Dec 2017 Comments: Bitcoin & Interest Rates

Sam Ngooi Comments

Since Bitcoin has become a very popular topic of discussion in and out of the financial world, we thought it was time for Park Piedmont to add our viewpoint. As you might imagine from a firm that advocates long-term investing with asset allocations implemented using low cost index funds, even the mention of Bitcoin would be highly questionable. Nevertheless, we outline our perspective below.

We start by referencing Warren Buffet, who is among the best, if not the best, investors of our time. A December 2017 article from (, quotes Buffett as saying: “You can’t value bitcoin, because it is not a value-producing asset…” (In 2014, Buffett said, “the idea that it has some huge intrinsic value is just a joke….”)

The Wealth Advisor article notes that “Bitcoin is a complex idea. It is a virtual currency, created, owned and traded entirely online in anonymous and unregulated settings. In theory, there is a limited number of these physically non-existent digital coins, though that limit hasn’t yet been reached. A few years ago they were almost worthless; in December 2017, their value reached $19,000.”

The article states that “what drives the value of an essentially value-free asset is – FOMO – the fear of missing out,” and explains that the intrinsic value (of an investment) is a continuous flow of actual cash from the operation of a business (referencing Buffett for this principle), and that “the ultimate source of cash flow from digital coins created on the internet is the dollars flowing from the buyers who want to own those coins, for FOMO.”

Echoing this view is Professor Robert Shiller, the former manager of Yale’s endowment, who foresaw the housing bubble of 2007-08. In a recent New York Times article (, Professor Shiller wrote, “True investing requires a rational appraisal of an asset’s value, simply not possible at present with Bitcoin. Real understanding of the economic issues underlying the cryptocurrency is almost nonexistent…. No one can attach objective probabilities to the various possible outcomes of the current Bitcoin enthusiasm.”

One problem in Bitcoin’s potential use as a currency is the extreme volatility of its price. This was illustrated on 12/22/17, when the price went from $17,500 to $12,000 in a single day, a decline of approximately 30%. (A similar decline on the Dow Jones, at 25,000, would be 7,500 points). In the same article describing this price decline (, the reporters commented that “Bitcoins have mostly been treated as an investment because there is a cap of 21 million on the number of Bitcoins that will ever be released.” Aside from the obvious question of whether someone can actually ensure that the cap is maintained, an even more fundamental objection to the Times article is that a numerical cap on the supply of some object does not by itself create any value in the object.  Even if self-described as a currency, why would anyone treat it as a currency without some underlying economic unit to support its value?

Investment News, a weekly magazine mostly for investment professionals, wrote about Bitcoin (12/4/17) that “rarity can bid up prices, but even though Bitcoin limits its issuance to 21 million coins, there are some 100 other cryptocurrencies.” The article concludes that “it is hard to imagine a practical reason for owning bitcoin, aside from trading, or hiding criminal activity” (

Two recent NY Times articles provide excellent examples of the validity of the Investment News observations. In a front-page article (, the Times reported that “Russian and Venezuelan officials are hoping virtual currencies can help their countries make an end run around American sanctions. Both governments … are looking to take advantage of the promise that Bitcoin introduces to the world financial system: a new kind of money and financial infrastructure, outside the control of any central authority, particularly the United States…. But economists and virtual currency experts have given these currencies low probability of success … because Bitcoin and other virtual currencies are decentralized systems with no one in charge, while Russia and Venezuela would give leaders of both countries a measure of control over the new currencies.” And in another NY Times article (, it was reported that the virtual currency Ripple has increased more than 30,000 percent in the last year, making the “largest holder of ‘Ripple tokens’ worth more than $59 billion.” (Yes, that’s billions).

If this isn’t a “bubble” of manic proportion, we don’t know what is.


One major interest rate story for the year 2017 deserves additional comment:  the fact that while there were three one-quarter point increases in the short term rates controlled by the Federal Reserve, the ten-year US Treasury rate, set by the marketplace of buyers and sellers, was almost unchanged for the year, starting at 2.45% and ending at 2.41%. The implications of this fact are discussed below.

Some context for this discussion: a key point in understanding bond price changes is that when market interest rates change, the longer the maturity, the more the price fluctuation. An example of this relationship follows: if market rates rise to 3%, a bond yielding 2% today and maturing in two years, will decline less than a bond yielding 2% today and maturing in six years, because investors get their money back sooner to reinvest at the higher rate with the shorter, two-year maturity.

Given this basic fact of bond investing, the question is how much more yield (interest income) do longer-term investors have to receive to be compensated for the extra price risk being taken?  In today’s bond market, the spread between a three-month US Treasury yielding 1.4% and a ten-year US Treasury yielding 2.4%, is quite clearly 1.0%.  So the question is: why would presumably rational investors take the risk of owning a bond for almost ten more years just to receive 1% more interest?

The explanation, to the extent there is one, is that the ten-year investors think that future yields will be going down, not up, in which case the longer-term bond becomes more valuable, and its price increases. These investors may be right, if economic growth slows and inflation remains low. (Our note: Inflation is the declining purchasing power of a currency over time, and interest is one way investors are compensated for receiving currency with less purchasing power in the future).

In the current environment of an expanding economy, high employment, a recently enacted tax bill that many observers believe is likely to increase the budget deficit and increase inflation, and a Federal Reserve seemingly poised to raise short-term rates again in 2018 (the consensus is for three more quarter point increases), the 1% spread between 3-month and 10-year bonds seems quite small.

Many investors looking for additional income from the longer maturity bonds are likely to absorb price declines in the bond portion of their portfolios if rates rise. Smaller price declines would come from shorter-term bonds, but that would reduce the income from the portfolio. These bond price declines, should they occur, are typically modest compared to possible stock price declines, and the bond price declines are offset in part by the higher interest received on bond portfolios.

At Park Piedmont, we suggest a mix of short and intermediate bonds, along with high yield investments and stocks, all in an allocation appropriate for each client and implemented mostly with low-cost index funds.

Nov 2017 Comments: Giancarlo Stanton & the Folly of Prediction

Sam Ngooi Comments

As you may know, the Levinsons are pretty big baseball fans. Vic and Nick actually coached Tom’s little league teams (photos are available upon request), and Nick and Tom (and their sister Lynn) grew up going to Yankees games on the 4 train in the 70s and 80s.  So there was some excitement upon the announcement, made this past weekend, that the Yankees had traded for Giancarlo Stanton, the reigning Most Valuable Player in the National League.

In the article on breaking the news, an interesting detail popped out: when Stanton was drafted back in 2007, he was the 76th player selected. Stanton is a towering slugger and four-time All Star. Yet, a decade ago, the teams of Major League Baseball selected 75 other players before him. Amazingly, of those 75, over twenty never played a single game in the Major Leagues.

How did so many teams, tasked with the most expertise and up-to-date information, get their predictions so wrong? Some players got injured, as you’d probably expect. Elbows wear down and knees give out. Some others just didn’t improve the way teams expected them to – in some cases the shortcomings were likely physical; in others, mental; in still others, both.

But the real answer is that fortune-telling is exceedingly hard.

At year’s end, forecasts for the year to come are everywhere. That’s especially the case in the financial markets. With various stock indices at or near all-time highs, analysts and pundits declare that it’s only a matter of time before a significant stock decline. “Whoa,” say other commentators, “why so gloomy?” With a growing economy both here and abroad, unemployment down, and significant tax legislation on the brink of passage, these observers exude confidence that there’s plenty of room for markets to rise.

Many – including many who are smart and sophisticated – attribute significance to the predictions. They base their actions on these predictions. They rely on them. Indeed, much of the investment advisory industry relies on the ostensible predictive ability of researchers and stock pickers, portfolio managers and quants. Are they reliably right?


According to the S&P Dow Jones Indices Persistence Scorecard, very few funds consistently outperform their benchmarks. The 2016 Scorecard reports: “Out of 631 domestic equity funds that were in the top quartile as of September 2014, only 2.85% managed to stay in the top quartile at the end of September 2016. Furthermore, 2.46% of the large-cap funds, 2.20% of the mid-cap funds, and 3.36% of the small-cap funds remained in the top quartile.”

In other words, roughly 97 percent of the active managers who are paid (handsomely) to outsmart the future failed to, even over a 2-year period. Jeff Sommer’s March 2015 column in the New York Times memorably explored this same territory.

Researchers have found that in various fields, experts have a hard time forecasting what’s to come. In a September 2011 episode of the Freakonomics podcast called “The Folly of Prediction,” Philip Tetlock, a professor of psychology and management at Wharton, explained that a signature challenge for experts lies in “think[ing] they know more than they do.” They tend to be “systematically overconfident.” As much of the field of behavioral economics continues to reveal, humans are predisposed toward emphasizing data that supports our positions, our viewpoints, and our biases, and undervaluing data that challenges those positions.

Perhaps needless to say, the difficulties of prediction aren’t limited to experts! We mortals aren’t too hot at predicting outcomes, either.

Frequently in conversation, the question is asked: where do you think the markets (or interest rates, or the economy) are going? You likely know our answer by now: we don’t know.

Park Piedmont has a deep institutional humility about our ability to forecast what’s to come in a complex world. It’s why our Comments routinely feature Larry Swedroe’s observation that “the biggest mistake investors make is treating the highly unlikely as impossible (such as having a massive crisis), and the likely almost as if it is certain (such as the probability that stocks will outperform bonds over twenty years).” It’s why we emphasize customized, broadly diversified asset allocations for you, our clients, in a way that’s respectful of your risk tolerance and designed to help accomplish your long-term goals.

It’s also why you won’t see us placing a wager on the Yankees’ World Series chances in 2018 after their blockbuster trade – even if that’s what the experts are predicting.

October 2017 Comments: Bond Investments

Sam Ngooi Comments

Last month we changed our focus from the surprising, ongoing advance of stock prices since the 2016 election, to bonds, the other major asset class in most client portfolios.

During September there was a substantial increase in market interest rates, which brought the benchmark ten-year US Treasury yield to 2.34%, up 21 bps from August’s close of 2.13%. October’s increase was a much more modest 4 bps, to 2.38%, still below the year end 2016 rate of 2.45%, even as the Federal Reserve has made two 25 bps increases (in March and June) in the ultra-short term overnight rates it controls during 2017.

Ordinarily, an increase in rates by the Fed would result in a similar increase in longer-term rates set by bond market buying and selling. Surprisingly, this has not occurred so far in 2017.  A new Fed Chairman replacing Janet Yellen, and a likely additional 25 bps short term rate increase by the Fed in December, provide some additional context to this discussion.

We are going to use Jeff Sommer’s recent article on bonds (NY Times, 10/29/17 Sunday Business, page 3) as background for our Comments.

The article observes, as we often do, that “Stocks and bonds are complementary partners in standard portfolios. While stocks typically have a higher return potential, bonds are generally less risky and provide a hedge against a stock market plunge, as they did during the bear market that started in 2007.”

PPA’s addition: the extent of the stock decline (and subsequent recovery) are most noteworthy, and add important detail to the rather bland statement of a “bear market that started in 2007.” The S&P 500 index declined from its October 2007 high of 1,565 to a March 2009 low of 677, a decline of 57%. That same index closed October 2017 at 2,575, a gain from low to high of 280%. This is an annualized gain of approximately 17% over the 8.5-year period.

The article continues that “despite a rocky bond market over the last month, bond prices are still too high, and their yields so low, that bonds simply can’t provide much buffering.”

PPA’s addition: we respectfully disagree. If long term market history is any guide, when stock prices fall 20% (the definition of a bear market), or more, the declines in bond prices attributable to rising interest rates are likely to be much, much smaller, and that is the whole point of owning an appropriately allocated and diversified portfolio of bonds and stocks.

The article then continues with a discussion of the wonderful returns in stocks over the last eight plus years, and whether they are likely to continue.

PPA’s addition: surely no one knows the answer to this question.

The article then returns to another recent article by the author: “the standard practice after a big run up in stocks is to rebalance, meaning to take profits out of stocks and put them into bonds. The goal is to create a well-diversified portfolio … the problem is that this is not an ideal moment to be putting money into bonds.” Reasons for the continuing upward pressure in interest rates are presented, ranging from the Fed’s desire to raise rates gradually to ward off future inflation, to the Fed program of selling bonds it had purchased in the aftermath of the financial crisis, to the identity and likely policies of the new Fed chairman, to the potential inflationary impact of the larger budget deficits coming from the government, including from possible changes in the tax law.

Sommer continues that “the bond market turmoil leaves investors in a bit of a muddle. The central reason for holding bonds remains intact: Bonds will still buffer a portfolio and generate income. But in the near future, they aren’t likely to do so as effectively as in the past.”

PPA’s addition: if the point of bonds is to offer a buffer against serious stock market declines, investors should focus on this purpose, and be less concerned about whether this is or is not a good time to buy bonds based on their future return potential.

The Sommer article concludes with some observations from John Bogle, the founder of Vanguard, one of which is that “compared to stocks, bonds are a good value, better than they have been in years … and it still makes sense to hold stocks and bonds in a diversified portfolio.”

PPA’s addition: we take no position on the relative valuations of bonds and stocks, but certainly agree that a diversified portfolio of stocks and bonds, allocated to the investment goals and risk tolerance of each investor, is the best defense against the unexpected (refer to Larry Swedroe’s observations about asset allocation above).

A few other comments may prove useful:

  1. Rebalancing (adding to bonds after large stock price advances) “is more a risk control measure than a return generator.” (This quote comes from Sommer’s article on rebalancing, and we agree. Note there is no mention in the quote of whether this is a good or bad time to own bonds, just that owning them is intended to provide risk control.)
  2. Investors expect to receive higher interest rates on their bond investments when inflation rises, to offset the reduced purchasing power of the money they receive when their bond investments mature. So when rates do rise, and bond prices decline, one other result is that investors receive higher interest payments in the future.
  3. The extent of price declines depends on maturities of the bonds, and on the amounts and time intervals of the interest rate increases.
  4. We are always available to discuss these issues in more detail, including how to balance stock and bond allocations in each client’s portfolio.

Don’t Touch My Money, Just Hold My Hand

Sam Ngooi Comments

A recent article by Wall Street Journal columnist Jason Zweig, entitled ‘Don’t Touch My Money, Just Hold My Hand’ (WSJ, June 9, 2017), touched on topics that reinforce the investment approach Park Piedmont has been conveying to clients since its founding in 2003.

First: many people look to investment advisers to boost their investment returns. If that’s your perspective, “you may be paying your adviser for the wrong thing,” according to Zweig. Just as investors tend to be their own worst enemy by “flinging money at whichever assets have gone up the most and then bailing out at the bottom, locking in losses” – typically during periods “when they are in the grip of greed or fear” – many advisers, driven by the perceived need or desire to outperform, act the same way. In their efforts to chase performance, advisers can lag significantly behind those who maintained a discipline in maintaining their long-term plan.

Second: investors often feel the urge to do something, when nothing may actually be a better investment decision. Zweig writes that investors tend to add and subtract money at inopportune times, leading to “what is often called the ‘behavior gap’ between the performance of an investment and its investors.” For instance, mutual fund investors earn average annual returns that are approximately 1 to 1.5 percentage points lower than the returns of the funds themselves. Zweig adds that investors in hedge funds “may lag those vehicles by up to 7 percentage points annually.” That’s what a financial adviser “should prevent,” writes Zweig.

Finally: Mr. Zweig closes his piece with the following quote, which further reinforces another of Park Piedmont’s consistent message to our clients. “You should hire an adviser not for his or her investing prowess, but to help organize your finances, prioritize your goals, minimize your taxes, and navigate the shoals of retirement and estate planning. Done right, those services can make you far richer – and happier – than the pipe dream of investment outperformance is likely to.”

There will always be events that affect the market in the short-term, in both positive and negative ways. But an adviser can give clients confidence and help them maintain their discipline, so that short-term events don’t undermine longer term goals.

Please contact us if you’d like more information about how Park Piedmont Advisors, a registered investment advisor with a fiduciary duty to put our clients’ interests first, provides asset allocation advice focused on clients’ goals and implemented with low-cost indexed investments.

Known Facts, Unknowable Future

Sam Ngooi Education

At Park Piedmont Advisors (PPA), we advise clients that trying to predict future events, and the financial market’s reactions to future events, can often lead to disappointing results.   Rather, we advocate ignoring most current events and focusing instead on long term financial goals and the cost efficient investments that help achieve those goals.

Here is an example of how even knowing future events can lead to disappointing results.

On Monday May 23, 2016, the US S&P 500 index was 2,048.

Since then, we have experienced the following events- some surprising- that, to most observers, would have been considered negative for financial markets:

  •   England’s vote to leave European Union (“Brexit”, June 23-24);
  •   Donald Trump elected US president (Nov 8);
  •   two Federal Reserve quarter point interest rate increases (Dec 14 and Feb 15);
  •   world wide hacking (mid-May);
  •   North Korea weapons testing (ongoing);
  •   Trump problems with FBI and Russia (ongoing).

Assuming you were able to predict the future and knew all this was going to happen, would you have thought the US stock market, as measured by the S&P 500 index, would be:

a)   closer to 1800 (approximately 12% lower than mid May 2016);

b)   2100 (approximately the same as mid May 2016); or

c)   2300 (approximately 12% higher than mid May 2016)?

Of course, we now know the answer is the 2300, but who would have thought that before the fact?

The moral of the story is to try and ignore the short term news, and focus instead on your long term goals. This is the ongoing message PPA provides its clients. Contact us to learn more about our investing approach.

“Dream Paychecks”: Thoughts on Hedge Fund Returns & Fees

Sam Ngooi Comments

We’re going to start commenting on investing/financial items we read or hear about in the media, in the hope that it’s interesting and informative for you. Please let us know if you have any comments or questions.

Our first post involves the 5/16/17 NYT article titled “Dream Paychecks.” It discusses the enormous 2016 earnings for hedge fund managers (ranging from $1.6 billion [not a typo] to about $100 million), many of whom significantly underperformed the broad stock and bond market indexes for the year. “The 25 best-paid hedge fund managers earned a collective $11 billion in 2016, according to an annual ranking published … by Institutional Investor’s Alpha magazine…. Nearly half of the top-25 earners made single-digit returns for their investors, a lackluster sum in a year when the S&P 500 stock index was up 12%, accounting for reinvested dividends.” To be fair, not all hedge funds invest exclusively in stocks, and so the S&P 500 might not be the best benchmark for all of the funds managed by the highest-paid managers. And as the article notes, “the original allure of a hedge fund was the promise of smoother returns during market upheavals along with risk-adjusted returns that would stand out.” But many of these funds and their managers have risen to prominence, and outsized pay, by taking enormous risks in search of market-beating returns, which have not occurred recently for several well-known managers. The article mentions John Paulson, “who is best known for reaping a windfall by betting on the collapse of the housing market in 2008, [and] has made $15.45 billion over the 16 years Institutional Investor has been compiling the list. But he was bumped off the list after double-digit losses in 2016…” Also mentioned is William Ackman of Pershing Square Capital Management, who “has had percentage losses in the double digits for two years in a row.”

The main points from PPA’s perspective are that active managers, whether of hedge funds, private equity funds, or simply actively-managed (as opposed to passively-managed or indexed) mutual funds, take big risks that might generate outsized returns over certain periods, but always have the possibility of significant declines in other periods. This lack of “persistence” in the returns of active managers is one of the main reasons PPA prefers index funds to implement client portfolios. And the cost of this significant risk, which is in turn “the key to these large paydays [at least for most hedge funds,] is the fee system known as 2-and-20. Hedge funds typically charge investors 2% of their investment annually, regardless of performance… In the event they make a profit, the funds take 20% of that as well.”

Please let us know if you’d like more information about how PPA, a registered investment advisor with a fiduciary duty to put our clients’ interests first, provides asset allocation advice focused on clients’ goals and implemented with low-cost indexed investments.

The Presidential Election and Financial Markets

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In the immediate aftermath of Donald Trump’s unexpected election as President of the United States, global stock prices are experiencing substantial short-term volatility.  As always, when events create this kind of volatility, we think it useful to step back and think more long-term with regard to your investment portfolio.  Here are some points worth considering:

  • The meaning of “big” declines: While the media likes to present declines in large numbers, a 900 point decline in the Dow Jones Industrial Average (DJIA) is a 5% decline. That means a portfolio allocated with 50% in stocks and 50% away from stocks should show a decline of 2.5% — significant but not devastating. The value of an appropriate asset allocation – for mitigating risk and cushioning against volatility – is always most clear when stocks experience substantial declines.
  • Your time horizon as an investor: It’s always important to understand how much of your money you’ll need to use, and when. The further away in time you need to use it, the more you can think of yourself as a long-term investor — measured in years, not days.
  • Historical perspective: At the end of October 2008, just before Barack Obama was elected President, the DJIA was 9,325, in the midst of an historic decline from 13,265 at the end of 2007 caused by the financial crisis of that time. In those first few months of the Obama presidency, the DJIA fell to as low as 6,547 in March 2009, or 30% below October 2008.  Since March 2009, the DJIA has advanced to over 18,000, a gain of almost 200%.  An even more recent example of short-term volatility that didn’t last was the late-June “Brexit” event, where Britain voted to leave the European Union. Despite a nearly 5% decline in the days immediately after Brexit, stock prices are now higher than they were the day before the Brexit vote.

Beyond money

We recognize that, for many people, this election result is about much more than finances and stock prices.  We understand that initial reactions can be powerful and offset longer term thinking.  Uncertainty about what the future holds is always uncomfortable.  But planning thoughtfully for an uncertain future is an important part of our work together.  As investment advisors, we continue to advocate a long-term approach, built around appropriate asset allocations. We are, as always, available to speak with you if you’d like to talk further.

Update on “Brexit”

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On Thursday, June 23, British voters, by a majority of 52% to 48%, voted to have their country leave the European Union (EU), an event dubbed “Brexit” by the media. Since the financial markets reacted sharply to this event (stock prices down, then quickly recovering; bond prices sharply higher, meaning continuing lower yields to investors), and the media proclaimed the event historic, this month’s Comments are devoted to this topic.

The print media’s immediate treatment of Brexit can be seen in the following headlines:

  • June 25, NY Times front page: “Global Shocks After Upheaval in Britain.”
    • Sub Headline: “Investors Gripped by a Panic Last Seen in ‘08”
  • June 28, NY Times, page B1: “Brexit Spreads Fear Far From Britain’s Shores.”
  • June 25-26, Wall Street Journal: “UK Vote Sets Off Shockwaves”
  • June 25-July 1, Economist Magazine cover:  “A Tragic Split”
  • July 2- July 8, Economist Magazine cover: “Anarchy in the UK”

The media discussion of Brexit covered many consequences: political (resignation of British Prime Minister and other political leaders), societal (vote partly against immigration), economic, and financial.  Our focus will be on the economy and financial markets, using the July 2nd-8th issue of The Economist (a magazine based in London, with a decidedly liberal, global, and upscale point of view) as the basic source of information.

In describing the outcome, the first of many Economist articles (page 9) states: “Anger stirred up a winning turnout in the depressed, down-at-heel cities of England. Anger at immigration, globalization, social liberalism and even feminism, polling shows, translated into a vote to reject the EU…. Unless these voters believe that the global order works to their benefit, Brexit risks becoming just the start of an unravelling of globalization and the prosperity it has created…. Proponents of globalization, including this newspaper, must acknowledge that technocrats have made mistakes and ordinary people paid the price. The move to a flawed European currency led to stagnation and unemployment and is driving Europe apart.”

Elaborate financial instruments bamboozled regulators, crashed the world economy and ended up with taxpayer funded bailouts of banks, and later on, budget cuts…. Trade with China, which lifted hundreds of millions of people out of poverty and brought immense gains for Western consumers, also left many factory workers with lost jobs, and they have been unable to find a decently paid replacement…. While American GDP per person grew by 14% in 2001-15, median wages grew by only 2%…. As Brexit shows, when people feel they do not control their lives or share in the fruits of globalization, they strike out, and the distant, baffling, overbearing EU makes an irresistible target.”

The next article (page 10), rather than seeking causes, focuses on the future. “The country needs a new leader, a coherent approach to negotiating with the EU, and a fair settlement with those nations within its own union that voted Remain (in the EU)…. Brexit comes in many varieties, from an arrangement, like Norway’s, involving continuing access to Europe’s single market, in return for allowing free movement of people from EU countries and a contribution to the EU budget, and at the opposite extreme, cuts its ties entirely, meaning no more payments to EU and no more unlimited migration, but no special access to the market which buys nearly half of Britain’s exports…. Britain’s next leader must explain to 17 million voters that the illusion they were promised – all of the EU benefits with none of its obligations – does not exist.” [Our note: negotiations on the terms of the British exit from the EU have a two year deadline from a still-to-be determined start time).

The next article (pages 17-20) focuses on the EU, and what Britain has chosen to leave (terms of departure currently unknown). Recent EU issues range from the “debt crisis in the euro zone (our note: mostly Greece; Britain is not a member of the euro zone), and the mass influx of refugees and other migrants. But Brexit is qualitatively different, since it strikes at the very idea of a union…. The EU is the world’s biggest single market, counting some 500 million rich-world consumers. It stabilized new democracies in southern and eastern Europe…. Two big questions… will anyone else follow Britain out of the union, and what reforms are needed if the institution is to cohere and survive?  Eurosceptics across Europe have similar dissatisfactions as Britain’s ‘Leave’ voters: resentment of globalization, estrangement from elites, a sense the EU is distant and undemocratic, and above all, the EU has let in too many foreigners who take away jobs, benefits and national identity.”

The article focusing on the “economic fallout” begins on page 21. “Business and financial markets hate uncertainty. The vote for Brexit gives rise to a surfeit of it…. Forecasts for economic growth are being revised down – markedly for Britain, materially for Europe, and modestly for the world.  A lot depends on the kind of trade deal Britain can negotiate with the EU and how quickly its outline will emerge…. Three broad scenarios cover most of the possibilities; … the Norway arrangement, reached quickly, in which case the spillovers to Europe and the global economy would be small and transitory. In the second case, discussions are considerably longer drawn out, key issues of disagreement remain, and businesses in Britain, and to a lesser degree other countries with which it has close ties, defer whatever spending they can… The pound remain weak, pushing up the costs of imported goods. Hours and wage growth fall…. In this middling scenario, the combined effects of business uncertainty and a weaker pound would be likely to cut the economy’s growth rate by 1-2 percentage points in the next 12-18 months….”

“A decent rule of thumb is the reduction in GDP growth in Europe will be between a third and a half as big as the loss to Britain’s rate of growth…. The worse outcome (third scenario) would occur if trade talks stall, the politics of Europe sour, and agitation for referendums in other parts of the EU grow…. Broader anti-EU or anti-euro sentiment would likely cause worried business leaders across Europe to cut back on investment. Europe’s banks might be spooked by tumbling stock prices into choking credit for firms and households.”

The article continues that “many forecasters are treating Brexit as a regional economic event, rather than a global one. Britain accounts for a bit less than 4% of world GDP; it is not big enough to make the global economic weather as America or China can.  Even so, there are worries that Brexit might disturb some existing fault lines in the world economy in a way that amplifies its impact.”

The financial market reaction is discussed in the Buttonwood column (page 62). “Shock, followed by frantic recalculation, was how astonished financial markets reacted to the British vote to leave the EU. The initial phase saw a worldwide sell-off in riskier assets, such as equities, and a flight to safe ones, prompting further declines in government bond yields. After the sell-off, equities started to bounce again on June 28th, in part because central banks may respond with easier monetary policy (or in the case of the Federal Reserve, slower tightening); in part because Brexit may not have much impact on the Chinese economy.”

The article continued that “the biggest casualty was the pound sterling, which went from $1.50 before the vote to $1.32, a 31-year low. A big drop in the pound, to make British assets more appealing to foreign investors and imports less appealing to Britons, is a necessary adjustment…. Now the initial shock has passed, investors need to work out what the economic impact will be…. One question is whether consumption will suffer because of the vote…. The bigger worry is investment, …many companies are waiting to see whether Britain decides to join the European Economic Area, alongside Norway, which would keep it in the single market…. In the meantime, uncertainty means few businesses will be inclined to invest in new projects…. For the rest of Europe the question is whether Brexit will encourage other anti EU movements.”

Given the extensive and fear-provoking media coverage of Brexit, we think it important to spotlight the actual price (and percentage) changes of some key stock indexes, starting with the day before the vote (June 23), and then over the next six business days (ending July 1)

               Dow Indus.      S&P 500      NASDAQ       FTSE 100

6/23      18,011                  2,113                4,910                6,338

6/27      17,140 (4.8%)    2,000 (5.3%)  4,594 (6.4%)   5,982 (5.6%)

7/1         17,949 (0.3%)    2,103 (0.5%)  4,863 (0.9%)   6,578 +3.8%

7/15       18,516 +2.8%     2,162 +2.3%   5,030 +2.4%   6,669 +5.2%

It is worth noting that this totally unexpected recovery of stock market prices in a few short days received much less prominent coverage than the initial declines. This again illustrates the point that much of the media coverage of financial events appears designed to frighten people, emphasizing the bad news, while addressing improving news in a far more muted tone. This suggests that the best course of action, far from hanging on the media’s breathless pronouncements, is to ignore the media’s play-by-play account of what’s happening, and instead focus on your longer term goals.

The fact is, had you missed all the news, you would have returned to stock prices that were almost unchanged, except for the Financial Times-London index (FTSE), which actually was 5.2% higher! As usual, after the fact, commentators fashion reasons for this totally unexpected price recovery. The focus now is on the idea that central banks are likely to continue to keep interest rates very low. (The low interest rates can be seen in the very high prices for high credit quality bonds in the US and certain other developed countries like Germany and Japan.) But since it will take two years from a still uncertain future date for Britain to negotiate its new status with the EU, it now appears that Brexit is likely to be a footnote in the history of stock price fluctuations.

Special Comments to Clients re: Brexit

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Financial stock markets around the world have reacted negatively to the unexpected victory of the “Leave EU” campaign in Great Britain.  However, US Treasury bond prices are higher, which often occurs when stock markets decline sharply.

While the immediate impact on the markets seems clear, the longer term outcome based on England’s negotiations with the EU over the terms of its withdrawal are unclear to all.

Further uncertainty is likely to arise over whether other countries are likely to follow Britain’s example.

Given all the uncertainty surrounding the consequences of the vote, we at Park Piedmont are advising that clients retain their existing allocations, and make no changes based on this one event.  As we consistently advise, the financial markets are impacted by many, many events and factors, and while Brexit is today’s main event, there will be many others to take the stage as the uncertain future unfolds.


The Importance of Interest Rates on the Economy and Financial Markets

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Since the financial crisis of 2008, and the resulting stock market declines (which reached 60% on the S&P 500 index, from October 2007 to the low of March 2009), interest rates have been maintained at extremely low levels by the US Federal Reserve (the “Fed”). While the Fed controls short term interest rates (overnight borrowing rates by financial institutions), it is the buying and selling in the bond market that establishes longer term rates, including the benchmark ten-year US Treasury rate. Since October 2007 that rate has fallen, with some interruptions, to the current extremely low level of 1.85%. The actual progression of fairly consistent declining rates is as follows (all month-ending figures):

Oct 2007:    4.47%          Dec 2010:   3.30%                      Dec 2013:   3.03%

Dec 2008:   2.25%          Dec 2011:   1.88%                       Dec 2014:   2.17%

Mar 2009:   2.69%         July 2012:   1.47% (the low)     Dec 2015:   2.27% *

Dec 2009:   3.83%          Dec 2012:   1.76%                       May 2016:   1.85%

* 0.25% Fed rate increase in December 2015, the first since 2008

Marriner_S._Eccles_Federal_Reserve_Board_BuildingTo begin the discussion, we will focus first on interest rates and their impact on the real economy. Since interest rates are a cost of doing business, lower rates should encourage more borrowing and more economic activity. That is the underlying idea behind the Fed keeping interest rates as low as they are in the US. It should also be noted that in parts of Europe and in Japan, interest rates have turned negative (below zero), with central banks charging commercial banks for maintaining deposits. This would seem to be the ultimate incentive to lend out money, and yet these economies, and the US to a lesser extent, are stuck with extremely low economic growth rates, now into the eighth year following the financial crisis of 2008.

Borrowers obviously benefit from low interest rates. Borrowers include national as well as state and local governments, all manner of businesses, and consumers buying goods and services and homes that qualify for financing (that is, paying off the purchase price over time). It is interesting to note that, in a period when borrowing rates are so low, many governments are unwilling to borrow further to improve infrastructure and otherwise invest in their respective economies, which would in turn add to economic growth. Of course the other side of this point is that the borrowing ultimately needs to be paid for with either higher taxes, or with additional borrowing at possibly less favorable future rates.

On the other side are all the people and businesses that have excess savings to invest, and are punished by ultra-low interest rates because they can’t get a decent investment return on their money. Businesses that are adversely affected include insurance companies, which rely on interest income to keep their premiums lower, and banks, which benefit from the spread between their borrowing costs and the interest they charge customers on their loans. In a recent Economist article about low rates in Europe, the conflict between trying to stimulate economic growth with low rates, and the impact of those low rates on savers, is presented well: “The conflict over the European Central Bank (ECB) has brought back tensions between Europe’s north and south that emerged during the euro crisis (with Greece). With their large current account surpluses, Germany and the Netherlands (and their citizens) are net lenders; low interest rates hurt them and help southern European countries which borrow more… But the Germans and Dutch seldom mention why the ECB is setting such low rates.  The Eurozone economy is barely growing, and may be on the verge of deflation, so that raising rates… could send Europe into recession. The chairman of the ECB said that “low interest rates are a symptom of low growth and low inflation, not the cause” (Economist, 4/30.16, page 47).

In addition to being a cost of doing business and a source of investment return for savers, interest rates have a direct connection with inflation. Inflation is the idea that the purchasing power of a given amount of money declines over time because of increasing prices. Interest rates are paid to savers as a way of offsetting the negative effect of inflation on purchasing power. The higher the level of inflation, the higher interest rates need to be to offset the impact of inflation. By the same token, low inflation allows interest rates to remain low. If inflation begins to rise, there is a case to be made for raising interest rates, which would conflict with keeping rates low to stimulate the economy. To further complicate matters, the same low rates designed to increase economic growth could end up creating too much growth, which would trigger inflationary pressures on prices, leading to an increase in rates.

This is the dilemma currently affecting the US Fed. “The Fed has held interest rates at low levels since the Great Recession, to stimulate economic growth by encouraging borrowing and risk taking. It started raising rates in December, seeking to reduce those incentives. But it paused as the economy appeared to weaken. Now it seems ready to continue” (NY Times, 5/28/16, pages B1-2). A second article in the Times stated that “the American economy is picking up speed after a slow start this year,… but the overall gains are still likely to fall short of what many experts would hope to see as the recovery nears the end of its seventh year. These crosscurrents highlight the challenge facing the Fed as they weigh whether to raise interest rates in mid-June, or wait until July or later in the year… Buried in the details of the gross domestic product report were signs that inflation was picking up to more normal levels after years of dormancy, with core inflation of 2.1%, just above the Fed’s 2% target” (5/28/16, page B2).

A NY Times editorial urging the Fed not to raise rates cited slow economic growth, recent disappointing job numbers, and inflation below the Fed’s 2% target, observing that “[r]ate increases are called for when economic activity is speeding up to the point of overheating, as reflected in an upward spiral in wages and prices. At its best the economy in recent years has managed to grow at an annual rate of about two percent, a moderate pace that has resulted in considerable slack in the job market. Raising rates in June would apply the brakes to a recovery that has never hit full speed and that now appears to be slowing.” The editorial also commented on the lack of government spending needed to “offset feeble spending and investment in the private sector” (NYT, Sunday Review section, 5/29/16, page 8).

Impact on Financial Markets

Turning to the impact of interest rates on financial markets, there are a few key points to establish (this subject is likely to be discussed frequently in future months):

  • When interest rates rise, the prices of existing bonds decline; the more gradual the time frame over which rates are increased, the less prices are impacted negatively.
  • Another significant factor on the extent of the price declines is how long it takes for the bonds to mature, at which time new bonds can be purchased paying the higher rates.
  • The impact of rising rates on stocks is far less clear. It may be positive, indicating stronger economic growth; but rising rates increase costs to businesses, and provide a more attractive investment alternative (bonds), which would then be paying higher interest rates.
  • The relationship between bond returns and inflation can be sobering: If savers earn 2% interest, and inflation is 2%, then purchasing power has not increased at all. If the interest is taxable, an apparent positive result can be negative, after accounting for inflation and taxation. Even so, bonds continue to provide a useful buffer in portfolios against the much more extreme price volatility of stocks.