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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. Are You Rolling the Dice with GASB Compliance? Ensure full compliance with RAMI’s Government4000 product suite which includes fixed asset accounting, inventory tracking and maintenance management. From acquiring to retiring, all assets can be maintained, accounted for, moved, revalued, tracked and disposed of. Contact us today for a free Fixed Asset Management Info Pack and ensure that your finance officers can be confident in the continuity of their fixed asset management data. Real Asset Management Phone: 617 426 0893 Web: www.realassetmgt.com Email: [email protected] October 2010 | Government Finance Review 61