Thursday, October 28, 2010

It is time to talk about expectations.

As we approach the mid term election next week I think it is time to talk about expectation for returns going forward. The day after the election the Chairman of the Federal Reserve will be meeting with the members of the Open Market committee to discuss QE2, not the boat, but Quantitative Easing Part 2 of monetary policy. The president, on the other hand, is leaving for Pakistan two days after the election. My guess is that it is better to be out of the country when you know what will hit the fan on Tuesday.

The Fed is concerned that the economy, jobs and the price of housing are not moving fast enough in the upward direction. The Fed is thinking about spending more money to buy longer date Treasury bonds in hopes of driving interest rates down. They already have the short end of the yield curve close to zero and they feel that if they can bring down longer term interest rates they can spur the economy.  Part of the logic is that lower interest rates will force people to buy stocks, houses and inspire companies to hire more people and therefore, in turn, make the economy grow. People who need fixed income investments to supplement their social security and pension will find their total income decline. With interest rates low at the short end of the yield curve people were forced to go out further on the duration curve to try and get yield. If the Fed is successful, through its purchases, in driving longer-term interest rates down then people will find their income dropping even further.

As one client pointed out to me recently, the money I have for him in growth mutual funds has gone up and of course has gone down, but in the interim they have not paid a lot in dividends. He said to me “I guess I’m not getting paid enough to take the risk in common stock.” We spent some time talking about what are reasonable expectations for returns going forward.

Before I talk about future expected returns I want to apprise you of two things that could happen in the next 30 days that could have significant impact on future investments. The trustees of the Social Security Trust fund have given indications that there will be no cost of living adjustment for beneficiaries in 2011. That would mean that beneficiaries will have had no adjustment for the last 2 years. Secondly, the Presidential Commission on Tax Policy which is charged with reducing the deficit is due to release it’s report with recommendations to the President by December 1, 2010. The commission has sent up three trial balloons. 
The first is the elimination of the mortgage interest tax deduction. This elimination would grandfather existing mortgages but going forward all new mortgages would lose the interest deduction. Our children would  not be able to buy a house and deduct the interest on the loan, which would make the expense of owning a home more of a drain on household income. I could do a whole blog on this issue and just may if it comes to be. The second deduction they propose to eliminate is the personal exemption for children. As grandparents we don’t take that deduction but as the children were growing up the tax benefit helped to offset the significant cost to raise a child. Again the impact would be to put a further drain on household income to pay the expenses and not be able to claim any of the money spent as a personal exemption. If you don’t own a home and have a mortgage you are safe with the first two items, but nobody, and I mean nobody, would escape the third test balloon; that of the VAT (value added tax). Everything we buy would have an additional tax all the way through the building and distribution process to you the consumer. A VAT, in my mind, is a progressive tax in that once it is in place the Congress can increase the percentage without asking us. If any of these three items are enacted then more money will be spent in direct and indirect taxes and all of us will have less to spend.

In the past I have told clients that I expect, over a 5-year period of time, to earn between 6% and 8% after fees and expenses. Based on what I see at the moment I have to ratchet down the expected returns to 4% to 6% return. Public and private pension funds will have to reduce their expected returns from 8% perhaps to 6% or less. Lower expected returns will strain the balance sheets and I see the only possibilities are reduction of existing benefits and retirees paying a larger share of post retirement healthcare. PIMCO the largest bond manager in the world has created a new phrase called the, “New Normal”. They believe “New Normal” will be lower growth, higher unemployment and low inflation.

I have said many times before in this Blog that I believe we are in for a Japanese type of recovery much like what PIMCO is projecting. If we are correct then return expectations have to come down. The real question is how low is low enough?

Dan Perkins

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