The Importance of Generational Listening

John E. Coyne, III, Vice Chairman, Brinker Capital

I had the opportunity to speak on a panel at the Nexus Global Youth Summit in New York City last week. More importantly, I had the chance to listen to and speak with a number of those in attendance.

Nexus is a global movement founded in 2011 whose network consists of over 1,000 young philanthropists, social entrepreneurs and influencers. Their unified goal is to increase and improve philanthropy and the social impact of investing. They come from more than 60 countries and represent more than $100 billion in assets. They have the commitment, intelligence, passion and clout to act on it.

I was in awe of the debate and discussion I witnessed among these ambitious, young leaders.  What they shared, how they felt, how they deviated from each other in plan but matched in vigor and passion—it was among the most intelligent discourses I have listened to in some time. The mindset of the social entrepreneurs in attendance turned the ways I have defined this area upside down.

If financial advisors, family offices and wealth managers wish to remain relevant, it is incumbent on us to help facilitate the dialogue within and across generations, understanding that if properly equipped, this rising generation will accomplish things on an unprecedented global scale. And if we, the Baby Boomers and Gen Xers of the world, don’t adapt to the methods of investing and communicating they are evolving towards, we will be left in the dust.

I want to thank Logan Morris at Snowden Capital for including me and congratulate Rachel Cohen Gerrol on this incredible event. I must give a particular shout out to the woman who spoke from Kopali Organic chocolates.  They are delicious, and you have made a convert.

For a more in-depth look into this year’s  Global Youth Summit, please read this event summary published by Forbes, or take a page out of the Generation Y book and check out their Facebook page.

Market Commentary: Liquidity

Joe Preisser, Portfolio Specialist, Brinker Capital

The powerful figure of the Federal Reserve Bank of the United States (Fed) continues to hold sway over the global landscape, as the collective eyes of investors around the world watch intently for any discernible hint of a shift in policy, which when detected, has radiated across the marketplace. During the course of the past five weeks, the American Central Bank has launched a veritable public relations barrage in an effort to stave off the steep sell-off in risk assets that accompanied comments issued by Chairman Ben Bernanke following the conclusion of a meeting of the Federal Open Market Committee on June 19.  During the ensuing press conference, Mr. Bernanke suggested that if the economic data from the U.S. continued in its current pattern of improvement, the time may be near for a measure of the support the Fed has provided to the U.S. economy. namely the $85 billion per month of asset purchases currently being made, to be curtailed.

Market participants reacted to the Chairman’s comments by throwing what has been called the “taper tantrum”(Bloomberg News), which culminated in a 4.8% decline in the Standard & Poor’s 500 over the course of five trading days, and a .35% rise in yields on the 10-year U.S. Treasury note during the same time frame.  The Central Bank’s officials, and especially the Chairman himself, have proven themselves particularly deft at quelling the market’s concerns in the day’s since, and in so doing have provided a catalyst that has sent stocks rallying around the world, and those listed in the United States to record highs. The volatility witnessed over recent weeks highlights the market’s continued dependence on the liquidity provided by the Fed, and further illustrates the difficulties surrounding its eventual removal, which may begin as early as September.

Reassurances from Fed officials—that the Central Bank remains committed to the continuity of its current accommodative stance for the foreseeable future—poured forth into the mainstream media as the selling pressure built within the marketplace. Beginning on June 25, the President of the Federal Reserve Bank of Dallas, Richard Fischer, and Minneapolis Fed President, Narayana Kocherlakota both issued comments designed to emphasize the fact that the Central Bank would keep in place its support of the economic recovery in the U.S. Mr. Kocherlakota was quoted by Bloomberg News on the 25^th as saying, “The committee should continue to buy assets at least until the unemployment rate has fallen below 7 percent.  The purchases should continue as long as the medium-term outlook for the inflation rate remains below 2.5 percent and longer-term inflation expectations remain well anchored.” What have been categorized as unusually direct statements, of these two, non-voting members of the Committee (Bloomberg News), served to soothe concerns among investors, and were followed in short order by those of Richmond Fed President, Jeffery Lacker, who helped to further assuage any lingering uncertainty.  Mr. Lacker reiterated the fact that continued, substantive labor market improvement was necessary for the tapering of asset purchases to commence, and noted his confidence that deflation was not an issue (Bloomberg News), which helped to accelerate the rebound in risk assets.

The highly anticipated release of the June employment report was well received by the market. Although it revealed the creation of 195,000 jobs within the United States, which exceed the consensus estimate of 165,000 (New York Times), it fell short of the whisper number of 200,000 that had circulated, and the unemployment rate remained stagnant at 7.6%. The report buoyed the belief that the Fed would need to maintain its current pace of asset purchases for a longer period of time than many had feared as the pace of job creation, although improving, does not warrant tapering.  Jan Hatzius, the chief economist at Goldman Sachs, was quoted in the New York Times on July 5—“Beyond the headline numbers for job growth, it gets a little more mixed. There is still a lot of slack in the labor market.”

Stocks received a further lift from Chairman Bernanke who, in answering audience questions following a speech he delivered at the National Bureau of Economic Research conference on July 10, made an effort to stress the fact that the Central Bank remained committed to furthering the economic recovery.  Mr. Bernanke was quoted by the Wall Street Journal—“There is some perspective, gradual and possible change in the mix of instruments.  But that shouldn’t be confused with the overall thrust of policy, which is highly accommodative.” The Chairman once again reiterated this pledge in testimony before Congress on July 17—“Our intention is to keep monetary policy highly accommodative for the foreseeable future, and the reason that’s necessary is because inflation is below our target and unemployment is still quite high” (New York Times). These statements served to further the belief that has come to be known as the, Bernanke Put for the Chairman’s willingness to intercede when financial market’s struggle, which has been perceived to offer protection to investors, remains in place and provided further support to risk assets.

Although benchmark indices in the United States have risen to record levels, a measure of uncertainty lingers beneath the surface as the inevitability of the scaling back of the Fed’s asset purchases remains, along with the question of who will succeed Mr. Bernanke as the next Chairman of the American Central Bank.  Despite no official word having been offered that his tenure atop the Federal Reserve will come to an end in January, this is widely considered to be the case.

Speculation as to who will replace Mr. Bernanke has risen to the fore with the two perceived leading candidates appearing to be the Fed’s current No. 2, Janet Yellen, and former Treasury Secretary, Larry Summers. According to the Wall Street Journal—“The race to become the next leader of the Federal Reserve looks increasingly like a contest between two economists: Lawrence Summers and Janet Yellen.”  In addition to the questions surrounding the identity of the next head of the Central Bank, a recent poll of economists, conducted by Bloomberg News, revealed the belief among a majority of those queried that the Federal Reserve would in fact begin tapering in September. With summer’s effusive glow illuminating Wall Street and the record gains of its equity markets, the cool winds of fall hold within them the possibility of bringing the unwelcome specter of volatility as these issues seek resolution.

Investment Insights Video: Responding to Rising Interest Rates

In May, Federal Reserve Chairman, Ben Bernanke, announced the possibility that they will begin tapering in the upcoming months. As that notion looms, so too does the prospective of rising interest rates.

We sat down with Bill Miller, Chief Investment Officer, and Jeff Raupp, Senior Portfolio Manager to discuss how Brinker is prepared to respond to the upcoming policy changes.  In this installment of Investment Insights, Bill and Jeff will give financial advisors and investors a clearer understanding of the tools available to Brinker Capital and how our portfolios can manage the impending environment of rising interest rates.

Detroit Files for Bankruptcy

@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital

On July 18, the City of Detroit filed for bankruptcy, becoming the largest American city to seek bankruptcy in court.  This course of action was anticipated by many market participants as Detroit’s fiscal situation has been deteriorating for some time. The city has accumulated more than $18 billion in debt, including $12 billion in unsecured obligations to lenders and retirees, over $6 billion in bonds secured by revenues, and has run operating deficits for a number of years. Detroit has suffered from a confluence of demographic and economic factors, including a significant loss of population and declining tax revenues, as described in the bankruptcy court declaration filed by Kevyn Orr, Detroit’s emergency financial manager (via Zero Hedge).

This situation will be contentious as there are a number of parties involved, including bondholders, retirees, and other creditors that will seek recovery through the bankruptcy process.  Revenue bonds, which represent $6 billion of Detroit’s outstanding debt, have historically had high recovery values in bankruptcies.  The case will be watched very closely as the outcome could determine whether this type of restructuring becomes a model for other municipalities under significant fiscal pressure.

We do not view the actions of Detroit to signify broader credit weakness for U.S. municipalities.  Overall, municipal credit has been improving as revenues have rebounded.  The recent sell off in municipal bonds can be more attributed to the concern surrounding the Fed’s tapering of asset purchases and some technical pressures, not to underlying fundamentals.

At Brinker Capital, we favor active municipal bond strategies that draw on the resources of strong credit research teams and emphasize high quality issues and structures.  We have not felt it prudent to reach for yield in the current environment and will maintain our high quality bias.  With yields moving slightly higher, some value can be found in municipal bonds at the long end of the curve with yields at close to 5%.  Our municipal bond separate account strategies have no exposure to Detroit paper.  The mutual funds used within our discretionary products have very limited exposure to Detroit, the vast majority in bonds backed by revenues of the Detroit Water and Sewer Department.

Additional Links:

• Billions in Debt, Detroit Stumbles into Insolvency (NY Times)
• Michigan Governor and Detroit’s Manager Call for Patience (NY Times)
• Detroit Files for Bankruptcy, Set Stage for Court Fight (Reuters)
• Detroit Files Largest Municipal Bankruptcy in History (Business Insider)
• U.S. Automakers Thrive as Detroit Goes Bankrupt (Bloomberg)
• Even a Half Century Ago, Journalists Were Predicting Detroit Would Go Bust (The Atlantic)

Should I Sell My Fixed Income?

Jeff Raupp, CFA, Senior Investment Manager

Now that we’re able to look back with the benefit of hindsight, it’s pretty easy to pick on the mistakes that investors made during the financial crisis of 2008. For instance, as equity markets sold off, emotion took over, and many investors that entered the crisis with a well balanced portfolio abandoned their plan and made wholesale changes to fixed income or, even worse, cash. At the time, it seemed like a rational reaction—Wall Street institutions that had existed for decades were insolvent, and each day seemed to bring a new, ineffective government program to stabilize the credit markets, along with yet another triple-digit loss in the stock market.

We know now that what had started as an economic slowdown and then recession extended into a full-fledged market panic, where investors sold indiscriminately of price. In the years that followed, those that kept their heads recovered and reached new highs with their investments; those that joined the panic are, in many cases, still hoping to recover their 2008 losses.

Today, many investors are considering a question that could very much have the same negative long-term consequences, namely, “Should I abandon fixed income altogether?”

The question comes up after interest rates spiked in reaction to Federal Reserve Chairman Ben Bernanke’s May testimony in which he outlined a scenario where, with the right economic growth in place, the Fed could start lowering the level of bond purchases they’re making as part of the quantitative easing (QE) program. Over a two month period, the yield on the 10-year Treasury jumped from 1.6% to 2.8% and at -2.3%, the Barclay’s Aggregate Index had its worst quarterly return since the second quarter of 2004 when it fell 2.4%.

To answer the question, first let’s look at the downside potential. It’s been a long time since we went through an extended rising rate environment. As our research indicates, from 1945 to 1981 the yield on the 10-year Treasury rose from 1.5% to over 14%. Over that 36-year period, the return an investor in the 10-year Treasury received was actually a positive 2.8%, with 75% of the calendar years in that period having positive returns. The worst one-year loss, 5.0%, was in 1969, and the worst multi-year losing streak happened twice—1955-1956 and 1958-1959 (1957 was a strong year and the five-year period 1955-1959 was close to flat). Compared to a stock market bubble, the downside on fixed income is extremely tame.

Secondly, you have to think about the role fixed income plays in your portfolio. In heavy stock market sell-offs, fixed income is often the only asset class with positive returns and therefore can act as a hedge against market volatility. Since 1945, there has only been one year (1969) where both stocks and bonds had negative returns. In today’s world, a global flight to safety results in demand for high quality fixed income, driving yields down and bond prices higher. No other asset class plays the low volatility hedging role quite as well. Responding to the threat of low rates by greatly increasing equity, or even alternative exposure, can prove disastrous if markets crater.

Finally, fixed income comes in many varieties. At any given point in time, there are areas of fixed income that provide opportunity and/or protection. By broadening your universe beyond simple treasuries to take advantage of these you can get a better end result.

Let’s be clear, core, investment-grade fixed income doesn’t provide a great investment opportunity right now. With yields still at low levels and likely to rise in the coming five to ten years, we’ll likely see muted returns at best with fits and starts of performance along the way. Inflation is currently in check below 2%, but if we started to see it flare up, investors, especially those with longer horizons, would need to consider the impact rising prices would have on their purchasing power. But even in an adverse environment, fixed income still plays an important role in portfolios.

Monthly Market and Economic Outlook – July 2013

@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital

Risk assets were off to a decent start in the second quarter but then retreated after Federal Reserve Chairman Ben Bernanke’s testimony to Congress on May 22 laid the ground work for a reduction in monetary policy accommodation through tapering their asset purchases as early as September. While the U.S. equity markets were able to end the quarter with decent gains, developed international markets were relatively flat and emerging markets experienced sizeable declines. Weaker currencies helped to exacerbate these losses.

After starting to move higher in May, interest rates rose sharply in June and into early July, helped by the fears of Fed tapering. The yield 10-year U.S. Treasury has increased 100 basis points over the last two months to a level of 2.64% (through 7/10). The increase in rates was all in real terms as inflation expectations fell. Bonds experienced their worst first half of the year since 1994, in which we experienced four short-term rate hikes before June 30.

While we have seen these levels of rates in the recent past (we spent much of the 2009-2011 period above these levels), the sharpness of the move may have been a surprise to some fixed income investors who then began to de-risk portfolios. In June, higher-risk sectors like investment-grade credit, high-yield credit and emerging market debt, as well as longer duration assets like TIPS, fared the worst. With growth still sluggish and inflation low, we expect interest rates to remain relatively range-bound over the near term; however, we do expect more volatility in the bond market. Negative technical factors like continued outflows from fixed income funds could weigh on the asset class. Our portfolios remain positioned in defense of rising interest rates, with a shorter duration, emphasis on spread product and a healthy allocation to low volatility absolute return strategies.

After weighing on the markets in June, investors have begun to digest the Fed’s plans to taper asset purchases at some point this year. Should the Fed follow through with their plans to reduce monetary policy accommodation, it will do so in the context of an improving economy, which should be a positive for equity markets.

We continue to approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we move into the second half of the year. A number of factors should continue to support the economy and markets for the remainder of the year:

• Monetary policy remains accommodative: The Fed remains accommodative (even with the scale back on asset purchases short-term interest rates will remain low), the ECB has pledged to support the euro, and now the Bank of Japan is embracing an aggressive monetary easing program in an attempt to boost growth and inflation. This liquidity has helped to boost markets.
• Fiscal policy uncertainty has waned: After resolutions on the fiscal cliff, debt ceiling and sequester, the uncertainty surrounding fiscal policy has faded. The U.S. budget deficit has improved markedly, helped by stronger revenues. Fiscal drag will be much less of an issue in 2014.
• Labor market steadily improving: The recovery in the labor market has been slow, but steady. Monthly payroll gains over the last three months have averaged 196,000 and the unemployment rate has fallen to 7.6%. The most recent employment report also showed gains in average hourly earnings.
• Housing market improvement: An improvement in housing, typically a consumer’s largest asset, is a boost to net worth, and as a result, consumer confidence. However, a significant move higher in mortgage rates, which are now above 4.5%, could jeopardize the recovery.
• U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash that could be reinvested or returned to shareholders. Corporate profits remain at high levels and margins have been resilient.

However, risks facing the economy and markets remain, including:

• Fed mismanages exit: If the economy has not yet reached escape velocity when the Fed begins to scale back its asset purchases, risk assets could react negatively as they have in the past when monetary stimulus has been withdrawn.
• Significantly higher interest rates: Rates moving significantly higher from here could stifle the economic recovery.
• Europe: The risk of policy error in Europe still exists. The region has still not addressed its debt and growth problems; however, it seems leaders have realized that austerity alone will not solve its problems.
• China: A hard landing in China would have a major impact on global growth. A recent spike in the Chinese interbank lending market is cause for concern.

We continue to seek high conviction opportunities and strategies within asset classes for our client portfolios. Some areas of opportunity currently include:

• Domestic Equity: favor U.S. over international, dividend growers, financial healing (housing, autos)
• International Equity: frontier markets, Japan, micro-cap
• Fixed Income: non-Agency mortgage backed securities, short duration, emerging market corporates, global high yield and distressed
• Real Assets: REIT Preferreds
• Absolute Return: relative value, long/short credit, closed-end funds
• Private Equity: company specific opportunities

Asset Class Returns

Behavioral Finance 101: Framing

Dr. Daniel Crosby, Ph.D., IncBlot Behavioral Finance

As we’ve discussed in the first two parts of this series, economic decision makers are not the cold, detached, decision makers they have historically been painted to be by efficient market theorists. Quite the opposite, human behavior is marked by irrationalities and fuzzy logic based more closely on mental approximations than hard and fast rules. We have already touched upon the impact of heuristics and irrational behavior and today will turn our gaze to the third pillar of behavioral finance – framing.

Simply put, framing is an example of a cognitive bias in which people arrive at a different decision depending on how the question is framed. While homo economicus would weigh all decisions equally and disregard framing effects, actual behaviors indicate that the lens through which we view a decision has everything to do with the eventual outcome. Frames can take a number of shapes; it could be the physical place where we make a decision, whether a question is positively or negatively framed, and even the way we mentally account for the options from which we are selecting.

Consider a real-life framing example with a huge cost to the U.S. taxpayer. Twice in the past few years, the government has tried to stimulate the economy by offering tax rebates to the hardworking citizens of the U. S. of A. Both times, these efforts have met disappointing ends, and behavioral finance may just be able to tell us why.

Belsky and Gilovich lead us toward the answer in their excellent primer, “Why Smart People Make Big Money Mistakes.” They describe a study conducted at Harvard wherein 24 students were given $25 to spend in a lab store as part of their participation in a research. Any unspent money, they were told, would be returned to them shortly via check. But wait, there’s a rub (there always is when psychologists are involved)! Half of the students were told that the $25 was a “rebate” and the other half told that it was a “bonus.” Could such a minute difference in cognitive framing have a measurable impact on spending behavior? It turns out, it could.

For those whose earnings were framed as a bonus, 84% spent some money in the lab store, a behavior mimicked by only 21% of those whose money was framed as a “rebate.” Now consider the decision of the U.S. government to give “tax rebates” to help stimulate the economy—an action that ultimately failed, probably at least in part due to framing effects. Irrational decision makers that we are, we fail to grasp the fungible nature of dollars and account for them differently based upon how they are framed in our mind. As Nick Epley, the psychologist who conducted the Harvard study, said more forcibly, “Reimbursements send people on trips to the bank. Bonuses send people on trips to the Bahamas.”

One of the most profound forms of framing effect plays on our fear of loss in times of fear or risk, or the related fear of missing out in times of plenty. This tendency, demonstrated most powerfully by Daniel Kahneman and Amos Tversky is known as “loss aversion.”[1] The basic tenet of loss aversion is that people are more upset a loss than they are excited by an equivalent gain. Consider the comical demonstration of loss aversion that resulted from a survey conducted by Thomas Gilovich. Mr. Gilovich asked half of the respondents to a questionnaire whether or not they could save 20% of their income, to which only half said yes. The second half of the respondents was asked whether they could live on 80% of their income, to which 80% replied in the affirmative. To-may-to, to-mah-to, right? So why are the responses so different?

The first phrasing frames it as a 20% loss of spending power (there is a large body of research that indicates that saving is viewed as a loss. Silly people), whereas the second frames it more positively. Thus, equivalent financial realities are viewed through entirely different lenses that lead to decisions with profoundly different outcomes.

One of the benefits of behavioral finance is that it shines a light on the little peccadilloes that make us the flawed but lovable people we are. But irrational as we may be, we can turn the tide on ourselves and use these quirks to our personal advantage. Framing is only disadvantageous inasmuch as the frames we are applying to our money are reckless. Viewing money through the frame of a charitable contribution or a child’s college fund can impact your financial decision positively just as surely as framing it as disposable can have a negative impact. At Brinker Capital, our Personal Benchmark system accounts for the human tendency to mentally account for and frame dollars, and does so in a way that helps ensure an appropriate allocation of assets across a risk spectrum. As we hope you’re aware after taking part in this behavioral finance survey course, you are not as logical and dispassionate as you might have guessed. Whether or not you use that irrationality to your benefit or detriment is now up to you.

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[1] Kahneman, D. and Tversky, A. (1984). “Choices, Values, and Frames”. American Psychologist 39 (4): 341–350.

Municipal Market Update from RNC Genter

City of Detroit Halts Payments on Outstanding Debt

The city of Detroit has been in a deteriorating situation for decades and unfortunately only received a limited benefit from the resurgence of the auto industry since the financial crisis. Although the initial home of the auto industry, it experienced its heyday back in the 1960’s.

Therefore, this course of action, which may or may not eventually lead to filing for protection under Chapter 9 of the bankruptcy act, has been expected by many market participants for well over two years. As a result, we have avoided the city’s outstanding bond issues. We do own a $1.14 million block of pre-refunded bonds that are defeased and secured by U.S. Treasury Securities (SLGS) that are held in escrow. Those bonds will mature on July 1, 2013 and are not affected by the action of the city.

The problem that bears close scrutiny with this situation concerns its present negotiations with bondholders, wherein they have proposed placing $369 million of full faith & credit “general obligation” bondholders on equal setting with $161 million of “limited general obligations”, $1.4 billion in “pension obligation bonds,” and the unfunded pension liability of $3.5 billion and OPEB (other post-employment benefits).

Depending upon the ultimate outcome from the negotiations, it is possible that concerns will be raised that not all GO bonds are created equal. So, just like the approach that Stockton, CA applied to their weak-linked lease type COP’s (certificates of participation) debt, this action is unprecedented. Essentially, Detroit is attempting to dissolve its capital structure.

It is too soon to determine an outcome from the action. However, we are hopeful that logical reasoning prevails. If not, this could potentially have a negative impact on the municipal bond market. Presently high-grade muni yields are ranging from 106% to 127% of taxable US Treasury benchmark securities.

In our view, there is a 50-50 chance that Detroit may use the bankruptcy option. However, we do not think that is the best plan of action. Based on other muni entities that have tried that approach, the only thing that is certain is that legal costs will escalate and must be paid. Vallejo, CA, the poster child for Chapter 9 Bankruptcy, certainly regrets their decision to go that route, while bemoaning the $12 million in legal costs that have accrued so far.

Overall, the situation reaffirms that some municipal entities continue to be under stress and that clients should be very cautious in stretching for yield. We will continue to be diligent and maintain our focus to add value through utilizing stronger credits with broad taxing and revenue sources. Please do not hesitate to contact us should you have any specific questions about this issue or other general questions about the municipal bond market.

The content above was provided with the consent of RNC Genter Capital Management. Information contained herein has been derived from sources that we believe to be reliable but has not been independently verified by us. This report does not purport to be a complete statement of all data relevant to any security mentioned, and additional information is available on request. The information contained herein shall not constitute an offer to sell or the solicitation of an offer to purchase any security.