the world beat a path to the U.S. dollar and U.S. Government securities, despite Standard and Poor’s downgrade of Treasury debt. Perhaps investors bought the best among poor choices. We disagree with that assessment, but the effect is the same. The yield on the Treasury’s 10-year bond predictably kept trending lower (CHART 2).
The Good News Began to Take Hold
So what changed after October 3 to trigger a 14% rally in U.S. stock prices through December 9? For one, the U.S. just kept on growing. As third quarter earnings were reported through October, the realization spread that companies were generally doing quite well, reporting year-over-year earnings growth of 14.98% versus third quarter 2010. If one excludes financial companies, the year-over-year growth was 18.23%.
Gasoline’s 25% decline from its April 29 high put dollars into American’s pockets. Retail sales, not surprisingly, marched upward. At +5.4% year-over-year growth as of November 29, sales are just below the peak +5.5% annual recovery rate hit on May 3 (CHART 3). The importance of this statistic is huge because consumption accounts for over 70% of U.S. gross domestic product.
The Job Market Is Gradually Improving
The latest Bureau of Labor Statistics (BLS) report shows the unemployment rate at 8.6%, still way above the pre-recession rate of 4.4%, but a huge improvement from the peak 10.1% registered in the October 2009 BLS report.
Buried in this trend is that production-or high-paying American jobs-is a material contributor to this job recovery. The Federal Reserve Bank of Chicago watches production closely, and its National Activity Index remains decisively at a level pointing to continued expansion (CHART 4).
The European Debt Situation Remains Uncertain
The messy policymaking in Europe has been scary to even the most casual observer. Interbank funding nearly dried up in September, bringing the world close to a Lehman-like moment. Last month the Federal Reserve stepped into the markets again with short-term loans, halting a self-fulfilling catastrophe. Sharon Bowles, the Chair of the UK Parliament’s European Economic and Monetary Affairs Committee, starkly summed up the mess, “We are potentially facing the demise of the euro by Christmas and, if that happens, it will wreck our [the UK’s] economy.”1
No one can know what will happen in the next few weeks. European leaders met on December 9, and let us hope that German Chancellor Angela Merkel’s apparent resolve to include fiscal oversight among Brussels’ tool kit will prevail. The evolving negotiations appear so far to be moving toward the German position. One outcome will assuredly be that China will gain more say in the International Monetary Fund and therefore global economic policy. To quote our last Perspective, “Tom Friedman, the New York Times columnist, reminded us that the world is indeed flat. Everything matters and affects everything else.”
1. Quoted in the 12/4/11 Financial Times, “Eurozone’s darkest hour is just before the dawn” by Tony Barber.
We Are Cautiously Optimistic
We have been recommending that our portfolio managers maintain higher levels of cash and short-term bonds in portfolios as the European crisis deepened and uncertainty rose over its impact upon global recovery. We now seem to be at, or may have just passed, that moment of such low investor expectations that any “less bad” news sets off a material market rally.
Sensing the change, we became somewhat less risk-averse in mid-November and our portfolio managers sought to use some of the cash to add to especially depressed securities. Several events were influential. European policymakers appeared closer to finding the resolve to put aside parochial differences and preserve the euro along with the enormous potential of an integrated continent-wide economy. The failure of the Congressional Super Committee to agree on a substantive way to reduce the U.S. Government’s deficit was hardly noticed. And news from China suggested it may avoid the feared hard economic landing after taking away the spiked punch of liberal, state-backed credit from real estate investors.
We Are Finding Strong Companies at Attractive Prices
We believe that the outlook for earnings and the health of U.S. companies, especially diversified multi-national ones, cannot be ignored at current depressed prices. Managers have carefully begun to use some of the cash to raise equity exposure, focusing on companies with durable growth and long, consistent histories of raising their dividends.
We have not altered our view of bonds: We believe they generally present more risk than reward at this time. One has to believe that deflation and recession lie immediately ahead to be a bond bull today. In our view, the evidence is quite otherwise. Interest rates are being held at artificially low levels by the Federal Reserve and other central banks across the developed economies. Someday, however, policy will begin to return to a more normal relation between growth and inflation. When it does, bond prices are expected to suffer. This long view does not mean bonds have no place in portfolios. Bonds can offset the inherent volatility of equities and provide income. Our exposures, however, are typically limited to shorter maturities and often opportunistically seek to take advantage of the higher after-tax yields that corporate issues offer.
The Economic Evidence Shows the U.S. Is Healing
Extensive evidence from the real economy shows that the U.S. is growing. The “new normal,” however, is likely to be higher unemployment until the jobs that have been permanently lost in construction and housing are offset by growth in manufacturing and exports. This takes time, perhaps many years, but it is underway.
The Tea Partiers, the Wall Street occupiers and the presidential aspirants are all loudly expressing Americans’ impatience and dismay with the pace of recovery and the inequities of incomes; each is calling for solutions to ever more widely understood chronic issues. As in so many crises before, our confidence is growing that leaders, pushed by global self-interest, will hammer out solutions.
December 9, 2011
FIXED INCOME PERSPECTIVE
Yields Remain Historically Low
EUROZONE CONCERNS HEIGHTENED DEMAND FOR U.S. TREASURIES
The fixed income markets continued to be dominated by fears of European credit instability. Investors flocked to U.S. bonds in spite of the United States’ $1.3 trillion deficit and the loss of its stable ratings outlook from all three of the major credit ratings agencies. Further, the Super Committee's failure to agree on deficit cuts did little if anything to curb demand for the safety of fixed income assets. As such, Treasury yields remained near all time lows.
MUNICIPAL BOND YIELDS FOLLOWED TREASURIES LOWER
The potential impact of the Eurozone crisis on the U.S. and global economies affected municipal bond markets as well. The muni market took its directional cue from Treasuries and yields also dropped lower, but at a slower pace.
Falling yields coupled with strong demand helped buoy prices and deliver positive total returns thus far in 2011. As an example, short-intermediate term municipal bonds, as represented by the Barclays Capital Short/Intermediate Municipal Bond Index, have delivered a 5.35% total return year-to-date through November 30.
In the fourth quarter, as the muni market confronted its largest new issue calendar of the year and Treasuries rallied on concern about European peripherals, municipal bond yield ratios (municipal bond yields as a percentage of U.S. Treasury bond yields) have been greater than Treasuries since September. In November, muni yield ratios reached their highest levels since April 2009, and they remain well above historical ranges.
CORPORATE BONDS ARE BENEFITING FROM STRONG BALANCE SHEETS
Recently, the difference in yield between corporate bonds and Treasuries has widened due primarily to policy and political tensions in Europe and concerns about slowing growth globally. We expect domestic-based corporate credit to perform relatively well, even with economic growth below long-term historical trends. Corporations in the U.S. have deleveraged and the resulting stronger balance sheets have improved the credit profile of the corporate sector. We are actively pursuing opportunities in this area to seek to capture additional yield for portfolios.
WE ARE TAKING A CAUTIOUS VIEW
After a year of strong returns in the fixed income markets and with Treasury yields just above their all time lows, we believe the risk-reward trade-off for either extending maturities or lowering credit standards to enhance yields is unfavorable at this time. Our posture is that fear and outside influences are conspiring to keep rates at unusually low levels.
Our view is that eventually at least some of this fear will dissipate. Investors simply may become more accustomed to living with uncertainty. Or, the U.S. economy could keep firming, or Europe could find at least enough of a solution to calm the frayed nerves of bond investors. As fear recedes, we expect that rates—particularly Treasury rates—will move modestly higher. In today’s environment, our primary objective continues to be the preservation of client capital. A simultaneous but secondary objective is to capitalize on dislocations that invariably present themselves during periods of fear and volatility.
STRATEGIC ASSET ALLOCATION
WE ARE MAINTAINING OUR TACTICAL DEFENSIVE POSITION, BUT ARE GRADUALLY MOVING TOWARD A MORE OPTIMISTIC VIEW
- Our tactical allocation recommendation remains unchanged since last quarter; however, our outlook—particularly for the US—has become somewhat more optimistic.
- The positive economic signals are giving us confidence to carefully and cautiously add some exposure to U.S. multi-national firms with records of dividend increases and above-market yields.
- We are maintaining a slightly below target allocation to emerging markets.
- Chinese and Indian efforts to combat inflation and real estate speculation appear to be nearing an end and we expect to growth stabilize in coming months.
- If Eurozone leaders can craft credible policies to restart recovery growth these major economies and the emerging markets in general should see their growth accelerate
- Our fixed income allocation recommendation remains below our long-term target due to acutely interest rates.
- Strong corporate fundamentals offer favorable opportunities for incremental yield in investment-grade debt.
- Municipal bonds are again relatively attractive as they now yield more than Treasuries.
- Cash levels in portfolios remain high as a hedge against widespread near-term volatility and uncertain growth ahead.
FIDUCIARY TRUST FORUM
PERSPECTIVE ON TRUST AND ESTATE PLANNING
TAKING ADVANTAGE OF TODAY’S GIFTING OPPORTUNITIES
Today’s generous tax exemptions as well as unusually low interest rates and asset values make for some unique planning opportunities. Our Fiduciary Trust Forum members discuss the potential benefits of utilizing Grantor Retained Annuity Trusts (GRATs) within an estate plan to help transfer assets to beneficiaries free of gift tax.
Q: How do GRATs help to save taxes?
Mary: GRATs are trusts that allow appreciation of assets to pass to beneficiaries free of gift tax. With today’s maximum gift tax rate at 35%, utilizing a GRAT can mean significant tax savings for your heirs.
Here’s how they work: A GRAT is funded with assets--usually shares of stock—that your portfolio manager believes will appreciate over a short period of time, generally two to five years. By the end of this term, you will have received back the value of the assets that you put into the trust, plus an amount of assets equal to an interest rate set by the IRS known as the Applicable Federal Rate (or AFR), which is also referred to as the hurdle rate.
Any growth in the trust that is in excess of the original value of the trust plus the hurdle rate is passed to the beneficiaries free of gift tax.
Q: How would it work if I set up a GRAT today?
Elisa: Assume you transfer $1 million worth of stock into a two-year GRAT. You would receive these assets back via two annual annuity payments, plus the amount of the IRS hurdle rate. At today's 1.6% hurdle rate, the annuity would be $517,517 per year.
If we assume the assets appreciate at a rate of 15%, the appreciation after the first year would be $150,000. You would receive the $517,517 annuity, so that leaves $632,482 in the trust to carry over to year two.
The trust starts year two with the $632,482, and we'll assume over the year that this amount appreciates by 15%, or $94,872. You'll receive the second part of the annuity, $517,517, leaving $209,836 in the GRAT to be passed to your heirs gift tax free. This amount can transfer to them in the form of the shares of stock, or in cash if you choose to liquidate the shares when the trust terminates.
Mary: A great benefit in the case of stock transfers is that the heirs own any future growth of those shares, and those assets are now removed from the donor's estate for estate tax purposes.
Q: Who can be named as a beneficiary of a GRAT?
Mary: A GRAT works best for tax purposes when the beneficiaries are in the same generation as the donor or in the next generation, such as children or nieces and nephews. This is because the remainder value at the end of the GRAT term is not exempt from the Generation Skipping Transfer tax (GST). If the beneficiaries of the GRAT are from a more distant generation, such as grandchildren or great-grandchildren, the assets would still be free from gift tax, but the GST tax would apply.
Q: How does today’s low interest rate environment make GRATs more attractive?
Elisa: As we’ve said, any appreciation in the GRAT that exceeds the IRS hurdle rate passes to heirs tax free. December’s 1.6% rate is in a historically low range--compared to a high rate of almost 12% in 1989—making it easier to achieve the excess gains we need to make the GRAT successful.
Jon: With a low hurdle rate like this, we generally don’t have to reach for investments that carry more risk in seeking to beat this hurdle. Of course, the higher the return the more that can pass to heirs, but even a small outperformance means some assets will transfer gift tax-free.
Q: Are there any special considerations given today’s volatile markets?
Mary: We recommend that trust documents are set up so that assets can be substituted in and out during the term of the GRAT. We recently had a GRAT that experienced a substantial increase in the value of the stock in the first year. Rather than risk giving up the gains if the stock goes back down in the second year, we took those shares out of the trust and replaced them with cash in the same amount. Doing so essentially locked in the appreciated value, and guaranteed that the gains would pass to the beneficiaries without taking any further risk.
Elisa: The idea of substituting is an excellent one because market moves these days are very short term in nature and sentiment is changing extraordinarily quickly. Substituting the original stock with cash is one way of locking in appreciation, but we also often replace the original stock with a different stock that we think might be ready to show some growth. We may make the substitution either because the original stock has appreciated in value and we want to lock in the gain, or because it has not increased in value as expected and we swap in another stock that may perform better.
Jon: This has been a risk-on, risk-off market. If the risk-on assets went up and reached a certain level of valuation, we would expect these assets to come back down as soon as a risk-off sentiment takes over. To capture that appreciation, especially if it is in excess of what one might anticipate, we remove that stock to immunize the portfolio from retrenching back on that gain.
It’s very important in this market environment to be nimble and active in managing GRAT assets. The best outcome can be achieved when we can capitalize on pockets of strength to capture appreciation, and on the flip side, use periods of weakness to place what we believe to be undervalued securities into the GRAT.
Q: How are capital gains taxes managed?
Mary: A GRAT is a "grantor trust" for income tax purposes. This means that the donor pays the tax on any income earned or capital gains realized in the trust. There are several ways to structure payments from the trust to manage capital gains taxes. If the GRAT transfers shares of appreciated stock to the beneficiaries, they will be subject to capital gains taxes when they sell the shares, based on the donor’s original cost basis amount.
Elisa: An alternative is for the appreciated stock to be sold within the trust before the assets are distributed to the beneficiaries. In that case, the donor is responsible for the capital gains tax liability and the beneficiaries receive a cash distribution at the end of the GRAT term.
Mary: In the case of a cash substitution, the shares of stock are returned to the donor during the term of the GRAT and their value is replaced with cash. Since the beneficiaries receive the appreciated value in cash and not shares, no capital gains taxes are involved. The donor’s shares of stock are treated the same as if they had never been used for the GRAT, so the donor will be subject to capital gains taxes when he or she sells the shares.
Q: Are there any drawbacks to using a GRAT?
Elisa: I think a GRAT is a very low cost, efficient way of tax-effectively passing assets on to the next generation. Setting up a GRAT requires an attorney to draft the trust document, but the cost is usually fairly modest. If the GRAT fails because the asset does not appreciate or because the grantor dies during the term, really the only cost to the donor is the cost of setting up the trust.
This communication is intended solely to provide general information. The information and opinions stated are as of December 9, 2011, 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.
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.
Vice Chairman and
Chief Investment Officer
Director of Fixed Income Strategies
Senior Relationship Manager
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