By: Jim Scheinberg – May 29, 2015
Swimming Against the Currency
In our Winter issue, we highlighted the dynamic created by last year’s massive rally in the U.S. dollar. Just one short quarter later, we are seeing the effects of that dynamic play out… in a very big way. To review our prior observation:
[T]he U.S. dollar rallied 10% versus the euro last year. Companies from Apple to PfiZer are reporting headwinds due to the appreciating U.S. currency making their products and services less affordable overseas… [C]urrencies always [have] a winner and a loser, this time its European firms that are gaining an advantage.”
Though the U.S. equity markets continued to advance during the First Quarter, it was European stocks that took the lead. This is to be expected as U.S. multinationals find it more and more difficult to compete against their European peers. Every data-point that we will review this quarter (as well as the year to come) must be examined with this revaluation in mind. The U.S. economy, in dollar terms, is facing a statistical headwind of remarkable proportions. If we can maintain our numerical growth during this adjustment period, it will be a testament to our strength. And it may well be the shot in the arm that Europe needed to join the party.
How the Markets Fared
Developed international markets (as measured by the EAFE) rallied nearly 11% in their own currencies during the first three months of the year, having their best quarter in over five years. U.S. investors in those markets didn’t feel all of those gains due to an additional 11% fall of the euro vs. the dollar. Even measured in dollar terms, the MSCI EAFE was up an impressive 5% vs. just 1% for the large cap dominated S&P 500. Smaller U.S. companies, which are historically less sensitive to currency swings, outperformed large caps by over three percentage points. The same was true for growth-oriented names, whose prices are pinned more towards their products and less based on the cyclical nature of global competition (think Facebook vs. Proctor & Gamble). The performance of emerging market stocks (EM) followed this logic. Consumer product focused Asian emerging markets were also up around 5% during the quarter, while the commodity-sensitive Latin emerging countries were down over 9% (commodity prices declined another 4% in Q1 after last year’s massive drop).
U.S. fixed income markets saw a fair amount of volatility during the quarter. The yield on the benchmark 10-year Treasury declined during the quarter from 2.17% to 1.93%, trading as high as 2.25% and as low as 1.67%. This helped the BarCap Intermediate Aggregate Index post another 1.6% return. Inflation-protected bonds saw similar gains. The high yield market reversed Q4’s losses with 2.5% gains, as confidence in the economy helped credit spreads narrow. Renewed appetite for risk in the debt markets also helped emerging market debt prices recover as well. Despite the continued advance in the U.S. dollar, EM debt managed to tack on nearly 3% during the quarter. The same could not be said for developed market debt, wherein upside performance, when measured in their own country currencies, could not overcome the relative strength in the dollar, resulting in continued declines.
Real Estate Re-rallying?
It looks like the deceleration in home price appreciation that we’ve seen over the last several months appears to be ending. As the spring selling season gets underway, home prices are starting to show initial signs of improvement. After a big double digit spike in 2012 and 2013 off the lows, gains had slowed to 4.3% year-over-year. The April report now shows them moving up 5.5% (NAR existing homes). An area that has been a point of complaint, inventory, is starting to show signs of improvement as well. Houses available on the market increased 10% in April to 2.21 million for a 5.3–month supply, which was up from 4.6 months the prior month. Real Estate professionals had said that it was the lack of quality homes on the market that had been responsible for the slowdown in sales (not a logical conclusion but nonetheless, plausible in the current environment). Low supply should be good for pricing; however if it’s too low, the market may frustrate some buyers. Help might be on the way with new units as well: housing starts jumped 20% in April on top of a 2% upward revision to the March number. Builders are a-building. All this suggests that the atypical spike off of the lows and then the digestion phase that followed may be over and we may be entering a normal and healthy real estate market.
The jobs market in the U.S. continues to improve, now approaching ‘healthy’ levels. Lately we’ve been hiring here at North Pier, and I can tell you, talented people are harder to find and cost a fair amount more than they did just a couple of years ago. Nationally, unemployment has dropped to 5.4%, which is now back in what most would consider a normal range, and certainly is at a post economic crisis low. Further, real wages continue to climb. Wages and salaries increased 1.1% in Q1 alone. Wage growth, or lack thereof, was a real complaint during the early years of the recovery. Now that there is a better balance between supply and demand, further improvements are likely.
Everyone Loves a Winner (Especially the Winner)
Consumer sentiment, as measured by both the University of Michigan and Conference Board, reached post-crisis highs during the First Quarter. In fact, the consumer is now nearly as confident as they were prior to the end of the Dot-Com boom in 2000. And why wouldn’t they be? In addition to a strengthening jobs market and healthy growth in residential real estate, gas prices are relatively low and the stock market is firm. With wages up, consumers are starting to take on more debt, with consumer credit rising at about a 7% year-over-year pace. Even with the expansion in the use of credit, household debt service remains near a 35 year low. Further, the personal savings rate remains well above 5%, a very healthy clip. The average American’s fiscal house seems to be well in order, which is something to feel confident about. The question is, is all this optimism sustainable? And if so, for how long? The Consumer Confidence Index declined into the 95 range in April and May from a 101.4 in March led by over an 8 point drop in the expectations component of the index. The University of Michigan data, showed a similar drop in May. Will this be the begging of a trend or just a one month blip?
A Tale of Two ISMs
On the business front, the service sector in the U.S. is humming along well. The April Institute of Supply Management Report on Business showed its non-manufacturing (services) index rising to 57.8% (readings above 50 indicates expansion). This data suggests that the services sector is likely to enjoy further advancement in the coming months. This logically tracks our euro/dollar-theme, as services naturally tend to be more domestically-focused. The manufacturing side of the coin, however, tells a completely different story: the manufacturing index from ISM, which is much more sensitive to international trade and currencies, has pulled back to just 51.5% in the last two months. Though still showing growth, these numbers are certainly not robust. Further evidence of the two very different conditions facing our economy is the fact that the vast majority of job growth has been in the services sector for the last several months.
The dollar’s a real drag, man.
Exports decreased a staggering 7.2% in the first quarter… again in U.S. dollar terms. The strong dollar led to a 1.8% increase in imports during the period as well. This was despite a labor lock-out in the country’s largest port, in Los Angles, which had goods backed up over a month. This caused the trade deficit to swell nearly 10% to $522 billion in Q1. That’s a $50 billion jump in just one quarter! Briefing.com reports that this increase in the trade-gap reduced first quarter GDP growth by 1.25 percentage points. Yet, the U.S., in dollar terms, still managed to post fractional gains of 0.2% in GDP. I can’t emphasize this enough: the move in the dollar is by far the most potent wild card in the global economic deck. The currency winds that are Europe’s back are clearly blowing across the Atlantic, right into our face.
Since the Euro bottomed at 105 vs. Dollar in March, it has rebounded nearly 7%. Assuming global exchange rates stabilize, economies should normalize around these new levels. The U.S. economy has proven to be remarkably resilient, despite the competitive disadvantage dealt to our large multinationals. I have no doubt that it will take a few quarters for the new “norm” in currencies to fully work their way through the earnings cycle. Further, domestic economic reports are likely to show signs of slowdown… when observed in Dollar-terms. If one keeps the impact of the rally in the Dollar in their perspective, they will realize that things are likely stronger than the numbers would indicate. Investors should be mindful that if looked at through a more global lens, our data is actually likely to continue to be strong. Investors should beware that it will likely take three to four quarters for comps to fully factor the net results of the revaluation. The investment media will not likely dissuade concerns with a sage viewpoint, so volatility should be expected as the year unfolds. Across the pond, the decline in the Euro should continue add stimulus to their economic engine that has been sorely lacking. Initial data for EU GDP suggests 0.4% growth for the quarter resulting in 1.6% for the trailing 12 months. This is a marked improvement over the last few years of malaise. Though ECB quantitative easing will likely get the credit, it is the cheap Euro that will continue to lift economic conditions for the region. At least that’s our PIERspective.
By: Brant Griffin – May 19, 2015
DOL Proposes Revised Fiduciary Rule
Currently, the law governing standards of conduct for those performing ERISA advisory services is nothing short of chaotic. Opposing regulations apply different performance standards depending on the stance of the organization providing services. This results in some retirement plan service providers assuming a fiduciary role under the law, while others do not.
A fiduciary relationship is viewed as the highest standard of advice available under the law and requires the fiduciary to put the clients’ interests first when making investment recommendations. Retirement plan sponsors and advisors, for example, have long maintained this fiduciary role while others including recordkeeping organizations and broker-dealers have not. A non-fiduciary position subjects them to a different, less demanding, “suitability standard” where their investment recommendations must simply be “suitable” for the client at the time the investment is made. This standard does not legally obligate individuals or firms to put the interests of their clients ahead of their own. In fact, it permits them to do the opposite. As a result, many who avoid this fiduciary role are able to make investment recommendations that are in direct conflict with the best interest of the plan.
Alternatively, Registered Investment Advisors (RIAs) are subject to an elevated standard of care as mandated by their legal framework under ERISA. RIAs, by definition, are fiduciaries and maintain a fundamental obligation to act in the best interest of their clients, and ahead of all others, including their own.
Unfortunately, investment services provided by broker-dealers and RIAs are indistinguishable to many plan sponsors and participants. Many investors believe that the advice they receive from financial professionals is objective, when in reality it is often biased in favor of investments that produce the greatest revenue or a tangential benefit. Due to this obscurity in standards, investors and plan sponsors often engage organizations without a complete understanding of their fiduciary standing and conflicts. As a result, the DOL is proposing a revision to the fiduciary rules to broaden the set of activates that mandates fiduciary conduct.
The current defining fiduciary standard was developed by the DOL in 1975, shortly after the passage of ERISA. The regulation defines a fiduciary through a five-part test defining the activities that trigger fiduciary status. Currently, a person who does not have discretionary authority or control with respect to the plan gives fiduciary investment advice if they:
- Render advice to the plan as to the value or the advisability of transacting in securities or other property for a fee
- Provided on a regular basis
- Pursuant to a mutual agreement with the plan
- The service will serve as a primary basis for investment decisions and
- The advice is individualized to suit the needs of the plan.
After several false starts and years of work and intense debate, the agency has re-proposed rules to update the 40-year old fiduciary standard. The intent of the rule is straightforward; to expand the definition of a fiduciary under
ERISA by seeking a more expansive, principle-based standard that puts investors’ best interests first, and requires disclosures when conflicts might arise. The proposal is currently in a comment period that concludes on July 6. It is anticipated that there will be a substantial remarks from stakeholders, that may yet alter the outcome of the law.
This long awaited regulation replaces the original five-part test with a four-part test that would substantially broaden the circumstances in which advice would be subject to ERISA and meet the definition of a fiduciary. The proposal identifies the following activities that give rise to fiduciary status, including:
- Renders investment advice to a plan (including recommendations regarding distributions and rollovers of IRAs) for a fee
- Provides services pursuant to an agreement, arrangement, or understanding
- The advice is given for consideration in making investment or management decisions regarding plan or IRA assets.
- The advice is individualized to the recipient
A welcome outcome of the regulations (from my PIERspective, at least) is the extension of the fiduciary net to cover advice to the entire $7 trillion IRA market. The industry was expecting the regulations to include the plan rollover process, but surprisingly the DOL integrated rules that cover services to all IRA accounts. The broadening of the definition is aimed at protecting employees from the rampant practice of self-serving investment recommendations committed during the rollover process. Often, former or retired employees are targeted by the investment community and encouraged to rollover their retirement plan savings into retail IRA accounts, which more often than not feature higher fees and sometimes commissions.
The proposal maintains a broad approach in its definition of advisor compensation. The proposal sites both “direct and indirect” compensation and “fee or other compensation” in order to cast a wide net around the numerous types of soft dollar compensation arrangements available in the qualified plan environment. Furthermore, the current requirement of advice being provided on a “regular basis” would no longer be required. One time advice is enough to trigger fiduciary status.
Best Interest Contract Exemption
One of the more controversial elements of the regulations is the DOL’s “best interest contract” exemption from ERISA’s prohibited transaction rules. The rule permits an exemption from the prohibition on self-dealing for the receipt of brokerage industry’s common compensation arrangements that create conflicts and violate ERISA’s prohibited transaction rules. This exemption would require advisers and firms to acknowledge their fiduciary status, in writing and adhere to “basic standards of impartial” conduct. Curiously enough, one of the requirements of basic standards of impartial conduct is to receive no more than reasonable compensation, but what is reasonable?
This prohibited transaction exemption is described by some as a necessary mechanism to provide flexibility to the brokerage community. In my opinion, it will simply make the proposed rule less effective by granting a legal loophole for firms to maintain practices that are in direct opposition to the fiduciary commitment they are required to make. Permitting “fiduciaries” to act in a non-fiduciary manner by accepting payments from vendors that are otherwise in violation of the rules, makes little sense and will gut effectiveness of the proposal.
The 2015 proposal is a bold attempt to broaden the circumstances that define an investment fiduciary, to not just ERISA plans but to the vast IRA market as well. The DOL withdrew its initial fiduciary revision in 2011, bowing to fierce resistance from Wall St., which claimed that the regulation would significantly increase regulatory costs forcing them to abandon clients with small accounts. The firms that successfully fended off the DOL’s first attempt at a unified fiduciary standard are again preparing for battle.
Many experts believe that all investment and financial advice should be held to a fiduciary standard, but remain concerned that there’s simply too much money being made to affect the real change that is needed and once again, investors’ interests will be subordinated to the profits of Wall Street. According to the White House’s Council of Economic Advisors, the cost of tainted investment advice is approximately $17 billion annually. Clearly, Wall Street has a strong financial incentive to maintain the status quo.
The watering down of the proposed regulations through exemption loopholes does not bode well for sponsors and investors alike. Any regulations that eventually are passed will undoubtedly be met with staunch opposition by the Wall Street firms who stand to benefit from such unsavory practices. The sad truth is that being a fiduciary in name does not make one a fiduciary in spirit. Sponsors and investors alike will need to remain vigilant and take renewed steps to clearly understand the fiduciary standing of the organization advising them.