– 3rd Quarter Overview –
“The game has its ups and downs, but you can never lose focus of your individual goals and you can’t let yourself be beat because of lack of effort.”
– Michael Jordan
Borrowing Costs on Roller-Coaster Ride
Fifteen and thirty year mortgage interest rates, after a prolonged period of setting a number of all-time historical lows, have rocketed higher. As recently as March and April of this year, the “best-execution” interest rate for a thirty year mortgage in our area was approximately 3%, with no closing costs the rate was an astounding 3.25%. National averages were slightly higher by 0.125% to 0.25%.
A best-execution rate is the interest cost for a loan that the ideal borrower will pay at any given time. An ideal borrower typically is someone with a great credit score, strong income, financial assets and a low debt to equity ratio on their home.
Fast-forward a few short months to early this month and the national average best-execution rates were 150 basis points higher, or 4.75% on a thirty year mortgage! Economists are chalking the changes up to recent Federal Reserve announcements and an improving economy. Experts in the mortgage securities markets are now referring to the skyrocketing rates over the past several weeks as one of the most, if not the most significant rate moves in the mortgage industry’s modern history.
These rate increases are also beginning to translate into higher borrowing costs for those purchasing assets other than a personal residence such as a business entity or commercial real estate. The upward trend in these areas, according to local bankers we talk with, has been a slower one than what has been seen for mortgages, at least in our area. Still, rates for these loans have climbed over the same time period by 0.25% to 1% depending upon the bank, asset being purchased and borrower financial condition.
These moves remind us that every opportunity in personal finance has an expiration date. There have been countless examples of this over the past six years, particularly surrounding the financial crisis in 2008 and 2009. The biggest mistake we have seen made as to opportunities like these is to attempt to find the “perfect” time to execute. Why is this often a mistake? Typically these individuals will miss the opportunity entirely while waiting for that “perfect” time. What is more important is to take action when timing is “good” but ensure that action is taken before an opportunity expires.
Our wealth planning team is more focused than ever on helping our clients identify these opportunities and act upon them in an appropriate way.
Shaken Stock and Bond Markets
Both stock and bond markets have been shaken over the past couple weeks by comments from U.S. Federal Reserve Chairman, Ben Bernanke. He said that the Fed may begin winding down its very accommodative monetary policy later this year if the economy continues to strengthen. By outlining a tentative plan for ending quantitative easing, traders with a short-term focus indiscriminately began selling stock and bond positions. Since Fed policy over the past four years has been a major factor in pushing interest rates down and stock prices higher, the thinking by these traders was that any tightening in monetary policy should have the opposite effect.
Since we take a very long-term focus with managing wealth, we strive to provide discipline when volatility increases. To help provide investment discipline, we develop a written Investment Policy Statement (IPS) for each client. This document provides guidelines for the mix of stock and bond investments that are appropriate for one’s goals and risk tolerance level. It specifies the types of investments that may be used in the portfolio, and it provides a strategic framework for placing trades. The IPS helps our clients stay the course when markets get choppy and also have the discipline to rebalance their asset allocation back to an appropriate risk level when market declines create dramatic changes in security prices. Although no investment strategy is foolproof, experience has taught us that having the discipline to rebalance one’s asset allocation during heightened periods of volatility can add value over the long-term.
It is important to understand that a tighter monetary policy will not affect all security prices the same way. It is true that higher interest rates will push bond prices lower; however, longer-term maturity bonds will see greater price declines than shorter-term maturity bonds when interest rates increase. To provide some protection against the potential for rising interest rates, we began reducing the average maturity of client bond holdings more than a year ago and then we recently reduced the percentage of portfolios invested in bonds.
We continually strive to protect against a variety of risks as we manage portfolios. As the economy changes and financial markets move through different cycles, the types of risks also change. One area that is causing us more concern lately is the potential for rising inflation. This is due to many of the events that have unfolded since the credit crisis of 2008. We believe the credit crisis sowed the seeds for potentially higher inflation. Central Bankers in the U.S., Europe and Japan have engaged in unprecedented levels of aggressive monetary stimulus in an attempt to improve economic growth prospects. Economics 101 teaches that more dollars (or euros or yen) chasing the same quantity of goods & services results in price inflation. Although we still have high levels of unemployment and excess capacity, we believe that at some point these unemployment and excess capacity levels will decline and the monetary stimulus will result in price inflation.
We have been through a period over the past 30 years with inflation in the U.S. averaging slightly less than 3% per year. It seems that this extended period of price stability has created a complacency about the impact inflation can have on the price of, and return from different asset classes. When you look a little closer at history, you can see that inflation regime shifts have typically occurred with little warning. And, once the inflation fire has been ignited it is typically too late to attempt to hedge or protect one’s investment portfolio. It should be said that we do not see the long-term prospects for inflation at an alarmingly high level, we simply believe that there will be a period of higher inflation and we further believe now is the time to begin to protect portfolios.
We believe that the cost of insuring a portfolio from the effects of inflation is still reasonably priced today; therefore, in the second quarter we began allocating a portion of all client portfolios to the PIMCO Commodities PLUS Fund. This fund invests in a broad-basket of commodities which have historically had a positive correlation with inflation helping to protect investors (i.e. when inflation spikes, commodity prices rise). Compared to many other types of investments, for each percentage point increase in the level of inflation, commodities have typically had on average the biggest gain. Thus, there is a levered response to inflation, such that investors can hold a relatively small amount of commodities to hedge a much larger overall portfolio value. Types of commodity positions included in this fund include energy, base metals, precious metals, agricultural products and livestock.
A second risk consideration is stock market volatility and trying to reduce the magnitude of volatility without significantly giving up long-term return potential. This is especially important for investors who have a lower temperament for experiencing wide swings in the value of their portfolio. We have been following and getting to know the management team of the Schooner Fund over the past two years. They manage a hedged-equity strategy that strives to outperform the S&P 500 index over a full market cycle while only taking about one-half of the risk of the stock market. The strategies they use are designed to limit downside losses, yet still offer some upside return potential. In today’s investment environment the costs incurred by Schooner to protect their shareholders’ capital are much less expensive than any other time since prior to the 2008 credit crisis. An analogy to help put this in laymen’s terms would be – it is much cheaper and easier to buy homeowners insurance before your house catches fire, as opposed to waiting until it is already engulfed in flames. Our most conservative model portfolios have the highest allocation to this fund, and we are not presently using it in our most aggressive growth-oriented model portfolio.