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2017 got off to a strong start during the first quarter, continuing the momentum sparked by the election results last year. At the end of the first quarter, returns for stocks of large domestic and international companies accelerated the growth experienced in the fourth quarter of 2016. In addition, bonds partially recovered losses incurred since November as interest rates eased their climb higher.
Financial market participants continue to closely monitor the situation in Washington for successful progress on anticipated policy prescriptions aimed at improving growth. Indeed, the sharp post-election increase in equity valuations is largely ascribed to the anticipated impact of the new Administration’s tax changes, infrastructure spending and regulatory reduction agenda. With policy making getting off to a shaky start this year, markets paused to evaluate the likelihood of successful negotiations in Washington. The geopolitical issues heating up in the Middle East, and the Korean Peninsula will make happenings in Washington the primary focus of financial markets.
Domestic policy activity – After the new Administration faced challenges moving their healthcare bill through congress, markets have become more skeptical about the implementation of other policies. Among those at the top of financial market’s wish list are corporate tax policy, both in terms of tax rates and arrangements to repatriate cash held abroad, along with easing of federal regulation. These policy and regulatory shifts have the potential to accelerate domestic growth and improve/sustain equity valuations. In the longer-term, proposed infrastructure investment plans also have the potential to bolster economic activity, and, rightly, expectations are that their proposals will have a much longer timeline and impact.
Central Bank activity, rates and inflation – For the second time in three months, the Federal Reserve increased its benchmark interest rate a quarter point, amid rising confidence that the economy is poised for more robust growth. The move, widely anticipated by financial markets, takes the overnight funds rate to a target range of 0.75 percent to 1 percent and sets the Fed on a likely path of regular hikes ahead. The normalization of interest rates will be a critical component of financial market activity this year, as the Fed will need to balance its policy with what appears to be a much more stimulative fiscal policy stance.
Corporate Earnings – After hitting a soft patch in 2016, largely driven by the slump in crude oil prices, domestic corporate earnings are set to reestablish a healthy growth pace this year. As we enter the second quarter, a renewed focus is on earnings reports and confirmation that expansion is back on track.
Geopolitical concerns – Clearly, since the election, markets have been positive regarding election results and anticipated policy changes. In the shadow of this optimism lies a sense of concern that some unpredictable policy blunder could cause systemic problems. These concerns are primarily focused on foreign and trade policy where relationships are complicated, delicate and sometimes tenuous. Investors should remain vigilant of these developments that could derail other economically positive policies.
As always, we remind investors that during these times of uncertainty it is paramount to remain focused on long-term objectives. Maintaining a disciplined approach during spates of volatility opens investors to opportunities, and perhaps, more importantly, prevents costly mistakes.
New Administration Memorandum Calls For Review
By Edward B. O’Gorman, MBA, CFA
Since the passing of the Employee Retirement Income Security Act (ERISA) in 1974, the Department of Labor (DOL) has had authority to protect tax-deferred retirement savings accounts. In April 2016, under the Obama administration, the DOL announced a new fiduciary rule for 401(k) and Individual Retirement Accounts (IRA).
The DOL spent five years refining the details of the Fiduciary Rule, which recognizes the importance of protecting consumers’ retirement accounts. Retirement savings, for a growing number of baby boomers, has shifted away from defined benefit plans into self-directed IRAs and 401(k)s. More than 40 million Americans have over $7 trillion in IRA assets that are not subject to a fiduciary standard under the current ERISA or IRS rules.
Fiduciary Standard vs. Suitability
Since 1940, regulations established by the U.S. Securities and Exchange Commission, have required that Registered Investment Advisors meet a fiduciary standard when advising clients. The fiduciary standard requires them to put their client's interests above their own and to act in their best interest. As a fee-only advisor, River Wealth Advisors adheres to the higher fiduciary standard, when advising clients about investments.
Broker-dealers, who are regulated by the Financial Industry Regulatory Authority (FINRA), had been held to a suitability standard. This lesser level only required that the broker reasonably believed that recommendations were suitable for clients. There was no requirement to disclose conflicts of interest to investors. Unscrupulous brokers could benefit from hidden fees or recommendations of investments with high costs and low returns without any retribution.
An analysis by the White House Council of Economic Advisers found that conflicts of interest by brokers resulted in annual losses of $17 billion per year for U.S. investors.
The proposed fiduciary standard was scheduled to be implemented on April 10, 2017. However, since the White House directed the Department of Labor to review and either revise or rescind the rule, the Department has proposed an extension of the implementation schedule. The proposal extends the implementation date to June 9, 2017, giving the DOL more time for their review.
Some financial and insurance industry groups have attempted to quash the rule since it was originally proposed in 2010. Their arguments against the rule include assertions that it will increase regulatory burdens, result in higher litigation costs and make it harder for advisers to serve clients for one-time transactions. The Indexed Annuity Leadership Council (IALC) and the American Council of Life Insurers (ACLI) brought suit in Texas, seeking to vacate the fiduciary rule. The federal judge in the case recently upheld the rule and refused to delay its implementation. Three other court rulings also rejected the industry challenges.
A variety of groups, including AARP, AFL-CIO, Pension Rights Coalition and the Consumer Federation of America, support the fiduciary rule. The Financial Planning Coalition, which represents certified financial planners and fee-only planners, said it was “gratified that the DOL prevailed in this case. We will continue to encourage the Trump Administration and Congress to avoid delay of the rule’s implementation so that the American retirement saver will benefit from investment advice in his or her best interest.”
Potential Impact To Be Reviewed
The Administration’s memo listed three factors for the DOL to consider when reviewing the rule.
- 1.) Would the rule eliminate consumers’ choice of products
2.) Would it cause disruption in the retirement market to the detriment of consumers
3.) Could it cause an increase in litigation
If there is a positive finding with any one of the three factors, it may be possible that the rule could be rescinded or revised.
The third point is perhaps the biggest concern to those who oppose the new rule. If upheld in its current state, the rule allows individual customers to pursue class action lawsuits against financial advisors. Currently, disputes between customers and firms are handled through individual arbitration. However it may be challenging to support a conclusion of higher litigation costs, since the obstacles to joining a class action suit are formidable.
Given all the shifting scenarios, predicting the potential outcome is nearly impossible. In a perfect world, all financial advisors would adhere to a fiduciary standard and do right by their clients, instead of acting in their own self-interest. Unfortunately, history has shown that industry regulations are needed to curtail unscrupulous behavior.
In bond investing, interest rate risk is often the risk individual Investors either overlook or underestimate. Interest rate risk, simply put, is the risk that market interest rates will change in a way that has a negative impact on a portfolio’s value, or the Investor’s ability to reinvest portfolio cash flow at an attractive yield. Interest rate risk is primarily determined by the term structure of a bond portfolio. An illustration is useful.
Consider two bond Investors. Neither wants exposure to credit risk so they are buying U.S. Treasury bonds. Investor A wants low interest rate risk in her portfolio, so she buys a 2-year bond paying 0.60% annually. Investor B is not thinking so much about interest rate risk, but is looking to generate income, so he invests in a 10-year bond paying 3.34%.
Clearly, Investor B will enjoy better income, but what happens to the value of the portfolios if, over the next year, market interest rates increase by 1.00% across all maturities?
Neither Investor fared well over the first twelve months of their investment. Including interest, after one year Investor A lost $39 dollars while Investor B lost $351. They will not realize the loss of value unless they sell the bonds, but this change in value is an important component in their investment’s total return. So, what happened? As market interest rates increase, today’s value of fixed interest payments in the future decreases. Investor B’s original investment of $10,000 could now earn him 4.34%, or $434 a year for the next nine years, but since his bond is paying $334 it is valued at less than $10,000. The longer an Investor is entitled to receive below market payments, the more the value of their portfolio will decline as rates rise.
Conversely, as interest rates fall, the effect of interest rate risk is just the opposite; bond values grow benefiting longer-term bonds more than short-term bonds. Decisions about the term structure of a bond portfolio need to be made in the context of the current and expected interest rate environment. When there is an expectation that interest rates are headed higher, sacrificing some current income and keeping your portfolio short may be necessary to protect the value of your fixed income assets. In addition, having bonds mature as rates increase provides an opportunity to reinvest cash flow at increasingly attractive yields.