The World Turned Upside Down

April 2, 2018

Written by Nathan Erickson, CFA®, CAIA, Partner and Chief Investment Officer

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If you’ve had the pleasure of seeing the Broadway play Hamilton, you may recall a song titled “Yorktown”. The song recounts the Battle of Yorktown in 1781; it is considered the most important battle of the Revolutionary War. General George Washington, with the support of the French naval fleet, completely surrounded General Cornwallis and his British troops in Yorktown, Virginia. After three weeks Cornwallis surrendered to Washington, effectively ending the war. It was said that as the British Army retreated from the field, they played an English ballad titled “The World Turned Upside Down”. The implication from Hamilton is that the song represented a scenario the British never envisioned would be possible: losing to the Continental Army.

As we look at the first quarter of 2018, we see increasing signs of “The World Turned Upside Down”, or things that should not be happening. The conversation could begin in 2017, when markets experienced unprecedented levels of low volatility. However, we want to highlight several scenarios worth considering as we look to the rest of 2018.

Negative Stock and Bond Markets

Since 1950, an index of the U.S. bond market has only experienced negative calendar year returns eight times. In only one of those eight times did the S&P 500 also have a negative return (1969). Conventional thinking in the investment industry is that stocks and bonds are uncorrelated and move independently of each other. However, through the first quarter of 2018 we have experienced negative returns across all equity markets, as well as negative returns in the broad bond market index. Furthermore, some of the volatility we have experienced in stocks in the first quarter has been caused by sharp increases in the 10-year treasury yield, as investors grew concerned about the impact of rising rates on economic growth in the U.S. While historically rare, we may need to be prepared for a rocky year in 2018 for both stocks and bonds.

 

Tariffs

For the past several decades, the U.S. has led the charge in trade and globalization. Its citizens and the global economy have benefited substantially, as technology improvements and global cooperation have improved the quality of life for everyone. People can access information and communicate faster than ever before, with nearly 63% of the worldwide population owning a cell phone. While President Trump has expressed displeasure with free trade agreements since his campaign, tariffs are a short-term solution that creates long-term problems. As we have already seen, the introduction of tariffs on goods imported from other countries may lead to other countries putting tariffs on goods we export. The expectation is that making imported goods more expensive will force companies to manufacture more of those goods in the U.S., which may lead to more jobs and higher pay for U.S. workers. Unfortunately, the retaliatory tariffs from other countries make U.S. exports less competitive. This could pose a counter effect leading to reduced prices, lower pay, and higher unemployment.

The U.S. has tried this before. As Economist Dr. Ed Yardeni outlines in a recent blog post, “In 1928 Republican candidate Herbert Hoover promised US farmers protection from foreign competition to boost depressed farm prices. Under pressure from Congress, he approved the Smoot-Hawley Tariff Act in June of 1930. The tariff triggered a deflationary spiral that had a deadly domino effect. Other countries immediately retaliated by imposing tariffs too.  The collapse of world trade pushed commodity prices over a cliff. Exporters and farmers defaulted on their loans, triggering a wave of banking crises. The resulting credit crunch caused industrial production and farm output to plunge and unemployment to soar.”

While the historical narrative is alarming, the U.S. is not the same country it was in 1930, nor is the rest of the world. That being said, tariffs appear to be an antiquated solution to a problem that doesn’t really exist, as the country continues to experience moderate growth and near record low unemployment. We have seen some modifications to proposed tariffs already. We hope the current administration fully vets the idea of tariffs before implementing changes that may have a long-lasting impact.

Repeal of the Fiduciary Rule

In the final days of the Obama administration, the Department of Labor implemented the “fiduciary rule”. The rule expanded the definition of an investment fiduciary under the Employee Retirement Income Security Act of 1974 (ERISA). The intention was to require all financial professionals who work with retirement plans or provide retirement planning advice to meet the standards of a fiduciary. Put simply, a fiduciary must act in the best interests of its clients and puts its clients’ interests above its own. It requires advisors to identify any potential conflict of interest and clearly disclose all fees and commissions. This is a much higher standard than the “suitability standard” required of financial salespersons. Suitability means that as long as an investment recommendation meets a client’s defined needs and objectives, it is deemed appropriate. Suitability ignores any benefit a financial salesperson may receive from recommending an investment and does not require that the client’s best interest comes first. Raising the standard for advice to fiduciary would eliminate many of the commission structures that exist in the financial industry today.

MRA Associates has operated as a fiduciary since the founding of the firm in 1991. Most people who understand the difference between a suitability standard and a fiduciary standard see a move toward fiduciary as common sense. However, the regulation was met with opposition from financial professionals who follow a suitability standard. It is estimated that the stricter fiduciary standards could cost the financial services industry an estimated $2.4 billion per year by eliminating conflicts of interest such as front-end load commissions and mutual fund 12b-1 fees paid to firms. As a result, three lawsuits were filed against the rule. On March 15th, the Fifth Circuit Court of Appeals vacated the fiduciary rule saying it constituted “unreasonableness” and the Department of Labor’s implementation of the rule constitutes an “arbitrary and capricious exercise of administrative power.”

While these are just a few examples of strange occurrences in the economic and investment world, there may be more to come. 2017 was a year of great success for most investors and for the country. While we hope it will continue this year and for many years to come, we know that there will always be challenging moments in the midst of long-term success. As a firm and as stewards of our clients’ assets, we remain vigilant in monitoring potential risks and preparing for challenging moments. As always, if you have questions or wish to discuss further, please contact a member of your engagement team.