Sovereign debt problems still the focus

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Sovereign debt problems still the focus

Can you trust your Trust?

The All Blacks and investments...both more predictable over the "long term"

By Bevan Graham, Chief Economist, AXA Global Investors

The new Italian Prime Minister Mario Monti has some serious challenges to meet. The fiscal challenges are well known. The bigger challenge will be to turn around long-term economic under-performance in one of the world’s largest economies.

Unlike Greece, which has a solvency problem, Italy’s fiscal crisis is one of liquidity. That being said, if a liquidity crisis is not dealt with effectively, it can become a solvency crisis.

Italy’s budget deficit this year is estimated to be around 4% of GDP. After accounting for interest payments, that’s a primary surplus of around 0.5% of GDP. Some commentators have argued recently that the primary surplus means Italy’s deficit is not as bad as it looks. Sorry, but a deficit is a deficit.
Italy has public debt of around 120% of GDP. The duration of that debt is quite long (7 years) by comparison with other countries, but there is approximately €350 billion in bonds that will have to be refinanced in 2012.

At issue is the level of interest rates Italy has to pay to finance that debt. Ten-year bonds at 6.5% (and higher again in previous weeks) make Italy’s debt dynamics unsustainable. Achievement of a balanced budget (or primary budget surplus), or at least a credible plan to get there, is essential to bring interest rates down. Measures passed last week before the resignation of Prime Minister Berlusconi look likely to achieve that goal, but not before 2014.

The bigger problem, which in our view must be sorted with the same level of urgency, is Italy’s poor economic growth performance. As we’ve commented before, the long-term answer to reducing Europe’s debt burden is stronger economic growth. That’s why we have always argued there needs to be an appropriate balance between achieving fiscal sustainability and supporting economic growth.

Italy’s economic track record is woeful. Trend GDP growth is probably no better than 1% per annum. The challenge is best exemplified by its recent performance on productivity. According to OECD data, Italy is the productivity laggard of Europe with a performance well behind that of Germany, the United States, and Europe as a whole. In fact productivity in Italy has gone no-where in a decade.

Therein lies Mario Monti’s biggest challenge - instituting structural reform that grapples with an inflexible labour market and a stifling bureaucracy. These are just as critical to Italy’s long-term health as dealing with the more immediate challenge of achieving fiscal sustainability. The other challenge is that by their very nature, structural changes take time to have an impact, and the near-term impact can be negative for both employment and economic growth.

While attention is firmly focussed on the ongoing debt crisis machinations in Europe, there is another critical fiscal deadline looming, this time in America.

On November 23rd the US fiscal “super committee” is scheduled to forward its recommendations to the US House of Representatives and Senate on how to cut $1.2 trillion from the US budget deficit over the next 10 years.

There doesn’t appear to be much progress being made. With six of the twelve committee members Democrat and the other six Republican the debate has, not surprisingly, been somewhat partisan. The Republicans are reluctant to raise taxes and the Democrats are protective of domestic social programs. To be fair, the Democrats have moved further on spending than the Republicans have on taxes.

Failure of the committee to reach agreement would be negative for market sentiment. $1.2 trillion is a mere drop in the bucket in terms of what needs to be achieved over the next few years in budget consolidation, but failure now would not bode well for the bigger job ahead.

New Zealanders have a love affair with Family Trusts.

It’s been estimated by Law Commissioner George Tanner that in New Zealand there is one Trust for every 18 people (or one for every seven households). Australia has a milder infatuation, with one Trust for every 34 people; while in the UK there is almost no attraction at all, with the ratio being just one in 294.

Following the explosive rate of growth in the number of Trusts in New Zealand in recent years, authorities here have become increasingly concerned that a large proportion of these Trusts are not being properly administered.

Some of the common issues are:

• the lack of a Trust minute book,
• no Trust records of any kind,
• no annual Trust meetings being held,
• a lapsed gifting program,
• and the lack of an independent Trustee.

In many cases, Trustees continue to treat the assets held by the Trust as if they were still owned personally. If any of these issues sound familiar to you then read on, there are important changes coming that might affect you…

The Law Commission is currently undertaking a review of the Trust industry and the Commission will report back to Government with recommendations in due course. While it is too early to predict the precise recommendations of this review, it is widely anticipated to result in a significant tightening in the transparency and accountability requirements of Trusts. In other words, if your Trust were audited and it exhibited some of the common ‘issues’ above, then the Trust could be overturned (by the IRD or the court system) and the assets placed back into your individual name(s).

This would be a disaster on several fronts – 1) the time and expense of putting the previous ineffective arrangements in place would have been wasted; 2) your long term estate, or tax, or asset protection plans would be right back to square one; and, 3) the individuals who take back ownership of these assets might find that it triggers an unwelcome taxable event for them personally.

If you need any more evidence that changes are on the way, then look at what has already arrived. As of October 1st 2011, gift duty in New Zealand was abolished. The previous duty-free gifting threshold of $27,000 per person per annum has been removed and the door has been opened for kiwis to potentially gift large one-off sums and assets into Trusts if they choose.

However, settlers should think very carefully before gifting everything into their Trust straight away. Government entities like the IRD, WINZ and the Official Assignee have indicated they will tighten their policies and use current legislation to prevent individuals who attempt to divest themselves of assets (to defeat creditors, relationship partners or Government agencies providing social assistance, i.e. rest home subsidy calculations), from successfully doing so.

Gifts above $27,000 may be deemed to be ‘extraordinary’ and thus may be subject to claw-back at any time. Legislation such as the Insolvency Act, the Property Law Act and Social Security regulations along with greater co-operation between agencies, will increasingly be used to police this area in future.

While our love affair with Family Trusts has so far been exhilarating, for the honeymoon to continue we must ensure the administration of our Trusts is disciplined and with excellent record keeping. Don’t be caught unprepared.

Given the Law Commission’s current review, perhaps now would be a good time to re-evaluate whether your own Trust is likely to meet the tighter administrative thresholds we can expect in the future. If you are not sure how to arrange an effective review of your Trust, a good place to start would be to contact a professional Trust management company such as NZ Trustee Services Ltd, who specialise in providing independent and expert guidance in this increasingly complex area.

By Spicers Portfolio Management Limited

In October, the All Blacks recreated their deeds of 20th June 1987 by beating France to secure the William Webb Ellis trophy for the second time. When the final whistle blew, the nation exhaled in a collective sigh of relief after a frustrating 24 year wait.

Whether in sport or in finance, 24 years is a very long time and over long enough time periods, performance expectations become more predictable.

The All Blacks are almost always favourites to win the World Cup, but we know that at any given tournament there are perhaps five or six teams who have a genuine winning chance. While this makes predicting the winner of an individual tournament more difficult, keen All Blacks supporters would probably like to imagine that in 24 years (encompassing seven World Cups) we “should”, on average, win the event on at least two or maybe three occasions.

Similarly, in finance, over very long time periods we can typically have a much higher level of confidence about expected returns.

Of the traditional asset classes, international shares are generally regarded as being the best performer over the long term. However, we also know that in any given year, just like the All Blacks, international shares may not perform up to these long term expectations.

In the last 24 years, international shares (represented here by the S&P 500 index1 in the USA) delivered a compound total return, including dividends, of about +775% in local currency terms. This represents a compound return of about +9.5%pa. Even though this period includes five individual years that were negative, the overall 24 year performance is definitely in line with long term expectations.

Unfortunately there is no universal definition of what “long term” actually means. Ten years would be considered by many to be long term, but in the recent decade from 2001 to 2010, the S&P 500 delivered a total return of just +15%, or a compound return of about +1.4%pa. This is well below the average long term return we expect from international share markets. A comparison of these results suggests the 24 year period provides a much more informative guide to long term share market returns than the shorter ten year period.

Some other asset classes with interesting returns over the last 24 years are Quotable Value’s domestic house price index2 (up +366% for a compound return of about +5.5%pa) and short term deposits, represented by the 30 day bank bill index3 (returning an average +5.7%pa gross, or around +4.0%pa after tax, depending on your individual tax rate).

While this may seem a surprisingly high average return for short term deposits, younger readers may be unaware that interest rates in New Zealand in the 1980’s reached extremely high levels and 30 day bank bills were still above 20% in the late 1980’s. It wasn’t until 1991 that these rates moved back below 10% again and, eventually, all the way down to 2.7% gross, where it sits today.

Having a good understanding of the expected long-term performance of the various investment asset classes is extremely useful – not only when formulating an investment strategy, but also in dealing with the inevitable periods when investment returns may disappoint.

It is impossible to consistently predict what most individual assets will return next week, next month or even next year. However, over longer and longer time periods we can have far greater confidence about the level of average return we can reasonably expect. Therefore, from an adviser’s perspective, correctly aligning an investor’s time horizon and risk profile with their actual investment/market risk, is a vitally important component of successful financial planning.

¹ source: www.standardandpoors.com;  ^{2 & 3} source: www.rbnz.govt.nz

Your feedback is welcome

Financial Update is a regular publication published by Spicers Portfolio Management Limited. It discusses topical investment and financial planning issues. A disclosure statement is available on request, and free of charge from you adviser.

The Spicers approach is to meet with a potential investor and ascertain what their individual needs are before making any recommendations. We believe that quality advice incorporating a robust planning process should be the foundation of any investment service provided.

The planning process starts with discussing what is important to clients. This may include achieving financial independence, repaying the mortgage, educating children, supporting ageing parents – all while enjoying a good lifestyle. We then review the overall financial position now and how it might unfold in the years ahead.

Once we know what is important and how the financial position looks, we can then work with our clients to tailor a financial plan to help make it happen. Importantly, once we understand what is important to our client, we can then provide a specific recommendation on the type of investment portfolio to support the plan.

Please provide feedback directly to your adviser or email spicers@spicers.co.nz

Disclaimer

The information in this publication is of a general nature only and is no substitute for personalised advice. If you would like advice that takes into account your particular financial situation or goals, please contact your financial adviser.

The information has been published in good faith and has been obtained from sources believed to be reliable and accurate at the time of publication (21 November 2011). The opinions contained in this document reflect a judgment at the date of publication by Spicers Portfolio Management and are subject to change without notice.  Past performance is not indicative of future performance and is not guaranteed by any party.