Investors face geographic investment shift

Since the 1980s, investors have known a world dominated by the developed economies of North America and Europe, falling interest rates and declining taxes.

The next generation of investors will know a world economy driven by developing and emerging economies of Asia, Latin America, Africa and Eastern Europe, said Ronald M. Florance, managing director of investment strategy for Wells Fargo Bank. Taxes and interest rates will both rise.

That means investors have to diversify their portfolios geographically, they must pay renewed attention to the tax consequences of their investments, and they will have to be more particular when it comes to debt investing, Florance said in a recent Journal interview before addressing the CFA Society of New Mexico Annual Economic Forecast Dinner in Albuquerque.

“Really, since World War II we’ve all been very accustomed to North America and Western Europe leading the world’s economy,” Florance said. “Well, those economies have to de-lever (reduce public debt). There is a rise of a global consumer outside of those regions. That’s a big change for investors.”

Middle-class boom

Florance, who is based in Scottsdale, Ariz., said there are 2 billion middle-class consumers in the world today. He expects there will be 5 billion by 2030. “That is an economic force that we think you should be exposed to,” he said. “That’s going to change capital investment, consumption, distribution of goods around the world. We went through that in the developed world after World War II. Now we’re going to do it in other parts of the world for the next generation.”

“We’ve had a generation of investors who have only invested in a declining interest-rate environment,” Florance said. “There have been spikes, but basically the trend has been down.” That sort of environment “can mask a lot of mistakes in a bond portfolio.”

The trend must reverse, Florance said. “Today the credit markets are not even compensating investors for inflation risk,” he said. “That’s not sustainable. Over a period of time people will not invest in bonds that are not paying them to take inflation risk, so those rates have to rise.” In a rising interest-rate environment, bond portfolio mistakes will surface.

Before 2008, investors looking for better returns would buy bonds with longer maturities. Those long bonds generally paid better interest rates to compensate investors for the risks associated with holding a security for a longer period of time. Starting in 2008, central banks have slashed interest rates until there is very little difference between a one-year bond and a 30-year bond — hence, the lack of compensation for risking inflation.

Credit risk

Today’s investors are not worried about that sort of duration risk, Florance said. They are worried about credit risk — the risk that they will not be repaid. That is why so many of them fled to U.S. Treasury instruments. “It was an asset class people perceived as the safest in the world,” Florance said. “When you’re doing post-traumatic-stress investing, you go to the safest place, and that’s where (investors) are.”

When interest rates start rising, investors will once again have to manage interest-rate spreads, which means they will have to pay attention to how big the gap is between long-term and short-term rates and what kinds of risks are behind different rates offered by different kinds of bonds.

“We have been in a fairly benign tax environment for over a decade,” Florance said. For investors with a higher net worth, “what you earn in your portfolio isn’t that important. What you have after taxes is what determines lifestyle.”

Making tax-efficient investment decisions “is extremely difficult because the tax code isn’t stable. Taxes in our economy are driven by politics, not economics. As a result, they are unstable. You couldn’t possibly project what your tax liabilities are going to be 10 years down the road.”

Florance expects that capital gains will continue to be taxed at a different rate than earned income. “Estate taxes are going to continue to be an important aspect for people of wealth, and they are going to be higher,” he said.
— This article appeared on page 11 of the Albuquerque Journal