As we enter October, we are now three quarters through a very eventful 2017. Summer has come to an end and Fall is officially here. As the days turn cool and the nights grow long we look forward to holidays spent gathered around tables with a mixture of both friends and family. Please read below for our thoughts on current market situations.
Review of Third Quarter 2017
For the third quarter of 2017, US markets rose again, with the S&P 500 climbing 4.5%. Bonds, as represented by the Bloomberg Barclays US Aggregate, grew by 0.9% this quarter, despite two interest rate increases in 2017. Internationally, equity markets rose with emerging markets moving well ahead of developed markets. For example, the MSCI EAFE climbed 3.4% while the MSCI EM index increased 7.7%.
Market performance was indicative of continued economic growth. In fact, despite the economic impact of the devastation caused by Hurricane Irma, Harvey, and Maria during the quarter, the fed recently raised its growth outlook and lowered its unemployment forecast. GDP growth was strong, despite remaining rangebound and is expected to finish the year at a little over 2%. Employment figures maintain their steady advance towards pre-recession levels.
These facts, while impressive for our economy, also mean that the Federal Reserve will likely take this opportunity to continue raising rates over time. To compound this issue, the Fed will simultaneously be reducing the size of its balance sheet. From the chart below you can see that before the "great recession", the Federal Reserve's balance sheet was relatively modest at under $900 billion. In 2008, after the recession started, the Fed embarked on its Quantitative Easing program. As of September 2017, the Fed's balance sheet stands at $4.5 trillion dollars, a staggering 400% increase from pre-recession levels.
So, what happens now? Under Quantitative Easing, the Fed purchased debt instruments (either Treasuries or mortgage-backed securities) to reduce the supply of publicly available debt in the marketplace. The Fed purchased this debt by electronically creating more money (often euphemistically referred to as "money printing"). With reduced supply, demand drove prices up and yields down (for those interested, if bond prices increase, say from 100 to 105 but still pay the same interest amount, the yield declines).
As the Fed reduces its balance sheet, the opposite will occur. As these bonds mature, the Fed won't reinvest the money, and the debt will start to fall off the balance sheet. The challenge, for the Fed and therefore for the markets as a whole, will be to allow enough debt to mature to accomplish two things 1) reduce the balance sheet over some realistic time frame, and 2) to take a measured approach so as to not create too high an increase in interest rates too quickly.
The impact of these changes is that interest rates will rise and fixed income will face performance challenges for some time. We think the solution for this is to maintain exposure to fixed income while focusing on managers that are relying on credit selection, shorter duration maturities, and on those that are not speculating on interest rates. This will provide continued income, reinvestment opportunities at higher rates, and lessen exposure to long-term rate increases.
Where Investors Should Focus
In general, we feel too many investors are complacent with respect to portfolio decisions. Overemphasis on the present, especially when things look good, are usually preferable to making forward-looking decisions based on negative events that can arise. Our process requires the consideration of several permutations regarding the future. We certainly can't predict the future, but we can position clients in an anticipatory manner that helps prepare portfolios against uncertainty.
One Area of Concern: Municipal Debt
One item we find increasingly troubling is the condition of the state, local, and municipal budgets across the country. Most disconcerting are the liabilities that these administrative divisions have amassed over time. A combination of unrealistically high return expectations and budgets that cannot afford to fill the shortfall have left a wide gap in unfunded pension liability that spans almost every state, county, and city in the country.
As of 2016, which is the latest data that is currently available, the stated unfunded pension liability for all cities and states is $1.4 trillion dollars. This is projected to swell to $1.8 trillion by the end of 2017. If you adjust this for enforceable rights by employees, this number swells to almost $4 trillion. Without getting into the technical minutia of pension plan accounting, the implications for the participants of these systems, as well as the confidence of investors to continue loaning these municipalities more money, could become compromised over time if the problem is not resolved.
Below is a table that shows the states with the direst scenarios, as measured by their funding ratio. Cumulatively, these states have a combined unfunded liability of almost $620 billion as of 2016. To make matters worse, the gap widened materially in just one year. In 2015 the funding ratio was an average of 45%, which then fell to 37% in 2016. (Table sources: Forbes)
| State | Funding ratio 2016 | Funding ratio 2015 | Total Pension Liability 2016 ($B) |
| New Jersey | 30.9% | 37.5% | $243.6 |
| Kentucky | 31.4% | 37.8% | $63.3 |
| Illinois | 35.6% | 40.2% | $219.4 |
| Connecticut | 44.1% | 50.2% | $61.1 |
| Colorado | 46.0% | 60.4% | $94.2 |
Conversely, the table below shows the states with the highest funding ratios as of 2016.
| State | Funding ratio 2016 | Funding ratio 2015 | Total Pension Liability 2016 ($B) |
| District of Columbia | 100.5% | 96.8% | $6.7 |
| Wisconsin | 100.0% | 100.0% | $95.4 |
| South Dakota | 96.9% | 104.1% | $10.9 |
| Tennessee | 95.9% | 98.8% | $44.6 |
| New York | 94.5% | 90.6% | $209.1 |
The reason this subject is important now is that the liabilities are increasing at an increasing rate. (Said another way, the magic of compounding is working in reverse, to the detriment of these pension plans.) This issue has not always been the case. Prior to the dotcom bubble bursting, most pensions were fully funded. The crux of the problem is expected returns. Actuaries and plan sponsors that use unrealistic assumptions of market returns only worsen the issue over time. In 2015 for example, the average liability-weighted return chosen by pension systems was 7.6%, meaning that plan assets would double every 9.5 years. That same year the average actual return was 2.9%, implying a doubling every 24 years. As you can see from the chart below, funded status has steadily declined for the last 15 years.
There is no clear solution for these problems. Changing market assumptions would help going forward, but it is not always that simple and does not solve the current underfunding. Legislation, union negotiations, and fiscal problems make real change difficult. So, what are the options available to these pension plans? There are no easy answers, but here are a few strategies that are being utilized:
- Do nothing. Most plans are relying on the hope that market growth will close the gap over time. We often say that "hope is not a plan". This is not a long-term solution, and is really just kicking the can down the road for future generations to handle.
- This would extend the time period that plans have to pay back these gaps.
- Cut benefits. Legislatively difficult and fraught with other legal complications.
- Pension buy-outs. Offering a smaller amount if paid immediately, in a lump sum, may entice some pensions to move forward.
- Issue bonds. Borrowing more money to pay other borrowed money. California is proposing to do this now. This is also not a long-term solution, as it is just moving debt from one column to another.
- Find new revenue. This is really a form of new taxes, which is never a popular solution.
- This is the most extreme solution, is an incredibly difficult process, and has wide-ranging implications. We have seen this play out in Detroit, MI, and Vallejo, CA.
In reality, a combination of several of these options will need to be utilized in order to achieve a solution. All these options will require substantial compromise by plan participants, local taxpayers, and bondholders. These issues will not go away and will likely result in restructurings and stress over time.
How did we get here?
Municipal debt has been soaring for many years. As interest rates fell, prices surged but demand kept climbing. By way of example, Connecticut is facing serious budgetary and pension shortfalls. At the same time, the state has one of the highest median incomes in the country, which results in high demand for non-taxable income by wealthy investors. New bonds in Connecticut are being purchased as fast as they are being issued. Investors need to be aware of the risks in the municipal market as they make portfolio decisions.
Conclusion
To manage the risks that these underfunded pensions systems represent, Silicon Valley Wealth Advisors is opting for a three pronged approach that includes 1) patience - not chasing high-priced bonds that could fall in value, and also pay us little in the interim, 2) focusing on quality - we avoid sub-tier or low-rated offerings that require funding from questionable projects or high economic risk regions, 3) focusing on short maturities - this provides income, but does not expose client portfolios to longer time periods that can be negatively affected by rising rates or economic setbacks.
As the beat goes on in US markets, where growth rates continue and the labor force continues at full speed, we are positioned to enjoy these benefits but also remain focused on the horizon and take notice of the things that can create unnecessary portfolio risk. We continue to rebalance into international markets due to the more favorable risk/reward scenario and employ alternative investment options that offer income and capital protection.
As always, we appreciate your confidence and welcome your questions.
Gratefully yours,
The Silicon Valley Wealth Advisors Team
Tracy Lasecke, CFP®
Chris Duke, CFP®
Scott Yang, CPA, CFP®
Juliet Anderson
Adam Gelhausen
Robert Lopez
Alison Lee
James Karel
What We've Been Up To
Roberta and Tracy waited sometime before taking an extended vacation. They decided to use Tracy's birthday as an excuse to travel to Europe. They enjoyed a week-long riverboat cruise down the Rhine, Main, and Moselle. They then connected with a Porsche group to drive the autobahn and the Swiss and Italian Alps. Imagine driving through the Swiss Alps when suddenly Roberta starts having severe lower abdominal pain. Well, long story short Roberta is recovering nicely from having her appendix removed in Switzerland. They are very grateful that the Swiss heal care system works well and the care was great. After four days in the hospital, they were able to rejoin the tour. Despite the hiccup, they are grateful for the opportunity to travel and spend time together. Many thanks to our wonderful clients and talented team for allowing us the luxury to spend time away.
Jim enjoyed the waning days of Summer on Lake Coeur ‘Alene. The only problem was not being able to see it due to smoke coming in from massive forest fires in Montana, as well as, local ones near Spokane. But given what was happening geologically elsewhere on the globe, he remained thankful.
Chris and his family had a fun, but very busy summer. This summer the kids went to a wide range of camps, including a soccer camp, a computer programing camp, and a sleep-away camp. While the kids might not be glad to be back in school, Chris and his wife Laura are, for the simple reason that they are now on a regular schedule!
Adam traveled to Colorado and spent some time in Denver, Boulder, and Estes Park. The weather was as incredible as the scenery. The kids attended camp in Spokane, as well. Football, art, and overnight camp were on the agenda this year. They also spent a weekend in beautiful Leavenworth, WA, a town modeled after a Bavarian village and enjoyed polka music and German food!
Scott and his family had a wonderful vacation in August, going to London to see all the sights including some notables such as Westminster Abbey, London Tower, Windsor Castle, and Stonehenge. They got to see the play Wicked and go the Wimbledon tournament tour, as Scott is a huge tennis fan and participant.
The beginning of summer included a nice visit by Juliet's brother and sister-in-law from Washington. Fourth of July in Los Gatos' block party was kid friendly with train, bouncy house, and face painting. Olivia's 5th Birthday party had a visit from Princess Moana and dancing with her preschool/now kindergarten friends. Great Aunt Eva celebrated age 108! Pool time and a visit to Half Moon Bay beach to thwart the very hot summer weather was a necessity. Staying out of the heat, Cars 3 movie for kids had the pleasant surprise of featuring a female car winner on a co-ed team. Summer ended with Juliet seeing her niece in her new dorm room at Stanford as a Freshman. A special thanks to Juliet's parents for always just being there.
Robert and his wife, Shirley have been busy with the move to California and are finally beginning to settle into their new home in San Jose. Shirley recently celebrated her graduation from Medical School and is enjoying her new position with Kaiser Permanente. To stay active, Robert has begun running with the local Silicon Valley Hash Organization and is preparing for a Spartan Obstacle Course Race in mid-November.
Ali and Guy really looking forward to a change in the seasons and some cooler weather. Halloween is one of their favorite holidays. This year they will be in New York and are dressing up as Pinocchio and Geppetto. While in New York, they look forward be being tourists, taking a break from every day and spending time visiting with family.
Happenings @ SVWA
After 12 years with the firm, Emy announced that she would be leaving to pursue new challenges. Her last day was at the end of August. She stopped by the office last week and had a new pep in her step. She was spending more time at the gym, doing a lot of cooking (one of her passions), and planning trips to see family overseas. We thank her for her service, dedication, and loyalty to the firm - and we wish her well in her new adventures.
This quarter we are adding two back-office professionals to the team. Amy Thomas and Jan Prospero work remotely, and between them have a combined 35 years of back office experience supporting financial services professionals. We define back office as all the things that are critical to the organization but aren't obvious - preparing paperwork, validating and checking all securities transactions, confirming appointments, and making the rest of the team look good. You can read more about their bio on our website. We are excited to have them on the team and are eagerly anticipating the impact they will have as we strive to meet and exceed your client service expectations.