Broker Check

August Newsletter 2022

 

 


July 27, 2022

“It Depends”

As I write this, Fed Chairman Powell has announced the highly anticipated Fed funds rate increase of 75 basis points, raising the Fed rate to the 2.5 percent level (highest since 2018) to combat the runaway inflation rate that reached over nine percent for the twelve months ended in June (a 40-year high).  Powell indicated that future rate increases will DEPEND on the month-to-month economic data. He also reiterated that the Fed is committed to lowering the inflation rate to an acceptable level of two percent. The equity markets immediately responded; with the NASDAQ jumping by over four percent to its best day in two years. The broader market S&P 500 index jumped by 2.6 percent on the expectation that the Fed could, in fact, control inflation without sending our economy into a tailspin. Earlier today, the Atlanta Fed released its Second-Quarter GDP Growth Estimate at a negative 1.2 percent (down from its July 19th estimate of a negative 1.6%). In either case, it marks the second consecutive quarter of negative GDP, confirming the economist’s definition of a recession. The rise in interest rates will impact the cost of borrowing for both consumers and businesses, from mortgage rates to car loans.

In truth, we do not need any economist to confirm what we already know and what the markets have been fearing for months now. In July, consumer confidence dropped from a measure of 128 from a year ago to a current reading of 95.7. As two-thirds of our economic output, consumer spending will naturally fall as prices of all the basics continue to increase daily. Between the high cost of gas and rising interest rates, consumers have no choice but to reduce demand. The result will be a slowing of the economy and the hoped-for lower inflation. That may be all well and good, but the new base cost of most things will not go down to the previous levels; all as a direct result of the devaluation of our dollar from the Government’s “money printing era” (in the name of rescuing us from the depths of the pandemic).

 The Quantitative Tightening by the Fed will certainly be disruptive to economic growth and add pressure on the markets until interest rates and inflation rates can be brought into sync. Most economists and market observers believe that the process could take more than a year as the Fed intends to only raise rates at a measured pace to avoid an economic crash in the process. Only time will tell, and it DEPENDS on many variables. The same commentators also believe that the recession will be short-lived. In the meantime, all equity valuations have been reduced to more traditional earnings multiples; meaning that high quality equities are now “on sale”.  Based on prior periods of containing and reducing the rate of inflation, our markets (and our portfolios) have seen the following year produce meaningful gains and go on to new highs. Our equity portfolio is positioned to benefit from that future growth. In the meantime, the total portfolio continues to generate cash flows from dividends and interest at over five percent, on an annual basis.

Taken together, the portfolio will again prove to be an inflation hedge. As evidence of that, the recession-induced equity market declines this year have already improved from a six-month decline at June 30 of -17.43%, to a YTD decline as of today of -13.84%. If today is any indication, the decline in valuations should moderate further as we go through the rest of the year. For the period July 1 through July 27, 2022, our Equity Portfolio returned 4.36 percent, led by the Domestic Equity category returning over six percent for the month-to-date period. The graph below prepared by Laura illustrates the year-to-date monthly performance of our Equity Portfolio, clearly showing the gradual rise in July. We cannot say that a “bottom” has been reached, but the upturn is a welcome sight and proves our strategy of being invested throughout these turbulent times.

So, what does this all mean to our clients as we adjust to higher prices (even stabilized) and a shrinking economy? Mostly, IT DEPENDS on where you are in your quest for financial security. We look at three distinct categories of clients that are generally at different stages of their life’s journey:

CLIENTS WITH TEN OR MORE YEARS UNTIL RETIREMENT. You have the greatest opportunity of all as you have many years ahead of you to add to your investment accounts and earn our long-term historical annualized rates of total return of ten percent or possibly more. Your investment returns will compound over many years of economic ups and downs; always trending up with a growing economy and experienced professional management. First, add to your accounts regularly at least fifteen percent of your annual earnings. Second, take advantage of the many tax-advantaged retirement account options, including maxing out all available employer matches to employer-provided plans. Third, add to your Roth IRA account the maximum available annual contribution as well as take advantage of the ability to “convert” balances from your regular IRAs to your Roth IRA. Now is an ideal time to do just that, while the markets are depressed the cost of conversion is therefore minimized and the future tax-free growth is maximized.

CLIENTS OVER 50 PLANNING TO RETIRE IN THE NEAR TERM. First, you need to re-evaluate your retirement timeline. Working longer and waiting for the economy to recover and for our markets to once again flourish could put you in a significantly better position.  Also, adding as much as possible to your accounts now to take advantage of lower valuations on quality equities will add big dividends in the future. As noted previously, market returns in the years following a recession have tended to be outsized and can add years to the longevity of your accounts. Roth conversions should also be considered if the cost of conversion does not raise your tax bracket significantly. Talk to your CPA and have them “run the numbers”.

CLIENTS IN RETIREMENT. Even if your retirement accounts were sufficient to cover the calculated distributions based on your spending pattern and assumed longevity under lower levels of inflation, it is unlikely that those “old calculations” will cover the significant inflationary price increases which will, for the most part, become the “new normal” in the years to come. Even though we expect the equity markets to once again flourish, you cannot take on much additional “risk” associated with those expectations by increasing the current allocation to risky equities. And the earned interest rate imbedded into your CD/Bond Ladder will not catchup with the higher rates of interest for some years to come. Being stuck between a rock and a hard place will require some adjustments to your lifestyle. The first key to making your money last will be to limit your withdrawals to the annual cash inflows from dividends and interest; currently at around five and one-half percent based on current valuations and expected distributions. Once you approach your eighties, you will be able to take more and dip into the principal of your investments as they will not need to last as long as when you were younger. With this approach, when the account grows from gains in the portfolio those gains can be withdrawn, as if you were receiving a “bonus” for your good work. We have been using this approach for many years and it has proved to be satisfactory to most clients. Lastly, until the markets bounce back and produce meaningful gains, our advice is to limit your spending on big-ticket expenditures; making your car last a few years longer and your travel less extravagant.    

ALL CLIENTS. Most importantly, STAY IN THE MARKET! It can be tempting to “get out while the getting is good” but this is always a bad idea. The biggest market gains are made in a relatively few days each year. If you miss those up days your portfolio returns will never catch-up.  Stick with the plan we all agreed upon and let us make the moves that are best for you, without letting your fears and emotions limit your opportunities to re-gain the valuations which have been diminished by the current inflation-driven recession. Please reach out to us and we can review your plans and needs and ADJUST THE PLAN, as needed.

Now, for the “good stuff”. Even as we face the many headwinds brought on by inflation and recession, there is clearly a brighter future for us all through investing in the technologies that will shape the economy of the future.  These investment ideas are included in one, or more, of the equity investments in your portfolio. In fact, technology is clearly the largest percentage of each of the domestic equity positions which will drive the future growth of all managed portfolios. GREEN TRANSPORTATION - Lithium battery innovations powering autonomous and electric vehicles is inspiring over seventy percent of Americans to buy or lease an EV, according to a recent survey. DIGITAL INFRASTURE - With the rise of 5G networks, the number of connected devices is expected to rise to over twenty-seven billion by 2025. At the same time, remote work and entertainment has spurred a wave of cloud computing innovation. AUTOMATION - Companies are exploring new ways of working which can reduce operating costs. It is expected that improvements in robotics and AI will grow the market for such technologies to as much as one trillion dollars by 2028. BLOCKCHAIN TECHNOLOGY - No, not cryptocurrencies, but the underlying technologies that can reimagine such things as legal contracts, health care records and supply chain management. The overall market size is projected to grow to over sixty-seven billion dollars by 2026.

With our experience of reporting long-term gains over many years of management, our clients have been telling us that the years of growth of their accounts, even with the current reduced valuations, has them encouraged that their goals will be met. Our personal portfolios are invested side-by-side with yours and we are clearly watching like a hawk to keep the train on the tracks.

Please contact us if you have any questions.

Sincerely,

Intelligent Investment Management, LLP