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IHA Quarterly January 2011 |
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The price of food recently surpassed its 2008 peak. At that time people in numerous impoverished nations rioted as food inflation threatened to eat up much of their disposable income.
 This year the only reported riots have been in Algeria, but fear of spreading is prevalent. Riots stemming from the price of food have been quite common throughout history and played a key role in the French Revolution. A severe winter in 1788-1789 led to a 90% increase in the price a loaf of bread, the staple food in pre-Revolutionary France. This caused discontent in the slums of Paris and widespread rioting (often led... not surprisingly.. by mothers angered at the rising costs of feeding their hungry children) and culminated in the Storming of the Bastille. Eventually, a revolution led by the lower class guillotined Louis XVI. Within a few years, rule by the masses had degenerated to the Reign of Terror where 20,000 people, mostly poor and middle-class, joined Louis under the blade of the guillotine. |
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Market Commentary
A remarkable year ended on a high note for U.S. stocks amid economic optimism. The rally was spurred on by improved data and a number of indicators. The Conference Board's Leading Economic Indicators, a broad index of the economy, was up 1.1% in November. Nine of the ten components of the index were positive, obviously a good sign of overall growth. The collapse of the Weekly Leading Index published by the Economic Cycle Research Institute (ECRI) had fanned the flames of bears on the economy earlier in the year but the index turned back positive in December- further indication that economic conditions have improved.
Positive data and an improved political climate for business has translated into sharply higher equity prices, particularly in U.S. markets. Small and mid size companies returned over 25% for the year despite being in negative territory as recently as September. This run in stock prices has pushed valuations- our preferred measure is based on cyclical earnings- to their highest level since the Lehman Brothers bankruptcy in 2008.
Take a look at the graph below. You'll notice that even with the surge in equity markets which has kept pace through the first weeks of 2011, prices are still relatively low as compared to recent years. Furthermore, today's prices would be further justified if a pickup in global growth- especially in the U.S.- allowed companies to leverage the productivity gains of the recession into even higher profits. 
During our first year in publication we described how over-leverage fueled the housing boom and its subsequent collapse. People borrowed too much, banks borrowed too much, and many companies borrowed too much. Up to their eyeballs in bills, over-indebted consumers and companies defaulted on loans, causing banks to default on their debts; culminating in a financial crisis when general devaluation of financial instruments stoked fears they represented empty promises. This chain differs from a normal business cycle recession in that the steps taken to recover from a financial crisis (bailout of banking institutions, increased government debt, etc) causes the recovery to be slow and painful. Carmen Reinhart and Kenneth Rogoff wrote an influential paper that examined financial crises and their aftermath (later expanded into a book) and found the record littered with sovereign defaults, extended periods of slow growth and both inflationary and deflationary spikes. In a time of growing optimism we think it is important to keep this historic record in mind and one economic 'foot on the ground'. Here we examine three obstacles to a full and speedy recovery:
In the U.S.- Structural flaws will take some time to fix.
1) Housing continues to lag... and not only in total number of sales (which are terrible). The following chart of new and existing home sales is from the blog Calculated Risk. The red and blue lines represent 'new home' and 'existing home' sales and perform a tightly choreographed dance for over a decade. Today these lines hardly know each other at all:
 There has generally been about a 6:1 ratio between existing home and new home sales. The pace of existing home sales tells developers when to build new ones. This recession has thrown that relationship out the door, into the snow. Homebuilders have practically stopped building as they face an ocean of supply from underwater homeowners and foreclosures. In our last newsletter we noted the important role home construction jobs played in leading the U.S. out of previous recessions. We don't see that happening anytime soon.
2) Fed Chairman Ben Bernanke has said that there is no structural change in employment due to the recession- we disagree. What is completely different this time is the difficulty some workers are having finding any kind of employment. The chart below spans 40 years and shows the median length of time those who are unemployed have been without work:
In previous recessions, this number topped out in the 10-15 week range. In the current recession it touched 25 weeks and remains above 20. This is partly indicative of the extension of unemployment benefits but also shows that people are having difficulty finding jobs in line with their experience and skills. Many of the long term unemployed will have to start new careers at great cost, representing a clear structural change.
3) The difficulties facing state and local governments have been well documented (click here for a 60 Minutes report on the matter) and we have recently highlighted the selloff in California muni bonds as an indicator of fiscal problems in the Golden State. While overall debt levels are high, the payments on that debt are a small percentage of states' expenses. It makes sound economic sense to pay these obligations rather than get shut out of the bond market. Keep in mind that Greece and Ireland have not defaulted on their debt but have seen their borrowing costs triple over the last year. So the bigger question is not of defaulting but of investors continuing to lend. The typical U.S. state's response to a recession has been to raid rainy day funds, impose "temporary" tax increases, and use accounting tricks such as one state agency borrowing from another. States have tried everything short of addressing the issues that leave them in a precarious financial condition during every recession. We expect a shakeup on the state level as elected officials will have to make real changes in the way governments operate. Like many other structural reforms, belt-tightening will prove beneficial in the long term but will have costs in the short term as those reliant upon transfers from the state will lose benefits.
The tangled web of European sovereign debt and European banks.
While the problems of Greece and Ireland dominated the European financial markets in 2010, the unspoken corollary is that the owners of those countries' debt are generally French, German, UK, and to a lesser extent, U.S. banks. While it is understandable that the German people are hesitant to bail out their neighbors, in reality the purpose of that money is to save the European banking system. We are confident the German government wouldn't give a lousy old Weimer Republic mark to another nation if German banks could avoid damage from an EU sovereign default. We are also careful not to point fingers... think back on the U.S. in late 2008 where the last thing any politician wanted to do was bail out a big bank or (worse) Wall Street, but fear of the widespread damage from a large institutional failure resulted in TARP and various other bailout programs. With all this in mind, there are a couple of questions about the European sovereign debt problems we are watching for answers on:
-Does the Union have the money, and will, to continue bailing out countries as the price gets steeper and steeper? The Greek and Irish bailouts are expected to cost about $250 billion. A Spanish bailout would cost twice that amount. If the pattern of bailouts continues, at some stage the costs will be too high.
-Will the recipients of the bailout continue to see it as the best solution to their problems? Those countries receiving bailouts have had to pay a big price in terms of lower government spending, higher taxes, and higher unemployment. It is possible troubled EU countries will ponder an effective default accomplished by leaving the Euro currency union. The following chart (from www.tradingeconomics.com) shows the Portuguese unemployment rate over the last decade.
While Portugal's per capita GDP has grown since joining the Euro currency, so has its rate of unemployment. This trend is not expected to change, especially if they take a seemingly inevitable bailout. Reasonable Portuguese citizens could question the benefits of ever joining the Euro... and of staying with it. If any of these highly indebted nations were to depart from of the EU, much of the cost would be paid by banks who own the sovereign debts. Vocal opposition within the Irish parliament has already expressed the intention of 'burning the senior bondholders'. Such actions would cause widespread losses throughout the banking system.
Rising Commodity Costs and Emerging Markets
Global growth over the last two years has been led by emerging markets, particularly China. For many of these countries, rising commodity costs are both a blessing and a curse. A blessing in that many export natural resources and higher prices mean greater income. A curse in that commodity inflation means higher prices for food and energy, which consume a large proportion of their populations' income. The following charts show price indexes for food and industrial materials (data from the International Monetary Fund). Both have reached all time highs.
These rising prices have significant consequences. There have already been food riots in Algeria. Countries have started halting food exports. In Asia, central banks have started to raise interest rates to stem inflation. Eyes are on China. Its economic policies are inherently inflationary but taking actions to stem inflation (raising interest rates, letting its currency appreciate) threaten internal job growth. If China raises interest rates or appreciates its currency significantly the repercussions will be felt in markets around the world. In the U.S. and other developed nations, commodity inflation has far outpaced economic recovery. Commodity inflation has preceded many of the most dramatic drops in equity markets over the last thirty years. If prices continue to rise at the pace they have for the last two months expect serious policy actions to stem inflation- rarely a positive for markets in the short term.
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Asset Class Returns
3rd Quarter 2010
Monthly and 52 week returns for major asset classes. Performance information is for total return assuming reinvestment of interest and dividends. It excludes management fees, transaction costs and expenses.
 December was a huge month for equities worldwide. However, the rise in stock prices has been accompanied by higher interest rates which has put a real crimp into bond returns. The run-up in commodity prices picked up speed in December and bears watching going forward.
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Financial Planning Highlight
2011 Tax Changes
President Obama and Senate Republicans reached a tax deal that finally gave certainty for most issues heading into 2011. We review some of the important aspects of the deal.
Income Taxes
All of the Bush tax cuts will remain in place for the next two years. This keeps the top marginal rate at 35% and keeps lower rates in place for every tax bracket. Also extended is the repeal of the phaseout deduction for personal exemptions and itemized deductions for upper income filers.
Dividend Taxation
Since the Bush rates were extended for another two years, the capital gains and qualified dividend rates for taxpayers below the 25% bracket is zero percent. For those in the 25% bracket and above, the capital gains and dividend rates will remain at 15%.
Estate Taxes
The most significant changes were to the estate tax. The deal sets the exemption at $5 million per person and $10 million per couple and a top tax rate of 35 percent for the estate, gift, and generation skipping transfer taxes through 2012. The exemption amount is indexed beginning in 2011. The proposal is effective January 1, 2010, but allows an election to choose no estate tax and modified carryover basis for estates arising on or after January 1, 2010 and before January 1, 2011. The proposal sets a $5 million generation-skipping transfer tax exemption and zero percent rate for the 2010 year.
Temporary reduction in employee-paid payroll taxes.
Under current law employees pay a 6.2 percent Social Security tax on all wages earned up to $106,800 (in 2011) and self-employed individuals pay a 12.4 percent Social Security self-employment taxes of on all their self-employment income up to the same threshold. The bill provides a payroll/self-employment tax holiday during 2011 of two percentage points. This means employees will pay only 4.2 percent on wages and self-employment individuals will pay only 10.4 percent on self-employment income up to the threshold. Essentially this means anyone who works will get to retain another 2% of their earnings up to the $106,800 limit.
Child and Earned Income Credits
The deal extends changes made in the Stimulus Act to expand these credits for lower income earners.
Our Take on the tax developments:
Outside some of President Obama's more liberal supporters, the tax deal has been remarkably well received by most pundits and policy analysts. It signals a path that the President can follow to get his policy ideas through a stronger Republican representation in Congress. We believe it paves the way for President Obama to reach some sort of tax reform deal in regards to corporate tax. This would lower the rate but probably increase actual collections as there are myriad ways companies can avoid this tax in its current form.
Thank-you for reading...
We enjoy writing this newsletter because it keeps us in front of our readers while using education as the platform. We hope we have given you some 'inexpensive' food for thought to start the New Year.
If "getting my finances organized" is on your list of resolutions or if you wish to speak to us in person about your financial planning needs, simply "Reply" to this email or call us: 212.949.0494 and we will be happy to discuss our services with you.
We wish you and yours a prosperous 2011.
Sincerely,
John O'Meara, CFP® and Michael Keating, CFP®
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What We Have Been Reading
To start the year, a collection of the best online financial calulators
Rent or BuyComparing the costs of renting and buying equivalent homes.
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