Stocks ended the third quarter up 3.3% which was unexpected, given the bad news about Deutsche Bank, Germany’s largest financial institution and uncertainty over when the Fed will raise interest rates. More importantly, investors have shrugged off diminished corporate earnings, which are expected to drop 2.1% from a year earlier. The profitability of large US companies has fallen for six consecutive quarters, again harkening back to 2007 – 2008. As a result, the S&P 500 is at its priciest level since before the great financial crisis. Year to date, the S&P 500 is up 6.1% with the narrower Dow Jones industrial average up 5.1%. Utilities had a poor third quarter, declining 6% but their year to date return far outstrips all other industries at a positive 15.6% as investors continue to look for a safe place to earn income. The technology index was up the same as the broader market, while small companies outperformed large companies by an almost 2 to 1 ratio.
International stocks fared about half as well as the US, climbing 3.8% despite the British referendum on European Union membership. European stocks have declined 6.3% so far this year with Italy faring the worst, declining 23.4%. Italy will hold a referendum sometime in the next six months which will determine that country’s future viability as a member of the European Union. Interestingly enough, the UK vote to exit the union has not hurt its economy or stock market, which has gained 10.5% year to date. Asian markets have risen in lockstep with the United States, gaining 6.1% for the first nine months of 2016. China continues to languish, returning a negative -15.1% while Taiwan led the pack with a positive 9.9% gain.
Bonds continue to attract attention, with investors moving approximately $65 billion during the third quarter from stock to bond funds. High-quality corporate bonds, the most commonly held by individual investors, gained 0.8% in the third quarter and are up 5.9% for the year. Over the last 12 months, corporate bonds have gained 8.6% on a total return basis, which includes price appreciation, alongside their average income rate of 2% to 3%. Lackluster corporate profits and acknowledgment that the markets are at the mercy of the Federal Reserve have kept interest rates at historically low levels. We will talk about that more in the Economy section below.
Municipal bonds declined slightly during the third quarter, 0.3% negative, but they are up 5.6% over the last 12 months. The most heavily traded bonds are US government bonds which are measured by the length of the bonds, which correspond with their level of risk. Longer-term bonds are the riskiest and they declined 0.2% during the third quarter while rising 4.8% over the last 12 months. These bonds serve as an indicator of the long-term optimism of continued low interest rates. Amazingly, high-yield or junk bonds rose 4.7% during the third quarter as investors continue to ignore the risk to highly leveraged companies, as their price would fall dramatically during a recession.
Commodities gave up some of their outstanding gains during the third quarter but overall, the commodity index has risen 17.28% so far in 2016 due to crude oil’s price per barrel rising 30.24%. Natural gas is not far behind, rising 24.35%. Home heating bills will likely be higher than last winter’s. Gold’s gain so far in 2016 is + 23.86%.
As stocks and bonds worldwide continue to move within a narrow range, actual volatility is the lowest on record. Investors nerves are generally calm but many experts feel that this unprecedented type of lockstep market action presents serious long-term dangers. Historically, investors have been able to move out of poorly performing markets into ones with better prospects, as different markets around the globe have previously had varied up and down timing. However, this seems to no longer be the case so it will be hard to find a place to hide during the next stock or bond market downturn other than cash.
Economic fundamentals around the world are fragile and there is no structural or cyclical expansion on the horizon. Central banks around the world are varied in their reliance on nontraditional activities such as negative interest rates and purchasing stocks for their central bank portfolios but even this has not instilled confidence that an economic expansion is around the corner anyplace on the planet. The unpopularity of both US presidential candidates and the likelihood that the executive and legislative branches will remain split means that serious reform on the tax code, international trade, or stimulative fiscal policy is still a long way off. All of this points to the possibility of continued mediocre returns for both stocks and bonds.
Two of the major reasons that the markets have held up so well over the last 3 to 4 years has been liquidity injections by corporations repurchasing their shares and stimulative central bank policies that involve sizable asset purchases. This serves to repress volatility and encourages investors to take on more risk than is commonly understood. There is mounting concern that ultralow and negative interest rates distort the health of the real economy and diminish the efficacy of Central Bank tools to combat future recessions. Investors with financial assets have been rewarded by the $1.7 trillion in US corporate stock repurchases over the last three years so in many ways, the markets have become addicted to cash injections and ultralow interest rates. This could go on for a while but does not change the fact that it is a mathematical certainty that there are corporate, city, county, state and federal debts that cannot be paid back, ever. At some point, price to earnings levels, the main component of stock market valuations, need to be recalibrated to acknowledge this fact of life.
One of the main investment questions facing the markets is what will happen when interest rates go up. The 10 year US treasury bonds interest rate hit a 1.4% level during the third quarter, the lowest on record. During the Great Depression of 1930s, when the US unemployment rate reached 25%, interest rates were higher than they are now. If interest rates go back to the level seen at the beginning of this year, 2016, the value of many bonds will drop by over 10%, something that has not occurred in several decades and many individual investors will be caught unprepared for the flight out of bond funds that will likely ensue.
Economists see prices for healthcare, housing and education continuing to rise in the US but this is not reflected in the level of interest rates paid to investors. Some people applaud the fact that the price for borrowing money is low but they fail to point out that it is extremely hard to qualify for bank financing these days. Banks have been snapping up safe bonds, so much so that investors are unable to find decent returns in this low interest rate environment. Holders of bond mutual funds have a greater risk than anyone else due to changes in rules which allow mutual funds to distribute principal back to investors in a way that does not create risk for the fund but could substantially inconvenience investors, especially if there is a rush to the exits.
Institutions continue to have an advantage over individual investors in the search for income. J.P. Morgan and Nuveen investments recently privately financed the Chicago school system because the managers of the city of Chicago realized that their dire financial condition is an embarrassment and that the public markets would penalize them as they go to raise money to support their deficit spending. The net result of this private auction has been for the municipal agency to recommend budget cuts and propose new taxes, so you could say that market forces are instilling a sense of discipline on delinquent borrowers. Puerto Rico is another example of how delinquent government payments can spiral and create a freeze in funding. Puerto Rico now answers to a panel of financial experts appointed outside of Puerto Rico because the mismanagement of the economy and mismatching of revenue and expenses went on for so long. We are likely to see situations like this repeat itself many times during the next four years.
As an alternative to bonds, many large investors have accumulated inventories of single-family residences to rent out. Nationwide, rents continue to rise, up 20% over the last four years. Due to credit restrictions on many individual borrowers, institutions can borrow money at low interest rates and buy homes, especially in depressed areas, at significant discounts. The US homeownership rate is expected to continue to decline, partially because the millennial generation has to face the reality of the burden of student debt, fewer lifetime employment opportunities, and a marked downshift in the desire to own “stuff”. This has fueled the popularity of companies such as Uber, which essentially provide an alternative to ownership via ultra-short-term rental. The list of items offered under these new arrangements, that now includes things like cars, offices, and homes will soon grow to include much more, the goal being to attain a super convenient and flexible lifestyle with minimal maintenance responsibilities.
At the same time as demographics produce some novel community building opportunities for developers, the six-year construction boom in luxury condominiums has seen its peak. The first decline in rents since 2010 are now being reported in major metropolitan areas, both on the East and West Coasts. While the influx of foreign capital from Asia and Europe has not dried up completely, it is diminished and developers can no longer count on ever escalating prices.
The US Election – Tax Proposals
As we enter a new era of political leadership, it may be instructive to compare and contrast the tax plans offered by the Clinton and Trump campaigns. People do respond to tax incentives and likewise react to disincentives such as increased prices due to higher taxes. Whatever kind of social policy one embraces, everyone has a stake in the tax code. Mr. Trump has proposed tax cuts that would remove 15% of projected annual federal revenue from the treasury coffers while Clinton plans to raise taxes by 0.6% of gross domestic product. About half of the Trump tax cut would benefit the top 1% of US households while Clinton would cut the after-tax income of the same top 1% of the population by 7.4%. About half of the Clinton tax increase would hit the top 1/10 of 1% of households defined by those earning over $3.8 million in income per year. Trump’s cut would double down on the proposals of George W. Bush that took effect in 2001 to 2003, while Clinton’s plan would increase taxes on everyone earning above $143,000 per year.
Since 1985, the top 1% of US taxpayers have seen their share of the nation’s wealth double over the last 30 years while their portion of the tax bill has only gone up by 50% so the tax burden has increasingly been shouldered by the middle and lower classes. Various aspects of Clinton’s proposal would levy new or increased taxes on the wealthiest Americans’ wages, business income, capital gains, and estates. Some say that it would reduce the incentive for high-income taxpayers to save and invest, but more likely it would result in the invention of new devices to try and avoid these higher tax rates. Trump would lower tax rates on the wealthy, itemized deductions, repeal the estate tax entirely, and set a new flat tax on businesses. He would also boost the standard deduction, eliminate personal exemptions and allow parents to deduct health care costs. Independent analysis shows that Trump’s proposed changes would raise taxes on families earning between $20,000 and $200,000, including many single parents.
One tax proposal that everyone might agree on, if climate change is a reality, will show up on the November ballot in Washington State. Modeled after a bill introduced in British Columbia in 2008, this tax policy curbed the average consumer’s fuel consumption by 7% and boosted the average car’s fuel efficiency by 4%. This was accomplished via a revenue neutral tax that is embedded in the price paid for energy in that province. A tax of this sort automatically encourages conservation without the need for regulations or directing subsidies to politically correct beneficiaries. The tax is revenue neutral, meaning that all of the tax dollars collected are returned to the economy via a cut in some other kind of tax rate, be it sales taxes, business taxes or as a direct tax rebate to low income workers.
The tax in British Columbia added 25 cents to the price of a gallon of gasoline and boosted the average electric bill by $8 a month. Many environmentalists oppose such a revenue neutral tax structure, believing that the tax collection proceeds should be used for the clean energy economy. Conservatives often feel that any tax increase is a bad thing. This kind of policy reduced carbon usage without taking money out of the overall economy. It navigated around thorny, irreconcilable differences between political parties about where the money should go. It succeeded in introducing a penalty for heavy carbon energy consumption and therefore benefited everyone.
Rob: I have been doing a fair amount of traveling this past quarter, to locations as diverse as Tassajara, CA; Trout Lake, WA; Asheville, North Carolina and Jackson, Wyoming. The weather has been extremely cooperative, even as some of the domestic airline carriers have not, as I’m sure most readers will likely have experienced for themselves. During off hours, my kombucha production has fallen off to nil while our garden’s green tomatoes and cucumber crop has yielded an opportunity to produce a variation on the Joy of Cooking’s famous chow chow recipe.
Jeff: We recently sold our house and bought a condo. It took lots of time and energy but we got through all the transactions and the move went fairly well so we are now mostly sane. There are many final decorating issues to make, like fussing with the best location for this chair or that painting and things like that. As we had hoped, we really like the simplicity of the condo. There is a nice fitness center and swimming pool and so I can do my favorite exercises right there with no hassle.
Kyle: It is hard to believe how quickly this year has passed. With the end of summer comes the start of school. My sons, James and Johnnie, started the first grade this year and we are all settling back into more routine schedules. This year, I decided to coach their youth soccer team and it has been fun getting to run around with all the kids while trying to maintain organized practices and games. My boys seem to like having their dad as the coach, although when asked if I am a good coach, they respond with “we’ll see”. I finally finished my kitchen remodel and I am hoping that I can sit on my hands for a while before starting a new project. I guess we’ll see.
Robyn: Happy Fall!! I love this time of year – After harvesting all of our tomatoes and making pounds of tomato sauce, I am already planning for my favorite holiday, Thanksgiving, for which my lovely mother and sister will be flying into town. After my recent directorial debut, a ten-minute Benchwarmer play, opened last Friday at the Santa Fe Playhouse, I turn my attention to “Almost Maine”, a show which will opens in a few months at the El Museo Cultural de Santa Fe.
Anthony: It’s been 3 months since I joined The Rikoon Group, and as names and faces become more familiar, I truly feel like I am starting to settle in. Our daughter, who is now 15 months old, continues to grow and come into her own. With the season change coming on, it opens a new and exciting chapter in our lives as we recently went under contract to build a new home on the south side of Santa Fe. The process has been both fun and stressful and we cannot wait to finally have a place to call our own. We are hoping for a December, 2016 completion date.
Dana: The summer flew by with much of my free time devoted to garden landscaping. Rows of lavender have really taken off and are blooming even now. I look forward to tasting its aromatic essence in the honey next year. While I lost one hive, it sat empty for only a few months before a swarm took up residence. The colony is doing nicely and I expect it will thrive next season if it survives the winter. I am holding rather the same prognosis for myself as I’m not relishing the reality of cold months ahead. I will rely on the summer load of fruits and vegetables that have been put up to remind me of the sun’s warming goodness and to see me through winter’s chill.
Please join us in early November when we gather together at our office in Santa Fe to enjoy delectable treats prepared by the staff and to discuss, in a group setting, unfolding market related activities. This will include a discussion of the economic impact of the presidential and congressional elections as well as international events. The in person gathering will take place at 2218 Old Arroyo Chamiso on Wednesday, November 9th from 3:30 PM to 5 PM. On the following day, Thursday, November 10, we will host a multiple party telephone conference call which is open to local and out-of-town interested persons and it will begin at 3:30 PM. The call in number is: 719 – 234 – 7872, conference code: 470070#.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by The Rikoon Group), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from The Rikoon Group. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. The Rikoon Group is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. If you are a The Rikoon Group client, please remember to contact The Rikoon Group, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. A copy of The Rikoon Group’s current written disclosure statement discussing our advisory services and fees is available upon request.