2016 Second Quarter

Kreitler Financial:

A Fork in the Road of Globalization?

In our March missive, we wrote about the continued volatility with the stock market selloff in January/February and the subsequent rebound. Today “Brexit” has captured the headlines and the attention of financial markets around the world. Surprised markets reacted to the news that Britain voted to leave the European Union by taking investors on a wild ride. Surprises in the markets are inevitable, and portfolios must be constructed to manage them.

In this newsletter, we’ll discuss what Brexit is and some of its potential implications for investors.We will also discuss our continued concerns about current central bank policy and the ultra-low interest rate environment.

Britain votes ‘no’ on European Union membership

Brexit, as it is being called, was the referendum held on June 23 in the United Kingdom on whether Britain should leave the European Union. The “Leave” camp argued that the UK had given up its sovereignty by submitting to laws passed by EU bureaucrats in Brussels, had lost control of its borders and immigration via the free flow of people within the EU, and was spending too much to fund the EU.The “Remain” camp’s position was that the UK benefited tremendously from free trade throughout the economic union, and that leaving was a far too risky and expensive proposition.Many pollsters said it was too close to call. In the days before the election, the markets began to anticipate that Remain would win, and asset prices rose.

Markets move most when surprised, and in this case the markets had called it wrong. Leave won. Global markets, which had been flat for the year at 0.2% year to date (MSCI EAFE) the day of the vote, dropped -9.8% in the two trading days afterward.European markets were generally hit hardest. The US markets (S&P 500) were not immune and dropped -5.3%, giving up their gains for the year. Currency markets were wild, with traders reportedly working overnight as the British pound plunged to a 31-year low of $1.34, a -9.1% slide in the same two days.

In the short term, we encourage investors to watch how events unfold rather than making rushed decisions. Well diversified portfolios have weathered the volatility created by Brexit so far, dropping less than the figures above might imply. Assets such as bonds, Asian and emerging market equities, real estate, and cash helped soften the drop. This is another illustration of the importance of risk management.

Britain’s exit process will evolve over time. The referendum was not legally binding, although reversing it would be extremely difficult.There will be a number of political decisions made before Britain departs the European Union, and some people even hope the UK reverses course. Even after the UK formally begins the exit process, there will be a negotiation process with the EU to agree on the actual terms. No nation has done this before, leading the Financial Times to call it the “world’s most complicated divorce”.The major issues will be the terms under which Britain is able to access the common market and how the flow of people will be permitted or restricted.

There are many possible outcomes at this point. Clearly losing access to their largest trading partner, the remaining 27 EU countries, would be a blow to the economy if that is the outcome. Longer term, Britain could presumably adapt to these challenges and even prosper.

A bigger question is whether the UK referendum is a signal of a larger change in the global economy— a potential step back from globalization, free trade, and immigration. It appears that the “Leave” voters in the UK were those most likely not to have benefited from globalization: older, less affluent, less educated, and more likely to come from rural or fading industrial centers. “Remain” voters, on the other hand, tended to be younger, more educated, live in urban centers, and be more economically mobile. This tension between the globalization ‘haves’ and ‘have nots’ has been building, perhaps accelerating ever since China joined the World Trade Organization in 2010.

Many in the press have drawn parallels between this and disaffected voters in other countries. In the United States, we have people who feel disenchanted with the status quo on the both the right (the supporters of Donald Trump and the Tea Party) and the left (Bernie Sanders and the very progressive left), although they propose different ways of addressing the problems. For Europe, the UK broke a taboo as the first country to vote to leave. Germany has elections in 2017, and the rise of the Alternative for Germany right-wing populist and Eurosceptic political party could present another challenge to EU unity.

For the moment, it appears politics are driving the markets more than economics, and we expect markets to remain volatile as events unfold. We made portfolios more conservative last year, and we are evaluating other changes to our strategies in light of these developments.

A continued low interest rate environment

The very low interest rate environment of today is unprecedented. Interest rates on the US 10-year Treasury have hovered between 1.4 and 1.6%. Rates in other parts of the world, particularly in Europe and Japan, are even lower. On June 2, the Wall Street Journal reported that negative yielding debt had topped $10 trillion—investors are willing to pay interest to governments in return for the safe payment of their principal in the future.

There are positive effects of very low rates. Individuals have refinanced home loans at very cheap rates. Companies have issued new debt, and state and local governments have refinanced or issued new debt at very low rates. This represents a real saving.

There are negative consequences as well. Inexpensive mortgage rates have pushed up housing prices, making it more difficult for young adults to purchase a first home. Additionally, lower rates will most likely affect future returns on bonds. The longer this occurs, the more likely it will be that individuals find their savings and retirement income plans under pressure. We find ourselves wishing interest rates rise in a controlled manner.

Another major concern is central bank policy. Since the 2008-2009 crisis, central banks propped up the markets and economies by pushing rates down and creating vast amounts of liquidity through quantitative easing.This elevated the price of many risk assets like stocks. It may have caused the markets to get ahead of themselves, creating volatile period of digestion while they wait for the economy and corporate profits to catch up.

There is also a lively debate over whether additional central bank stimulus has diminishing effects. We think this is true, and this creates the risk that at some point the markets stop believing that the Federal Reserve or other central banks will bail investors out of a future crisis—the so called “Fed put.”

Between the more turbulent political climate and less impactful central bank policies, people and investors may need to adjust expectations on what the government is capable of doing to solve problems.We may need to adapt to more volatility than what we have been accustomed to.Portfolios should continue to emphasize risk management, diversifying among the risky assets that can contribute to long term growth like stocks and real estate, while also holding assets to explicitly hedge the portfolio or to contribute to its overall stability like bonds.

Warren Buffett once observed, “The stock market is a highly efficient mechanism for the transfer of wealth from the impatient to the patient.” The challenge in constructing portfolios is to find the balance between achieving long term returns while controlling risk for inevitable downturns.

Now seven years into a bull market in stocks, there remains tremendous uncertainty in the world.There will be opportunities. We believe stocks should outperform long term, but of course there are no guarantees. Investors need to look long term and be able to live through short term volatility. In the meantime, we continue to attempt to manage portfolio risks.

Investment Management Process Update

With all the uncertainty in the world, we try to emphasize those things one can control.

A year ago we moved to using a formal investment committee, allowing us to put more talent and time into portfolio management.We have found it helpful in maintaining greater consistency in the asset allocation of our portfolios. We continue to make specific investment changes in each portfolio based on to our clients’ unique objectives, risk and return goals, and tax situations.

We continue to shift to lower cost and more tax efficient investments, in particular shifting more toward index or passive positions in US large caps in taxable accounts. This market is so competitive that it is increasingly difficult for active strategies which may have higher turnover to generate superior after-tax returns. We use active management in areas where we believe managers can enhance performance after tax. Even with active managers we emphasize low cost as this affects long term returns.

Tax management is one of the biggest benefits of a customized portfolio. We try to optimize after-tax returns by holding assets in the most advantageous accounts. For example, we emphasize tax-exempt municipal bonds in accounts that pay taxes, and try to put bonds that generate taxable interest in retirement accounts. We attempt to place trades where they will not cause unnecessary taxes. Each year we screen for loss harvesting opportunities in taxable accounts. We also try to identify investments that may have expected capital gains distributions that are larger than actual gains, and we sell them preemptively to avoid the potential tax burden. This is a time consuming way to manage portfolios, but we believe the benefits to be significant.

The Fiduciary Rule

Recently the Department of Labor released the final version of what is being called the “fiduciary rule.” The rule is very complicated at over 1,000 pages long, and some are calling it the biggest change to financial services in thirty years. In essence, the rule says that advisors working on retirement accounts should put their clients’ interest before their own when making recommendations, and that they need to eliminate conflicts of interest. The new rule has received a lot of press. Many investors were surprised that their advisor or broker might not already be acting in a fiduciary capacity.

We have always held ourselves to a fiduciary standard. Therefore, we do not anticipate significant changes in how we work with you, our clients and friends.

There will likely be operational changes we need to adapt to. Charlie has been invited to join an advisory panel comprised of top Raymond James practices to help Raymond James navigate the impact of the new rule. The rule is big, complex, and evolving. One trend may be for greater transparency, which we think is a good idea. We do have concerns that increased regulatory compliance costs could make it harder for small investors to get quality advice and service.

Happenings at Kreitler Financial

Charlie and Bob went to the Raymond James National Conference for Professional Development in April to stay up to date on industry trends and network with our peers in other top offices around the country. We also spent a day in New York with the GaveKal organization, a think tank based in Hong Kong whose research we utilize.

Charlie was recently interviewed on WTNH Channel 8 to discuss the impact of Brexit on US Investors. You can view the interview at WTNH Connecticut News

Bob recently finished 3rd place in the Squash Nationals for his age bracket. His honeybees are having a particularly good season this year. We look forward to sharing the honey with our clients.

Recently we had a wonderful evening as one of the sponsoring firms for a fund raiser held at Long Wharf Theatre to benefit the Fair Haven Community Health Center. The event featured a reading of the play July 7, 1994, written by Pulitzer prize winning New Haven playwright Donald Margulies and inspired by people and events at the Center.

With warm regards,

Charles F. Kreitler, CFP®
Robert P. Kreitler, CFP®
Founding Partner

This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of Charles and Robert Kreitler, CFP and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Diversification and asset allocation do not ensure a profit or protect against a loss. Investing involves risk and investors may incur a profit or loss regardless of strategy selected. Inclusion of any index is for illustrative purposes only. Individuals cannot invest directly in any index and index performance does not include transaction costs or other fees, which will affect actual investment performance.Past performance does not guarantee future results. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. RJFS does not provide tax advice. You should discuss any tax matters with the appropriate professional. International investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investments mentioned may not be suitable for all investors.

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