Spring Economic Commentary

What happened to the Fiscal Cliff?

Well, it was more like a speed bump than a cliff, but after a great deal of drama about the Fiscal Cliff it’s been a bit of a non-event. While it doesn’t rise to the level of “much ado about nothing” the outcome of the two biggest parts of the fiscal cliff have only been noteworthy in that nothing much happened. After all the ballyhoo for the past few years, we have resolved the issue of the expiring Bush tax cuts and have recently passed the deadline for the beginning of the sequestration that Congress and the President were unable to avoid. So we did go over the cliff, so to speak, but the effects of both of these expected economic traumas have been relatively benign.

The tax increases in the new act fall mainly on high income earners and introduce a new, higher level of complexity to the calculation of income taxes, along with the implementation of surtaxes on high income taxpayers. For the most part, there have been no dire consequences or notable effects on the economy. The only exception is that consumer spending has been negatively impacted by the expiration of the payroll tax holiday, raising the payroll tax 2% on all taxpayers beginning in January. We are still in the process of assimilating all of the changes for our clients, but with a year to develop an understanding of the peculiar effects on each of our clients, there should be no surprises and, where possible, we can adapt our tax or investment strategies to minimize the damage of these tax increases.

Meanwhile, sequestration has begun, effective March 1. We had plenty of advanced notice that no agreement would be reached, which may have helped to lessen the market reaction to the developing spending reductions. Hopefully, the gradual implementation of the sequester cuts will lessen their impact; however, it is quite impossible to cut spending without affecting programs and services. We just hope that there can be some clear and thoughtful decisions about which programs get cut and by how much. There is no end of clearly wasteful and redundant government spending which should be cut instead of important services such as airport security and food inspections. Hopefully our leadership can set their priorities in ways that are smart and efficient, although given the continuing divisive political environment, this is not a sure thing. But at least this is a small down payment on the seemingly necessary belt-tightening that will be required to improve the U.S. fiscal situation for the long run.

How Has the Market Reacted?

With a general sense of relief, the stock market has been on a bender thus far in 2013, with all major markets delivering handsome gains for the New Year. While we’ve had a good run so far this year, equity market prices remain below their long-term averages. So, further upside remains a possibility. However, we must always temper our enthusiasm after such a long period of positive equity market performance. As market sentiment turns more bullish, investors need to resist the temptation to expect the trend to continue indefinitely. We have continued to rebalance our client portfolios over the past few years in order to keep portfolio risk in line with our clients’ longer term objectives.

Fixed income returns for the year have been more volatile than normal and bonds, in general, remain expensive relative to historical prices. We think this makes fixed income a riskier asset class than it has been for many years. The reason for this is that we are near all-time lows in interest rates and we expect interest rates to eventually begin to rise. While we don’t know the timing, we expect bond markets overall to suffer as rates begin their inevitable rise. On balance, our outlook for our diversified portfolios remains positive.

Addressing Historically Low Interest Rates

One of the most common questions we receive from our clients and friends is:

“Why should I be investing in bonds today? Interest rates are so low, I’m getting paid almost nothing and bonds will go down in value when interest rates rise.”

We’ve addressed this individually with many of our clients, but thought we’d share our thinking in a broader way.

For many years, until recently, bonds have provided a steady stream of predictable income, which is very comforting to retirees and other investors alike. As part of a balanced portfolio, bonds have also provided a buffer to the higher volatility of stocks. While stock returns have a high variability, bond returns are steadier and provide an anchor to windward for overall portfolio volatility.

But current concerns focus on what may be an end of a more than three decade decline in interest rates. As measured by the 10-Year U.S. Treasury bond, bond yields have fallen from an all-time high of 15.8% in September of 1981 to the current yield of roughly 1.9%. This has resulted in terrific long-term price appreciation for bonds. From September 30, 1981 to February 28, 2013 the total return for bonds, as measured by the Barclays Aggregate Bond Index, has averaged 9.0% per year. Considering the relatively low level of volatility for bonds, this compares favorably with the total return of the stocks in the S&P 500, which averaged 11.4% per year over the same period.

From our perspective, we have been concerned about rising interest rates for several years. We have been a little early in implementing our strategy, but have not suffered greatly as a result and have mitigated some of the risk in a possible steep rise in interest rates. The fixed income portion of our clients’ portfolios is arrayed in the following fashion:

· 40% Short Duration Bonds – As the name indicates, these bonds have short maturities and should not be greatly affected by increases in rates, although the tradeoff is somewhat lower income.

· 30% Core Bonds – This a broader selection of bonds, generally government or investment grade bonds with a wider mandate. Bond duration here is controlled by the managers we have selected.

· 20% Strategic Bonds – This is a go-anywhere fund with a sizable allocation to higher yielding bonds, which should have higher current returns as well as a somewhat lower exposure to the effects of rising interest rates.

· 10% International Bonds – This fund invests primarily in foreign government bonds. This part of our portfolio also has a low duration by manager positioning.

Our aim is to provide a balanced approach to our clients’ bond exposure, with a decided tilt to the safety of short duration bonds to protect the portfolios from the possibility of dramatically rising interest rates. While their expected returns are currently low, bonds continue to provide important ballast to a balanced portfolio. We’ll have to wait and see how everything works out in the long run to see how successful our approach is, but it seems a reasonable and measured way to address the likelihood of rising interest rates. Of course interest rates make up only part of the picture in the current investment landscape.

A Heightened Awareness of Uncertainty

We continue to be bombarded with news raising concerns about the U.S. economy, the Eurozone, China, the domestic political impasse and all manner of other problems. We are not sure things are more uncertain than they have ever been, but people and markets remain anxious. While markets have decidedly improved and market volatility has subsided, it is hard to forget the recent past, although 2008 and early 2009 are now more than four years removed. Yet, there remains a heightened awareness of uncertainty which colors investors thinking today. It is a fact that can’t be avoided.

So, how are investors to proceed in the midst of continuing uncertainty? You can’t really ignore it, but we spend a lot of time worrying about things that, with 20:20 hindsight, don’t turn out to be important. As advisors to our clients, we must remember that our clients’ investment profiles are looking out years or even decades. Author Steven Covey suggests that people “Begin with the End in Mind.” For long-term investors, “the End,” is usually a comfortable retirement or family wealth objective. Ordinarily, this requires investors to grow their portfolios over long periods of time and, historically, the way to do this is to invest in stocks. Investing in publicly traded companies, within the context of an intelligent long-term investment program, remains a proven way to build lifetime financial security.

So, over long periods of time, it’s about investing, not trading – the long run rather than the short run. If you are an investor, it is all about making decisions in context of your long-term plans. To be comfortable with this position, you have to have clarity about your long-term goals and confidence in your long-term course of action so that you can control your emotions and think rationally during the short-term ups and downs of the investment markets. So, in our view, it’s much simpler to stick with a plan than to make ad hoc investment decisions in the face of the constant pounding of the day-to-day news.

So, as we look back, over the past few months and years, we see that despite the recent rise and fall of the so-called new economy, the internet bubble, the financial crisis, the increased threat of terrorism and the increasingly linked global economy, the tried and true tenets of long-term investing continue to make sense and withstand the test of time. Invest for the long-term. Diversify your portfolio. Avoid market timing. Expect markets to rise. Expect markets to fall. Don’t expect miracles.

As you have experienced, this advice is easier to give than to follow. But, if you can keep a long-term perspective, you may be able to avoid overreacting to events. In all events, we’re here to help you with the process and are always willing to work through any questions or issues you may have. Please don’t hesitate to call if you get distracted or need help staying on track.

© Horizon Advisors


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