The Financial Landscape – June 2020

Global Macro Environment

Green Shoots Appearing in the Global Economy
The global economy has received encouraging news of late that could signal a bounce back. First let’s begin with the US. Friday’s jobs report indicated the economy may be able to pull out of the downturn faster than expected. Data showed the economy defied expectations as payrolls rose by 2.5 million in May.The unemployment rate declined from 14.7% to 13.3%, which is still a staggering absolute number, but much better than consensus views. The underemployment rate (U‐6 rate) is currently 21.2% vs. the previous 22.8%. On the downside, the permanent jobs lost number continued to rise and stands at 2.3 million. Even amidst this encouraging report, high unemployment should not be discounted as a headwind for normalization. The Institute of Supply Management (ISM) Manufacturing Purchasing Managers Index (PMI) improved month‐over‐month to 43.1 in May from 41.5 in April. The ISM Non‐Manufacturing PMI also rose month‐over‐month to 45.5 in May from 41.8 in April, a hopeful sign the sudden shock to the US economy from COVID‐19 is beginning to abate. The April reading ended 122 consecutive months of expansion for services‐related activity. Another expansion record was broken as the National Bureau of Economic Research (NBER) declared the US entered into a recession in February. The expansion, which began in June 2009 and lasted 128 months, was the longest on record.

In Europe, countries are re‐opening and implementing more stimulus measures, which are making their way to the data. Business climate and economic sentiment for May both improved from rock‐bottom levels seen the past two months. The IHS Markit Eurozone PMI Composite Output Index, which includes manufacturing and services, bounced back in May to 31.9 from the series low of 13.6 in April. Three of the four biggest economies all posted three month highs beginning with Italy (33.9), France (32.1) and Spain (29.2), while Germany (32.3) hit a two month high.

China continues to stand out as the only country operating in expansion territory. Easing of restrictions for business operations is helping lead new orders higher and client demand is improving. If global demand continues to improve, the economy in China could recover to the pre‐virus levels quicker than anticipated. However, geopolitics could be a major headwind. Tensions with the US include Hong Kong, Huawei and the World Health Organization.

Next Generation European Union Proposal
The European Commission has announced a recovery program of 750 billion euros (about $847 billion) to support its member states and those economies hit hardest by COVID‐19. This recovery program, along with a 1.1 trillion euros budget proposal over the next seven years, is being led by Germany, which is typically reluctant to support fiscal transfer programs. The European Central Bank also announced the expansion of its bond‐buying program beyond $1.5 trillion, putting the central bank’s stimulus effort on par with the Federal Reserve.

Market Observations

US Equities
US equities continued to rise in May as the S&P 500 gained (+4.8%), which puts the rally for the index from the March 23 lows at (+36.6%). Positive sentiment around the US economy re‐opening continues to power the market with support of massive intervention by the Federal Reserve. Businesses are eager to get back and demand is picking up among the US consumer. Growth stocks continue to outperform on the back of lower real rates as large cap growth (+6.7%) outperformed large cap value (+3.4%). Small cap (+6.5%) outperformed large cap (+5.3%) in May, but the spread year to date (+11.0%) still favors large corporations. However, this trend could reverse as the economy re‐opens. All S&P 500 sectors had positive performance in May as information technology (+7.1%) led while consumer staples (1.5%) lagged.

International Equities
Developed international equities were up (+4.4%) at the end of May, while emerging markets finished slightly positive at (+0.8%). The German market had strong performance for the month (+12.4%) on the hope the global economy continues to show signs of improvement.

Fixed Income
The 10‐year treasury yield reversed course in May and rose to 0.7% from 0.6% in April. Yields on the longer end of the curve, 10 to 30 year, have shown a slow steepening trend. The most probable cause of this is the optimism around the economic re‐opening. The Bloomberg Barclays US Aggregate Index rose (+0.5%) during the month. The municipal market had strong performance in May as the Bloomberg Barclays Municipal Aa+ 1‐ 10 Year index rose (+2.6%). The finances of states and local municipalities across the country will be a key data point in assessing the impact of the quarantine on tax revenues.

Real Assets
Real assets continued to deliver positive returns in May. Master Limited Partnerships (+9.0%) had the strongest performance followed by natural resources (+3.7%) and real estate (+0.2%). Oil (+88.1%) registered its best month on record as demand expectations increased and further supply adjustments were made by OPEC and non‐OPEC producers.

This commentary represents the consensus of the Oxford Investment Fellows as of 6.11.20, is subject to change at any time due to market or economic conditions or other factors and offers generalized research, not personalized investment advice. This commentary offers generalized research, not personalized investment advice. Statistical data is derived from third party sources believed to be reliable and has not been independently verified by Oxford. Content is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment and tax professional before implementing any investment strategy. Oxford Financial Group, Ltd. is a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and is headquartered in Carmel, Indiana. Registration does not imply a certain level of skill or training. For more information about our firm, or to receive a copy of our disclosure Form ADV and Privacy Policy call 800.722.2289 or contact us at info@ofgltd.com. OFG-2006-39

The 2020 Estate Planning Trifecta

At times, the extremes of a negative event are matched by the extremes of a positive planning opportunity, and such is the case with our current market, economic and tax law environment. While 2020 has been a year of unprecedented set-backs, in the world of estate planning we have the veritable trifecta of positive planning opportunities: historically low interest rates; suppressed asset valuations as a result of market and economic influences; and a variety of favorable laws and authority for ‘estate freezing’ strategies.

In this three part series, we will first discuss the scope of the current planning opportunity and the ‘why’ behind it. In our second and third articles, we will dive deeper into the specific strategies that we believe provide optimal results in the current environment, both for overall federal estate tax planning and for charitable planning strategies.

The Estate Freeze
Broadly speaking, estate freezing strategies are designed to freeze the taxable value of an asset in the grantor’s estate. All future appreciation after the strategy is implemented goes either into a trust for intended remainder beneficiaries or directly to the beneficiary outright. The former strategy, utilizing a trust, is generally preferred for its superior asset protection benefits, as well as the opportunity to design a trust for ongoing multi-generational tax benefits.

The specific strategies by which to accomplish an estate freeze are numerous and each strategy has inherent pros and cons. However, in terms of the foundational requirements and factors that lead to optimal success, there are several ‘absolutes’ for each strategy.

Absolute One – Each Family’s Strategy Has a Unique Fingerprint
As most affluent families are aware, the current Gift/Estate and Generation Skipping Tax exemptions for 2020 are $11,580,000. All wealth in excess of this exemption amount is, at some point, taxed at the rate of 40%. For many affluent families, it is imperative to be as strategic as possible to get the maximum benefit of these lifetime exemptions.

Poorly planned gifts and non-strategic use of the exemptions can result in reverse estate planning, where wealth that was successfully transitioned out of the grantor’s taxable estate gets shifted back onto the grantor’s balance sheet. To avoid this result, practitioners are challenged to find the most optimal strategies to maximize the use of the exemption in a thoughtful and tailored way for each and every family.

Absolute Two – Hurdle Rates
Many estate freezing strategies require a certain amount of income to be paid back to the grantor over the course of the planning technique. The amount to be paid back to the grantor is referred to as a hurdle rate and is dictated by the IRS for each particular strategy.

There are two main ways to construct a freezing strategy:

  1. Utilizing gifting techniques
  2. Utilizing sale strategies

For gifting techniques (other than a simple outright gift), the required payments back to the grantor are defined as annuity payments and the hurdle rate is based upon the IRS published Section 7520 rate. For a sale strategy, the IRS requires that the interest payments back to the grantor must be, at a minimum, the published Applicable Federal Rates, or AFRs.

Recalling that the goal of a freezing strategy is to minimize the amount of wealth that must be poured back into the grantor’s taxable estate, low interest rates provide the ideal environment to maximize the positive impact of these strategies. In fact, there is a 100% correlation between declining interest rates and an increase in the success of a freezing strategy.

For June 2020, the hurdle rate for an annuity-based strategy is 0.6%. All appreciation over and above this historically low rate accrues to the benefit of the grantor’s heirs or other trust beneficiaries. A 9-year interest-only balloon note, resulting from a sale-based strategy, would require a minimum AFR of only 0.43%.

In other words, the required income/wealth to be paid back into the grantor’s taxable estate is at an all-time historical low under either scenario.

Absolute Three – Passing Muster with the IRS
Many techniques are directly governed by statutory authority within the Internal Revenue Code. Currently, our laws are extremely favorable to several strategies, as will be further discussed in this series. These strategies, however, are vulnerable to political whim and potential changes in our Internal Revenue Code in the coming months.

One of the more publicized pending changes to our tax laws includes the December 2025 sunset of the currently increased federal estate tax exemption, although the increased exemption could be reduced by earlier legislative action.

In addition, the statutory authority supporting many estate freezing strategies is also subject to legislative challenge. While the ‘practitioner’s toolbox’ is currently full of favorable laws and legislation, many challenges to these strategies have been the subject of political platforms going into the coming 2020 elections.

Absolute Four – A Freeze is Ideal for ‘Appreciating’ Assets
The greater the appreciation of the asset after the strategy is implemented, the greater the positive impact. It is the appreciation that a freezing strategy is designed to protect from the 40% gift/estate tax. The earlier these strategies are implemented, ahead of a full valuation rebound, the greater the positive impact.

As such, when an asset value is suppressed by a variety of macro- or micro-economic influences, we believe this presents an optimal time to implement a freezing strategy. It is no coincidence we are discussing this issue at a time when broad market values have not fully rebounded to their highs earlier in the year. Further, many business owners may find the impact of COVID-19 on their business will result in a suppressed valuation in the months and quarters that lay ahead.

Herein lies the intersection of the world of estate planning with the world of investment management. Collaboration is a necessity in order to determine the optimal time to implement a freezing strategy. It is an ideal time to speak with your planning and investment management teams to glean when this type of strategy is most suitable for your family.

Engaging Your Planning Team
As values experience a rebound, our Oxford team is positioned to ensure that our affluent families retain the value of their rebound appreciation, rather than sharing it in a 60/40 split with the Internal Revenue Service (IRS). Consultation with your Oxford team and a full analysis of the pros and cons of each potential strategy will allow your full team of advisors to identify the optimal solution for your family.

In the upcoming articles in this series, we will discuss the techniques and tangible means by which you and your Oxford team can partake of these extremely positive planning opportunities.

 

The information in this presentation is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. The opinions expressed are those of Oxford Financial Group, Ltd. The opinions are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward looking statements cannot be guaranteed. Oxford Financial Group, Ltd. is a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and is headquartered in Carmel, Indiana. Registration does not imply a certain level of skill or training. For more information about our firm, or to receive a copy of our disclosure Form ADV and Privacy Policy call 800.722.2289 or contact us at info@ofgltd.com. OFG-20-11

The Financial Landscape – May 2020

Global Macro Environment

Global Economies in Free Fall
Economic lockdowns across the world and a plunge in consumer confidence is taking a major toll on the US and global economies. The US economy shrank -4.8% in the first quarter and the second quarter number is almost certain to be much worse. Consumer spending fell 7.5% in March, the steepest monthly decline in records tracing back to 1959. Household incomes fell 2%. New unemployment claims are at unprecedented levels, in the last six weeks claims reached over 30M for the week ending April 25. While initial job losses were concentrated in the retail and hospitality sectors in the states most affected early on, recent job losses have been much more widespread. Suppliers and other industries across the nation are adding heavily to an underemployment rate (the U-6 rate) which now stands at 22.8% and has more than erased the 22M jobs created in the longest employment boom in US history. The Institute of Supply Management (ISM) Manufacturing Purchasing Managers Index (PMI) for April came in at 41.5, down from 49.1 in March, the largest one month decline since September 2008. The ISM Non-Manufacturing PMI printed its lowest reading since the index was initiated at 41.8. The contraction ended 122 consecutive months of growth.

In Europe, economic activity contracted -3.8% in the first quarter, the biggest contraction on record for the bloc, as shutdowns and social distancing policies remain in place. Sweden, the lone outlier, is taking a different approach by not completely shutting down their economy and asking people at risk to shelter in place. This attempted balanced approach between economic and health concerns should be monitored by other countries around the globe. The IHS Markit Eurozone PMI Composite Output Index, which includes manufacturing and services, fell to a new series low in April of 13.6, down from March’s previous record lowof 29.7.

Data in China continues to show improvement in economic activity. Both PMI readings (Manufacturing/Non-Manufacturing) were in expansion territory. Activity in China may be picking up locally, but the global economy is still shut down which is a headwind for this prominent export nation.

Conclusion: The global economy is on track to suffer its worst contraction since the Great Depression era. The consensus appears to be that until there is a medical solution to COVID-19, it seems implausible for the global economy to get back to normal.

Governments Continue to Pull Stimulus Levers
Governments around the globe are doing their fair share to support lending and provide economic relief. The US government is set to borrow a record $2.99 trillion in the second quarter, dwarfing the borrowed height of the 2008 financial crisis by more than a factor of five. In addition to the CARES Act, the $484 billion relief package for small businesses, hospitals and testing was approved. Germany, a country known for fiscal discipline, has declared stimulus measures totaling 12% of their GDP. China has recently declared a larger fiscal package than the one announced in 2008. There is no doubt policymakers are communicating that aggressive action will be taken to support the economy and the eventual recovery.

Source: BCA Research; Strategas

Market Observations

US Equities
What a difference a month makes. US equities had their best month since 1987 as the S&P 500 was up (+12.8%) in April. At the end of the month, US equities had rallied (+30.2%) since the March 23 lows. The disparity between stock market and economic data has been puzzling, but massive intervention by the Federal Reserve has no doubt buoyed market prices and valuations. Large cap growth (+14.8%) outperformed large cap value (+11.2%) as the large technology companies continued their leadership. At the end of the month, the top five stocks in the S&P 500 were about 21% of the index. In sector performance, energy (+30.8%) rebounded from extreme selling pressure in March, despite volatility in the futures market. Utilities (+3.2%) and consumer staples (+7.0%) lagged for the month of April.

International Equities
Developed international equities were up (+6.5%) at the end of April, while emerging markets finished higher at (+9.2%). The growth outperformance relative to value story continued overseas as developed growth returned (+7.4%) vs. value (+5.2%), and emerging growth returned (+9.8%) vs. value (+8.5%).

Fixed Income
The 10-year treasury yield continued to slide in April from 0.7% to 0.6%. The Bloomberg Barclays US Aggregate Index rose (+1.8%) during the month. The municipal market has been an interesting area to watch during COVID-19 as financial stress continues to elevate across states. Economic stoppage, tax-filing deferrals and a severe decrease in revenue sectors such as airports, hospitals and universities will all weigh on municipal finances. All of this resulted in a robust and popular financial aid response by the federal government. However, investors are still taking a wait-and-see approach to this market as the Bloomberg Barclays Municipal Aa+ 1-10 Year Index was flat for the month (+0.0%).

Real Assets
Real assets reversed course in April and significantly outperformed global equities driven by strong performance in Master Limited Partnerships (+49.6%). Natural resources (+13.8%) and real estate (+7.1%) also had a positive month. Storage capacity for crude oil disappeared at a rapid pace and caused oil prices to make history as the price for oil to be delivered in May fell below zero, the first ever negative contract.

 

This commentary represents the consensus of the Oxford Investment Fellows as of 5.11.20, is subject to change at any time due to market or economic conditions or other factors and offers generalized research, not personalized investment advice. This commentary offers generalized research, not personalized investment advice. Statistical data is derived from third party sources believed to be reliable and has not been independently verified by Oxford. Content is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment and tax professional before implementing any investment strategy. Oxford Financial Group, Ltd. is a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and is headquartered in Carmel, Indiana. Registration does not imply a certain level of skill or training. For more information about our firm, or to receive a copy of our disclosure Form ADV and Privacy Policy call 800.722.2289 or contact us info@ofgltd.com.

Where Does It Stop?

We are now six weeks and over 30 million new unemployment claims into the US fallout from the coronavirus pandemic. Despite significant drops in new applications over the last three weeks, new claims for the week ending April 25 were still five times that of the worst week for new unemployment claims during the Great Recession of 2008-2009, as can be seen in the chart below. Worse yet, as eye-popping as the latest figures from the Labor Department are, they still don’t fully capture the extent of the layoffs due to the persistent lag in the processing of new claims and the reality that the Labor Department statistics may well be significantly understating the actual number of new unemployment claims due to the unprecedented level of new claims overwhelming unemployment offices and staff.

While initial job losses were concentrated in the retail and hospitality sectors in the states most affected early on, recent job losses have been much more widespread. Suppliers and other industries across the nation are adding heavily to an unemployment rate which now stands at 21% and has more than erased the 22 million jobs created in the longest employment boom in US history. Worse yet, it is estimated that over 95% of these job losses have come from the private sector, with public sector employment remaining relatively stable thus far. With wide-ranging forecasts of up to an additional 5-10 million new unemployment claims expected in May, it now seems entirely probable that, depending on the success of state efforts to reopen the economy, the US unemployment rate will reach or exceed the peak rate of the Great Depression.

With the global economy collapsing at a pace not seen since World War II, the CARES Act, passed by Congress and signed into law on March 27, 2020, provided $2.2 trillion in economic relief for the American economy. It also sought to address the reality that newly unemployed workers needed money quickly to continue paying bills and to avoid the hole that the larger economy has fallen into from getting deeper and more difficult to crawl out of. While individual states manage their own unemployment insurance programs and set the level of benefits and eligibility rules, they are also now responsible for administering new federal emergency relief benefits that provide payments for an additional 13 weeks of coverage, cover previously ineligible workers like part-timers and freelancers and add $600 to the regular weekly unemployment benefit.

While historically unprecedented in scale, and nearly three times the size of the Great Recession’s $831 billion 2009 Recovery Act, the realization that the CARES Act would be insufficient came quickly. Just two weeks ago, less than 30 days after the signing of the CARES Act, an additional $484 billion relief package was approved, consisting of loans to small businesses, additional funding for COVID-19 testing and aid to hospitals, to further support and expand the Cares Act. Of the $484 billion, $321 billion is earmarked to replenish the original small business loan and grant program from the CARES Act. Even with the additional small business funds being made available last week, the continued flood of new loan applications is expected to exhaust the additional relief funds by the end of this week as more that 60% of the new relief funds were allocated in the first five days of eligibility.

While governments across the globe, both local and national, are struggling with when and how to walk the tightrope of re-opening economies, it’s not just government, but individual businesses that will need to convince employees and consumers that it’s safe to return. As several US states began relaxing restrictions May 1, there does not seem to be broad support for this action and the CDC is already predicting the impact of these early state openings will cost an additional 100,000+ US lives. Despite coverage focused on government re-opening plans and re-opening procedures, it will ultimately be the consumer who will drive the shape of the economic recovery.

While COVID-19 may or may not forever change consumer behavior, one thing is certain. Despite the most thoughtful and deliberate plans to re-open local and state economies, local, state and the national economies will continue to be affected as long as the consumer feels unsafe.

The above commentary represents the opinions of the author as of 5.5.20 and are subject to change at any time due to market or economic conditions or other factors.The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice.

The Financial Landscape – April 2020

Global Macro Environment

Global Economy in the Midst of a Recession
A global recession is underway as COVID-19 cases increase around the world. Fear has set in as consumers are not spending, firms face down bankruptcy, and unemployment skyrockets. The GDP numbers in the next quarter or two will be some of the worst on record since the Great Depression. Unlike the Great Depression or the Global Financial Crisis (GFC), which were both caused by excesses in the financial system, the pandemic is an exogenous event. Simply put, the COVID-19 virus has left countries around the world with one short-term option: shut down economic activity to try and slow the spread while a possible vaccine is developed. In the US, this strategy has led to 10M initial jobless claims in the last two weeks. Employers shed 701,000 jobs in March, the start of a labor-market collapse that could push the US unemployment rate to record highs. The unemployment rate for March rose to 4.4% from 3.5% in February. These employment numbers do not fully reflect the millions of individuals who recently filed for unemployment insurance. The St. Louis Federal Reserve research indicates at this pace the US unemployment rate could touch 32% in the next several months, depending on how long the US economy stays locked down. The Institute of Supply Management Manufacturing Purchasing Managers Index for March came in better than expected at 49.1, however, the low New Orders reading of 42.2 confirms that a continued slowdown is likely.

In Europe, economic data is worsening as shutdowns and social distancing take place across the bloc. The IHS Markit Eurozone PMI Composite Output Index, which includes manufacturing and services, experienced its largest single monthly fall in March to a record low of 29.7, down from 51.6 in February. Given the spread of COVID-19 across Europe, and the subsequent measures taken to contain the virus, this was not a surprising result.

Recent data in China showed that economic activity experienced a sharp “V” recovery. Manufacturing PMI rebounded from an all-time low of 35.7 in February to an expansionary reading of 52.0 in March. Nonmanufacturing, similar to manufacturing, rebounded from an all-time low of 29.6 in February to an expansionary reading of 52.3 in March. It is important to note that this data comes from the Chinese government. Activity in China may be picking up locally, but the global economy is still shut down which is a headwind for this prominent export nation.

Massive Stimulus in Response to Pandemic
In a lesson learned from the GFC, the Federal Reserve (FED) responded more quickly and with more measures this time around. In addition to unlimited treasury and mortgage backed securities (MBS) purchases, the monetary response included the return of lending and purchasing facilities in an attempt to provide liquidity to the market. Following the FED, congress eventually passed the $2T stimulus bill now known as the CARES Act. A high-level breakdown of the bill is below*:

  • Approximately $500B in direct payments to families
  • $500B in loans to hard-hit industries
  • $350B in loans to small businesses
  • $250B in unemployment aid
  • More than $100B for hospitals and health care systems
  • $150B to help state and local governments fight the virus

Market Observations

US Equities
The longest bull market in history ended on March 12 and US equity performance had the worst quarter since the 2008 financial crisis, pummeled by fallout from the coronavirus. It seems a distant memory but the S&P 500 was up (+5%) through mid-February. However, the second half of the quarter pulled down performance and the index finished down (-19.6%) at the end of March. Large cap growth (-14.1%) outperformed large cap value (-26.7%) over the quarter. Small cap equities were hit especially hard as the Russell 2000 index returned (-30.6%). Information technology (-11.9%) led sector performance, while the energy (-50.5%) sector suffered the most due to the massive plunge in oil prices.

International Equities
In times of crisis, equity market correlations rise and stocks in all geographies and sectors decline. This was the theme for market performance overseas. Developed international equities were down (-22.8%) at the end of March, while emerging markets finished (-23.6%). The viral outbreak and supply chain disruption negatively impacted returns in the back half of the quarter.

Fixed Income
The 10-year treasury yield has dropped from 1.9% at the turn of the year to as low as 0.3% on March 9 before ending the quarter at 0.7%. Investors piled into safe-haven assets resulting in the Bloomberg Barclays US Aggregate Index returning (+3.2%). In the middle of March credit markets saw a sharp widening in treasury bid-ask spreads, LIBOR-OIS spreads and commercial paper T-bill spreads due to disruption in the repo market. This liquidity crunch was the event that ultimately led the FED to intervene swiftly and set up the lending facilities (discussed on page 1). The Bloomberg Barclays Municipal Aa+ 1-10 Year index was down sharply as mutual funds endured significant outflows, but fully recovered by month end.

Real Assets
Real assets experienced a difficult quarter as Master Limited Partnerships (MLPs) (-57.2%), natural resources (-32.9%) and real estate (-28.5%) all saw dramatic declines. Oil prices suffered as Saudi Arabia and Russia squared off in a market share war. The price tumbled to an eighteen year low in late March but has risen recently on the hopes for a truce between the two countries and the possibility of US action via the Texas Railroad Commission.

*Source: BCA Research

This Financial Landscape represents the consensus of the Oxford Investment Fellows as of 4.9.20 and is subject to change at any time due to market or economic conditions or other factors. Statistical data is derived from third party sources believed to be reliable and has not been independently verified by Oxford. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice.

The D Word

You thought I was going to say “Depression”, didn’t you? While we do see that specific “D” word being thrown around with increasing abandon, our focus in this piece is another D word that is a major culprit behind recent market stress. I am referring to the natural market process of Deleveraging. My hope is that a brief review of the structural mechanics that cause deleveragings may help frame recent market dislocations as well as future investment opportunities.

You may recall the old quip “the market takes the stairs up, and the elevator down,” insinuating that bear markets tend to be quick and painful relative to the elongated growth wave of the market cycle. Bear markets are often attributed to panic-driven selling, but the truth is less psychological and more mechanical. The rapidity with which bear markets play out is a by-product of forced deleveraging amongst market participants.

Leverage, debt or gearing as our British friends call it, comes in many forms. It may seem trivial during placid market environments but our modern economy is built on a foundation of credit/debt. In fact, what people often associate as money is actually credit, which takes the form of borrowings or debt. Businesses leverage themselves through long-term liabilities and often rely on short-term funding to maintain operations. Investors leverage themselves by borrowing short-term to invest in higher returning assets to earn a spread; affectionately referred to as a carry trade. Individuals utilize leverage by effectively borrowing from their future selves to make otherwise unaffordable purchases such as homes or autos.

So, leverage is pretty much everywhere thanks to our fractional-reserve banking system. In truth, it is this availability of credit/debt and vibrant capital markets that enable prosperity, and an ever-increasing standard of living.

However, the leverage sword is said to cut both ways. In fact, leverage has the mathematical feature of always going against you; meaning that when asset values appreciate, equity appreciates relative to the debt, and thus “leverage” goes down. The opposite of this is true as well, meaning that declining asset prices can rapidly increase the leverage profile of a borrower to precarious levels. In this scenario, even previously conservative borrowers can find themselves grossly overleveraged and forced to sell assets in order to raise cash.

When the credit cycle turns, be it from natural causes or exogenous shocks (such as COVID-19), the availability of leverage is reduced and the cost of credit increases significantly. This tightening of credit markets typically coincides initially with a decrease in asset prices as the market discounts uncertainty and reduced future cash flows. The combination of declining asset prices and reduced credit availability forces many market participants to sell assets or de-lever. As you might imagine, the act of widespread selling of financial assets leads to ever lower collateral values, further decreasing the creditworthiness of borrowers. If the deleveraging shock is severe enough, this dynamic can quickly become a self-reinforcing vicious cycle whereby selling pressure depresses asset values leading to ever more selling.

This phenomenon has major macroeconomic implications as well. When foreign entities with US dollar borrowings are forced to de-lever, the world sees a massive spike in the demand for dollars needed to repay dollar denominated debts. This results in an ever stronger US dollar, and further tightening in dollar liquidity, which has its own set of self-reinforcing negative side effects. Sadly, this dollar squeeze often hurts the least robust developing economies the hardest.

Unfortunately, we have been in the clutches of a deleveraging resulting from the severe demand destruction of COVID-19. Some market segments are further along in their deleveraging process than others with the deciding factor typically being the liquidity of the underlying asset and the willingness of lenders to lend against that asset as collateral. The Fed and policymakers are doing everything in their power to soften the blow, but there will be severe pain felt by debt-laden market participants; be they corporates with over-leveraged balance sheets or investment vehicles reliant on leverage to generate adequate returns (REITs, BDCs and potentially Hedge Funds and Buyout Funds).

Market uncertainty remains exceptionally high, but the conditions that produce bargain investments are certainly materializing. There will undeniably be instances of distress in the near term, however. When the forced selling subsides and the discounted view of the future is most dour, generational investment opportunities will be present.

We have no way of knowing when this deleveraging process will be exhausted or where the market bottom may be, but we can focus on the variables within our control. Specifically, we can continue to systematically seek investments with strong fundamentals and attractive valuations. We can continue to utilize active managers where appropriate to capitalize on pockets of market inefficiencies. We can continue to lean on the benefits of diversification across asset classes with fundamentally different economic return drivers, including intentionally uncorrelated alternative investments. We can do our best to remove emotions from the equation and to methodically execute the psychologically difficult portfolio actions such as rebalancing, even when it is uncomfortable.

The structural forces of a deleveraging should remind us that in times of peak uncertainty and stress, the best response is to remain unemotional, objective and systematic when evaluating investment decisions.

The above commentary represents the opinions of the author as of 4.8.20 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice.

Critical Estate Planning Check-Up For Uncertain Times

IN BRIEF
Our current environment reminds us of the importance of taking care of the basics when it comes to estate planning, in particular the following items:

  • Durable Financial Power of Attorney
  • Health Care Power of Attorney and Advance Directives

Without these essential documents in place, loved ones may be unable to access medical information or assist each other with healthcare or financial matters in the event of an extreme illness or incapacity.

Uncertainty in our current times can lead to much stress: economic stress, stress over our healthcare systems, the stress of social distancing and the stress of protecting ourselves and our loved ones near and far. One item that should not be a stress is whether you and your adult family members have the proper estate planning documents in place to ensure that you each have the ability to receive medical information for one another and that you are able to make healthcare and financial decisions for each other should such a need arise.

Ensuring these basics of estate planning are accounted for can eliminate an additional layer of stress in the event of an extreme illness or incapacity. Discussing your respective healthcare wishes with family will enable you to honor each other’s preferences. These conversations should include your spouse, as well as your adult children, parents and other family members who live close by or those who reside in another geography.

These essential documents include Durable Financial Power of Attorney and Health Care/Advance Directives. A summary of each follows:

  • Durable Financial Power of Attorney – A Durable Power of Attorney allows you or your loved ones to designate a trusted individual or individuals to make financial decisions or handle financial matters on your or their behalf in the event that you or they are unable to act.
  • Health Care/Advance Directives – Health Care Power of Attorney and Advance Directives cover a broad range of issues and items such as Medical Power of Attorney, Appointment of a Health Care Surrogate, HIPAA Authorization and Living Wills. These documents enable a healthcare provider to share medical information with the appointed family members or other individuals, provide guidance as to personal wishes and further define who is authorized to make important medical decisions on you or your loved one’s behalf.

A review and communication around Durable Financial Power of Attorney and Health Care/Advance Directives can provide some peace of mind in an otherwise uncertain time in our lives. Please contact your Oxford team of advisors for further information on how to shore up this essential element of your family’s estate planning.

The information in this presentation is for educational and illustrative purposes only and does not constitute investment, tax or legal advice.