Third Quarter Rebound

The third quarter of 2006 produced very good results for our clients as investment markets, generally, recovered from the mild correction of the second quarter.   After a dip in mid-July, results were positive in August and again in September, especially in publicly traded real estate and emerging markets and in overseas and domestic large cap stocks.

We attribute this good performance to several big investment developments over these past three months.

Probably most significant was the decision by the Federal Reserve to pause in its long sequence of short-term interest rate increases.  This was followed by a second meeting  with, again, no increase in rates, signaling that the monetary watchdogs are reasonably confident that they’ve, for now at least, achieved the right balance between minimizing inflation risks while continuing to foster sustainable economic growth.  Meanwhile, mid-to longer-term interest rates have declined, producing again this year an inverted yield curve.  In earlier times, this might have spelled trouble ahead for the domestic economy; now, with continued great demand for US debt obligations from overseas investors, the news is probably good: continued credibility of the US economy combined with an expectation of a lowering of short term rates ahead.  This would bode well for the equity side of the investment equation, where almost all of our clients devote most of their exposure.

Further, despite the handwringing tone of some commentators, a relatively “soft landing” in housing values seems to be underway.  Rather than a sharp housing downturn with its negative effect on consumer spending, sales volumes and prices are experiencing, so far at least, only modest relaxation from what were extraordinarily robust levels.  Interest rates are helping here too, with long term mortgage rates, contrary to many fears, coming down from recent, modest increases.  Much broader than just the domestic real estate picture, however, is the domain we will pursue for our clients’ portfolios’ real estate exposures.  Despite lingering risks of a bursting of a “bubble” in specific domestic residential real estate markets, we are very confident that a globally diversified portfolio, reflecting a variety of real estate categories, will handsomely reward our clients over the coming years.

The other major influence favoring good investment performance this quarter was the dramatic easing of energy prices.  Oil grabbed a lot of media attention as it approached $80 a barrel, but not nearly so much as it has declined by over 20% in just weeks to less than $60 in response to the happy combination of new oil discoveries, no disastrous hurricanes, a cease-fire in Lebanon, a toning-down of the reciprocal saber-rattling over Iran’s nuclear ambitions, the end of the summer driving season, and some reduction in worldwide energy demand.

We don’t suggest that prices can’t spin upward again (and many would actually prefer a more sustained elevation of prices to provide impetus for greater energy conservation and development of greener energy sources); they can and no doubt, someday, will.  Rather, our point is that prices reflect the expectations of supply and demand.  History shows that supply is amazingly responsive to demand.

Reflecting this energy price softening, one of the few weak elements of clients’ portfolios this quarter occurred in the small commodities exposures many clients have.  We’ve taken appropriate opportunities to capture the tax losses that have occurred as a result.  While we would have preferred positive results in these holdings (and that could have occurred even with price declines in the underlying commodities, see our 1st Quarter 2006 Wealth Management Commentary for more on commodities), they gave us what we had bargained for most fundamentally – a portfolio component that behaved differently from the predominant equity exposures of our clients’ portfolios.  As we have discussed here before, finding an optimal exposure to this asset class that is tax efficient has been a challenge.  We believe we’ve found an excellent solution.  See the box on “iPath.”

Options “Backdating”
One of this past quarter’s cause celébres and of considerable concern to many of our corporate executive clients is the most recent chapter in real or suspected wrong-doing in stock options.  Because of the general climate of suspicion, virtually every public company is conducting its own investigation of option timing practices, if not already under scrutiny from the SEC, federal and state prosecutors, or shareholder activists.  We plan a more thorough and, we hope, balanced comment on this matter in a future issue. 

For now, we present as our major article in this Commentary remarks by Karen Blodgett and Jason Thomas on the subject of socially responsible investing.  By many definitions, that often involves concerns about wise corporate governance and appropriate executive compensation.

Amazing China
China’s cumulative trade surplus is approaching one trillion dollars.  Whether due to Treasury Secretary Paulson’s effective schmoozing of high Chinese officials or because of its own need to deal with its red-hot economy, China seems poised to continue to permit the yuan to appreciate, probably at a slow pace but just enough to forestall attempts in Congress to impose tariffs on Chinese imports.  As a consequence of my serving as Chair of the Financial Planning Standards Board, I’ve been able to witness, first hand, some of the very rapid development in countries such as Malaysia, India, and China.  And most recently, as Chair of the International Advisory Panel for the Financial Planning Standards Council of China, I’ve been privileged to meet several senior government officials, financial services executives, educators, and fledgling professional counterparts in China.  Wealth management, while still in its infancy in China, is robust and rapidly developing.  We hope to find ways to bring this exceptional access to developments in China and other key, rapidly growing economies to the benefit of our clients.

A counterpoint to the thrill of overseas travel is the major inconvenience of heightened airport security, especially if one’s routing involves Heathrow airport in London.  Avoiding the time and discomfort could make the cost of almost any alternative worthwhile.  Sarah Bailey presents some of our research on options that could appeal to our clients who travel by air very frequently.

Advance Planning for the Predictable…and Unpredictable
2006, thus far, has been spared the major disasters of recent years.  No tsunamis, earthquakes, or hurricanes.  Maybe now is an especially good time to think ahead.  Linda Fitz describes our plans to provide uninterrupted client service and presents some very important information for your personal emergency preparedness in an article below.  Young Kim outlines a long list of year-end planning opportunities that we are eager to help you with and we summarize several key feature of recent tax legislation to help you take maximum advantage of some new or expanded opportunities. 

Expectations for the 4th Quarter
Since we’ve already achieved or exceeded our initial expectations for client portfolio performance for the full year of 2006, we hesitate to expect much more from these last three months.  Nevertheless, we do see the likelihood of some further good news before year-end.  Interest rates should stay low and inflation seems unlikely to spike.  Always a wild card, however, geopolitical turbulence could erupt and regime changes in Japan, the UK, and possibly in the US Congress (the world’s three largest equities markets) could spawn market fears.  Closer to home, there are no guarantees that the Fed has “got it right” and either or both inflation and slow economic growth could be in store.  On balance, however, we don’t think so.  So, we believe that clients should not depart from existing, well-considered investment strategies and that prospective clients need not fear adopting and promptly implementing reasonably aggressively investment plans

Tim Kochis,
Editor