“History never repeats itself, but it rhymes.” The purported quip by Mark Twain leads us to ask if the 2020s will rhyme with the 1920s, a decade of booms and busts, tremendous economic expansion and dislocation, and dramatic changes in social mores and fashion.

Like the 2020s, the 1920s began with great uncertainty about what would follow the Great War and the Spanish Flu, which together killed approximately 40 million people. Like the 2020s, the 1920s stumbled out of the gates with sickening stock crash and a “mini depression” that lasted seven months.

Former Forbes publisher and now editor-at-large and futurist, Rich Karlgaard, will speak to Whittier Trust clients on the hope and fears of the 2020s, using the 1920s as a guide.

Whittier Trust Company and The Whittier Trust Company of Nevada, Inc. are state-chartered trust companies, which are wholly owned by Whittier Holdings, Inc., a closely held holding company. All of said companies are referred to herein, individually and collectively, as “Whittier”. The accompanying materials are provided for informational purposes only and are not intended, and should not be construed, as investment, tax or legal advice. Please consult your own investment, legal and/or tax advisors in connection with financial decisions and before engaging in any financial transactions. These materials do not purport to be a complete statement of approaches, which may vary due to individual factors and circumstances. Although the information provided is carefully reviewed, Whittier makes no representations or warranties regarding the information provided and cannot be held responsible for any direct or incidental loss or damage resulting from applying any of the information provided. Past performance is no guarantee of future results and no investment or financial planning strategy can guarantee profit or protection against losses. These materials may not be reproduced or distributed without Whittier’s prior written consent.

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Buying U.S. stocks could be a superior way to gain international exposure

Smart investors balance their portfolios between domestic and international financial investments. However, what might not be obvious when selecting stocks is that often investments in domestic companies come with significant international exposure.

“Most investors I speak with unwittingly have way too much international exposure,” says Sam Kendrick, portfolio manager and vice president at Whittier Trust Company. 

Due to globalization over the last 50 years, U.S. companies have been investing more and more overseas, and the amount of international exposure in the S&P 500 has gone up over time. “Around 40% of domestic large cap company revenues come from outside of the U.S. so you’re actually getting a really nice amount of international exposure when you buy the S&P 500,” he says.

Here, Kendrick explains why you get a superior form of—and enough—international investments when buying U.S. stocks.

It’s Less Risky

When you invest in a domestic company that has invested abroad, there’s more oversight at a micro level. “You get U.S. accounting standards, U.S. auditors reviewing the financial statements and the SEC monitoring the buying and selling of the stock,” says Kendrick. “If I just buy Chinese stock in a Chinese company and they said they made $100 million dollars last year, I’m less sure that’s true. Whereas in the U.S., you can be more confident here than elsewhere that they made that money.”

On a larger level, by investing domestically, your investment is being domiciled in a large, stable, democratic country with stocks that trades in dollars, which is the reserve currency of the world. “There is less risk because in times of crisis, investors across the world seek dollar denominated exposure. Because our economy is large and resilient, investors want to own companies with the majority of their revenue generated here rather than from countries that are less stable,” Kendrick says.

It's More Diversified and Less Cyclical

The U.S. stock market is extremely well diversified in a few different ways. For starters, the S&P 500 gets 60% of its revenues from the U.S., 14% from Europe, 7.4% from China and 3% from Japan, according to Factset

“Then from a sector perspective, there are very robust allocations within the S&P 500 to healthcare, technology, communications and industrials. All of these sectors have large, high-quality companies with differentiated products,” says Kendrick. More commoditized sectors, such as energy, materials, financials and real estate, have a relatively low exposure in the S&P 500 compared to foreign markets.

On top of that diversification, Kendrick notes that the S&P 500 is less cyclical than foreign indexes, meaning it encompasses more companies that are less dependent on the economic cycle to grow. According to JP Morgan, 34% of the S&P 500’s exposure is to cyclical sectors, whereas emerging markets’ exposure is 49%, Europe’s is 53% and Japan’s is 57%.

“All else being equal, it’s better to invest in companies that have less volatility in their revenue and earnings growth,” Kendrick says.

It Has the Cheapest Cost of Capital

Kendrick often speaks with investors who are hesitant to allocate more money to domestic stocks because they are more expensive than foreign stocks. However, the other side of the coin is that the expensive price tag reflects a cheaper cost of capital for U.S. companies. 

“Higher valuations mean that U.S. companies can raise money more cheaply. This means large U.S. companies can raise capital and buy foreign assets rather than selling their assets to foreign firms,” says Kendrick. “When it comes to small companies, entrepreneurs, venture capital firms and private equity firms focus on the U.S. because of the higher valuations businesses receive here versus abroad. In turn, having many of the most successful startups based in the U.S. increases our country’s growth rate.” 

He cites Tesla as an example of cheap capital driving U.S. growth. “Despite not being profitable for 17 years, U.S. markets provided the funds it needed to grow. Now it has reached scale and is raising debt and equity in U.S. markets to expand overseas with large factories in Germany and China,” Kendrick says. “It’s hard to imagine the same growth story taking place in another country.” 

When thinking about your portfolio and buying domestic vs. international stocks, consider the above three reasons to buy U.S. over international. Also, consider this: giving up some outperformance in a bull market is ok if the downside protection is better. “Everyone focuses on how U.S. markets have outperformed since the global financial crisis, but the truth is, even if U.S. and international were expected to perform the same, we would still buy U.S. because it’s less risky,” Kendrick says. 

With the 2021 tax filings behind us and the 2022 tax year drawing to a close, it’s already time for tax updates coming in 2023. The IRS released its 2023 tax year annual inflation adjustments covering updates to more than 60 tax provisions. The 2023 tax year adjustments will effect tax returns filed in 2024. For 2022 tax year filings due in 2023, certain tax due dates fall on a weekend. The actual due date is the following Monday. A list of 2023 federal tax due dates can be found in the attached PDF.

 

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The right kind of insurance can mitigate tax exposure and maximize legacy-building

No matter the length of your balance sheet, preserving the wealth means being smart about how your investments are structured to minimize tax exposure, both in life and as you look to pass wealth on to the next generation.  Some of the best investments for tax efficiency might be a specialized kind of insurance. 

“Private Placement Life Insurance (PPLI) policies have existed for quite some time and have become increasingly popular with wealthy individuals seeking to mitigate tax exposure,” says Whittier Trust Assistant Vice President for Client Advisory Shea O’Gara, J.D. “PPLI policies provide a unique solution for holding tax inefficient investments while maximizing intergenerational transfers of wealth.” Generally, PPLI is most suitable for accredited investors including high net worth individuals, banks, brokers, and trusts. 

PPLI attempts to couple the tax advantages of Variable Universal Life Insurance (VUL) with the growth often associated with alternative investments. This renewed interest in PPLI is largely being driven by wealthy individuals in top tax brackets, with good reason. For instance, in certain circumstances top earners in California and New York can face a combined federal and state income tax rate in excess of 50%. Additionally, assets above the federal estate tax exemption can be subject to a 40% death tax. When structured appropriately, PPLI can mitigate both income and estate tax exposure.

“While a PPLI does offer some estate planning opportunities, the main focus is to capitalize on the tax-free treatment of income and gains produced within the policy,” O’Gara says. Because PPLI incurs no immediate income tax, there is no need to wait for a Schedule K-1 to report the incomes, losses and dividends of a partnership

“PPLI stands in contrast to traditional life insurance policies in many ways, but perhaps most notably it provides an opportunity for the insured to hold non-traditional investment positions,” O’Gara explains. For example, a PPLI policy can consist of private equity, hedge funds, private credit and other alternative investments otherwise not accessible in a traditional life insurance policy. The policy usually contains a high cash balance affixed with a lower death benefit to reduce ownership costs. Although insurance costs vary when owning a PPLI, the long-term tax savings usually greatly exceed the policy cost.

A PPLI operates as an income tax mitigation strategy, but it can also serve as an estate tax strategy if structured properly. Ideally, the policy would be owned outside an individual’s taxable estate through an irrevocable trust. When the PPLI is owned by an irrevocable trust, the death benefit passes estate tax free. If an individual has yet to utilize their lifetime gift exemption, owning a PPLI in an irrevocable trust is a potential option. It can be a smart addition to an overall wealth management strategy, executed by a trusted wealth management advisor. 

Notwithstanding a multitude of advantages associated with a PPLI, there are some drawbacks to consider. Mainly, (1) medical underwriting, (2) lack of control, (3) costs and (4) early surrender consequences. 

  1. The individual insured must be in good health and willing to undergo a comprehensive review of medical records and insurance exam. 
  2. An IRS investor control rule stipulates that the policy holder cannot influence the selection of individual securities held within the policy either directly or indirectly. However, policy owners dictate which funds their policy owns.
  3. Costs vary, but generally PPLI fees include a structuring fee, federal deferred acquisition cost tax, state premium tax, asset-based mortality expense charges, and cost of insurance charges. Initially, PPLI policies are fee intensive and in the short term could exceed the immediate tax benefits. 
  4. Generally, there is no fee associated with surrendering the policy. However, tax may be owed on the appreciation of investments at an ordinary income tax rate.

PPLI is a nuanced solution that can be beneficial to high net worth individuals. PPLI requires a thorough analysis to determine if such a strategy is beneficial due to its complexity.  

Nov 15th

Winter Chill

The 2022 holiday spending forecast and why this year will be different than last

It’s that time of year when Americans are making their lists and checking them twice, but for the 2022 holiday season, many will be slimming down their spending. “I don't think there's any question that holiday spending will be slower this year,” says Whittier Trust Senior Vice President and Senior Portfolio Manager Teague Sanders, a phenomenon that will impact every socio economic segment. Here are some of the reasons why we’re likely to see a chilling effect on holiday spending for the 2022 season. 

Most consumers have already made their sizeable pandemic purchases 

Late 2020 and 2021 were big years for consumers making durable goods purchases such as new washers, dryers and other appliances, as well as automobiles. “These one-time, large expenses have all mostly been bought,” Sanders explains. “Once you’ve made such a purchase, you don’t have to buy it again anytime soon.” There was somewhat frenzied buying activity around these categories due to supply chain disruptions and the early part of the pandemic when many consumers were saving money thanks to stores being shut down. 

“That wealth effect has begun to diminish. We have also seen some slowdown in home prices, amid higher interest rates, higher borrowing costs and depletion of a lot of the excess savings that was sitting in people's bank accounts for the last 18 months,” Sanders says. “There’s simply less of an inclination, across all demographics, right now for people to go out and spend.” 

Luxury travel and goods might be somewhat exempt from the downturn

However, for the top echelon of income earners in the United States, some categories of holiday spending might be less impacted by lower spending. The pandemic era saw the introduction of a trend called “revenge travel”—essentially where consumers were taking their bucket list trips (often more than one) as a reaction to being cooped up at home for months on end. While this spending trend is slowing some, certain segments of the population are still booking high-end, luxury trips to faraway destinations. 

“Two areas that are proving to be more resilient are ultra-high-end luxury goods and airline prices,” Sanders says. “While portfolios of these consumers are down perhaps 18 to 20%, demand continues to remain robust owing to an increased wealth effect and supply demand imbalances respectively.” 

Plan to spend wisely 

No matter how much money you have, it pays to be wise with it. “Even when people have a larger pool of funds to pull from, they tend to still be rational in their purchasing decisions. They're just rational in slightly different ways,” Sanders says. When the vast majority of the country thinks about a large purchase, it might be a home appliance, but when ultra-high-net-worth individuals consider a sizable purchase, the scale is much larger. 

While most Whittier Trust clients have a strong understanding of how wealth works, advisors make it a point to keep an eye on every facet of their clients’ portfolios. “We’re not doing our job if we're not counseling people on the direction of borrowing costs and where expenses are likely to run,” says Sanders. With higher interest rates and increased costs of just about every good and service, everything is pricier in 2022. 

While those things may not immediately impact someone’s lifestyle, the Whittier team realizes that wealth is just one important facet of a person’s overall peace of mind, and it can be emotionally charged. “When we counsel people, we take their thoughts and emotions into account as we make our recommendations,” Sanders says. “That approach is really helpful because our clients see what's going on in the world around them. No matter how wealthy someone is, it’s important to be empathetic and realize that what’s going on in the world at large is impacting them too.” 

Practical implications for this holiday season and beyond

Some people might be thinking about whether the gifts they’ll receive this holiday season will change, but more broadly, decreased spending can have significant implications for markets overall. 

“Consumer spending is 60 to 70% of GDP growth in the United States, so consumer sentiment matters quite a bit,” says Sanders, who notes that recent Google Trends reports—a predictor of what’s on people’s minds—have seen a sharp increase in searches for the word “inflation.” Higher prices on everything from gas to groceries tends to dampen consumer spending. “It really impacts your emotional state because those sharp price hikes are disconcerting,” he explains. 

His advice? Take a deep breath and keep an eye on the long game you’ve agreed with your wealth management advisor. “Adjusting to the new normal is going to take a little bit of time, because there's been an entire generation of spenders who have really known nothing besides zero interest rates,” Sanders says. Markets are fluid by nature, and the right advisors and advocates can help you weather the storm.  

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How to focus your philanthropic activities for maximum impact

If you’re starting your journey toward philanthropic giving, either because you’re launching something new or because you’ve inherited a role in a family foundation, all of the options for charitable contributions can feel overwhelming. From environmental causes to poverty relief—and everything in between—the options are endless. Rather than trying to help every good cause, it makes sense to hone in on specific areas to maximize your impact. 

“When our clients come to us wanting to start their philanthropic journeys, we help them focus on creating a mission statement,” explains Whittier Trust Client Advisor for Philanthropic Services Amanda Buntmann. “It helps bring everyone together around the same issue area. It’s a key step to figure out what everyone cares about and what's most important to them.” Sometimes that’s easier said than done, since many causes might pull on your heartstrings. Here are some ways to get started. 

Identify Your Highest Values

There are an almost endless array of values most of us aspire to, and the things that we care most about may change and evolve over time. Often, Buntmann and her team will share a deck of cards with more than 75 values—such as innovation, integrity, courage, freedom, dignity and much more—to help clients cultivate their plan. 

Take heart: It’s not uncommon that family members disagree on at least some of the specific focus areas but most can find a few core values that define and motivate them. Once these values are identified, choosing focus areas and grantmaking philosophies becomes easier.  

What Motivates You? 

The National Center for Family Philanthropy put together a helpful Philanthropic Purpose Primer, designed to ask questions that spark ideas for developing a charitable giving focus. Buntmann and her team often talk through some of these questions to help understand what philanthropic causes make clients tick. Some questions are: 

  • What motivates me to be generous? Why do I care? 
  • Who were my role models for generosity when I was young? What did I learn from them? 
  • What life experiences have inspired my philanthropy? 
  • What am I grateful for now? 
  • What is my definition of wealth with responsibility? What is the purpose of our wealth? 
  • Beyond money, are there other resources I have given or could give? 
  • How would I like to be remembered? 

Partner Up 

Trying to identify an area of focus for your charitable contributions alone can feel overwhelming. That’s why hands-on help from a team of experts can be invaluable. When a new client comes to Whittier Trust, the team spends time getting to know them and asking questions about their lives and interests. 

For example, one client, Vanessa, expressed interest in animal welfare. But when Buntmann went to lunch with her and her Whittier client advisor, she asked Vanessa about her favorite pastimes, and her eyes lit up as she talked about her love of reading and her sprawling home library filled with books. Her passion for reading and literacy prompted Buntmann to set up a site visit with a local nonprofit dedicated to building libraries in lower-income communities. “The library wasn't open yet, but local kids were coming to see it. The joy on their faces prompted Vanessa to pursue the goal of funding a library herself,” Buntmann says, which allowed her client to make a meaningful contribution to a community in her home city. While she’s supporting other causes as well, this is the one that pulls on her heartstrings. “Working in private philanthropy services, you have to keep digging and get to know people to understand what they're passionate about,” Buntmann adds. 

Once you’ve identified your values and the causes that motivate your philanthropic endeavors, it’s important to establish procedures and guidelines to streamline the process. The philanthropy services team at Whittier Trust can provide the strategy and support to help you get there. That may involve engaging other departments at Whittier Trust to implement tax efficient investing or other wealth management services to maximize your legacy and reach. Regardless of your goals, you’ll always have a team around you that is wholly committed to helping you achieve them. 

Establishing a family office is a holistic family wealth management solution

Traditional models of wealth management focus solely on the portfolio. This model is flawed, however, as it doesn’t take into account the entire family picture. Seventy percent of family wealth doesn’t transition to the next generation due to a lack of both preparing the wealth for the family and preparing the family for the wealth. 

“Families often don’t have an orderly way to pass on their wealth, but the odds of failure are too large to ignore,” says Lauren Peterson, Senior Vice President, Client Advisor at Whittier Trust in Family Office services. “It is important to ready heirs for the transition to be good stewards of the wealth that is to come.”

Here, Peterson explains the integrated approach that creates sustainable best practices for successful families.

Establish a Family Office or Engage a Multi-Family Office

Establishing a family office is a holistic approach to wealth management and legacy that guides, supports and educates heirs for a more successful wealth-transfer rate. “A professional family office will engage with a family to support investments, values and the next generation,” says Peterson. 

While the older generation can certainly create a single-family office themselves, there is a lot of heavy lifting to do, which might not be appealing at this point in their lives. “Our clients often turn to Whittier Trust for our expertise. We are a multi family office with expert professionals working with similar families who have complex needs who need guidance to meet their goals,” says Peterson, who notes that unlike other firms that might have 100 families per advisor, Whittier has a Client Advisor and support team with unlimited availability for families or less. A team might consist of a Senior Advisor, Junior Advisor, Analyst, Senior Portfolio Advisor and other team members in real estate, philanthropy and more as needed.

Another unique aspect of Whittier’s family office services is that while a Senior Advisor may work with the parents, a Junior Advisor is assigned to younger family members so that everyone can feel comfortable working with someone closer to their age to get support, training and guidance. 

Create a Holistic Governance Structure

Once team members have been selected based on the family’s needs, the family office team then does a deep dive to look at all aspects, from financial documents to family dynamics. “We revise any governance structures, work with their CPA and legal team, look at all their documents and discuss it with the family so that they know what their documents say and mean,” Peterson says. 

Many of the clients Whittier works with have been CEOs or business owners and are used to creating a strategic plan. The goal of the family office is to help clients put together a structure and family strategic plan that lasts multiple generations. “We help them look at their family as a family business including all aspects, such as the legal structures, financial statements, operating companies, and if necessary, different entities. We often review the different agreements for profits split amongst family members,” says Peterson. “We do this to ensure quality communication and transparency among all stakeholders, as this build family continuity.” 

She adds that this process typically involves creating a family constitution that includes the family’s values, who makes the decisions and goals for how the family will interact together now and well into the future. Peterson and her team work to give every family member a voice and family unity, which may include coordinating a family retreat and/or training about the purpose of a family office.

Promote Family Harmony

One of the most important ways to promote family harmony is communication and for everyone to know their roles and responsibilities. “We like to involve the entire family—both bloodline and spouses. The family will tell us how much they want their kids or family members to know, but we make a concerted effort to make unifying decisions,” says Peterson. She notes that this often includes the parents accepting the input of their heirs without giving up their mission and values, as well as spouses being able to weigh in on what they want for their children.

Another popular way families choose to promote harmony is by focusing on philanthropy. “Establishing philanthropic giving goals through a family charitable trust, foundation or donor advised fund can be a way of facilitating good family dynamics and to work together to create a long-term family mission,” Peterson says.

Prioritize Education for Long-term Sustainability

Many heirs have had no direct experience with family finances or in making decisions about their family’s wealth. Therefore, the Whittier team does a lot of work to help prepare children to become good stewards of their family’s wealth. This can go as far as providing a deep dive talent assessment and looking at hard and soft skills to determine the roles that will be a good fit for each individual, in addition to educating them about those roles.

“Education and communication are the two solutions to prepare the next generation,” Peterson says. By establishing a family office and following these best practices, a family can transition wealth successfully and prepare heirs for wealth and maintaining the family legacy. 

“When families come to us, they stay for generations. We’re a long-term relationship company,” Peterson says.

Cancer prevention tips from experts at the USC Norris Comprehensive Cancer Center

Whittier Trust partnered with USC Norris Comprehensive Cancer Center to provide exclusive access to a panel of four cancer experts, thanks to our longstanding relationship with Keck Medicine of USC. During this ask-the-experts webinar, the panel shared the latest research on urological, gynecological and skin cancers, including risk factors, prevention and treatment insights.

Whittier Trust Company and The Whittier Trust Company of Nevada, Inc. are state-chartered trust companies, which are wholly owned by Whittier Holdings, Inc., a closely held holding company. All of said companies are referred to herein, individually and collectively, as “Whittier”. The accompanying materials are provided for informational purposes only and are not intended, and should not be construed, as investment, tax or legal advice. Please consult your own investment, legal and/or tax advisors in connection with financial decisions and before engaging in any financial transactions. These materials do not purport to be a complete statement of approaches, which may vary due to individual factors and circumstances. Although the information provided is carefully reviewed, Whittier makes no representations or warranties regarding the information provided and cannot be held responsible for any direct or incidental loss or damage resulting from applying any of the information provided. Past performance is no guarantee of future results and no investment or financial planning strategy can guarantee profit or protection against losses. These materials may not be reproduced or distributed without Whittier’s prior written consent.

From Investments to Family Office to Trustee Services and more, we are your single-source solution.

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Foreign Contagion Risks and the Policy Path 

The U.S. economy continues to show remarkable resilience in the face of stubbornly high inflation and tighter financial conditions. Core inflation, which is more influenced by the sticky components of rents and wages, remains elevated even as headline inflation recedes at a glacial pace. The Fed has already raised short rates from zero to 3% and remains steadfast in its commitment to more rate hikes.

The fallout from persistent inflation and a hawkish Fed has led to several adverse outcomes. The U.S. dollar and long-term bond yields continue to soar higher. And stock prices continue their downward trajectory as they discount rising risks of a global recession.

Despite the Fed’s efforts to cool the economy down, the jobs market remains surprisingly strong. The unemployment rate is still at its all-time low of 3.5% and weekly unemployment claims are close to historical lows. There are still 10 million job openings, which far exceed the available pool of 6 million unemployed workers.

Healthy job creation and steady wage gains have supported consumer incomes and spending. As a result, real GDP growth for the third quarter is projected to rebound from negative levels in the first two quarters to above +2%.

On the policy front, the Fed has repeatedly communicated that restoring price stability now is crucial for achieving sustainable growth and full employment in the long run. In this context, the Fed has made it abundantly clear that it is willing to accept “short-term pain for long-term gain”.

The current economic backdrop in the U.S. will likely encourage the Fed to continue tightening aggressively. After all, why worry about the possibility of breaking something in a big way or unleashing systemic risk from a financial crisis when we haven’t even slowed the economy materially?

With investor focus squarely on U.S. inflation and Fed policy, it may be worthwhile at this juncture to take a closer look at the broad global economic landscape. The U.S. has enjoyed strong growth fundamentals through both the Covid crisis and this latest inflation shock. The rest of the world has not been so fortunate. The inflation problem is significantly worse and growth is materially weaker outside the U.S.

In a still tightly integrated global economy, we examine the impact of U.S. policy actions on global growth. To what extent has the rapid pace of Fed tightening contributed to global economic stress?

At a more relevant level, we also assess the risks of contagion back to the U.S. from ailing foreign economies. We focus on two themes:

  • Can the U.S. remain an oasis in an increasingly barren global growth landscape and avoid cross-border contagion?
  • Can U.S. policy responses better mitigate global systemic risk and minimize contagion risks?

We look at recent developments in key foreign economies. We identify the strong dollar as a potential driver of future U.S. and global weakness. Finally, we offer some thoughts on the Fed’s optimal policy path forward within a broader global context.

Foreign Economic Risks

We begin our brief tour of foreign economies with a quick look at recent volatility in the U.K. bond market and its global fallout.

On September 23, the new administration in the U.K. announced a new fiscal plan to spur growth from supply-side reform and tax cuts. However, this focus on fiscal stimulus was at odds with restrictive monetary policy from the Bank of England and risked a further escalation of already-high inflation.

The lack of any funding details also raised concerns about an unsustainably higher debt burden and sent U.K. bond yields soaring. This upward spiral in bond yields was further exacerbated by forced liquidation of U.K. long-term bonds, also known as gilts, by local pension funds.

The unexpected rise in U.K. bond yields spread through the global bond and currency markets. This contagion is seen clearly in Figure 1.

Source: FactSet as of October 12, 2022

Immediately after the initial announcement, the 30-year U.K. gilt bond yield (shown in green) rose by more than 100 basis points to almost 5%. The spike in U.K bond yields reverberated across the globe. The 10-year U.S. bond yield (dark blue) moved higher by 50 basis points to almost 4% and the U.S. dollar strengthened against the British pound (light blue) by more than 5%. Higher bond yields and the strong dollar, in turn, sent U.S. stocks significantly lower at the end of September.

The rise in U.K. bond interest rates also highlighted another vulnerability for the global economy. As much as higher interest rates crowd out consumer spending in any economy, the problem is particularly severe in foreign economies.

The U.S. consumer is unique, and fortunate, in being able to access fixed rate long-term mortgages ranging in term from 15 to 30 years. For example, think about a U.S. household that refinanced its long-term mortgage during the period of low interest rates prior to 2022. With a low interest rate locked in for many years, that household is now immune to higher housing costs from rising mortgage rates.

Our readers may find it interesting to note that few mortgages overseas are at a fixed rate over long terms. Figure 2 provides a glimpse of how mortgages vary across countries by the term over which the interest rate is fixed.

Source: European Mortgage Federation

More than 90% of mortgages in the U.S. have a fixed rate over a long term in excess of 10 years. In Germany and Spain, that proportion drops to just around 50%. The impact of rising rates on housing costs is even worse in the U.K., where long-term fixed rate mortgages simply don’t exist.

More than 90% of mortgages in the U.K. offer a fixed rate for only 1-5 years. In a country already hit hard by high inflation, the greater proportion of mortgages resetting to a higher rate and higher payments significantly add to the odds of a U.K. recession.

The situation is also grim in Europe, but for a different set of reasons. Europe’s historical dependence on Russian energy is well known. Prior to the war with Ukraine, roughly 40% of Europe’s natural gas imports came from Russia. Since the invasion, Europe has looked for new sources of supply and Russia has retaliated by shutting off some of its existing supply of gas.

The resulting energy shortfall in Europe has led to sky-high energy prices, high inflation and significantly weaker growth. We show the outsized impact of energy costs on Eurozone inflation in Figure 3.

Source: European Central Bank

The nearly ten-fold increase in natural gas prices in Europe has led to a mega-spike in energy inflation and double-digit headline inflation in Europe. While energy inflation in the U.S. has started to decline, it shows no signs of abating in Europe. And things are likely to get worse during the dark winter months as Europe contemplates reduced energy consumption. Any cutbacks in production within energy-intensive sectors will likely lead to more layoffs and lower economic growth.

European policymakers are particularly hamstrung in balancing inflation and growth considerations at this point. The inflation problem in Europe emanates from a true supply shock, which cannot be remedied simply by raising interest rates. Any fiscal stimulus to counter lower industrial production and employment runs the risk of driving already-high inflation even higher.

Our baseline outcomes for Europe are listed below.

  • The European Central Bank is unlikely to hike rates as aggressively as the Fed.
  • A weak Euro will likely contribute to higher energy prices and more persistent headline inflation.
  • Europe may be forced to consider fiscal stimulus at some point to soften the recessionary hit.

Finally, we touch briefly on growth challenges in China. For a long time, China’s high growth trajectory was achieved by investment and trade. It has recently tried to shift growth more towards domestic consumption, but with limited success. China’s two key drivers of growth are now under significant pressure.

China’s investment share of GDP is almost twice the global average and has come at the expense of an unsustainable surge in debt. As an example, the heavily indebted real estate sector is now slowing dramatically. A zero-Covid policy has reduced mobility of people, goods and services, increased supply chain problems and decreased global trade. China’s trade and competitiveness have been further compromised by the new U.S. export controls on semiconductor chips and machinery.

We note in summary that foreign economies are far more fragile than the U.S. and remain quite vulnerable to policy missteps and exogenous shocks.

Pitfalls of a Strong Dollar

The U.S. economy is stronger than any foreign economy for a number of reasons. The recent monetary and fiscal stimulus in the U.S. was the largest in the world. As a result, the U.S. consumer is still resilient and its jobs market is still strong. U.S. inflation is, therefore, as much a demand issue as it is a supply-side shock.

As we have discussed above, this is not the case in the rest of the world. Foreign central banks are unable to raise rates aggressively because of weaker demand. Foreign inflation is also far less of a demand issue than it is a true supply-side shock.

This divergence between growth and policy dynamics in the U.S. and the rest of the world argues for continued dollar strength. We highlight two key risks from a persistently strong U.S. dollar.

First, a strong dollar reduces earnings for U.S. multinational companies from a simple currency translation effect. Revenues booked in foreign countries get translated back to lower dollar levels at a higher exchange rate. Figure 4 shows this intuitive strong-dollar / weak-earnings relationship.

Source: Bloomberg

The blue line in Figure 4 shows the year-over-year change in the U.S. dollar on an inverted scale on the right axis. A downward sloping line, therefore, denotes dollar strength. The green line shows the year-over-year growth in S&P 500 earnings estimates for the next twelve months (NTM) on the left axis.

We can clearly see here that S&P 500 earnings go down as the dollar goes up. A sustained rally in the U.S. dollar going forward could further reduce corporate profits and potentially trigger a dangerous self-reinforcing spiral of more layoffs, lower consumer spending, weaker economic growth, lower company revenues, back to lower profits … and so on.

And second, a strong dollar poses risks to foreign economies as well. A strong U.S. dollar raises the cost of their imports and drives up their inflation. Supply-side energy inflation is already high overseas; a strong dollar only makes this bad situation worse. Currency fluctuations affect trade balances and foreign exchange reserves. And emerging market economies find it increasingly difficult to service their dollar-denominated debt.

The strength of the U.S. dollar remains an important conduit for global contagion of economic weakness.

Possibilities for the Policy Path

The Fed has repeatedly reiterated its relentless pursuit of monetary tightening to quell inflation. It has so far been unmoved by the prospects of a U.S. or global recession.

We have recently suggested that the Fed may be well served from a shift in positioning where it becomes less rigid and more data-dependent. Our view is based on the observation that real-time U.S. inflation is likely coming down even as lagged measures of inflation such as shelter CPI continue to rise. We believe that the downward trajectory in upstream and coincident inflation will eventually bring overall inflation below policy rates.

Our focus on the fragility of foreign economies bolsters the argument for a more flexible approach to Fed policy. There is now an increasing chance that a central bank or government misstep is an accident waiting to happen. The calamitous fallout from the U.K. mini-budget crisis is just one small example.

We also believe that it is premature for the Fed to pause right now and a grave mistake for it to pivot towards rate cuts. We support the notion of continued rate hikes in 2022 to keep inflation expectations in check.

However, the Fed will likely have done enough and the U.S. and global economies will likely have weakened enough for the Fed to signal a pause in early 2023. A prescriptive upward march in U.S. policy rates in 2023 may very well lead to an unexpected and dire financial crisis somewhere in the world.

Summary

We are still in the midst of unprecedented economic and market uncertainty. U.S. core inflation remains sticky even as more timely measures of inflation appear to be declining in real time. Foreign inflation is less influenced by demand and largely remains a supply-side shock.

Against this backdrop, foreign economies are fragile and especially vulnerable to policy missteps. We believe that a pause in rate hikes by the Fed in 2023 will mitigate the risks of unexpected financial crises.

We continue to emphasize our strong regional preference for the U.S. over foreign markets. We also continue to target sufficient liquidity reserves to help our clients weather this storm. More so than ever, we remain vigilant and prudent in diversifying risk within client portfolios.

 

Foreign economies are fragile and remain vulnerable to policy missteps and exogenous shocks.

 

The strength of the U.S. dollar remains an important conduit for global contagion of economic weakness.

 

A pause in rate hikes by the Fed in 2023 will mitigate the risks of unexpected financial crises.

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Dean Byrne New Headshot 9_1 (1)

Whittier Trust Company promotes Dean Byrne to Regional Manager of Whittier Trust Company of Nevada, Senior Vice President, Senior Portfolio Manager. 

In addition to his new duties as head of the Whittier Trust Reno office, Dean manages equity, fixed income, and alternative assets for high-net-worth individuals and foundations. Dean advises clients on issues such as efficient wealth transfer strategies, the Nevada Tax Advantage, holistic asset allocation, risk assessment, and the importance of after-tax performance. Dean sits on the board of The Whittier Trust Company of Nevada and is a member of the Investment Committee at Whittier Trust.

“Dean is a fabulous portfolio manager, and an extraordinary leader. As we were carefully weighing our options for this role, Dean rose to the top immediately. Dean also has an outstanding team of talented and dedicated professionals. As the largest private multi-family office headquartered in Nevada, leadership is critical to our mission of serving clients. Nevada is in great hands, and we look forward to our continued growth in Reno, Lake Tahoe and throughout the state,” stated David Dahl, CEO of Whittier Trust.

Dean holds the designation of Chartered Financial Analyst (CFA®) and is a member of the CFA Society of Nevada. He received his Bachelor’s degree in Finance from the University of Nevada, Reno (UNR), and currently serves on the Board of the University of Nevada Foundation as a member of their Investment Committee. He is a member of the university’s Silver and Blue Society and sits on the Advisory Board for the University of Nevada’s College of Business. Dean also serves on the Board of Directors of Classical Tahoe.

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