Fallout From U.S. Election Results
Dear Members of the Vodia Community,
Well, I don’t exactly know where to start. The election results from Tuesday night are a turning point for this country and for the world in a way that I never expected to witness in my lifetime. Unfortunately, it points to a distressing chapter in our history. I have a number of theories on what happened and what will happen but we will cover that in depth later.
The markets have responded positively after a night of utter chaos. The Dow swung a total of 1,000 points from high to low in twelve hours, currencies have gone every which way with the Peso losing 10% and commodities are flying around as well. The salient points for our portfolios, as of right now, are:
– Our equities have all done well despite this chaos. We have a large concentration in healthcare (for fundamental reasons) and healthcare is well ahead today based on the prospects of no Congressional action against drug company price increases – a strong part of Clinton’s platform.
– Our financial holdings in equities also rallied based on the perception of expected lower regulations for the banks.
– The heavy emphasis on fixed income investments has buffered all portfolios. The expectation of higher inflation combined with dovish Fed policy has created a steeper yield curve, boosting the income stream in our structured notes.
– The private pooled investments are entirely decoupled from this volatility. Only long-term economic trends will have the potential to impact those investments and we are assessing what this impact may be.
For lack of a better phrase, this is a s***-storm that we are weathering well based on our relatively conservative positioning focused on income generation. It will take us several weeks to assess the actual impact of the election on our investment portfolios during which time you should expect to see adjustments in your holdings to reduce risk.
Overall, this “change” is likely to harm our economy over a long time span while it, in the short-term, creates some optimism around business-friendly legislation by a Republican Congress. Though we seem to be well positioned in all aspects as of now, the potential for abrupt change is cause for us to review the portfolios.
As many of you know, together we have weathered other distressing times and our staff has worked consistently during such times to protect your portfolios. We have never taken for granted your trust in our work and appreciate your partnership as we move forward.
We will be hosting a Live Market Commentary webinar on Tuesday, November 15th, at noon to fully assess the impact of the election on markets, the economy and our society.
Until then,
David Matias
Focus on Fixed Income
In the last Live Market Update for our clients, we talked about the importance of the bond market in predicting economic conditions. For all the talk about how the stock market is a perfect aggregation of information across all market participants (i.e. people), it actually does a pretty crummy job of predicting future economic troubles. In fact, equities lag behind economic decline in most cases. For instance, the Great Recession was well under way by the time the stock market corrected and collapsed nearly a year later. Keep in mind that it takes months to a year to collect enough data to determine the actual start of an economic decline.
While academics and theorists claim the market is “efficient,” the opposite is often true. Equities appear to move almost entirely on expectations formed from the last 30 days of market experience, with news “shocks” randomly bumping it off that trajectory. This can be seen today in the fear gauge, or the VIX. As markets climb the fear gauge creeps lower and lower to reach historical levels when the markets are doing fine. Yet as soon as something comes along to disrupt expectations, such as the yuan devaluation last August, the VIX soars to levels indicative of a massive economic collapse—reactively, not proactively.
That leads me to a discussion of bonds. Also called fixed income, this market is many times larger than the stock market and encompasses a wide range of instruments from mortgages to auto loans. It is also a space retail investors have eschewed for the past five years. Back in 1994 when I interned on the floor of the New York Stock Exchange, I already noticed an interesting contrast between people working in equity markets versus those working in fixed income. Those working in the equity markets were typically guys of moderate education with strong sports backgrounds. Those in fixed income were a more diverse bunch of quants, often with advanced degrees in physics, mathematics and economics.
While the nature of equity trading has evolved since that time, it is still true that the fixed income arena requires a more nuanced understanding of mathematics and economics. For reasons that likely are related to these factors, the bond market is a remarkably good indicator of future conditions. Figures 1 and 2 show this in both the Dot-Com burst and the Great Recession. In both cases, the difference in yield between 2-year treasury notes and 30-year treasury bonds moved to zero. The positive yield difference in these two instruments is usually a reflection of expectations of future inflation. In both instances, this bond market metric correctly predicted that future inflation disappear as the economy went into a severe contraction.
While nothing is perfect in any market, the analysis of the bond market is typically a good indicator of what is to come, at least at its extremes. Today we sit at an odd point with those indicators. The 10-year U.S. treasury rate is at its lowest point ever (see Figure 3). Comparative rates in Germany, Switzerland and Japan are all negative—meaning investors will get less than their principal back when they buy a 10-year bond from those governments. And looking here at the U.S. yield curve (Figures 1-2), the 30 minus 2-year rate is declining slowly but steadily.
So while neither of these indicators is a clear signal of trouble ahead, the trends undermine the prospect of strong economic conditions inferred by the equity market rally. Going forward, these conditions start to make a strong case for depressed equity returns in the next few years with modest gains in the bond market. In other words, play for a relatively safe investment strategy with less reliance on equities coupled with modest expectations for returns in the next few years.
Regards,
David B. Matias
Managing Principal
U.K. Facing a Brexit Hangover – and Markets Aren’t Happy
Be careful what you wish for – You just might get it.
Today the United Kingdom is facing one massive hangover. After months of discourse over the grand consequences of an exit from the European Union, the Brexit referendum passed by a rather slim majority (52-48), or by roughly 1.3 million votes out of a country of 46 million eligible voters. With a 70% turnout overall, you have an extremely divided country. Some regions voted 70-30 in favor of Remain, and vice versa.
The voting pattern was extremely distinct along demographic and geographic lines. Scotland voted overwhelmingly to Remain, as did London – both areas where bad weather dampened turnout. Northern Ireland voted to Remain, albeit more tepidly. Wales and the rest of England were solid Leave. The Remain camp veered young and wealthy, and the Leave camp older and poor.
This voting pattern reflects the two core trends in the U.K.: wealth inequality and immigration. Both have created anger and frustration among Leave voters. It is the same two issues that have fueled Trump’s campaign. Interestingly, during the last major shift in U.S. politics – Reagan’s rise to the Presidency in the 1980s – the U.K. endured a similar upheaval with the rise of Thatcherism and the New Right. After all these years, America and England are in lockstep.
An actual Brexit is a disaster. It will provide no economic gains to the UK and likely increase the wealth gap even further. It might stem unwanted immigration, but the ensuing economic recession will destroy far more jobs than what is reclaimed. In the meantime, the Scottish independence movement is expected to be revisited and the consequences of a weakening European Union, containing our strongest political and economic allies, will be significant.
As for us, the actual impact on the U.S. economy is likely to be nominal. It will take at least two years for the terms of a Brexit to be determined, and it is to be noted that yesterday’s vote is not binding, but instead a recommendation. While there will be change, we don’t know what happens next in the political process.
What we do know is that there will be volatility – the bane of markets. The pound is swinging wildly today (hitting historic lows) and markets are selling off because of fear. We have seen this before – some event triggers widespread volatility and markets decline – followed by months of swinging markets until rational heads prevail.
We have positioned the portfolios to buffer such moves, and have a large cash position to take advantage of buying opportunities. Our exposure to the U.K. is negligible, but the impact outside of the U.K is yet unknown. With Europe still recovering from a recession, this will further challenge that region while continuing to place a premium on U.S.-based assets. In short, change is scary, but there are always opportunities for the long term.
And now we have a lovely start to the summer of 2016.
Cheers,
David
New DOL Rules a Blessing for Investors
This past February, prompted by President Obama, the Department of Labor (DOL) established new rules for retirement advisors requiring they work under the fiduciary standard. In short, this closes the door on an industry-wide practice of abuse that needs to end.
Currently, there are two separate standards than an advisor or broker is required to meet depending on the type of license they obtain. A broker under the suitability standard is required only to ensure that the advice is suitable for the client at that moment and no more. Under the higher standard of fiduciary, the advisor is required to ensure that the investments meet the client’s risk profile and needs at the time of purchase and on an ongoing basis. This standard demands more work from the advisor, as well as the disclosure of any conflicts of interest.
Brokers under the suitability standard maximize profits by increasing embedded fees on certain products and allowing for commissions on trading within the account. As a result, a retirement account in a brokerage environment can often incur total fees of 5% per year or more, levels treated as excessive and subject to legal exposure in a fiduciary environment.
Unfortunately, many advisors carry either just the suitability license or both, using the weaker guidelines to increase their profits while eroding client assets over time. I have seen on several occasions an advisor with both licenses pitch a client on their “safe” strategies, then immediately proceed to invest all their assets under the suitability standard.
In one such instance we saw recently, an investor nearing retirement handed over a large account to an advisor at a major retail bank. As soon as the cash transferred, the broker used his suitability license to purchase a handful of high-fee investment products, pocketing $10,000 in commissions. These products were mutual funds designed to provide “safe” returns, but in fact they lost 20% in just a few months when the market was down only a few percent. Not only was the investor unaware of the commission structure, but there was also no obligation on the part of the advisor to monitor the investments. The individual was left to watch their account go into free-fall while the advisor did nothing.
So the new rules make a ton a sense – retirement investors win and gain some protection from the damage done by unethical practices. But the industry is fighting these rules in every way possible. Just last week, I saw the headline, “DOL Rule May Force Advisors to Abandon Small Investors”, under the premise that as servicing small accounts becomes less profitable, the account holders will lose access to as broad a range of investment services.
Given the number of tools out there to serve small accounts at scale, this argument undoubtedly serves the interests of fear-mongering trade groups. Sound investment strategies for the long-term can be crafted from a range of low-cost, exchange-traded funds. But unlike the example above, the advisor does have to monitor the markets and manage the account accordingly. In other words, they would need to focus on managing the account instead of selling products.
Note: Vodia Capital always has been and always will be registered under the fiduciary standard as a fee-only advisor.
Signals Point to a Troubled Economic Psyche
Since our last update, a few events have occurred that are worth discussing. Starting with the more benign, the jobs numbers for April were disappointing. There were 160,000 new jobs created, which is healthy but a deviation from the 200,000 new jobs that have been created each month on average over the past two years.
We have also begun to see a quiet trend forming of a few large corporations trimming down travel and consulting budgets. These areas are the first to get cut when there is a contraction in the economy, with the potential that this is an early sign of economic trouble. The trend is not fully formed enough to indicate economic trouble ahead, but we will be watching it extremely closely in the coming summer months.
Secondly, Apple had a miss on earnings and reported that iPhone sales dropped significantly in the past quarter. While we anticipated this event and took measures to reduce our exposure to the company earlier in the year, it nonetheless took the market by surprise and cut 15% from Apple’s market value. It is yet to be seen how pervasive this trend becomes for the broader consumer economy, but as the largest technology firm, it is an important indicator to watch.
In a similar vein, Macy’s announced their worst quarterly sales since the recession. It is not yet clear what this indicates – it could be a reduction in consumer confidence in response to Q1’s stock market volatility or simply the shift from physical retailers to online merchandisers. Either way, it is another datapoint pointing to a troubled economic psyche.
Finally is the uncertainty around the presidential race. Plenty of ink has been used to describe the abhorrent policies of the presumptive Republican nominee, despite the lack of specificity that has characterized his proposals. While primary results show a Democratic victory in the general election (ignore the national polls released this week, they are grossly inaccurate this far away from the election), there is still a chance that Trump could be president. Should that happen, the agenda he has outlined would lead to near certain economic decay for the U.S., of unknown duration.
Given this signaling towards an economic contraction, we remain light on equities and heavy on cash and fixed income to take full advantage of their inherent stability. For equities that we do hold, we have companies that will continue to expand their cash flow despite variable economic conditions.
It is a more uncertain time than most in recent memory. Awareness, transparency, and thoughtful discussion are vital to managing through this period.
All the best,
David
Market Volatility
We are postponing the publication of our Market Update by a day to address the recent market volatility this week.
The market opened this morning with a bad hangover, dropping three hundred points on the Dow before the official open. By midday that market was down over 3%, on top of a miserable start to the year in which we are already in correction territory (down 10% from the recent highs). Put this on the heels of a rocky and lifeless 2015, and people are understandably worried.
This current market has fallen below the levels we saw in August and September of last year, when fears of an actual collapse were circulating. Now that we are past those levels, the question arises as to whether this slide will continue. Are we about to experience another 2008 with a halving of the stock market?
While I am the first to admit that this market has us worried – energy prices are dropping without an end in sight and China continues to drag down global markets – I am also optimistic. The data continues to be very strong in the U.S. and many of the factors driving down this market are grossly overstated. We are also seeing signs of calm in this volatility with the VIX remaining in the 20s, a relatively benign level showing the mindset of institutional traders.
If this plays out as expected, we are seeing a good buying opportunity for stable companies as we head into a slower growth period in the U.S. and abroad. We do not expect to see equity returns of the magnitude of the past few years, but there are modest amounts to be made in this environment.
This and plenty more will be covered in our Market Update tomorrow.
David