End of an Age

According to official International Monetary Fund (IMF) forecasts released earlier this week, the “Age of America” is coming quickly to its end.  The report provides projections for the growth in size of major economies worldwide and has calculated the year in which China’s economy will be larger than the U.S.’s in real terms (purchasing power adjusted).  And it’s a lot closer than you may think. 

Shot Across the Bow

For quite awhile now we’ve been writing about our concerns over our country’s budget deficit and growing mountain of debt.  Now that a prominent rating agency has fired a warning shot across the bow, we are hopeful that lawmakers will put aside political differences and start to take this situation seriously. 

On Monday morning, Standard & Poor’s delivered a strong warning shot to U.S. lawmakers urging them to get a handle on the finances of our country or risk losing our nation’s AAA credit rating.  The rating agency says the U.S. faces a one in three chance of a downgrade in the next two years.  This would likely happen if the White House and Congress could not come together to create a credible plan for reducing our budget deficit and resultant debt, all as a percentage of our overall $14 Trillion economy.

March 2011 Market and Planning Update (Posted to our blog two weeks after sending to clients.)

“If inflation continues to soar, you're going to have to work like a dog just to live like one.”

George Gobel, Comedian, 1919-1991

(Quoted during the late 1970’s)

PLANNING Commentary

Everyone agrees that excessive inflation (or the opposite - deflation) is not an economically healthy trend.  From a personal finance perspective, the inflation rate used in wealth planning is a key assumption that must be monitored closely.  More importantly we want to understand as best we can the potential impact of future inflationary trends on client financial goals like retirement, education and maintaining a comfortable lifestyle.  As we review historical inflation rates for specific expenses, we have found that they often experience wildly different trends than the historical averages. 

For example, we use in our wealth planning work 3% for general lifestyle expenses (i.e. utilities, food, gasoline, clothing, etc.) although have found that tuition and fee expenses related to attendance at a private four-year university have grown at double that rate in the past (thus we use 6.2% for these expenses in our work).  More importantly, we think due to a number of emerging trends that these types of expenses could grow even faster in the future.  Public four year university expenses have increased 2.5 times as fast as our baseline rate of 3% and thus we are using rates between 7% and 9% for this type of cost. 

Medical care can experience even steeper increases whether due to technological improvements, supply constraints due to baby boomers or cost sharing changes (i.e. business’ and the federal government being unable to afford to share in these costs with individuals as they have in the past).  In our work we estimate these changes for future planned expenses relative to what we have found to be true in the past while continuing to consider the impact of current and future trends. 

Market Commentary

After a dip during the middle of March, the stock market has shrugged off global concerns and uncertainty to continue its upward advance.   For the first three months of this year the S&P 500 index has seen a total return of 5.9%.  The bond market has generated a small gain of 0.5% since December 31 as measured by the Barclays Capital Aggregate Intermediate Bond index.   International stock markets have also shown strength for the first three months of this year with the MSCI EAFE Developed Market stock index increasing 3.4%.  Emerging market stocks have been volatile and down for most of the first quarter; however, a 5.7% rally during March has led to a small gain of 1.7% for this year.

Employment and economic numbers in the US continue to look promising.  However, as we look out over the balance of the year we are concerned about the spike in food and energy prices and the impact this will have on consumer spending in other areas.  The most recent reading of consumer confidence showed a decline because of the bite that higher prices at the pump and grocery are having on everyone’s pocketbook.  

We are also paying close attention to what the US Fed may do with monetary policy when they end their second round of quantitative easing in June.  We see Treasury yields increasing over the next few years as investors demand a higher return for buying our bonds (due to the fiscal irresponsibility of the US Government).  In the bond portion of our portfolios we have reduced the average maturity of our bond holdings to protect against future interest rate increases.  And, we continue to assess investment opportunities to guard against inflationary pressures.   

CONCLUSION

Inflation can be devastating to long-term financial goals if it is not planned for properly.  Saving strategies, appropriate lifestyle decisions and constant goal planning are cornerstones of our wealth planning work that help to deal with these future risks.  Also, monitoring appropriate investment holdings and diligently allocating appropriate levels of the portfolio to inflation-protected positions helps protect asset values. 

Municipal Bonds

Municipal bond prices have been weaker over the past several months due to ongoing negative media attention given to the potential for rising defaults.  Investor nervousness about the potential for more defaults has led to redemptions from municipal bond funds, and selling of individual bonds.   

We believe many of the media reports and negative commentaries have greatly exaggerated the potential default risks.  Yes, careful credit evaluation is more important than ever and challenges do exist in many states (California and Illinois) and cities (Vallejo, CA and Harrisburg, PA).  However, in our opinion these examples represent localized problems, not systemic risks that will lead to wide-spread defaults across the entire municipal market.

Crossroads

Our country is coming closer and closer every day to financial crossroads that must eventually be faced.  Two options as to the path we take to move forward have emerged- one that closely resembles the path we are on today (and have followed in the past) and a second that takes a hard turn in a different direction.  There are vastly different opinions on which of these paths is most appropriate for the country going forward. 

Home Prices

Even though we’ve seen home prices decline 24% over the past 5 years, two key home indices show that prices nationwide are continuing to trend lower.  We saw a drop in prices last year due to the expiration of the homebuyer tax credit.  Now, home prices are being driven gradually lower by foreclosures and the ongoing imbalance between high supply and low demand. 

Current banking reform proposals requiring at least a 20% down payment are good for the long-term health of the housing market; however, it would surely lengthen any price recovery.  First-time buyers will find it harder to get on the property ladder and existing homeowners will find it even harder to move up. 

We’re not sure if home prices have bottomed yet, but affordability is certainly at the most attractive level we’ve seen in 30 + years.  Between 1979 and 1990 the average interest rate on a 30 year fixed rate mortgage was at least 10%.  Today the national average for a 30 year fixed rate mortgage is 4.8%.  A popular home affordability measure calculates that the average family will spend roughly 12% of their household income on mortgage payments this year.  Compare this to the early to mid – 1980’s when the average household spent closer to 35% of their personal income on mortgage payments.  This historical comparison shows the magnitude of affordability changes. 

Home prices are important for one key reason - they affect consumer confidence.  If we see a significant further decline in prices and subsequent declines in consumer confidence it could slow consumer spending and challenge our economic recovery.  This makes home prices an important indicator going forward.

Sources:  HUD, Freddie Mac, Case-Shiller, Capital Economics and JP Morgan.