Solvency is maintained by means of a national debt,
on the principle, “If you will not lend me the money,
how can I pay you?”
Ralph Waldo Emerson, philosopher and poet
As with prior letters, this letter will address both planning and investment market issues. At Payne Wealth Partners we believe proper handling of both planning and investments is important for clients to best achieve their goals.
PLANNING COMMENTARY
Like many things in life, you get out of wealth planning what you put into it. When we prepare client wealth plans we put particular emphasis on getting our facts and assumptions straight- there’s nothing we’re more serious about getting right. Some “plan inputs” are facts yet some must be assumptions- life expectancy, investment rates of return and tax rates, just to name a few.
What separates a meaningful plan from a plan not worth the paper it’s printed on is the independent critical thinking involved in determining what those assumptions should be (the facts are the easy part). As to investment rate of return- the “industry standard” seems to be, even after all the market turmoil of late, to “take the historical average” when determining what to expect from an investment portfolio in the future. While this is certainly the easiest approach (historical rates going back to the early 1900s are published annually by providers such as Ibbotson) it’s hardly adequate when determining the direction of our client’s financial future- and at this point seems overly optimistic.
Our approach has been to revisit these assumptions at least annually (this has been semi-annual revisits since 2007 due to market swings). Historical averages are a very small piece of the puzzle, while current market prices, economic outlook and macroeconomic trends are the vast majority of the puzzle (historical returns truly are not predictors of future performance!). As a part of this process there is always a vast amount of technical information gathered along with commentary from economists and thought leaders we follow. This aids us in formulating our best estimates to use in planning.
The point is that we must be intellectually honest with our clients about where investment markets will take them in the future, and how much we can rely purely on market returns to fuel financial goals. In the 1990s it was customary to see plans using average annual portfolio return assumptions well in excess of 10%. To our dismay we see others in our industry using similarly high returns even today, while our portfolio return expectations are much less than this. While it may be fun to look at how big the numbers can get when using a high return assumption, it certainly doesn’t aid in making prudent, informed decisions. We will continue doing our best work to determine the appropriate returns to use while planning our clients’ financial futures as we seek honest answers grounded in independent, unbiased thinking.
MARKET COMMENTARY
The month of May saw the S&P 500 decline 8.2% amid increasing concerns over European debt problems and their possible effect on worldwide growth. Greece received most of the media attention, but several European countries have high levels of debt relative to their overall economy including Portugal, Italy, Ireland and Spain. Observers have coined a term for these countries, PIIGS. With the concerns over PIIGS debt the Europeans together with the International Monetary Fund set up a one trillion dollar facility to purchase debt when needed; markets initially reacted in a positive manner as European stocks, currencies and debts appreciated, but by months-end all had resumed their decline.
Receiving less attention, but important nonetheless, are China’s efforts to control inflation and rapidly increasing real estate prices. During May China implemented rules requiring high levels of down payment on 2nd and 3rd homes and on May 31 announced what looks to be their first property tax at the homeowner level. May saw the Chinese Shanghai index drop about 10% to bring the year-to-date decline for the index to 22% as investors worry how much China’s economic growth rate will drop.
The “flash crash” also happened during May, with the Dow declining almost 1,000 points in just minutes and then recovering a majority of the losses before the day’s close. The regulators still don’t have a full explanation as to what happened, but computer generated orders undoubtedly played a major role. Unexplained volatility can only harm investor confidence in an already fragile market.
Despite the many problems, there is a positive backdrop of U.S. companies showing nice profit growth (1st quarter was 57% growth versus 1st quarter 2009), low inflation, and low interest rates. It would not be surprising to see stock price gains if the news flow would become a little less negative. But we are much more focused on key long-term themes to build our client portfolios, with such themes including:
• Most developed economies have issues with debt due to present historically-high levels combined with new debt to fund ongoing deficits, all exacerbated by the 2008 economic crisis. The better government debt to own over time is that of the emerging economies who as a whole have a debt to GDP ratio of 37% while developed markets are at 94%.
• Although the U.S. dollar has seen recent strength in a flight of money to perceived safety, expect the dollar to be pressured over the long-term (when compared to countries with sound fiscal policies) by dollar creation to fund deficits.
• Shorter maturities of debt are more attractive (as compared to longer term) since the trend of declining interest rates in place since 1981 will at some point reverse and become one of interest rate increases which could last for decades.
• Well managed companies (as chosen by experienced managers) will benefit from present economic challenges by gaining market share and making strategic acquisitions. Investments in these companies are favored to earn an above average return over time.
• Equity investments in emerging economies will benefit from their higher levels of growth, but will experience significant volatility.
These themes are expected to significantly affect our portfolio management decisions going forward and were reflected in our recent decision to increase portfolio allocation to emerging country debt. To get a better sense of our thinking you may wish to sign up to receive our weekly blog posts via email by visiting www.paynewealthpartners.com.
