Investment Insights Podcast – April 17, 2014

Bill MillerBill Miller, Chief Investment Officer

On this week’s podcast (recorded April 16, 2014):

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What we like: Strong stock market last year with $5.6 trillion added to shareholder wealth


What we don’t like: Blowout tax-collection season as a result of this wealth creation; tax burden reaching into the middle class demographic


What we are doing about it: Expect more demand for municipals

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Source: Strategas Research Partners, Policy Outlook, April 16, 2014

The views expressed are those of Brinker Capital and are not inteded as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

The Name is Bond, Muncipal Bond

Magnotta@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital

As interest rates have moved higher over the last six weeks, municipal bonds have sold off along with other fixed income sectors, but to a slightly greater degree. From May 1 through June 17, the Barclays Municipal Bond Index declined -2.25%, compared to -1.98% for the Barclays Aggregate Index and -1.72% for the Barclays Treasury Index. While municipals are still in negative territory year to date, they are slightly ahead of taxable bonds.

6.19.13_Magnotta_InterestRatesBoth the technicals and the fundamentals in the municipal bond market remain on solid footing. From a technical perspective, supply and demand dynamics are favorable. New issuance isn’t keeping up with maturing debt, resulting in a reduction in total outstanding supply. With 10-year municipal bonds now yielding 2.4% and 30-year maturities yielding above 4%, we will likely see buyers step back into the market. The muni/Treasury ratio is north of 100%. In addition, June and July are typically large months for reinvestments, potentially creating more demand for municipals.

On the fundamental side, state and local government finances have improved. State revenues are back to pre-2008 levels across the board and are expected to increase. Local governments, which source their revenues primarily from property tax receipts, have received a boost from stabilizing home prices. Most states have taken steps to address their longer-term entitlement program and pension issues in some form. While credit is improving generally, there are still areas of concern. Headlines surrounding Detroit, MI, Stockton, CA and Puerto Rico could negatively impact the municipal bond market, but we do not see a concern regarding widespread municipal defaults.

The backup in interest rates has resulted in significant outflows from both taxable and municipal bond mutual funds over the last two weeks. ICI reports that municipal bond funds experienced $2.2 billion in outflows the week ending June 5 and $3.2 billion in outflows the week ending June 12. The recent sell-off could provide an opportunity for municipal bond investors, especially those focused on higher quality intermediate and longer-term bonds where valuations are attractive.

One For The Muni

Magnotta@AmyLMagnotta, CFA, Brinker Capital

Municipal bonds have delivered very strong positive returns since Meredith Whitney famously predicted hundreds of billions in municipal defaults during a 60 Minutes interview in December 2010. Municipal bonds outperformed taxable bonds (Barclays Aggregate Index) by meaningful margins in both 2011 and 2012.

iShares S&P National AM T-Free Muni Bond Fund

Source: FactSet

Municipal bonds have benefited from a favorable technical environment. New supply over the last few years has been light, and net new supply has been even lower as municipalities have taken advantage of low interest rates to refinance existing debt. While supply has been tight, investor demand for tax-free income has been extremely strong. Investors poured over $50 billion into municipal bond funds in 2012 and added $2.5 billion in the first week of 2013 (Source: ICI). This dynamic has been driving yields lower. The interest rate on 10-year munis fell to 1.73%, the equivalent to a 2.86% taxable yield for earners in the top tax bracket. Similar maturity Treasuries yield 1.83% (Source: Bloomberg, as of 1/15). We expect new supply to be met with continued strong demand from investors.

*Excludes maturities of 13 months or less and private placements.  Source: SIFMA, JPMorgan Asset Management, as of November 2012

*Excludes maturities of 13 months or less and private placements. Source: SIFMA, JPMorgan Asset Management, as of November 2012

While technical factors have helped municipal bonds move higher, the underlying fundamentals of municipalities have also improved.  States, unlike the federal government, must by law balance their budget each fiscal year (except for Vermont).  They have had to make the tough choices and cut spending and programs.  Tax revenues have rebounded, especially in high tax states like California.  Last week California Governor Jerry Brown proposed a budget plan that would leave his state with a surplus in the next fiscal year, even after an increase in education and healthcare spending.  Stable housing prices will also help local municipalities who rely primarily on property tax revenues to operate.

While we think municipal bonds are attractive for investors with taxable assets to invest, the sector is still not without issues.  The tax-exempt status of municipal bonds survived the fiscal cliff deal unscathed, but the government could still see the sector as a potential source of revenue in the future which could weigh on the market.  Underfunded pensions – like Illinois – remain a long-term issue for state and local governments.  Puerto Rico, whose bonds are widely owned by municipal bond managers because of their triple tax exempt status, faces massive debt and significant underfunded pension liabilities and remains a credit risk that could spook the overall muni market.  As a result, in our portfolios we continue to favor active municipal bond strategies that emphasize high quality issues.

Fiscal Cliff Update

MagnottaAmy Magnotta, CFA, Brinker Capital

The odds of a deal in Washington before year-end have increased as conversations between President Obama and Speaker Boehner have become more serious since Sunday. There has not been any public discussion of the negotiations, which is a positive sign. With less than three weeks left in the year, we need to see major progress soon, allowing for enough time to draft and vote on legislation before Congress leaves Washington for the Christmas holiday.

The highest probability outcome remains that a short-term deal is agreed on that serves as a down payment on tax and entitlement reform in 2013. This deal will include the framework for increased tax revenues and spending cuts, as well as an increase in the debt ceiling, which we feel will result in a fiscal drag of closer to 1% of GDP in 2013. It is our belief that this type of deal would be a positive for markets and confidence.

If time runs out on a larger deal, the House could pass a bill that maintains all of the current tax rates for those with incomes below $200,000, raises the capital gains and dividend taxes to 20%, and patches the Alternative Minimum Tax. However, the fiscal drag under this option is significantly higher than consensus. In addition, the brinkmanship would continue as the debt ceiling would have to be dealt with in early 2013.

The final potential outcome is that no deal can be reached and we go off the cliff completely. While we believe this is a lower probability event, it remains a risk. The markets would likely react negatively as the resulting fiscal drag would be greater than expected, and there would be a lack of confidence that Washington is serious about getting a handle on our long-term fiscal issues.

One big catalyst that should force both parties to reach a deal before year-end is that the Alternative Minimum Tax (AMT) patch expired at the end of 2011 and needs to be extended for this calendar year. If the AMT is not patched there will be a significant increase in the number taxpayers who are impacted, shifting the burden into the middle class. According to the Tax Policy Center, under current law if Congress does not act, the percentage of taxpayers affected by the AMT will increase from 4% to 32%. This increased tax bill would be a hit to consumers and a significant negative for growth in the first half of 2012.

12.11.12_Magnotta_Fiscal Cliff

Source: Strategas Research Partners, LLC

A deal on the fiscal cliff could restore some confidence that both parties in Washington can compromise on policy and are serious about setting us on a sustainable, long-term fiscal path. Some level of certainty on a deal could also boost business confidence, and as a result, investment and economic growth.

Follow Amy on Twitter @AmyLMagnotta.

Global Equities Rise on Hopes for End to U. S. Budget Impasse

Joe PreisserJoe Preisser

Optimism cautiously crept back into the marketplace this week, as investors continued to cast wary eyes toward Washington D.C. and the high stakes drama playing out around the looming budgets cuts and tax increases of the, “fiscal cliff”.  Stocks on Wednesday marked a turning point as they reversed earlier losses, and staged a late day rally with indications that policy makers in the United States were moving closer to bridging their differences helping to support share prices.  Although the momentum of late has been positive, indices around the globe remain beholden to news reports discussing the state of negotiations, with any hint of stagnation or progress toward resolution holding the power to move share prices significantly in either direction.  Joseph Tanious, a Global Market Strategist for J.P. Morgan was quoted as saying, “I think we’re going to have these markets that react to every single headline.  I think an agreement will be reached, and I think we’re likely to see a relief rally at the end of it.  But until then, hold on to your seat” (Wall Street Journal).

Through the confusion of this unnecessarily complex dance of politics, it appears as though the two sides are inching closer to common ground.  In a break with his party’s line, senior Republican Representative, Tom Cole of Oklahoma on Tuesday advocated to fellow G.O.P. members that they accept the White House’s proposition to extend tax rates for those making $250,000 or less (New York Times).  With the issue of possible tax increases on the highest income earners among the most contentious of the current debate, it has become apparent that the President may be amenable to adjusting the size of such an increase, potentially creating the conditions for compromise.  If the current tax rates of those Americans making more than $250,000 and $388,000 respectively, which represent the highest brackets, were permitted to expire they would reset to the Clinton era levels of 36% and 39.6%.  The co-chairman of the President’s 2010 deficit-reduction panel, Mr. Erskine Bowles suggested, following a meeting with President Obama this week, that those rates may be permitted to rise to a lower level as part of a broader deal.  According to the Wall Street Journal, “Mr. Bowles said White House officials made clear to him that the rates might not have to increase quite that high, as long as they increased a significant amount and were paired with some limits on tax breaks.”


Equity markets got an additional lift this week from an article published by the Wall Street Journal, in which Jon Hilsenrath, who is widely considered a de facto mouthpiece for the Federal Reserve Bank of the United States, suggested that the Central bank will likely continue their unprecedented monetary easing policies into next year.  Mr. Hilsenrath wrote, “Three months after launching an aggressive push to restart the lumbering U.S. economy, Federal Reserve officials are nearing a decision to continue those efforts into 2013 as the U.S. faces threats from the fiscal cliff at home and fragile economies elsewhere in the world” (Wall Street Journal).  Although volatility will almost certainly surround the remaining days of the “fiscal cliff” negotiations in Washington, if the framework for compromise which has been created is completed, the extrication of this uncertainty coupled with the possibility of additional action by the Federal Reserve will be strongly supportive of equity markets around the globe.

Divergence in Confidence

Amy Magnotta, CFA, Brinker Capital

Consumer confidence fell to extremely low levels during the financial crisis.  While improving in the 2010/2011 period as economic conditions stabilized and markets rebounded, consumer confidence had still remained at levels previously associated with recessions.  Confidence retrenched again in the summer of 2011 when S&P downgraded U.S. debt; however, it has been steadily improving since.

While consumer confidence is strengthening, business confidence has weakened.  Companies have downgraded their growth expectations.  Despite healthy balance sheets, policy uncertainty in the U.S. is causing companies to hunker down and delay capital spending and hiring.  CEOs of U.S.-based companies have urged policymakers in Washington to act “to end the crippling uncertainty that is stifling business investment and hiring” (Source: Business Roundtable).  On November 18, the Wall Street Journal reported that “half of the nation’s 40 biggest publicly traded corporate spenders have announced plans to curtail capital expenditures this year or next” (Investment Falls off a Cliff).

It is clear that the paralysis in Washington is keeping business investment muted.  Until the rules of the game are settled by Congress and President Obama, capital expenditures and hiring will likely remain on hold.  Companies have the ability to invest for the future and drive economic growth in the process, but we must wait until fiscal policy uncertainty is removed.

Source: Thomson Reuters, Conference Board

While consumer sentiment has improved, we remain concerned that consumers have not prepared for a fiscal drag that may hit next year.  Even if a deal is reached to extend a number of the tax and spending provisions for 2013, it seems that there is very little support in Washington to extend the 2% payroll tax cut.  Even if current rates are extended for most taxpayers, everyone will see their take home pay decrease as a result of the expiration of this temporary tax cut.  Consumers have already drawn down their savings rate to a level of 3.3%, so there is limited cushion to fall back on.  If the fiscal cliff does hit, it could result in further pressure on consumers, and serve dampen confidence.

Source: Bureau of Economic Analysis

Concerns Over “Fiscal Cliff” Continue to Dominate Markets

Joe Preisser

The sharp selloff in global equity markets that, through Thursday, had sent the Standard & Poor’s 500 Index down almost 6% since the reelection of President Obama, brings into stark relief the depth of the concerns among market participants over the looming “fiscal cliff” in the United States and the potential impact on the global economy if it is not averted.  With the compilation of automatic spending cuts and tax increases totaling more than $600 billion which comprise the so called, “cliff”, scheduled to take effect in January, unless an accord can be reached to forestall it, investors have quickly begun to pare back their exposure to risk based assets.  As Amy Magnotta pointed out in her most recent blog post, the effects of a failure of policy makers in Washington to reach an agreement would be severe, resulting in a  4 percent drop in Gross Domestic Product and casting the world’s largest economy back into recession.  Marko Kolanovic, the Global Head of derivatives and quantitative strategy at JPMorgan Chase & Co. was quoted by Bloomberg News, “about 90 percent of the drop in the S&P 500 since election day can be attributed to concerns about the U.S. fiscal cliff.”

The divided government, which remains in the United States following the Nov 6th elections, with a Democratically controlled White House and strengthened position in the Senate, and a continued Republican hold on the House of Representatives, has led to a continuation of the stalemate that has gripped the Capital for much of the past two years.   Although the representation of differing philosophies and governing styles is essential to a functioning democracy, the current environment inside the ‘beltway’ has degenerated to the point of stagnation.  Neither side of the proverbial ‘aisle’ appears, at least publically, willing to compromise with Republicans declaring their resolve to avoid tax rate increases of any kind, and Democrats extolling the need to increase the percentage paid by the top income earners in the country.  It is impossible to know how much of the recent rhetoric is simply political posturing and how much represents entrenched positions, but what is evident is that it has created an atmosphere of uncertainty which financial markets abhor. One potential area of concession, that has lately developed, is the rate of increase Democrats are seeking.  Although it had been earlier suggested that a return to the 39.6% level last seen under President Bill Clinton was all that would be accepted, that stance has softened in recent days,(Strategas Research Partners), suggesting that a smaller increase could be where an accord is found.

As I am writing this morning, leaders from both political parties are preparing to meet at the White House to begin negotiations on bridging the gap that divides them.  If they are successful in their efforts and common ground is reached, even on a temporary basis, which is the most plausible scenario, we should see a strong rebound across financial markets.  While the process of resolving the differences that separate the two sides of this debate will undoubtedly take time and potentially create turbulence in the marketplace, if our policy makers can fulfill their responsibilities and find a resolution to this issue it will greatly strengthen the recovery in the global economy and lead to a substantive rally in risk based assets.

It’s Time for the “Cliff” Conversation by Sue Bergin

Sometimes the media grabs on to buzz phrases that instill fear in the minds of our clients.  The latest examples are the phrases “fiscal cliff” and “taxmageddon.”  Both phrases intentionally conjure images of impending doom.  They are meant to scare and that is entirely what they will do to your clients unless you get out in front of it.

As Susan Weiner points out in her Your Mother and the Financial Cliff blog post, it’s a mistake to assume clients and prospects understand financial vocabulary.  These terms may roll off the tongue easily, score millions of Google hits, and be repeated ad nauseam on the news, and still be misunderstood.

You have a fiduciary responsibility to focus on education.  Let clients know what the fiscal cliff means to the country and to the economy.  A good article to reference is What You Need to Know About the Fiscal Cliff, written by Morgan Housel for Daily Finance.

Your clients will look to you to size up the potential impact of the fiscal cliff on their portfolio and their life goals. You should be the person that delivers this news, rather than letting them stumble upon the MyTaxBurden calculator on the web (this calculator models an individual’s federal tax burden under three scenarios: full expiration of Bush-era and Obama tax cuts, the Republican plan to extend Bush-era cuts, and President Obama’s plan partially to extend these cuts for families making under $250,000 per year as well as extending tax cuts in the 2009 stimulus bill).

In the weeks remaining after the election and before the end of the year, the Congressional drama will unfold before us. Your client should be well informed as they observe the discourse just how critical the issue is to the country’s overall economic health. A “cliff” conversation now gives you the opportunity to outline potential strategies that will help minimize the client’s 2013 tax burden if a compromise is not reached. They should also have confidence that no matter the outcome, you will help ensure that they are best positioned.