INSIGHTS: HOW MODERN GOVERNMENT POLICY COULD AFFECT LONG-TERM INVESTORS
In 1994 the Federal Reserve increased its discount rate from a then-record low of 3% to 6% – equivalent to a 100% increase in rates – in response to inflation fears. Expectedly, bonds followed suit. According to Morningstar, the total bond market dropped by over 4.5%. Investors, who had been enjoying yields from bonds in excess of 6-7%, got spooked. Between the rising rates and the sell-off in bonds, the stock market went berserk.
So what’s different now?
For starters, the discount rate now is just .25%, much lower than it was then. If one were to correlate the events of 1994 to now, a quarter point hike (or in other words a 100% increase) by the Fed would be a comparable situation. The only difference being that yields are much lower (3-4%).
From 1994 until now, the relationship between investors and bonds has also changed.
In the last twenty years there has been a shift of investing philosophy. Retail Investors have embraced the modern portfolio theory, otherwise known as asset allocation. The premise being that asset classes (stocks, bonds, alternatives, etc.) all have different correlations – thus diversification acts as a hedge if one asset class loses value. Today most investors have diversified. The average retirement plan likely has 20-40% of its balance in bonds.
The average person in their investment portfolio or 401(k) uses mutual funds or exchange traded funds, or a basket of investments, as their predominant investment vehicle. For bonds, these pooled investments use ‘duration’ as a measure of risk. A duration of 5 years implies that every 1% rise in the corresponding interest rates will result in a 5% decline in the price of bonds. Keep in mind that government, municipal and corporate bond rates don’t necessarily move in tandem.
In the early 2000s, in the wake of significant events like the technology bubble, September 11th, Enron, Worldcom and others, the Federal Reserve initiated a rate reduction policy. Most financial expectations, from as far back as the early 2000s expected rates would ultimately rise. This has proven to be false.
When lending stopped altogether in 2008, the U.S. government implemented untested strategies by creating an artificial entity in the bond markets. Through aggressive rate reduction and buying its own bonds (while simultaneously refinancing the rates and durations of these loans) they stepped in with what we commonly know now as the stimulus program. It was successful to the extent that it reignited the bond market.
But then something new happened. Bonds metamorphosed once again. Investors found an alternative to the negligible interest rates paid by banks. The short-term bond fund became the cash alternative. This propped up bonds and further perpetuated the low interest rates.
So while previously investors had been using bonds as a source of income or a hedge, another incarnation emerged – that bonds could be a used as a cash alternative. Consequently, many more investors are holding bonds, especially in the United States.
Bonds have thus become a crowded and overbought asset class, and this has resulted in an expensive low yielding vehicle that bears significant risk. Between rising rates, and an inevitable movement away from these “cash alternatives” to other asset classes, there will be a doubly dubious affect to the average investor.
Financial experts have now started divesting away from conventional bonds (government, high quality corporate and municipal bonds) to lower quality (aka Junk), floating rate and foreign bonds. They’ve also created sophisticated option strategies to minimize the aforementioned duration risk. The emergence of these products alone is a forward indication of changes to come.
The Federal Reserve, in announcing the end of the Stimulus program, in effect shot a cannonball over the bow of investors. The U.S. government, which for 5+ years compressed the short-term interest rate world, has effectively announced that nature will be allowed to take its course.
The same way investors have been generously rewarded by the Federal Reserve’s easy money policy, they could also be damned. If the gravity of the Federal Reserve’s past actions is any indication, it would seem that volatility is bound to return to the markets.
Bond owners, which likely include all long-term savers, must beware. This is one of those rare events where investors must take a closer look at what once worked and pivot to an uncomfortable place. They need to reevaluate their definition of bonds. Now is when you need to move from what was once conventional to what is not.
ON THE ECONOMY: WHAT’S FAIR IS FAIR
OK alright, you’re going there, but you will find, I’m too much to bear. It’s not alright when you know, but you don’t care. It’s not alright, it’s just not fair, it’s just not fair. We’ll get nowhere. We’re getting nowhere. So say the Trews, a Canadian hard rock band in their 2014 song.
One thing that is never fair is tax policy. In fact, that is one thing that Republicans and Democrats, conservatives and liberals, the poor and the wealthy … well everybody, agrees on. The Tax Code in the United States is a monstrosity that is filled with perverse incentives and disincentives and taxes me at a higher rate than Warren Buffett. It’s not fair, and we are getting nowhere when it comes to fixing the code.
The main reason behind this – and I am not being cynical – is that much of Congress’s power, and all of the power of many individual members comes from their ability to manipulate the tax code. If you want a break for a specific industry then you need to make sure that you have a majority of members on Ways and Means willing to vote for it. Over time, the code simply becomes more cumbersome, more complicated and does more to harm the economy.
There is a simple truth. As of today, it costs $5.8 trillion dollars to run the government in this country. Sure, much of this consists of transfer payments where the government collects tax from one group to give to another group, but if Americans want government to do what it currently does, the cost is $5.8 trillion. At the same time, the economy produces a total of $14.7 trillion in income. This is income to people in the form of wages, income in the form of rent payments, income in terms of investment returns and income from transfer payments. The math is simple, if America wants a $5.8 trillion government, it needs to levy a tax equal to 39.4 percent of income.
That’s it. To fund the government fairly, evenly, honestly and with the least economic distortion, simply levy a tax equal to 39.4 percent on all income no matter what the source and no matter who the recipient. There is no need to have distorting levies like excise taxes, or customs duties. No need to levy a double tax on income produced by C-companies, no need for an IRS or any state revenue departments. Even better, to start paying down the national debt make the tax an even 40 percent.
There would be a number of significant economic benefits from a tax of this type. Corporations would no longer need to hide income in tax havens and could repatriate it to America tax free. This income could be used to build new factories, purchase new equipment and to invest in research and development tax free. This alone would significantly grow the nation’s GDP. There would be no incentive for companies to borrow money to buy back stocks as capital gains would be taxed at the same 40 percent rate as income, so there would be less pressure on interest rates. Common taxpayers would save billions of dollars on accounting fees and on the cost of expensive investment vehicles like SEP plans. All of these things would benefit the overall economy
True a 40 percent tax rate seems high, but this is exactly what we are paying now (less some due to deficit spending). When one adds up their federal and state income taxes (which in New York City are already over 40 percent), their sales taxes (in most states somewhere in the neighborhood of 6 percent), gas taxes, property taxes and the cost of corporate taxes imbedded in products on average Americans are paying 40 percent of what they make in taxes.
There is a principle in public finance that suggests that the wealthy should pay more in taxes than the poor. Under a flat income tax system this can be accomplished by simply taxing each marginal dollar at a slightly higher rate, with say a 1 percent tax on the first $1,000, and a infinitesimally higher rate on each additional dollar of income.
There is a saying in economics that incentives matter, and right now there is simply no incentive to make America’s system of public finance fair and reasonable. Until those incentives change, we will continue to get nowhere.
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