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August 17, 2015

Dear Clients and Friends,

 

Summer is my favorite season. Warm days, blue sky, lots of daylight, no ice on the road - what’s not to like? For those of us who don’t live in a warm climate all year, summer is our gift for putting up with the bitter cold of winter. Enjoy the gift.  

Our weather is unpredictable from day to day, but rather predictable as it moves from season to season throughout the year. The investment markets are also unpredictable on a daily basis, but tend to follow patterns over time. We have periods of high and then low inflation, stock advances followed by stock declines, periods of high interest rates followed by periods of low interest rates, and periods of a weak U.S. dollar followed by periods of dollar strength. Our perception of the future, however, is grounded in the framework of the moment. Instead of anticipating the inevitably of change, we think that an existing trend will continue without reversal: oil prices will continue to fall, interest rates and inflation will remain low, to name a few existing trends.

We came across a video interview with John Bogle, the founder of the Vanguard funds. In the video he recalled a conversation with a financial advisor. The advisor explained that he had a series of meetings with a client to discuss the client’s portfolio allocation. The client had a 60/40 Equity/Fixed Income allocation and asked what should be done in light of recent news. The advisor responded “nothing”. A year or so passed and the client asked again. In light of recent news, what should we be doing with the portfolio? The advisor responded “nothing”. Becoming a little frustrated, the client said, “Every year, you tell me to do nothing. What do I need you for?” The advisor asked John Bogle how he should respond. Bogle told the advisor to say, “You need me to keep you from doing anything.”

Bogle was addressing the fact that a client’s overall investment allocation can appropriately remain the same for many years. He did not mean that it is advisable to set one’s investment allocation once and then forget it. An investment advisor’s role is to periodically review the allocation and confirm its appropriateness in light of a client’s recent withdrawals or additions, or changing goals, and recommend a change if needed. Our advisors do this through periodic Investment Policy Renewals.

However, Bogle’s well-taken point is that action for action’s sake could result in doing something both the client and the advisor could later regret. In the example above, knowing that the client’s goals and cash needs had not changed, the value of the advisor was in keeping the client on course.

 
Our job as investment advisors falls within our broader role as financial planners. Practicing financial planning allows us to understand the role and the limitations that investment management plays in the achievement of your goals. While important, too often the value placed on investment management is overemphasized while other areas in personal financial management are underemphasized, neglected, or underappreciated. In thirty years of business, we can confidently say that not one client’s financial plan has ever failed because investment returns have not been high enough. On the other hand, we have seen financial planning failure when there is a lack of savings discipline, or when lifestyle spending exceeds available resources.

Many of you are familiar with the Serenity Prayer of St. Francis of Assisi, which opens as follows:

“God grant me the serenity

To accept the things I cannot change;

Courage to change the things I can;

And wisdom to know the difference.”



These are powerful words that have helped many people face life’s day-to-day challenges. They can also help to understand the role of financial advice.

As financial advisors, it is important for us to work on the things we can change and make a positive difference. Returns from financial investments can be estimated within a certain range, but the timing and actual level of those returns cannot be accurately predicted. Once a portfolio is carefully constructed, in harmony with an appropriate risk level and designed to sustain a reasonable lifestyle, reacting to the latest noise in the world can be counterproductive. Better to concentrate on areas clients and advisors can control and change if necessary, like spending or savings discipline, debt management, education expense funding, multi-year tax planning, asset protection planning, retirement accumulation and withdrawal strategies, Social Security claiming elections, and estate strategies to provide for survivors and charitable intent.  
 

Investment Commentary

Energy is the fuel of a growing economy. If the outlook for economic growth darkens, as it has recently, the price of energy drops. A growing economic outlook results in higher prices as growing demand is anticipated. There is a saying in the commodity (energy, food, minerals) markets that goes something like this; “High prices are the cure for high prices and low prices are the cure for low prices.”

When prices rise, consumers learn to do with less or look for substitute commodities. In doing so, demand falls with prices declines not far behind. When commodity prices fall, it encourages more economic activity. More activity increases demand and prices begin their ascent. The fact that commodity prices are either very high or very low encourages activity that will move prices in the opposite direction.

 The key reason we include commodities in portfolios is the diversification benefits they provide in an inflationary environment. Despite the heavy hand of central banks around the world to spur economic activity with low interest rates, a mostly disinflationary environment has existed since the credit crisis of 2008 (see chart below). 

 
 

World Consumer Price Index

Source: http://data.worldbank.org/indicator/FP.CPI.TOTL.ZG/countries/1W?display=graph



As a result, commodity prices have struggled.   While it is tough to stomach the recent poor performance of this asset class, it merits retention in the portfolio because it will showcase its diversification benefit when inflation returns. A successful investor does not abandon exposure to an asset class simply because it is currently out of favor.

A 2012 paper authored by Xiaowei Kang, CFA, Director Index Research & Design at S&P Dow Jones Indices of McGraw Hill Financial included the following:

 

“Since commodity prices are among the direct drivers of inflation, commodities are often considered one of the key real assets that can protect against rising inflation. While equity and fixed income returns are negatively correlated with inflation, commodity returns have a significant positive correlation with both expected and unexpected inflation (see Exhibit below). Commodities tend to thrive in rising inflation environments while equities and fixed income assets generally generate poor returns, bringing both inflation protection and diversification benefits.”

 

The chart below and to the left shows a positive correlation between commodities and inflation. The chart below and to the right shows asset class returns under different inflation scenarios from 1972 to 2012.
 
 

Portfolio Changes

Given the heavy hand of central bank policy makers to influence interest rates and currency moves, we want to add some additional flexibility to our recommended fixed income investments. We will be moving out of the Pimco Emerging Local Bond and Global Bond funds and replacing them with the Templeton Global Total Return Fund. The security exposure that the new fund will provide will be substantially the same as the funds that are being replaced. However, while the Pimco funds are fully exposed to currency fluctuations as mandated by their prospectuses, the Templeton fund can be unhedged, partially hedged, or fully hedged against foreign currency, at the manager’s discretion. We believe this added flexibility is important.

In addition, we will be replacing the Pimco Total Return fund with the Scout Bond Plus fund. Both funds aim for the risk and reward qualities of high-quality intermediate term bonds in their portfolios. However, the Scout Fund is much smaller in size allowing it to benefit from the opportunities available in smaller bond issues. As an added benefit, the new fund uses no derivative exposure which, if not used very carefully, can carry higher risk. One of the key differentiators in investment philosophy between the Scout fund and others in the intermediate bond fund category is its willingness to deviate from the benchmark (Barclays U.S. Aggregate Bond Index).  The managers of this fund are intent on reducing interest rate risk when real yields (yield, net of inflation) are negative.  When real yields are negative, it takes a drop in interest rates to produce a positive return, something Scout is less likely to rely on.  As a result, we believe that this fund offers better downside protection from an interest rate increase, accepting that its performance will tend to lag in a falling rate environment compared to other bond funds that stay closer to the benchmark.

 
 

Enjoy the rest of your summer.

We continue to work daily to earn your trust and confidence.

 
 
Best Regards,                             

Vincent A. Schiavi, CFP®, CPA/ PFS                        Ravi P. Dattani, CFP®, CPA

President                                                                      Vice President

 

 


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