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Best Practices
Making Sense of Conflicting
Economic Signals
By Robert Eichem
The formal investment
outlook is a powerful
tool for making sense of
economic information
and crystallizing what
projections should be
based on.
A
ccording to the projections of
Esteemed Economist A, there
will be a long, slow recovery
with an average annual increase in
GDP of 2.5 percent. Equally Esteemed
Economist B says the economic world
as we know it will change forever,
deflation is a definite possibility, and
the recovery could take years, if not
decades. Given the contradictory outlooks, it’s difficult for finance officers
to know what to do with our jurisdictions’ investment portfolios, to finalize
revenue projections for the next budget,
to propose options for capital financing,
or to make any of the financial projections we are required to make.
Adding to the pressure is the need
to document why we have chosen our
projections. How will you get the message across to the community, policy
makers, senior management, and other
interested parties in lay terms that can
be understood? It is also best to document the reasoning for your projections, in case you need to defend them
at a later date.
A basic premise of budget projections is to underestimate revenues and
over-estimate expenses. However, your
credibility is not enhanced in today’s
tight budget situations if your projections are so conservative that programs
are eliminated and people lose their
jobs, only to find out the projections
were far exceeded. At the same time,
This article was originally published in the October
2010 issue of the GFOA’s Treasury and Investment
Newsletter.
overly optimistic projections can lead
to layoffs and downsizing. It can also
create credibility problems with policy
makers, senior management, unions,
and the community if the numbers are
too far off.
Making sense of the data
One of the best methods for making
sense of the morass of economic information and crystallizing what projections should be based on can be found
in the GFOA book, Investing Public
Funds, by Girard Miller with Corrine
Larson and Paul Zorn (second edition,
Chicago: Government Finance Officers
Association, 1998). It provides a format
for preparing a formal investment outlook. The concept is to identify major
forces and factors likely to influence
the markets during the time horizon
you are considering. Then, succinctly
describe the situation, the result, and
your conclusion.
Major objectives of the matrix are:
n
I dentify important forces and factors
likely to influence the markets.
n
ecord the present developments,
R
status, and trends.
n
I dentify expected future scenarios
and their investment implications.
n
I dentify factors that signal a change
in the trend and the need to reconsider the investment strategy.
See Exhibit 1 for a matrix the City
of Boulder, Colorado, recently completed.
October 2010 | Government Finance Review 59
Exhibit 1: Formal Investment Outlook
Major Force
Situation
Result
Federal Debt
Very High Inflationary
Compared Long Term
to Historical
in the Future
Demographic Trends
Aging Spending on Services
Fed Fiscal Policy
Loose
Inflationary Long Term
Depository Sector
Challenged
Few Loans
Election Cycle
Mid-Term Turmoil Monetary Policy
Easy
Inflationary Long Term
Treasury Financing
Very High
Inflationary Yield Curve
Normal
Rates Up — Steep
Housing
Little Progress Slowing Again
since Tax Credit
Jobs
High Slow Recovery; Unemployment GDP 70 Percent; Continues
Consumer Driven
What does it mean
for the portfolio?
Use the matrix information to summarize your conclusions and make your
overall decisions about how you will
invest in the coming quarter (or whatever time horizon you choose). Boulder’s
summary was:
n
here continues to be great amount of
T
uncertainty in the financial markets.
n
onger term, there are signs of potenL
tial inflationary pressure, but there is
no indication that it will occur in the
short term (three to six months).
n
hough interest rates are low, extendT
ing the maturities could be risky, since
rates could rise rapidly. This would
cause unrealized losses and real losses if the security must be sold.
n
e will continue to buy round lots
W
for liquidity.
n
e may purchase some one-time
W
calls if they fit our portfolio needs.
60 Government Finance Review | October 2010
n
Conclusion
In the Future
Less Disposable
Spending
In the Future
Slow Economic
Growth
A Wild Card
In the Future
In the Future
Long Term Interest Rates Up in the Future
Slow Economic
Growth
Slow Economic
Growth
e will continue to ladder the portW
folio for known disbursements in the
next two-year time frame.
Once the parameters have been determined, use them to make your investment decisions. It is a good idea to
document and file the conclusions so
you can go back later to compare what
actually happened to what was predicted. A major gap between the actual and
the projected provides an opportunity to
learn more about economics and what
should be considered in the future.
The idea behind preparing a formal
investment outlook is to show others
that we have carefully considered the
data, prepared a plan, and then implemented the plan. It is evidence that our
actions were cautious and methodical.
Getting the message across
Several of the major force categories
in the formal investments outlook above
provide strong indications that there are
flashing yellow signs for the longer term.
Flashing yellow means proceed with
caution. In the past few years, the goal
has been to maintain the principle of
our investments, and if any income was
generated, it was a plus.
As we move toward what appears
to be a long, slow recovery and our
revenues remain under constant pressure, the lure of obtaining a few more
basis points on investments will become
stronger. The easiest ways to increase
yield are to extend out the yield curve
or to participate in investments that
possess greater risk. To maintain reasonable expectations among policy makers and senior management, we must
be able to explain complex economic
information and how it can influence
our own investment portfolios — in
terms anyone can understand, quickly
and succinctly. Policy makers are busy
people, so the time you will have their
attention is limited. Get to the point and
make it quickly.
One method that has been successful
for the City of Boulder is to use graphics or pictures that indicate it is time
to pay attention to what is coming up
— we use them to represent the most
important aspects of the formal investment outlook. For headwinds (things
that hold the economy back), pictures
of vacant housing developments, long
unemployment lines, or stacks of currency representing federal debt can
quickly convey the idea of what is occurring, and your words can emphasize
the impact. Tailwinds (things that help
the economy) could be represented by
smiling shoppers, to represent gains in
consumer confidence, or pictures of skiing a high mountain, if the yield curve is
steep, cross country skiing, if yield curve
is flat, or a bunny slope, if it is a gradual
inverted yield curve (this is, after all,
Colorado).
Putting it to work
The City of Boulder and surrounding
districts had been in dire need of a new
fire training center for 20 years. In 2000,
a countywide tax was passed by the voters to fund it. Unfortunately, the recession that occurred after 9/11 meant that
the actual tax collected fell far short of
what was needed. Alternatives were
considered, but none put the project on
the path to completion. In 2006, the city
council asked staff to determine how
large a one-year city sales tax, added to
the county tax collections from 2001,
would be required to make the training
center happen. One council member
passed on the following encouraging
words: “Don’t mess it up because we
won’t get another chance.”
The formal investment outlook served
multiple purposes in this project. Costs
were revisited and updated. Inflation
was of a key concern, as construction
costs were advancing rapidly. Interest
rate projections had to be reasonable
because once the tax was collected,
it would increase by only the amount
of interest income received. When the
proposal went to the city council staff,
it was presented as a one-page bar
chart. The assumptions behind it came
from a formal investment outlook that
was prepared by staff. The graphic
showed what would be generated by
the end of 2007 (the year the tax would
be collected). The construction estimates were then increased by a low
and high inflation range for a multiyear
period. A line graph was placed over
the top of the bar chart to show how
the tax collections plus interest income
would grow, compared with the con-
struction costs. The chart showed that
the construction contract for the fire
training center had to be completed
and locked in by early 2009, or inflation
might overrun the funds available —
meaning the design and long planning
process common in the city had to be
navigated and completed in a timely
manner. The voters passed the tax, the
design and planning process deadlines
were met, the revenue projections were
also met, and the formal ribbon cutting
was held in July 2010.
The formal investment outlook is a
powerful tool. y
Robert Eichem is director of finance for
the City of Boulder, Colorado, and a member of the GFOA’s Committee on Treasury
and Investment Management.
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October 2010 | Government Finance Review 61