Big Bad Bond Market

11/18/2016

By Michael McKeown, CFA, CPA - Chief Investment Officer

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter.  But now I would like to come back as the bond market.  You can intimidate everybody.” – James Carville, political advisor

The biggest post-election news is the bond market.  Yields are up over one half of a percent to 2.25% on the 10-Year Treasury, which means bond prices fell.

The main reason behind the move in prices was higher inflation expectations. One of the main risks bond investors take into account is future inflation.  With President-Elect Trump’s big plans for infrastructure spending and tax cuts, it could mean greater money flowing in the system.  In addition, protectionist trade policy, if implemented, would also be inflationary for goods and services due to less competitiveness among companies.  In turn, this would lead to a larger federal budget deficit.  Traders and investors are pricing in the likelihood of these policies being passed by the Republican led Senate and House.  These policies go against many Congressional Republicans who spent the last several years threatening to shut down the government due to high budget deficits.

The breakeven inflation rate measures the difference between yield of nominal Treasury bonds and Treasury inflation-protected securities (TIPS).  It measures the inflation premium investors demand.  Inflation expectations were very low in the early part of 2016.  This measure increased sharply over the last few months and post-election.  This can be attributed to increasing wage pressures, oil prices bottoming, and talks of infrastructure spending by both candidates.

In the top half of the graph below, the price of the Barclays Long-Term Treasury Index is in teal blue.  Today, the bonds are trading at 108, which is in the lowest 6th percentile since 1990.  In other words, prices have been higher 94% of the time.  The green horizontal line is the average of the past 20 years. 

In the bottom half of the chart, the red area shows Treasury yields.  There has been a defined downtrend over decades.  Every few years it comes up to hit the diagonal downward blue dotted trend line when bond prices sell-off. 

While many worry if now is the time to sell bonds, others are asking if this is an opportune time to buy?

The Cleveland Fed publishes inflation expectations for the next ten years.  Per the website:

“The Federal Reserve Bank of Cleveland’s inflation expectations model uses Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectations to calculate the expected inflation rate (CPI) over the next 30 years. The Cleveland Fed model is run every month on the date of the CPI release.  The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.75 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.”

In the big picture, what matters is whether there is secular change for inflation expectations.  If so, bond investors will demand a higher inflation premium for the risk of owning bonds.  The 35-year downtrend in interest rates may come under pressure, depending on how functional the government can be in its push for deregulation, fiscal spending, and tax cuts.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Post-Election Outlook

11/9/2016

By Michael McKeown, CFA, CPA - Chief Investment Officer

Political values are important to individuals, but mixing politics with portfolio decisions is not profitable on a consistent and repeatable basis.

Analysis based on fundamentals and the valuation of asset classes is what matters for investments.   We plan to stay in our lane and take a non-partisan view to what this election means for the economy and investments.

It is difficult to discern the planned policy implementation of Republican President-elect Trump based on his campaign.  Nonetheless, the control of the House of Representatives and the Senate by Republicans means that aggressive change may be coming and we will see healthcare, interest rates, trade policy, tax policy, and fiscal policy set off on a new course from the previous paths.  The unknown for these changes is the implementation timeline, the magnitude, and unintended consequences.

Aurum maintained a long running assumption that the coordinated executive and legislative branches of the government would be bullish for the domestic economy.  Trump proposed tax cuts and fiscal spending (both areas we implored for cooperation in over the last five years).  Specifically, he discussed infrastructure spending of $500 billion to $1 trillion in addition to individual federal tax cuts.  Of course, this does not align with the more vocal wings of the Republican party as it would increase the federal budget deficit.  If passed, though, the likelihood of higher growth and inflation would be probable.  This would be a net positive for wage earners and the economy overall.  The rise in inflation expectations would push up yields on government bonds (as of this writing, the 10-year Treasury is up 0.26% from the overnight lows to 1.96%).

At risk are global trade and companies tied to exports.  Protectionist policy could offset the positive domestic economy to a certain degree.  Despite the initial reaction by the currency markets, this should be good for foreign currencies against the U.S. dollar.

Geopolitical risk is another key area of concern.  Given the campaign rhetoric, it is unknown what policies will or will not be implemented; but a heightened sense of uncertainty could cause greater global stock market volatility.

Just like pilots do not take off without a contingency plan for a storm, our investment committee laid out plans for multiple scenarios.  This includes analyzing and maintaining the prices at which we would be willing to commit more money to stocks and bonds.  This is a constant process that occurs regardless of political events or elections.

We believe the largest new opportunity is in the global bond and currency markets.  Today, our analysis shows that we are getting paid the most in the last ten years to own a thoughtfully constructed global bond portfolio. 

In an emotional time (both exhilarating or outright negative), this is a period to look at lessons from behavioral finance.  Emotions drive decision making in most areas of our daily lives, and we simply rationalize those moves to ourselves.  Awareness of the psychological shortcomings (from hindsight bias, to recency bias, to loss aversion) can help prevent mistakes that can plague long-term investment results.  Being the strong hand of investing does not mean buying or selling on a whim.  It means thoughtfully incorporating changes in fundamentals and executing on the investment plan.  As we gain clarity on what the pending shifts in policy are, we will keep you apprised of the effects on the economy, client financial plans and portfolios, and the changes we implement to capitalize on the situation.

If you have questions or comments, we welcome the opportunity to discuss the election implications further.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Do You Know What’s In Your Index?

11/4/2016

By Michael McKeown, CFA, CPA – Chief Investment Officer

Passive investing is all the rage these days.  Low fees, tax efficiency – who wouldn’t want to be in on this party?  We sure are.  In our view, it makes sense for certain parts of our portfolios.  Per Morgan Stanley, since 2007, US passive strategies have seen $914 billion in inflows while active funds had $857 billion in outflows.

In certain asset classes, there are nuances with indices that may not be what the end user intends.  But because indexing is automatically considered great these days, few are going beyond the surface to dig deeper.

The Barclays Aggregate Bond Index will soon include the name “Bloomberg” at the beginning of its name, as Bloomberg purchased the licensing rights.  Before Barclays, it was named after Lehman Brothers.  It is the key benchmark for most bond allocations.  Though interesting, the name of the index is not the most relevant fact to investors. 

Despite this broad measure of the fixed income market being around since 1973, the Barclays Aggregate Bond Index does not cover even half of the U.S. bond market!

The graph below from Guggenheim Investments displays the sectors and value included in the index.  The left side of the bar chart displays just shy of $17 trillion in value.  The right part of the bar chart, at $21 Trillion in value, displays the non-indexed securities and sectors.   Many of these sectors such as corporate, bank loans, ABS, and Non-agency MBS have much higher yields and credit risk profiles than the index.

The index is dominated by government debt from both Treasuries and agency mortgages.  It was previously more diversified.  An increase in government issued debt grew the Treasury piece of the Barclays Index from 23% in 2007 to 43% in 2016.

Major stock market indices are based on size (also known as market capitalization).  The bigger the company or country, the bigger the weight in the index.  The Morgan Stanley Capital International (MSCI) Emerging Markets Index contains 23 countries, yet the top three make up over half of the index.  China (27%), Korea (15%), and Taiwan (12%) are the big three, though some index providers classify Korea as a developed nation.  Just another argument to know what’s in your index!

Weights as of 9/30/16

While this may be the intended allocation for some, getting greater exposure to a country such as India requires the use of active managers or country specific Exchange Traded Funds (ETFs).

Indexing can make sense over using an active manager when the opportunity set is low.  For example, there are many mutual funds that invest exclusively in Treasury Inflation Protected Securities (TIPS) and use the Barclays U.S. TIPS Index as the benchmark.  There are only 38 different bonds that make up this index.  With such few security choices, making a portfolio look much different than the index can prove difficult for active managers.  This can also be true in niche areas of the market that have high correlation among securities, such as REITs.

While the proliferation of indices of all shapes and sizes is great for investors and constructing portfolios, it does have shortfalls.  Knowing what’s on the inside of an index fund or ETF that tracks an index is just as important as choosing the most efficient implementation.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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IRA + HSA - The Alphabet Soup of Retirement Savings

10/19/2016

Michael Baker, CFP® - Manager of Financial Planning

Health Savings Accounts (HSAs) have been around since 2003 as a tax-preferred savings vehicle for participants in high-deductible health insurance plans. Despite their name, HSAs can serve as an excellent tool for retirement savings as well.

First, the basics. If your health insurance plan includes a deductible of at least $1,250 ($2,500 for a family), it is considered a High-Deductible Health Plan. Participants in a High-Deductible Health Plan are eligible to open an HSA and contribute up to $3,350 per year for an individual, or $6,750 per family per year. Like an Individual Retirement Account (IRA), there’s a “catch-up provision” that allows you to save an extra $1,000 per year if you’re age 55 or older.

Let’s be clear: HSAs are not retirement plans; but they are structured much like IRAs under IRS rules. Like an IRA, contributions to HSAs are pre-tax and grow tax-deferred. In addition, withdrawals are tax-free when used to cover qualified health care expenses, thus providing a triple tax-free benefit.

While the accounts were created to help people save for health care expenses, the reality is that they aren’t required to be used for this purpose. Unlike with Flexible Spending Accounts (FSAs), there is no “use it or lose it” provision. Funds in an HSA can roll over year after year. So even if you don’t take any withdrawals, you can continue to contribute to the HSA and enjoy the tax-deferred accumulation.

Once you reach the age of 65, any non-medical withdrawals from an HSA are taxed at your ordinary income rate, just like a traditional IRA. Younger investors face an extra 20% penalty. For a married couple maxing out their 401(k) and/or IRA contributions every year, the ability to save another $6,750 per year pre-tax is an appealing option.

Unfortunately, HSA holders often don’t take advantage of the investment component offered by some providers. According to the Employee Benefit Research Institute (EBRI), only 6.4% of HSA owners used the investment option in 2014. “A lot of people who have these accounts don’t know they can invest with them,” says Paul Fronstin, EBRI’s director of health research.

Retirement savings aside, a recent study by Fidelity suggests that health care costs for a 65-year-old couple living into their 80s will come to an estimated $260,000 during their lifetime. Given the choice between paying for these expenses with taxable/after-tax dollars from an IRA or savings account, or leveraging the triple tax-free benefit of an HSA, the benefits of including an HSA in the financial planning discussion becomes obvious.

As always, fees are a concern. It’s important to make sure you understand the underlying fees charged by your HSA provider. Some providers charge a monthly fee; others charge check-writing fees and/or transaction fees. It’s critical that you understand the nuances of your plan.

In the end, because you are able to contribute to an HSA even after you’ve maxed out your 401(k) and IRA, it does raise the cap on tax-deferred savings. Given the potential for massive health care expenditures in retirement, an HSA can serve as a way to increase retirement assets with the bonus of tax-free withdrawals for qualified medical expenses.

Contact Aurum Wealth Management Group to learn more about this and other strategies to meet your financial objectives.

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Real Estate is the New Kid on the Block

9/23/16

By Michael McKeown, CFA, CPA - Chief Investment Officer

For the first time since adding technology in 1999, Standard & Poor’s is adding a new sector to the S&P 500 Index.  Real estate, previously falling under the classification ‘financials,’ just became an independent sector.

Below is an excellent history of the composition of the S&P 500 Index.  It is a market capitalization weighted index; which means that the value of the company determines its percentage weight in the index (the greater the value, the higher the percentage weight).  Back in 1957, industrials made up 85% of the index.  In 2016, industrials are just below 10%.  Today, technology is the largest sector at 21% and healthcare the second largest at 15%.  Real estate will start off with a 3% weight.

Source: Wall Street Journal

The Real Estate sector is made up of many different types of Real Estate Investment Trusts (REITs).  REITs are not necessarily a pure play on real estate.  There are mortgage REITs which primarily own debt on residential and commercial real estate.  A few REITs are infrastructure plays on assets like cell phone towers.  Others are just real estate operating companies.

With real estate becoming an official sector in the S&P 500 large cap index, as well as small and mid cap indices, this forces all equity managers to reassess where they could be underweight a sector.  Since portfolio managers are concerned about risks relative to a benchmark, this matters a great deal.  

Passive assets in real estate ETFs make up the largest sector specific category.  It attracted $68 billion in new money since 2010.  Investors have been attracted to the yield and growth as low interest rates have pushed valuations higher.

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Let’s check in on real estate fundamentals.  Below we show the four major ‘food groups’ of commercial real estate.  Office is in sky blue, apartments in orange, retail in green, and industrial in purple.  Each sector reached a temporary vacancy low before the 2008 recession (the grey vertical bar in each chart).  Vacancy rates peaked in 2010 for each sector.  In the graphs on the left, office and retail are still at relatively high vacancy rates compared to the last ten years.  Both are closer to the peak vacancy rate than a trough.  On the other hand, apartments and industrials each reached cycle lows in 2015.

With more people working from home, and too much suburban office supply in many markets, it makes sense to see office vacancy rates quite high.  The retail sector has been disrupted by Amazon and online retail, thus demand for space is much lower.

Apartments have been a hot area since credit standards are so much tighter for people.  This makes it tough to become a homeowner for the marginal buyer, leaving renting as the only option.   Industrial properties are doing quite well for the same reason retail is not, e-commerce.  There is much more demand for buildings due to storage and delivery trends.

In the next chart we can see how rental growth rates have changed over time.  All four sectors are shown.  Office rents grew the fastest during the 2004 to 2007 cycle.  Apartments have had the fastest rental growth since 2010, peaking at 5% last year.

With yields at about 4.5% for the core (or the four main) real estate sub-sectors, and property and rental growth in the 3% range, returns in the 7-9% range seems like a reasonable assumption.  It is also important to note that because real estate is financed with leverage, interest rates matter a great deal.  Future valuation is highly dependent on the path of interest rates.

Finally, in terms of boots on the ground, we can look at what our private opportunistic real estate manager sees when allocating capital.  In its latest outlook, the manager notes:

  • Fundamentals diverge significantly across sectors and sub-markets
  • Core (major property types) offers good income and protection against a potential slowdown
  • Non-core (non-major property types) selectively mispriced
  • Upside is now driven more by ability to grow Net Operating Income [rather than valuation / cap rates]

Just like stocks and bonds, real estate prices are at all-time highs.  Technology was the last sector added to the S&P 500 Index in 1999, near the peak of the technology bubble.  This timing may give investors in public REITs pause, especially considering the positive sentiment and fund flows.  Managers of funds may increase REIT exposure to keep portfolios close to benchmark indices.

Still, the near term fundamental outlook looks to be intact.  At this point, we do not see overly aggressive financing of properties.  Yields on private real estate also still maintain an average spread to Treasuries, relative to the last twenty years. 

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Show Me the Money Markets Reform

9/9/16

By Michael McKeown, CFA, CPA - Chief Investment Officer

In July 2014, the SEC passed new rules and regulations around money markets that were to be phased in by October 2016.  The main objective of the reforms was to create greater stability within money market funds.

Here are how investors were impacted:

  • There is a new distinction between retail (where humans are the beneficial owners) and institutional money market funds (where an entity is the beneficial owner).
  • Retail prime, municipal, and all government money market funds will have a constant Net Asset Value (of $1.00).  Institutional prime and municipal money market funds will have a floating Net Asset Value.  This means the price will float around $1.00, depending on the value of the securities.
  • Retail and institutional money market funds will have tools to curb heavy redemptions, including liquidity fees and redemption gates.  Government money market funds are permitted, but not required to impose these fees or gates. [1]

When the regulations came out, a grey area for categorizing retail versus institutional was the retirement plan space, mainly 401(k) plans.  Because the end owner of the funds are individuals, these were deemed to be retail.

Investors prepared for the changes, as we see below, with assets flowing into government money markets and away from prime funds.

In considering money markets funds to select (especially in the era of 0% interest rates), let’s go back to basics for any investment.  First, “What is my expected return?”  That answer is easy, the yield.  Next ask, “What is the risk?”  With government funds, the risk of default is essentially zero while issuance by others (such as corporations or other governments) is above that zero percent.  So an investor should expect a higher yield from a prime fund than a government fund.  Unfortunately, the higher yield is marginal at best.  In most cases, it is a few basis points and sometimes the yield is not higher at all.  In our opinion, the small difference in yield is not enough compensation to take on the credit risk.

What is the bottom line?  Know what you own.  For accounts holding cash, where is it actually invested?  A government money market?  If not, why?  Is it a retail fund?  If not, why?

For us, the preference is spending our risk budget investing in stocks, bonds, or alternatives strategies – not on money markets to eke out a little extra yield.

The area money market funds swim in has been acting different lately.  LIBOR rose slowly and big asset flows occurred (as shown above).  Among all of the other happenings this fall, keep one eye on this.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

[1] Schwab.com

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The Emerging Gap

8/19/16

By Michael McKeown, CFA, CPA - Chief Investment Officer

Despite the high stock prices and a great run in bond prices, investors can hardly be described as exuberant.  Perhaps it is because they look at the investment landscape and do not see much that they like. 

Bond yields fell from 15.75% in 1981 to 1.51% today (see below).

By definition, this yield is the expected return on a risk-free 10-year Treasury bond held to maturity.  It is tough to get excited about these yields as well as meeting financial planning objectives.

It is easy to argue that stocks are priced above fair value.  Price-to-sales, price-to-earnings, price-to-cash flow – all traditional ways to measure relative value – are well above their historical medians.

After looking at these ideas, people are throwing up their hands and asking, “what is the alternative?” 

We look at the world a little differently.  The first rule of investing?  Buy low, sell high.  Where have prices been low for a while?  It is emerging markets.

Historically, there are 5 to 7 year cycles where emerging markets and developed markets take turns leading. The U.S. won the ebb and flow recently.  The S&P 500 dramatically outperformed emerging markets by 98% in the last five years.   

Signs of a change in this trend are evident.

As has happened in most cycles, the U.S. dollar peaked right around the first interest rate hike.  One of the largest detractors from returns over the last few years for emerging markets has actually been their currencies, rather than just share prices.  Currency markets have turned around since February of 2016. 

Prices bottomed at 10% lower than in the 2002 bear market, making them a great value 14 years later. 

Earnings are also turning the corner, with the fastest six-month growth rate since 2011.

Finally, inflation is coming under control.  In Brazil, inflation was at 10.7% just a year ago and it has since fallen to 8.7%.  India also stabilized its inflation rate in the 5 to 6% range.  Price stability is an important attribute for countries to display for investors.

So what are the alternatives?  While U.S. stocks prices are high, our favorite stocks are in emerging markets. With lower valuations on both share prices and currencies, emerging market equities look appealing.  This is apparent as emerging markets outperformed the U.S. by 8% in 2016.  Considering the strong demographic and productivity trends, along with lower overall debt levels compared to developed markets, emerging markets have many tailwinds.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Politicians Changing Attitude toward Debt

7/28/16

By Michael McKeown, CFA, CPA - Chief Investment Officer

It was only a few years ago that people from both sides of the aisle in Congress were calling for austerity.  The same went for members of the ECB and politicians in Germany and the UK.  All across the globe cutting debt was the way to prosperity.

It turns out those policies were wrong.

Perhaps ‘wrong’ is too harsh a term.  'Poorly timed' given the economic situation, may be more descriptive.

Countries are changing their approach when it comes to debt.  This may be due to the rise of populist political movements or growth that is not what it used to be.  In July, several countries announced plans to expand spending.

  • A 60 billion Canadian dollar fiscal stimulus plan was unveiled by Justin Trudeau, including infrastructure spending.  This equates to 3% of GDP.
  • 20 trillion yen stimulus package including projects for high speed rail and infrastructure (including loan and guarantees) was introduced.  This equates to 4% of GDP.
  • UK’s Philip Hammond, Chancellor of the Exchequer, indicated a possible stimulus package this autumn to counter the negative effects of the vote to leave the European Union.

"The US is doing better than the rest not because its quantitative easing worked better, but because it is the only country with a central bank that openly argued against fiscal austerity."  This quote is from Richard Koo, Chief Economist from the Nomura Research Institute. He is one of the few economists to witness and live through Japan’s 20 years of quantitative easing.  In addition, he correctly diagnosed the balance sheet problems for the nation.

The U.S. indeed turned out to be the least austere, despite some people actively campaigning for it.  This turned out to be the correct policy.  Why? Households were deleveraging and corporations not investing.  A government deficit was necessary to fill the gap left by households and corporations.  It is a big reason why the U.S. is the only country out of the 4 major economic blocs to not battle deflation over the last year.

The chart above shows the inflation rates across the developed world.  The U.S. topped Europe, Japan, and the UK at 1% over the last year.

Both of the major parties' Presidential candidates this fall both support greater spending.  The fiscal spending impulse could result in higher inflation.  In turn, this could cause bond investors to want more compensation for inflation risks.  This would cause yields to rise and bond prices to fall.

Just like greater fiscal spending, rising bond yields go against the trend of the last several years.  A rise in U.S. bond yields over the next year or two, does not mean a secular change is ahead.  Other factors, such as the yields offered by global bond markets and growth trends, will determine the path of interest rates.

Adding to the short-term risk of a rising bond yields is the positioning of real money traders.  Commercial traders have the largest bet against bonds since early 2013 (just before the Taper Tantrum when yields spiked).  In contrast, small traders have the largest bet on bonds in four years, which is usually a contrarian indicator.

The chart above shows that the U.S. 2-year Treasury note yields far above Japan and Europe.  Thankfully, it is in positive territory.

Based on the data presented, and compared to the rest of the world, America is not doing that bad.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Brexit Breakdown

6/24/16

By Michael McKeown, CFA, CPA - Chief Investment Officer

After four decades as a member, on Thursday, voters in the U.K. voted to leave the European Union.  It was a close vote, 52% for “Leave” to 48% for "Stay."  This means that the long-standing trade and immigration agreements that covers 28 countries will no longer apply to Great Britain after its official exit.  The majority of citizens clearly felt that EU membership was inhibiting growth and prosperity.

Currencies and stock markets fell around the globe on Friday as votes were tallied the previous night.  Europe was obviously hit the hardest by sellers as the uncertainty about other countries potentially leaving the bloc and the economic outlook gets murkier.

The demographic split among the vote is getting attention as the ‘older’ generation voted to leave and ‘younger’ voted to stay in the EU. But the London-based Financial Times went further and explained:

“As the votes were counted on Thursday night and Friday morning, the piles of ballot papers told their own story about those parts of Britain that felt comfortable in a modern, connected world, and those which felt cut off from the fruits of globalisation.

Voters in London and Scotland, the two most prosperous parts of the UK, turned out in large numbers to deliver a clear message that they wanted to remain in the EU and its huge single market.

But elsewhere — in the old industrial centres of the north, the small towns of the Midlands and the faded seaside resorts — the ballot papers were stacked high in favour of Leave, rejection of an establishment that had let them down.”

Politics… well, we won’t touch that here, but suffice it to say the environment could be better and it is a sign that populists' leanings across other countries have momentum.  This is a headline risk to the economy and markets, but it does not always mean there will be fundamental changes to either.

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“This will end badly.”

This is pretty much the phrase at least one person says concerning any headline risk in the financial world right now… low interest rates, the U.S. dollar, China, the Middle East, venture-backed technology companies being overvalued, oil prices… Brexit.

But what if it doesn’t?

Exhibit A – Japan.

Yes, the country has negative interest rates, its society is very old with poor demographic trends, and its stock market has shown signs of life but is no higher than where it was in 1989.  But by and large – the standard of living improved incredibly over the last couple of decades and its nominal growth was positive on average.

In the U.S., the unemployment rate is low.  Inflation is also low.  Growth is lower than in the past, but it is still positive and at the same trend of the last few years. Still, the stock market is near all-time highs and bond investors enjoyed great returns the last couple of years. 

Everyone in Cleveland is seeing things a little rosier today thanks to the Cavaliers winning an NBA championship (though in my defense, I began drafting this note two weeks ago).

There is always an event in the financial news merry-go-round to bring out the pessimists.  Nonetheless, the term “Secular Stagnation” is being thrown around by ‘top’ economists to describe the disappointing output level, implying it is simply fate that we are at a permanently lower plateau.  Perhaps it is an inopportune time to have a pro-cyclical view but being an optimist paid off over the very long term – for the lowly economists and investors alike.

In terms of portfolios, we came into the Brexit vote tactically underweight international equities, meaning the allocation was below the long-term strategic target.  Morgan Stanley Research believes there is approximately 15-20% downside risk to European equities, which we would view as an opportunity to buy international stocks and rebalance to equalweight or back to the strategic targets.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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The Mortgage Rate Vortex

6/10/2016

By Michael McKeown, CFA, CPA - Chief Investment Officer

Interest rates are nearing the lowest level in three years.  While we discussed what this means for future returns on the asset side of the balance sheet, it is an advantage on the debt side.

In many ways, mortgages are the tail that wags the interest rate dog.  If interest rates rise too fast, it can hurt the housing market, which the Fed certainly does not want to see.  When interest rates fall though, it allows homeowners to refinance mortgages to lower interest rates, assuming enough home equity is there.  It also creates a hedging vortex for real-money mortgaged-backed security investors, which can plunge rates even lower. 

The trend in mortgage rates over the last 15 years was down, though not without many zigs and zags.  Today, rates are at the lowest point since early 2013.

15-year term mortgages always offer lower interest rates than a longer 30-year mortgage.  15 years ago, this difference was relatively small; only about 0.4%.  For the debtor, this was a fairly nominal difference.  Today, the difference is approximately 0.75%, which is also a low spread.  But when rates go from 3% to 4%, instead of from 7% to 7.5%, it is important to not only look at not the raw numbers, but also the ratio between 15 and 30-year mortgage rates.  Doing so, one can see a high percentage increase in interest expense.  In addition, we can look at that previous ratio with respect to the 10-year treasury.  As seen below, today’s 30-year mortgage rate is about 23% higher than the 15-year.

Refinancing after interest rates fall gives homeowners the chance to pay down mortgages faster, lower interest rates, and lock in a great return on investment (when considering the extra payment as the ‘investment’ and the reduction of interest the ‘return’). 

Let’s look at an example of a $250,000 mortgage in year one of the term.  Comparing mortgage rates in 2001 to 2016 lets us see how much more valuable a refinancing can be when interest rates are low.  

The annual payments increases by $6,153 but the interest paid drops by $1,233, which goes towards principal.  This results in a 20% return on investment (ROI), which was four times the risk-free rate of return for the 10-year Treasury.

Let’s look at an example using the average conventional mortgage rates today.

With the 30-year at 3.93%, it makes sense to move to a 15-year at 3.20%, though the tradeoff being that the payment goes up nearly 50%.  Still, the interest saved of $1,937 results in a 28% ROI.  Since the 10-year Treasury risk free rate is so low today compared to that ROI, it is that much more valuable to refinance.  One can make 17 times the risk free rate in the above scenario in the first year.  This only increases in subsequent years as the mortgage principal declines at a quicker pace.

The average rate for all outstanding mortgages today in the United States is 4%.  In a hypothetical scenario where 15-year mortgage rates fall to 2.5%, the mortgagee could refinance from the original 30-year term to 15-years.  That is, if the mortgagee is willing to pay a 34% higher mortgage payment per month.  This may sound like a lot, but it is almost matched dollar for dollar by greater principal pay down.  The return on this investment is a whopping 80% per year over the first five years!  Moreover, assuming the payments are always made, it is a guaranteed return – well worth it in any interest rate environment.

In light of the negative interest rates from Japan to Europe hitting record lows, we will be watching in the months ahead to see if the downtrend in U.S. interest rates continues to create another wave of refinancing activity.  Mortgagees should be ready to pounce (and go through the painful refinancing process of pulling documents), but just think about that return on investment and it is well worth it.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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