Broker Check

April Newsletter 2022

 

 

 

April 5, 2022


Inflation Is…..

  To our Clients:

I have been around a very long time and have seen many economic and market ups-and-downs over the last fifty years. I graduated college during a recession and survived the runaway inflation in the seventies; even profited from the inflationary increases in home prices and wage growth. I took it all in stride as I was naive enough (read foolish enough) to not realize what that lesson would mean later in life. Now that I am actually in my seventies, the lessons of the last fifty years now give me pause as we navigate the choppy waters of 2022 and beyond. My younger partner, James, is now accumulating the knowledge and experience to guide our younger clients into the distant future as they all have time on their side. Youth and time are wonderful things! By the way, I spent almost $100 to fill my gas tank last week!

My granddaughter just recently turned thirteen and is embarking on her teenage years with wide eyes and wonders of the future she has inherited. I am surely biased, but her academic performance is outstanding (she just made the “high honor list”) and her favorite subject is math. I have been collaborating with her for years now on how knowledge of math will be very useful throughout her life as she pursues her dreams. To that end, we have been discussing how money works; how it is earned; how it is used to measure many things; including what inflation means. She has been selling Girl Scout cookies for a number of years now; and, this year, the selling price of a box of cookies increased from four dollars last year to five dollars this year. She likes to go to the Dollar Store to buy things she thinks she cannot live without, and she recently declared, “That’s not fair!” when she saw that the dollar store is now the dollar-twenty-five store. She is also a budding baker and I love her brownies. I have been paying her ten dollars for an order of her brownies or cookies and she now sees that she, too, will need to increase her prices “just to keep up” with inflation. She truly is a bright kid!

At our regular staff meeting just last week, we had a long discussion about how current economic and geo-political events might continue to pressure portfolio values to the downside under the weight of all the current headwinds which are impacting economies and securities markets around the world. To put things into perspective, I threw out a string of events that we have successfully navigated since we began managing money for our clients in 1996. My memory detailed such things as the Dot-Gone years in the late nineties; 9/11; the Financial Crash and Russia’s takeover of Georgia in 2008; the Great Recession, European Debt Crisis, Global Market Selloff that began in China and the Greek Debt Default between 2011 and 2016; Brexit,  Covid 19, and now Putin’s war against the people of Ukraine. Over that entire period the securities markets fell, recovered and then grew to increased valuations as our resilient economy and capitalistic system flourished. As a point of reference, the Dow Jones Average of only stocks grew in value almost 339 percent over the above period. Over the same period, our broadly diversified and inherently less risky portfolio of equity AND income investments grew by almost 390 percent (currently invested roughly 50%/50%).

So, why am I going over all this history? Well, I now believe that from January first of this year: throughout all of 2022 and even into 2023, we could be in for a very rocky ride as we work through all of the challenges we are facing as a nation and leader of the free world.  As reported to you in our last two monthly letters (and the two interim email blasts), our markets have gone through a “correction” (market value decline of 10%) and entered and rebounded from a “bear market” (market decline of 20%).

Listed below are a number of remarkable events that have preceded significant market declines during our years of managing client portfolios:

 

Based on the past, one would think that a remarkable recovery will happen again. I firmly believe that a recovery is inevitable, as our capitalistic and democratic system, fostering imaginative and creative entrepreneurs will surely rise to the occasion as the current challenges are in the rear-view mirror.

Unlike all the above periods, 2022 is struggling with the Covid shutdown, the inflationary results of printing vast amounts of money to “save” us all from the Virus, the decisions to stop producing enough energy to meet our needs and the horrific events unfolding in Eastern Europe. When you pile all of the above on top of the supply chain problems, the vaccination debate, the great resignation, wages not keeping up with inflation rates not seen for forty years; we are led to conclude that increasing interest rates to fight inflation while Europe enters a recession may be more than our markets can handle in the short term. In fact, several of the major investment banks and many economists are now using the word “stagflation” to describe our current condition. Without getting all technical, the short and long-term interest rates on treasury notes and bonds have “inverted” (short-term rates are more than long-term rates). It is notable that every recession at home has followed such an “inversion”. Stagflation has been described as: “the combination of economic stagnation and high inflation, characterized by soaring consumer prices as well as high unemployment”. When that happened in the 1970s and early 1980s, as spiking oil prices, rising unemployment and easy monetary policy pushed the Consumer Price Index as high as 14.8 percent in 1980, the Fed raised interest rates to almost twenty percent. Even in my younger years, I can remember the ravaging impact on the US economy as the manipulated supply and cost of foreign oil strangled our economic growth. As I see it; either the current oil crisis or the war needs to end for our economy to avoid another market collapse. It is notable that the market drawdown between November 1973 and March 1975 was forty-eight percent.

We will continue to actively manage all our client portfolios to reduce the potential effects of the economic challenges; while at the same time to maximize the underlying cash flows from dividends and interest needed for all portfolios in distribution. For many of our clients, the volatility will create buying opportunities to add to the broadly diversified equity positions representing the future growth of our economy. For others, it will create opportunities to increase the interest and dividend rates on the Bond/CD ladder of income and alternative income positions.

The first three months of 2022 and the preceding twelve months bridging 2021 and 2022, reflect the challenges reviewed above.


Of greater importance
is the recognition that the Dividends and Interest amount reported is “real” money flowing into your portfolio. On the other hand, the Gain/Loss amount reported is almost entirely “unrealized” and as the markets recover the “paper losses” will go away. There is also a “subtlety” to be aware of when considering unrealized losses in the income portfolio. As discussed above, the Fed will be raising market interest rates in its efforts to control inflation. When that happens, all securities with fixed rates of interest and dividends will be inherently “devalued” as new issues of such securities must bear a higher rate of interest to attract new investors. Unless we sell those securities in your portfolio, you will not “realize” the market decline as you will receive the full-face value of the securities upon maturity or redemption. Individual circumstances may dictate selling at a loss, but we have no intention of otherwise selling. Due to the drastic measures expected to be taken by the Fed to control inflation, the market value decline in the total income portfolio for the three months ended March 31, 2022, is over half of the market decline in the total portfolio of equity and income investments. 

It is also worth noting that the Alternative Equity category (primarily real estate and energy) returned almost 32 percent for the full twelve months as compared to the Total Equity category returning just thirteen percent for the same period. Likewise, the Alternative Income category returned four percent and the Total Income category returned less than one percent. Again, those returns include the UNREALIZED losses discussed above. As we manage each client’s individual portfolio during these challenging times, we will continue to heavily weight both alternative categories for a combination of inflation protection and maximum cash flows.

While market valuations are still below market highs, this could be a good time to review with your tax advisor the idea of a Roth conversion, if you have a traditional IRA. While current tax rates are low, Roth conversions offer an opportunity to insure against higher tax rates in the future on the growth of the Roth IRA account. They provide flexibility in the timing of future income in retirement and avoid Required Minimum Distributions (RMD’s).  A $50,000 conversion done today that averages an eight percent return over ten years could grow to over a $100,000.  If that same $50,000 was left in a traditional IRA, the $50,000 of growth would be subject to taxes when withdrawn.  If that $50,000 is left to grow for 20 years at an eight percent average return that could create $130,000 in growth that would be subject to taxes in a traditional IRA; or it would be tax free in the Roth IRA account for you and your heirs.

Please contact either James or me if you have any questions.

Sincerely,

Intelligent Investment Management, LLP