FOMC Closes Out Q3 2018

As Treasury markets had correctly predicted, the FOMC raised its target range for federal funds by 25 basis points to 2.0%–2.25% at its meeting on Wednesday, Sept. 26.

Federal Reserve - FOMC

Perhaps more importantly, it also deleted the observation that policy remains accommodative, though Chairman Powell went out of his way in his opening remarks to point out that its removal should not be interpreted as a signal about the future path of rates. Rather, it was simply a reflection of where the Committee saw policy. This so-called clarification, however, didn’t square entirely with his observation that financial conditions remained “accommodative.”

Since the meeting was also one in which the Committee revised its Summary of Economic Projections (SEP), it is worth noting that there were really only three changes or additions worth commenting on. First, both the median GDP growth for 2018 and its central tendency were revised up slightly, which Chairman Powell said reflected the strength of incoming data and robust consumer and business confidence. Second, forecasts for 2021 were added, and GDP for each year after 2018 was projected to be lower than the preceding year’s, with the figure for 2021 showing growth of only 1.8%, equal to that forecast for the longer run. At the same time, there were no significant changes in the forecasts for unemployment or inflation. When asked about that, Chairman Powell simply stated that the inflation dynamics now appear to be different from those of the past, implying that the Phillips curve is essentially flat. Finally, even by the end of 2021, the median federal funds rate is expected to be still almost a half percentage point higher than the longer-run rate.

Looking beyond September to the end of the year and possible rate moves in 2019 and beyond, the dot chart suggests that 12 of the 16 participants think there will be one more hike in 2018. Given that by December the Committee will have an observation on Q3 GDP and a new set of SEP forecasts available, the likelihood is that the rate move will occur at that meeting. Moreover, with regard to the moves that have occurred this tightening cycle, there has been no instance when an increase was approved at a meeting when no press conference was scheduled and no SEP forecasts were available. Note that all meetings in 2019 will be followed by press conferences.

Interestingly, for 2019 the median-rate data suggest three moves that year and two more in 2020, stopping at 3.25% to 3.5%. This policy path would put the funds rate above the Committee’s equilibrium longer-run rate, and that fact triggered questions directed at Chairman Powell as to whether there is likely to be a policy overshoot. His response essentially suggested that people should not take those longer-run rate projections as being firm, since knowing when to stop will be data-dependent. He did observe that the gradual pace of the Committee’s policy moves enables it to monitor how the economy is responding and to minimize the risks of a policy mistake that might trigger a recession.

This observation by Chairman Powell raised the question in the press conference as to what could impact the policy path. Tariffs, deficits, oil shocks, and greater-than-expected growth were all key factors Chairman Powell identified that could impact both the pace of policy and the decision to pause. All in all, Chairman Powell continued his strong performance, exhibiting not only depth and breadth of knowledge but also patience in responding to questions. Given the information flow and the short-term forecast for another rate move in 2018, it would not be surprising to see the term structure move up rather abruptly, by about another 25 basis points, in advance of the December FOMC meeting, as it did leading into this September meeting.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


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Q3 2018 Municipal Credit Commentary

Updates, budgets, potential future stresses, state ratings, default study, and last but not least, storms

Market Commentary - Cumberland Advisors - Q3 2018 Municipal Credit Commentary

Last quarter we focused our 2Q 2018 municipal credit commentary on two SCOTUS (Supreme Court of the United States) rulings. One allows states to collect tax on out-of-state internet sales while the other restricts public unions from requiring that non-union public sector employees pay agency fees to contribute to the cost of collective bargaining and other activities through fair-share agreements. We consider both rulings positive for municipal credit (http://www.cumber.com/scotus-two-major-rulings-with-positive-implications-for-municipal-bond-credit-quality/). In particular, the ability to collect online sales taxes should help financial operations. A study by the National Conference of State Legislators (NCSL) and the International Council of Shopping Centers (ICSC) estimates that total U.S. uncollected sales and use taxes increased to almost $26 billion in the year 2015. Of this $26 billion, more than $17 billion in uncollected taxes were projected to be from electronic sales. http://www.ncsl.org/research/fiscal-policy/e-fairness-legislation-overview.aspx

Updates

Regarding the sales tax ruling, some states are working toward collecting sales tax retroactively; however, a bill entitled the Online Sales Simplicity and Small Business Relief Act has been proposed that would ban retroactive imposition of a sales tax on out-of-state internet sales, delay implementation to January 2019, and establish a small-seller exemption for companies with gross annual receipts below $10 million, (compared with the $100,000 threshold or 200 transactions per year in the case of South Dakota). The proposed legislation, if passed, should not be a burden, because states have already been adjusting to the lower collections as internet sales have increased over the years. Regarding the fair-share agreements, it may take some time for the SCOTUS ruling to have an effect on public sector-union coffers and political influence. We noted in our Q1 commentary the abundance of teacher strikes (http://www.cumber.com/q1-2018-municipal-credit/). They continued this quarter, with strikes or threatened strikes in a number of Washington state school districts and a vote by the teachers of Los Angeles Unified School District to strike if state mediation does not result in a satisfactory contract.

Budgets

In addition to the SCOTUS rulings, Q2 was notable because all states passed budgets on time or nearly on time – even the states notorious for passing late budgets, such as Illinois, Connecticut, and Pennsylvania. Common threads for this phenomenon include election-year politics, good revenue growth driven by a generally improved economy, and the acceleration of tax collections in 2017 due to the Tax Cut and Jobs Act.

Future expectations

States

A number of states’ rainy day funds are not up to pre-recession levels, leaving analysts and others to worry what might happen in the next downturn. S&P released a September 2018 report in which they subjected state financial operations to the stresses of moderate and severe recessions and then compared 2018 reserves to expected drawdowns. Only 20 states had reserves sufficient to cover loss of revenue and increased social service spending during a moderate recession, and overall the states showed an average revenue shortfall of 9.9%. S&P went further and made adjustments for dependence on more cyclical revenue streams (capital gains taxes for example), level of social-service spending, and fixed costs including pensions and OPEB. After the adjustments 14 states were considered low risk, 21 moderate, and 14 elevated. S&P contends, however, that states have the capacity to make fiscal adjustments in response to a downturn. S&P also notes, though, that there were 19 state downgrades from the beginning of 2016 through August 2018, compared with just four upgrades, and observes that this ratio is abnormal this far into a recovery. The downgrades could reflect increased reliance on income taxes, eroding tax bases, rising entitlement costs, and liability growth.

 

Cities

The National League of Cities’ annual City Fiscal Conditions report, a survey of 341 of its members, found that while cities’ fiscal health is not yet declining, growth is slowing, and there are cautionary signals that echo previous economic downturns. Cities are facing wage pressure as well as shortfalls in required and/or needed contributions to pensions and healthcare. Although revenues are not in decline, they grew only 1.25% in FY 2017 and are expected to stagnate in FY 2018. Expenditures grew 2.16% in FY 2017, with growth for FY 2018 budgeted at 1.97%. The results are uneven. Communities in the Midwest are faring worse than those in other regions. Smaller cities, too, have a poorer fiscal outlook than their larger counterparts do. The report attributes these differences to population declines and industrial losses that began before the Great Recession but were accelerated by it. And not surprisingly, the report found 35% of finance officers report seeing negative fiscal impacts associated with the elimination of tax-exempt advance refunding bonds. According to the NLC, this critical municipal finance tool saved taxpayers more than $2.5 billion last year.

This picture may sound dire; however, municipal analysts are generally a conservative group. In Moody’s annual US Municipal Bond Defaults and Recoveries, 1970–2017, released in July, the rating agency notes that municipal bankruptcies have become more common in the last decade (think Puerto Rico) but are still rare overall. The five-year municipal default rate since 2008 was 0.18%, compared to 0.09% for the entire study period. This figure compares with the global corporate five-year default rate of 6.6% since 2008. The ten-year municipal default rate is 0.17%, while the corporate default rate is 10.24%.

The Municipal Analysts Group of New York (MAGNY), a constituent group of the National Federation of Municipal Analysts (NFMA) staged a luncheon program at the beginning of summer, in which panelists discussed what the next recession may look like. Their conclusion? It depends. Is weakness going to be on the consumption side and affect sales taxes, or will it be on the employment or stock market fronts and affect income taxes? Recently, oil prices have been predicted to rise, so states that are dependent on energy taxes may benefit from additional revenue.

Given the risk of future revenue declines, it is important to know where the risks could rise to determine whether a municipality is preparing for those risks and striving for structural balance. Are revenues at least equal to expenditures, and are those expenditure needs being realistically addressed? When evaluating an issuer we like to see flexibility in the form of conservative assumptions built into a budget. This prudent practice generally means overestimating expenses and underestimating revenue, so that the entity can end the year with a positive balance, contributing to the buildup of a rainy day fund. Rainy day funds are used to address revenue shortfalls or unexpected expenses. Conservative budgeting and the willingness to cut spending or increase revenues are characteristics of strong financial management. This principle is true for the issuers of general-obligation bonds as well as revenue bonds.

State Ratings

Why do we always have a section on states in our quarterly municipal credit commentaries? States provide funds and services to municipalities and institutions in the state, so what is happening at the state level can have implications at the local level. Additionally, as I mentioned in my inaugural commentary at the firm (http://www.cumber.com/3q2016-municipal-credit-its-never-boring-in-muniland/) – wow, has it been two years already?), state ratings are now more volatile than they were in the past.

Since June 2016 there has been only one quarter that has not seen a state rating change, and that was the first quarter of 2018. Historically, state ratings were fairly stable (with some exceptions, such as California). The variability in the past few years is unusual and is attributable to rising pension costs and OPEB expenses, political gridlock, and/or exposure to energy-related revenues.

Some states’ ratings are naturally more cyclical because those states depend more heavily on a cyclical revenue stream. For example California, which is AA-/Aa3 rated now, has been as high as AAA and as low as A because it is a high tax state with high-income earners, which creates swings in income and budgeting. This history contrasts to that of Georgia, which has been rated Aaa by Moody’s since 1974. Fitch has rated the state’s GOs AAA since 1993, while S&P gave its highest rating to the Peach State in 1997.

State Rating Changes

After no changes in Q1, the changes seemed to accelerate in Q2 and Q3. In Q2 there were three downgrades, one upgrade, and a few improvements in outlooks or trend. In the third quarter all rating actions were positive!

 

Finally, our thoughts are with those in North and South Carolina who are still dealing with the aftermath of Florence. In addition, many around the country and the world were affected by fires, volcanoes, and tsunamis this quarter. The initial costs to communities affected by natural disasters can be great; however in the U.S., after a natural disaster, there is usually a surge of economic activity that continues for an extended period as people and communities rebuild and money (insurance and federal aid) and workers flow into the area, increasing income tax and sales tax revenues to municipalities. That economic flip side, however, is not much immediate comfort for those who have lost homes and other property, pets, livestock, income, and for some, even family members. Our hearts go out to those whose lives have been impacted.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


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The Tale of Two Ratios: Shorter and Longer

In a year when we have seen commentators talking about the relative flatness of yield curves, we have a conundrum when we look at the US Treasury yield curve and the US muni yield curve (shown here as the Bloomberg AA general obligation yield curve).

Market Commentary - John Mousseau

Curve 1 below is from the beginning of 2017. Curve 2 is from September 2017. Curve 3 is from September of this year.

Curve 1
Source: Bloomberg

Curve 1, at the beginning of 2017, shows a very cheap muni yield curve across the board. Muni yields were at or above Treasury levels at EVERY POINT ON THE YIELD CURVE. This reflected the entire uncertainty surrounding the presidential election. There were questions as to whether we would see a tax bill and how munis would be treated, fear of a big infrastructure bill (and uncertainty over how that would affect munis), what the president would do regarding a new Fed chair, and whether Fed policy would change. All in all, it was an extraordinarily cheap moment for muni bonds. The long end was particularly cheap, as the market had undergone a selloff in the wake of the Trump election, with extreme bond-fund selling.

Curve 2
Source: Bloomberg

Curve 2 is from September of 2017. What happened? Short-term muni yields dropped. The trend really started in the first quarter when then-Chair Janet Yellen made it clear that the Fed would continue on its path of raising short-term interest rates gradually (read: not at every meeting) but would need to keep raising rates to reflect an improving economy. Thus the shorter end of the market essentially began to go lower in yield to reflect the tax structure, and the ratio moves were dramatic for paper inside of five years. Longer munis continued to exhibit cheapness of yield relative to Treasuries. We believe this was related to market knowledge that there would be a change in the tax code coming with the tax bill and to the uncertainty as to how municipal bonds would be treated under that bill. The expectation was that municipal advance refundings (which allowed municipalities to defease older, higher-coupon bonds in advance of their call dates) would be eliminated. Bond markets also expected that private-activity bonds – issued by charter schools, private universities, state housing agencies, and airports among others – would be prohibited. In the end the tax bill eliminated advance refundings but allowed private-activity bonds. The cheapness in the long end of the muni market was due to the expectation that SUPPLY would bulge at year end to beat the tax code changes, and indeed that is what happened.

Curve 3
Source: Bloomberg

Curve 3 is from this September. Two observations jump out. The long end remains absurdly cheap. One factor is some erosion of the buying base. Banks have been smaller buyers of munis because of the lower corporate rate; and individual demand for long munis has been good, but bond funds have not recouped the outflow of funds that they saw in the wake of the 2016 election. The more dramatic move has been the continued drop in ratios inside of 10 years – in some cases to lower than the break-even rate if we assume an average marginal tax rate of 25%.

One of our thoughts is that investors are expecting a possible change in the makeup of Congress this fall and possibly a change in the White House in 2020 and a potential revision of the tax code again. The current individual rates expire in 2025. Therefore, investors are turning over muni portfolios faster and paying more for short-dated securities. They would therefore have money back faster if there if a tax law change in the wake of a switched Congressional majority.

However, we believe the longer end of the bond market remains an extremely good value. A 4% tax-free yield is the taxable equivalent of 6.35% if an investor is in the 37% top tax rate bracket. For states with high income taxes that are no longer deductible, a 4% in-state bond yield is worth even more. At the top state tax rate, a 4% New Jersey tax-free bond is worth 8.97% taxable equivalent; a 4% New York bond is worth 8.82% taxable equivalent; and a California 4% tax-free yield is worth 8.04% taxable equivalent. This is for AA or higher-rated securities. To position the 4% in-state bond correctly credit-wise, it compares to high-grade corporate and long, taxable municipal bonds at the 4.0–4.5% level or a BB junk bond long yield index of 6.5% (source: Bloomberg).  In general, the muni yield curve drifted up 20 basis points during the quarter, across from 2 years out to 30. This is in sympathy with the treasury yield curve, which also experienced slightly higher yield movements across the board.

Curve 3 also is a way to understand Cumberland’s current barbell approach to tax-free bond portfolio management. We want shorter-term securities turning over faster as the Fed raises short-term rates, but we want the longer end locked in because we believe the current cheap yield ratios will eventually go to 100% or below. This happened during the Fed’s hike cycle of 2004–2006, when long muni/Treasury yield ratios fell from 103% to 85%. Our approach should give long munis a great deal of defensive value if overall interest rates rise. It is this defensive quality that causes us to include some longer tax-free bonds in the management of taxable bond portfolios of clients such as pensions, foundations, and charitable trusts. The total-return characteristics of owning a tax-free bond at these levels is very compelling when the expectation is for lower yield ratios over time. Certainly it will take some time for the strategy to work out, as longer Treasury yields are somewhat anchored to the general low level of longer bond yields in the Eurozone countries.

As the Federal Reserve continues to raise short-term interest rates (and we believe they will continue to do so to get the fed funds rate decently above the level of core CPI [currently 2.2%]), we will eventually move some of the shorter end of the barbell out somewhat longer, some of the longer end (where most bonds are callable) to more noncallable structures, and some bonds to the “belly” of the yield curve (where we don’t want to be now but will certainly want to be if we get to a point where the economy slows).

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio


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Trump Trade War & The Keystone Kops

Market Commentary - Cumberland Advisors - Trump Trade War & The Keystone Kops

In his Thoughts from the Frontline letter on Friday, John Mauldin wrapped his own strong remarks on Trump’s trade war with China around a tweet from the vastly experienced and hugely connected Harald Malmgren (https://www.mauldineconomics.com/frontlinethoughts/china-for-the-trade-win):

“Check out this unusually blunt tweet from former trade diplomat Harald Malmgren, who literally wrote the book on US trade policy, serving under presidents starting with JFK. He’s retired now but remains ‘plugged in’ to global finance better than almost anyone I know.”

Mauldin continues, “Now, it may be that the White House team is less talented than they think. Peter Navarro’s continued presence, and the president’s apparent confidence in him, is not reassuring. I said when his name was first mentioned that Navarro understands neither economics nor trade. He has done nothing to change my opinion.

“But another possibility is they have an entirely different strategy than we think. Some of my contacts believe the real goal is to make US businesses pull back from operating in China at all. If that’s the goal, they are off to a good start. But that is not good for US businesses or for the US.”

Then, on Friday evening, the Wall Street Journal chimed in with a news alert titled “China Cancels Trade Talks With U.S. Amid Escalation in Tariff Threats,” which outlined the Chinese response to US pressure:

“China scotched trade talks with the U.S. that were planned for the coming days, according to people briefed on the matter, further dimming prospects for resolving a trade battle between the world’s two largest economies.

“The decision to pull out of the talks follows the latest escalation in trade tensions. On Monday, President Trump announced new tariffs on $200 billion in Chinese imports, prompting Beijing to retaliate with levies on $60 billion in U.S. goods. Mr. Trump then vowed to further ratchet up pressure on China by kicking in tariffs on another $257 billion of Chinese products.

“Chinese officials have said such pressure tactics wouldn’t induce them to cooperate. By declining to participate in the talks, the people said, Beijing is following up on its pledge to avoid negotiating under threat.”

With the Trump Trade War escalating and worsening, we sought to convene a serious and civil discussion about where Trump-Navarro trade policy is inclined to take the United States. To that end a seminar was organized with the help of the Keystone Policy Center (KPC) and the Global Interdependence Center (GIC). It was held on September 20th at Keystone, in Summit County, Colorado. (For geographic orientation, since our readers are worldwide, you may think of the Keystone or Breckinridge sky areas or the towns of Keystone, Frisco, Dillon, or Silverthorne.)

The KPC has been around since the mid-1970s, as has the GIC. Both organizations have a history of neutrality and of convening civil discussions.  KPC’s history is more domestic in focus, with agriculture and mining being strong areas of interest. GIC has a history of global focus on monetary and trade issues.

The Trump Trade War has now offered a bridge for policy forums like KPC and GIC to partner as they pursue truth without the intensity of political acrimony. That is what happened on September 20. At the seminar, opinions were diverse and perceptions varied, but considerable learning occurred through the civil exchange of information.

Mike Englund, Megan Greene, and yours truly as a participating moderator populated the seminar panel. Among the invited attendees were Democrats and Republicans, businesses and white-collar professionals, and public guests. The event was open to the general public at no charge.

Participants included IT businesses that work in China and that have experienced intellectual property theft. Representatives of the soybean industry, finance and market agents, and the retired executives of major institutions were also on hand..
Mike Englund of Action Economics opened with slides and a data set. He has graciously allowed them to be publicly released. Here is the link to Mike’s PowerPoint presentation: Action_Economics_Keystone_GIC_Sep_2018.pptx. (Mike Englund is principal director and chief economist for Action Economics, which offers premium intra-day commentary for the fixed-income and currency markets. They feature analysis of a wide range of global bond and FX markets, with a focus on central bank policy and market activity in the G7 countries. You can learn more here: https://www.actioneconomics.com/index.php/.)

Mike’s slides were updated to include the latest Trump escalation and China’s response. They capture what was known as of September 19. They estimate the primary effects. The second derivatives were a subject of our panel discussion. Suffice it to say, this is a negative picture for US growth and US job creation, and the secondary impacts will only make the situation worse.

Megan Greene is the chief global economist at Manulife Asset Management, whose team includes more than 325 investment professionals, located around the world, who manage a full spectrum of asset classes. You see her on TV and can read her column in the FT. She added a global perspective and described how trade-war effects spread internationally, citing many anecdotes of global interactions. If anyone needed convincing that this Navarro-conceived, Trump-directed policy is now on an irreversible course toward failure, they had only to listen to Megan’s rundown and extrapolate to logical outcomes.

I added a few observations to the discussion and will summarize them here.
1. Shrinking the US trade deficit means shrinking the capital account surplus. To do this when the federal deficit is headed above $1 trillion is to invite a financial crisis. We should be expanding the capital account surplus and enhancing the US dollar’s status as the reliable world reserve currency of choice. Instead, this administration is doing the reverse. Trump and Navarro are shooting our country in both feet.

2. Americans don’t want this. A majority (75%–80%) think that free trade is opportunity. Survey sources include Gallup, 2018 (https://news.gallup.com/poll/228317/positive-attitudes-toward-foreign-trade-stay-high.aspx); Chicago Council Survey, 2017 (https://www.thechicagocouncil.org/publication/chicago-council-survey-data); Pew, 2015 (http://www.people-press.org/2015/05/27/free-trade-agreements-seen-as-good-for-u-s-but-concerns-persist/); and WSJ/NBC, 2017 (https://www.wsj.com/articles/americans-back-immigration-and-trade-at-record-levels-1493092861?mod=wsj_streaming_latest-headlines). Thank you to Barclays research for pointing us to some of these polls.

3. The same political views with regard to trade are held by Democrats, Republicans, and independents. The polling data show that disdain for the direction of this Trump-Navarro policy is bipartisan and growing as the anecdotal evidence of negative effects pile up at Trump’s doorstep.

4. Trade still ranks low in issue importance when voters are asked. Guns, terrorism, education, and immigration rank much higher; but that picture is changing slowly. Remember, trade-war rhetoric has been around all year, but actual policy implementation is just getting underway, and measurable effects are just beginning to appear. Look at Mike Englund’s forecast slide to get a sense of where this is heading.

5. “The United States federal excise tax on gasoline is 18.3 cents per gallon and 24.3 cents per gallon for diesel fuel” (https://www.eia.gov/tools/faqs/faq.php?id=10&t=10). Every penny change in the price of fuels amounts to about $1.5 billion spent annually in the US. At present, with the announced and threatened tariffs, the total cost imposed on Americans will be the equivalent of nearly one dollar of additional tax per gallon of gasoline and diesel fuel. That reference may help readers understand how serious an economic growth threat may greet our nation by early next year.

My takeaway is that the stock markets and bond/credit markets are only starting to worry. Companies are, however, warning about possible future negative earnings surprises from trade-war effects. Credit spreads are still tight. The pain is seen in emerging markets and foreign debt issues. While the amount of US corporate debt is at a record high and the junk-credit portion is high, we haven’t seen credit spreads widen yet. We are minimizing that risk for clients. When markets are priced for perfection, they are fraught with risk. At Cumberland we won’t take that added risk for our clients.

Last thought. For decades we have focused on monetary issues and numeracy and trends that exhibit linearity and mean reversion. At our September 20 seminar, the professionals in attendance admitted how difficult it is to model trade shocks. Unintended consequences are often larger than the initial actions that precipitate them, and the multipliers are unknown. Trade shocks are sequential cliffs. They are nonlinear. Many are irreversible.

We thank the leadership of the Keystone Policy Center and the Global Interdependence Center for agreeing to this first joint organizational forum. We thank the invited attendees and the public guests for taking a few hours away from the beautiful golden Colorado fall foliage to sit in a meeting room and civilly discuss this critical inflection point in America’s trade policy. Many of our participants expressed the wish that our national political leadership might act as we were doing and cease the bellicose, offensive behavior. That wish applies to both Democrats and Republicans.

I was fortunate to moderate this session and to learn from those who attended. Thank you.

Sixty years before the founding of the GIC and KPC, silent movies were the latest rage. The Keystone Kops may now be little-known, but they were a big hit in their day. (See https://www.britannica.com/topic/Keystone-Kops) We all do well to keep our sense of humor in these trying days, and so we can’t help but wonder whether the Keystone Kops might have been the inspiration for today’s trade war police ensconced in Washington. Here’s a taste of those crazy constables: https://www.youtube.com/watch?v=a8jphxpi1ro.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Donor-Advised Funds (DAFs): Warehouses of Charitable Dollars or a Democratic Vehicle for Philanthropy?

The long-standing debate surrounding the lightly regulated world of donor-advised funds has been gaining traction on the pages of the Nonprofit Quarterly (NPQ).[1]

Gabriel Hament, Foundations and Charitable Accounts, Cumberland Advisors

To help frame the discussion, here are some bullet points from Bruce DeBoskey on the history and growth of DAFs, published by the Denver Post:

(*) “Today, there are about 300,000 DAFs in the United States, holding nearly $100 billion.”[2]

(*) “Often, DAFs are associated with financial investment firms, such as Fidelity Charitable or Schwab Charitable, or with independent entities like the National Philanthropic Trust or the American Endowment Foundation. DAFs are also housed at more than 700 community foundations, such as The Denver FoundationRose Community Foundation, and Community First Foundation.”[3]

(*) “Most DAFs report that from 16 to 20 percent of donated assets go out to charity each year. This is much higher than the five percent required-payout for private foundations.”

(*) “The major DAFs report that from 80 to 84 percent of their assets are paid out to charities over a ten-year period, leaving 16 to 20 percent of their contributions sitting dormant. An IRS study found that nearly 22 percent of DAF sponsors in 2012 made zero distributions.”[4]

The criticism leveled at the DAF vehicle centers around two contentions:

(1) The absence of any state or federally mandated rule compelling DAFs to distribute funds to “working charities” results in billions of dollars lying dormant while charitable needs go unmet.

(2) Financial firms that have established 501(c)3 arms in which their clients’ DAFs are housed, have little incentive to accelerate the distribution of monies from the DAFs because the firm likely collects an investment management fee for investing the funds.[5]

Ray Madoff, a professor at Boston College Law School, suggests some policies that may encourage a faster flow of funds from DAFs to charitable initiatives:

(1) “Congress could incentivize distributions from DAFs by tying some of the charitable tax benefits to the release of DAF funds. For example, Congress could enact rules that would allow donors to avoid capital gains on transfers of property into DAFs, but would delay the charitable deduction until such time as funds are distributed from the DAF to non-DAF beneficiaries.”[6]

(2) “Alternatively, Congress could impose a maximum time period for DAF accounts to be distributed outright to charities. This could easily be accomplished by requiring donors, as a condition of the deduction, to name a non-DAF charity that would receive any undistributed funds at the end of the designated period.11 For example, if Congress were to impose a maximum time period of ten years, then a donor who funds a DAF in 2018 would be required to name a charity that would receive any remaining funds in the 2018 DAF account by 2028.12 DAFs would maintain their flexibility, because donors could change their charitable designations by simply making distributions from that account before the termination date. A maximum distribution period would not undermine the effectiveness of DAFs or their appeal to donors. It would simply establish a limit that would ensure that tax-benefited dollars are granted outright to nonprofits within a reasonable period of time.”[7]

We will add another wrinkle to this conversation, and that is the consideration of intergenerational equity – a foundational principle governing the management of funds established for the perpetual benefit of nonprofit organizations. Nearly every jurisdiction in the United States has adopted the Uniform Management of Institutional Funds Act (UPMIFA), which mandates that fiduciaries of perpetual funds balance the needs of the present and the future. Please see our previous writings on this topic. (Here: http://www.cumber.com/intergenerational-equity/ and here: http://www.cumber.com/the-imprudent-man-rule/.)

We will conclude with a question to our readers: Is the goal of a donor-advised fund to provide perpetual support for charitable initiatives, or is it a temporary pass-through vehicle that is to be spent down to zero, sooner rather than later?

We look forward to your feedback.

Gabriel Hament
Foundations and Charitable Accounts
Email | Bio


[1] NPQ launched as a national print journal in the winter of 1999, with the mission to provide credible, research-based articles for nonprofits about management and governance. The editorial mission evolved to cover issues related to the operating environment for nonprofits – specifically, public policy and philanthropy. https://nonprofitquarterly.org/about-us/
[5] Read more about for-profit financial institution donor-advised funds (FIDAFs) here: https://nonprofitquarterly.org/2018/07/25/daf-reform-a-chance-to-provide-a-real-benefit-to-working-charities/

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Eurozone Economy’s Expansion Ongoing and Broad-Based, Downside Risks Worrying

The European Central Bank (ECB) left its monetary policy stance unchanged at its September 13 meeting. Net asset purchases will end in December, but with the Bank’s maintaining its stock of assets, the reinvestment of redemptions will maintain substantial stimulus. No increase in policy interest rates is signaled until at least after the end of next summer. Note that the main ECB refinancing rate is still zero.

Cumberland Advisors Market Commentary - Bill Witherell, Ph.D.

Attention, therefore, focused on the updates of the ECB staff’s macroeconomic forecasts as presented by ECB President Mario Draghi. The Bank’s assessment of the economy is upbeat, viewing the expansion as ongoing and broad-based. The economic growth projections reflected very small downward revisions. GDP growth for the current year is now forecast at 2.0% instead of 2.1%. Growth in 2019 is forecast to be 1.8%, also a reduction of 0.1% from the previous projection. The moderation from the 2.5% pace in 2017 is due mainly to a weakening of global trade, while domestic demand remains strong.

The Eurozone Purchasing Managers’ Index (PMI) for August continued to indicate a robust economy but one with a growing imbalance. Growth accelerated in the two largest economies, Germany and France, while Italy, the third largest, experienced a sharp growth slowdown, and Spain also looks weak. A disturbing development is that business confidence concerning future activity has declined to its lowest level in 23 months. For Italian and Spanish companies, expectations are at a five-year low. Global trade tensions and political uncertainties, including the difficult BREXIT negotiations and the battle in Italy over the budget, are undermining confidence.

The positive factors cited by Draghi as underlying the ECB’s upbeat analysis related to the underlying strength of the domestic economies in the region. These factors include the continuing monetary stimulus, record-low interest rates, a more positive fiscal stance, and the strength of the labor market, with healthy employment growth and rising wages that are fueling consumer demand. Draghi argued that the strength of the economy balances the downside risks from global factors. He also offered assurances with respect to Italy, noting that the rise in Italy’s borrowing cost did not spread to other member states, and the cost has recently declined.

Downside risks to the outlook were underlined last Friday, September 21, by the release of the Flash Eurozone PMI for September. The drop in this statistic to a 4-month low, according to preliminary data, indicates that Eurozone manufacturing-sector business activity is growing in September at the second weakest rate since late 2016. The slowdown is said to be due to a stagnation of exports. New orders were the weakest since October 2016. Trade war concerns and reduced global demand, notably in the auto sector; increased risk aversion; and political uncertainties, both within the Eurozone and globally, were all cited as factors. On the positive side the service sector is continuing to experience buoyant growth and strong job gains. Also, despite the current slowdown, business optimism about future activity ticked up somewhat from the gloomy August levels.

Eurozone equities are recovering from declines earlier in the year and so far have been shrugging off the negative concerns cited above. The comprehensive iShares MSCI Eurozone ETF, EZU, while still down 3.2% year-to-date, is up 1.06% over the past three months and has gained 3.10% over the past five market days through September 21. The decline in the euro versus the US dollar earlier this year (still down 2.7% year-to-date) accounts for much of this performance for dollar-based investors. The equity market of the largest Eurozone economy, Germany, has been underperforming in the region but is finally getting a bid. The iShares MSCI Germany ETF, EWG, is still down slightly over the past three months, -0.23%, but is up 2.96% over the past five days. The French market has been outperforming most of its neighbors, with a positive year-to-date return for the iShares MSCI France ETF, EWQ, of 1.83% and a three-month return of 3.11%. The equity markets of Italy and Spain, despite the current concerns about their economies and political uncertainties, are performing strongly, with the iShares Italy ETF, EWI, rising 4.29% and the iShares Spain ETF, EWP, up 3.87% over the past five days. We are maintaining market-weight positions for the Eurozone in our International Portfolios.

Bill Witherell, Ph.D.
Chief Global Economist & Portfolio Manager
Email | Bio

Sources: European Central Bank, Financial Times, Goldman Sachs Economic Research, HIS Markit, CNBC, ETF.com


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Market Volatility ETF Portfolio 3Q 2018 Review

The US equity market has had a strong third quarter this year. Our quantitative strategy benefited from the market rebound in July and August and took profits off the table at the end of last month. We have been sitting in all cash and waiting for the next entry signal since we exited near the market top.

 

Cumberland Advisors - Quarterly Review - Market Volatility ETF
 

The S&P 500 large-cap index is up about 9.69% YTD (ex-div) and hasn’t significantly deviated from where the market was at the same time last year. These numbers are certainly making investors happy, since the 10-year Treasury is yielding only about 3% nowadays. Although 2017 and 2018 show some similarities in the overall numbers, the detailed paths are quite different. We may still remember the ultra-low-volatility regime in 2017. But after a correction in February and some large spikes in volatility in the first quarter of 2018, we haven’t seen many short-volatility trades floating around this year. Needlessly to say, it was painful for the “short-vol” funds just half a year ago.
However, the third quarter proved to be another contrarian case. Market volatility continued its downward trend, falling to a 11-handle (Figure 1 below) and showing signs of relief after the spiral jump back up in February. While the 50.85% drop in VIX since April helps to explain the market comeback so far, it may be a misleading signal with regard to the underlying market. With the heated tariff war and midterm election coming up, we caution our readers not to interpret the VIX too literally. As we learned in the first quarter, VIX can spring up drastically in no time.

Chart 1. VIX since April 1, 2018. Chart source: Yahoo! Finance
The spread between the S&P 500 and VIX (Figure 2 below) continues in the third quarter: VIX is down over 20% while the market is up over 6%. This trend may be a sign of rising complacency in the market, as this type of widening does not typically happen during summer swoons. Nevertheless, as we always remind our readers, although we decided to go to cash with our quantitative strategy, that is not a short call from our model. Of course, “cash is king” has its merits. Our strategy is not to be afraid to hold cash and to be ready to enter when the time is right.

Chart 2. S&P 500 vs. VIX in 3Q 2018. Chart source: Yahoo! Finance
*Data updated on September 20th, 2018.
Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio

 


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US ETF Q3 2018 Review

Third-quarter US stock markets have faced a formidable array of media distractions, ranging from hurricanes to Trump tweets to SCOTUS scuffles – and on and on.

Cumberland Advisors - Quarterly Review - 2018 Q1 - US ETF
For markets the trade war and the Fed have been key. Fed policy seems predictable as the hiking path continues. Trade war effects are worrisome and starting to reveal themselves in data. We worry most about the trade war effects on markets. Meanwhile the Dow set a record high.

We’ve focused on portfolio structure that is buffered from the Trump Trade War. We favor domestic and smaller and mid caps. We like healthcare and defense. And some cash reserve is in place as the quarter ends. That could change at any time.

The negative effects of the Trump Trade War are offsetting the positive effects of lower taxes, repatriation, and deregulation. The rest of the year is likely to be volatile.

Two expected impacts from the Trump Trade War are more inflation and a growth slowdown. The first will eventually show up in higher consumer prices, since the tariffs are really just a form of a national sales tax collected at the US border and remitted to the US Treasury. China does NOT pay the Trump tariffs; American consumers pay this cost.

The slowdown element takes time to reveal itself in reductions of earnings. We already see company warnings. It will take a few quarters to get to actual earnings revisions and disappointments.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Yield Curve?

A while ago we wrote about a one-time tax-code change and why it might be causing the yield curve to flatten. Here is that commentary: “Why the Yield Curve Is Flat & Why It May Steepen” (https://www.cumber.com/why-the-yield-curve-is-flat-why-it-may-steepen/).

Market Commentary - Cumberland Advisors - Yield Curve?

Now we are past the September Treasury note and bond auction and past the tax-code-change deadline. So will the yield curve steepen? Flatten? No change?

We think it will steepen, but we recognize that forecasting the yield curve is notoriously dangerous. The standard quip is that economic forecasters were created to make astrologers look good.

Many factors impact the yield curve. We happen to think that the tax-code regime change is one of them, and we may be able to confirm that quickly (within a month or two). The reason is that the tax-code change caused a one-time shift of demand-driven buyers. They allocated away from Treasury bills (their preferred habitat) to long-term Treasury strips, derived mostly from newly auctioned Treasury 30-year bonds (market segmentation).

That process is now finished, so we expect a normalization to steepen the yield curve again. Of course, there could be other factors at work as well. There always are.

The Fed is divided on this subject. Boston Fed President Eric Rosengren recently said, “I don’t take as much information from the yield curve as some other people. It is one of many things I look at, but I don’t give it a special attribute in terms of telling us cyclical changes.”

Peter Boockvar notes how this statement stands in contrast to those of other Fed members such as St. Louis Fed President Jim Bullard or Atlanta Fed President Raphael Bostic. Boockvar argues that Fed members should always give the yield curve special attention. I agree.

Let’s put this into a numerical perspective. By year-end, the short-term overnight risk-free rate will be above 2% and may be close to 2.5%. The 10-year Treasury yield may stabilize between 3% and 3.5%. If it is well under 3%, the yield curve would be very flat, and forward rate calculations would be worrisome. The long-term 30-year Treasury bond could be 3.5% or higher.

Let’s call that a baseline scenario and recognize that it could easily prove to have been an erroneous forecast within three months. Also note that forecast errors may be in either direction and that confidence is low in the accuracy of this scenario.

So what does a bond portfolio manager do?

The answer is to seek active bond choices with a rationale that works to the advantage of clients. Remember, the bond market frequently offers an anomalous pricing structure, and the challenge for the bond manager is to be sharp and to seize it quickly before the anomaly disappears.

Here is an example. When the 30-year Treasury bond was recently in the market at a yield of about 3.1%, we purchased very-high-credit-quality, tax-free new issues at 4% and slightly higher yields. The durations of those munis were not far away from those of the Treasury bond. The Treasury is taxable while the munis are not, so a tax-arbitrage cushion favors the muni bondholder.

The spread was so enticing that we also bought the tax-free bond in certain types of portfolios that do not pay taxes. Why? Because getting an extra point in yield while having a downside price cushion is a gift to the client.

Did we sacrifice credit quality? No. The bonds were all very-high-grade, with ratings of AA to AAA.

In sum, we expect the yield curve to steepen. There are ways to deal with that risk. You don’t have to sacrifice credit quality to do it. And when the tax-free yield exceeds the taxable yield, a crossover buyer will quickly become active.

Now let’s wrap up by offering serious readers three links to research pieces that discuss the shape of the yield curve and influences on Treasury interest rates.

“The Effect of the Federal Reserve’s Securities Holdings on Longer-term Interest Rates.” Brian Bonis, Jane Ihrig, and Min Wei. FEDS Notes, Board of Governors of the Federal Reserve System, April 20, 2017. https://www.federalreserve.gov/econres/notes/feds-notes/effect-of-the-federal-reserves-securities-holdings-on-longer-term-interest-rates-20170420.htm

“Predicting Recession Probabilities Using the Slope of the Yield Curve.” Peter Johansson and Andrew Meldrum. FEDS Notes, Board of Governors of the Federal Reserve System, March 1, 2018. https://www.federalreserve.gov/econres/notes/feds-notes/predicting-recession-probabilities-using-the-slope-of-the-yield-curve-20180301.htm

“Information in the Yield Curve about Future Recessions.” Michael Bauer and Thomas Mertens. FRBSF Economic Letter, Federal Reserve Bank of San Francisco, August 27, 2018. https://www.frbsf.org/economic-research/publications/economic-letter/2018/august/information-in-yield-curve-about-future-recessions/

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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The Rise of Municipal Separately Managed Accounts 2018 Update

Cumberland has utilized separately managed accounts to execute its fixed-income strategy since its inception in 1973, long before separately managed accounts (SMAs) were popularized in the early 2000s.

Market Commentary - Cumberland Advisors - The Rise of Municipal Separately Managed Accounts 2018 Update

What exactly is an SMA? Per Investopedia: “A[n] SMA is a portfolio of assets under the management of a professional investment firm. In the United States, the vast majority of such firms are called registered investment advisors, and operate under the regulatory auspices of the Investment Advisors Act of 1940 and the purview of the US Securities and Exchange Commission (SEC). One or more portfolio managers are responsible for day-to-day investment decisions, supported by a team of analysts, operations and administrative staff. SMAs differ from pooled vehicles like mutual funds in that each portfolio is unique to a single account (hence the name). In other words, if you set up a separate account with Money Manager X, then Manager X has the discretion to make decisions for this account that may be different from decisions made for other accounts.”

The reasons for managing money in this fashion are the same today as they were then:

  • Transparency (you know what you own)
  • Flexibility to make strategic changes
  • Ability to manage transaction costs and best execution
  • Active management
  • Individually catered management of clients’ objectives, including tax management, income production, state-specific needs, cash flow-specific needs, and ability to institute investment restrictions

Many of the elements of this update are the same as last year’s because the benefits of SMAs remain; however, the markets, technology, and regulation are always changing, which can affect supply, cost of execution, and relationships to other markets. New areas discussed here are municipal CEFs and ETFs, growing algorithmic trading by specialty investors and dealers, and new regulations designed to increase transparency, requiring brokers to show markups and/or commissions in certain situations.

At Cumberland we have a top-down approach to investment management. We look at global macroeconomic conditions and policies to assess interest rates and growth prospects and position our portfolios accordingly. Each market and/or sector is evaluated as to how it fits in the global outlook as well as how its idiosyncratic elements may affect supply and credit quality. The majority of our fixed-income portfolios are managed on a total-return basis using a barbell strategy to more quickly take advantage of changes in interest-rate and technical changes. In a total-return account, the return is measured against a benchmark, which is usually an index that is widely recognized. Outperformance may mean that individual portfolio returns are less negative than the benchmark’s in addition to positive returns that are greater than the benchmark.

Fixed-income total-return investing takes into consideration price appreciation or depreciation and the effects of coupon income generated and reinvested. Coupon payments over time are a large contributor to the return of an account, but the timing of buying and selling and where along the curve to buy or sell can greatly impact returns. Other buy-sell considerations include duration, or the sensitivity of a bond to changes in interest rates; embedded options such as call features; technical features like supply and demand, and credit-quality trends. All of these can affect the performance of a portfolio relative to an index or benchmark. Finally, to quote Cumberland’s John Mousseau, ”Active management means active thinking, not always active trading.”

We have been in a 37-year rally in the bond market, but if you don’t pay attention to points of entry and the other details, you can miss out on performance. Similarly, in an increasing-interest-rate environment, points of entry and exit can affect performance. The use of a barbell strategy allows us to invest in various short-term instruments that are liquid and to use them as ammunition to buy longer-dated bonds when interest rates rise or to take advantage of the higher coupon of longer-maturity bonds compared with shorter-dated bonds. Floating-rate notes and inflation-protected securities are investments that can help returns in the face of inflation and rising interest rates. We are prepared for various scenarios; however, unemployment and inflation remain low, and growth remains steady. In a recent piece, http://www.cumber.com/its-in-the-stars/, Bob Eisenbeis opines that the FOMC would continue with gradual tightening, since policy is still accommodative, but will be prepared to change course if inflation and, importantly, inflation expectations change.

We will address municipal assets in this commentary; however, we also manage taxable fixed-income, equity, and balanced accounts. In managing equity accounts we utilize exchange-traded funds (ETFs) and actively conduct sector rotation. Exchange-traded funds allow flexibility and generally lower total trading costs than individual-stock portfolios do, and they avoid sales and purchases that mutual funds must make due to funds flows.

The benefits of SMAs have led to their increased use by investors. According to Citi Research, SMA municipal fixed-income assets, both taxable and tax-exempt, have grown from $100 billion in 2008 to $565 billion at the end of Q1 2018. The details are not separately reported by the Federal Reserve, so Citi Research uses a quarterly survey of its customers and certain Federal Reserve flow of funds data to arrive at an estimate.

2008 – Q1 2018: Mutual fund rate of growth has declined while SMA growth has increased
Source: Citi ResearchDirect retail muni assets have declined since 2010 from $1.9 trillion to $1.1 trillion.
Source: Citi Research (SMA + direct retail = Fed flow of funds Households of $1.64 trillion)

Mutual fund performance is affected by fund flows and herd mentality and thus presents opportunities for active fixed-income management. When investors are dumping assets, the mutual fund portfolio manager may not be able to fully practice active management and must liquidate funds as required by redemptions. In these cases, the most liquid and generally higher-quality assets may be sold first in order to minimize effects on net asset value (NAV). Alternatively, when assets are pouring into mutual funds, the increased demand for assets, resulting in higher prices, can present a selling opportunity for SMA managers.

Closed-End Funds and Exchange-Traded Funds

Closed-end funds (CEFs) have been around for a long time – since 1893![1] This was years before the first mutual fund or open-ended fund – Massachusetts Investors Trust was established in 1924. As the name implies, closed-end funds are closed: They operate with only the funds they raise in the marketplace and have a fixed number of shares. CEFs have a net asset value based on the assets in the fund, but shares in a CEF are traded on an exchange so the price can vary from the NAV. In addition, CEFs can use leverage. By comparison, exchange-traded funds (ETFs) are relatively new: They originated in Canada in the 1990s. They differ from CEFs in that there is not a fixed amount of assets, and the number of shares can change. (For more detail on ETFs see Cumberland Advisors’ revised second edition of From Bear to Bull with ETFs, which discusses mostly equity ETFs).

Municipal CEF holdings were $87.3 billion, or 2.3% of all municipal holdings at the end of Q1 2018 and they have bumped around that level for years. Municipal ETFs are a smaller segment of the market but have been growing recently to $30.7 billion (0.8% of municipal holdings) at the end of Q1 2018 from $19 billion in 2013.

Algorithmic trading in the municipal market

The effects of algorithmic trading in the municipal market are being closely watched by market participants. These algorithms use actual trade data as well as observed bid and ask spreads, ratings, sectors, volume, and any other data the developer of the algorithm finds predictive. Hedge funds were the first market player to use this type of trading. It is used most frequently for trading odd lots (trade sizes below $25,000), where spreads are generally wider per unit of risk and the algorithms can take advantage of mispricing in the market. The municipal market is large at $3.84 trillion at the end of Q1 2018 and consists of over 80,000 issuers that can issue many types of debt and issue sizes ranging from $75,000 to finance a fire truck to billion-dollar issues for major city projects. Market observers that I talk with think the ‘algo’ traders provide liquidity to the marketplace, and they wonder what would happen if hedge funds/algos were to leave the market. However, the use of algorithms is growing, and many trading floors employ their own algos while retaining traders and salespeople. Technology can take some of the human element out of equation, but the nonhomogeneous market still requires live human input.

Regulation

New and revised regulations by the Securities and Exchange Commission (SEC) and the Municipal Securities Rulemaking Board (MSRB) that require the reporting of markups or markdowns on bond trades could increase the transition to SMAs or wrap accounts that charge a flat fee for execution and advice. Municipal bond trading always has a markup or markdown, because there is a spread between the price to buy and the price to sell; previously, however, these markups and markdowns did not have to appear on confirmations. The size of the markup or markdown can depend on numerous factors, including size, complexity, and liquidity. The reporting of the transaction costs is designed to make the trading of bonds more transparent and could generate conversations between clients and brokers or managers. The MSRB’s Electronic Municipal Market Access (EMMA) system (emma.org) is a central repository of information and is accessible by anyone. It provides trade data as well as issuer offering statements and annual and event-driven disclosures. There are specific rules on when and how a markup is reported, so a client may not always see the markup. The rules are new, and guidance is developing, so it may take some time for the industry and regulators to arrive at a standard.

We expect the growth in SMAs to continue because of the benefits SMAs offer in comparison to direct retail investment and mutual funds.

At Cumberland we buy bonds in large lots and allocate positions to individual portfolios, which allows for better execution and pricing for our clients compared with individual trades for each client.

Cumberland has been able to take advantage of oversold situations during times of stress such as the Meredith Whitney incident (2010), the “taper tantrum” (2013), President Trump’s election (2016), and the excess supply at the end of 2017.

Cumberland’s policy of investing in high-quality bonds improves liquidity and the ability to execute an active strategy. At the end of last year, the huge volume of supply as municipal issuers rushed to access the bond market before the tax law changes went into effect (see John Mousseau’s piece www.cumber.com/tax-free-munis-continue-to-perform/) resulted in higher yields on municipal bonds and a buying opportunity.

Retail accounts do not enjoy the economies of scale that are available to an SMA manager. In addition, active SMA managers that practice total-return investing may have credit-research resources and relationships with many broker dealers that allow them to achieve competitive execution and develop strategies to optimize investment holdings to meet individual clients’ needs.

Some argue that while mutual fund shares can be purchased and sold any day in any amount, an SMA account has many individual holdings that may take longer to sell. However, when an investor sells shares in a mutual fund, the price received is calculated at the end of the day based on the net asset value of the fund. If an investor is instead invested in high-quality liquid bonds like the ones Cumberland purchases in its accounts, then barring an extraordinary event in the market, there should be ample liquidity, and the bonds will be sold at a time that maximizes price. Additionally, knowledge of our clients’ needs has Cumberland looking ahead to provide liquidity when needed. SMAs may also give every client the advantage of providing the portfolio manager with sectors or categories to be excluded or included, such as “green” or “ESG.” Customization is not possible with a mutual fund.

Separately managed accounts have higher minimum investment requirements than mutual funds do, so they are not available to all investors. But as an investor acquires more assets and develops more highly tailored goals and objectives, an SMA may be appropriate.

Finally, the management fee charged on SMA accounts can be affected by the competitive environment. The fee is based on the type of strategy and can be scaled based on the level of assets invested. There may also be custodial fees charged to the account. Mutual funds have an expense ratio, which includes a management fee as well as miscellaneous ancillary expenses, custodial expenses, and a distribution charge. Many have various levels of sales charges. So it is important to look at all expenses when comparing funds.

At Cumberland we continue to operate as our founders did, investing clients’ funds in separately managed accounts. Our approach to investing is top-down and takes account of global interest-rate expectations and credit-quality trends. Accounts are actively managed with a total-return or income orientation, depending on clients’ needs.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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