A Quarterly Reflection

In place of our Weekly Reflection, we are sharing the Quarterly Reflection that we publish at the end of each quarter. It is a little longer read (7 minutes!) with a spotlight shown on the economics, markets and financial planning topics of the current time. Please share your feedback, thoughts and questions by clicking here.

On the Economy

A banker is a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain. (Neither the Mark Twain Society or Robert Frost’s legacy group are willing to claim this quote outright but it’s a stinging comment that either of Twain or Frost may have shared out loud.)

The banking sector might be missing its moment. After a dozen years of barely-there interest, rates are now the highest they have been this century. Yet financial companies are pulling down the shades on their lending windows. After all, the failures of Silicon Valley Bank, First Republic Bank and Signature Bank spooked lenders, savers, investors and the Federal Reserve alike. Combined those three accounted for 2.4% of all assets in the banking sector, a huge percentage. No one wants a repeat, even though now that seems like a shrinking possibility.

In the shadow of that crisis, banks have become more cautious. Commercial U.S. bank lending is down 1.75% from its peak in March. It is rare to see a dip of any more than 1.5%, outside of any corresponding chaos in the world.

Per the Federal Reserve Board’s April 2023 Senior Loan Officer Opinion Survey, not a single bank expects to ease their lending standards for most personal loans for the remainder of 2023. 46% of banks say they will go the other way and make it tougher to get a loan.

Banks are also hesitant to lend to mid-size and large companies needing a commercial and industrial (C&I) loan. C&I loans are usually short, about one to two years in term, and are the essential capital that businesses need to make a bigger project happen or to get an acquisition over the line. Without these loans, business momentum will stall.

This comes at a time when it appears we are near the end of the monetary tightening period. At most, the Federal Reserve seems set to raise rates another 0.25% - 0.50% in the next few months, but then start lowering rates next year, per their own projections. Rates will drop to approximately 4.75% by the end of 2024 and 3.25% in 2025.

This corresponds with moderating inflation, not only in the U.S. but around the world. Of the richest nations, only the U.K. is still seeing prices tick up; the latest reading was 7.9% in May. Elsewhere, rates and inflation are stabilizing or easing.

The job market remains wildly resistant to all of these tougher business conditions. Fed Chair Powell has said, albeit reluctantly, that essentially too many people have jobs, and this makes it more difficult to get inflation back to the 2% target. It does seem that the job market is too much of a good thing right now and it will change.

There is a statistical relationship between gross domestic product (GDP) and job market growth that is currently off kilter, suggesting employment will fall in the future. For the 30 years leading up to 2019, the U.S. GDP grew more quickly than employment. That was bullish, a positive for our economy and typical of previous cycles. Now employment is growing more quickly, at 2.9% annually, then our GDP, which has been up just 1.8% in the same time frame. All those working people have not contributed to more productivity.

While there is not absolute certainty that we are staring down the barrel of a recession in the U.S., some of the ingredients are in the air. The cautious banks seem to think one is possible. Deutsche Bank says one is inevitable but it will be moderate. Goldman Sachs says there is a 25% chance of one. “There will be a recession at some point, but I don't see, for the moment, a crisis," said JP Morgan Chief Operating Officer Daniel Pinto. And 93% of CEOs in a recent survey said that they expect one.

Liz Ann Sonders, the Chief Investment Strategist at Charles Schwab believes we have been experiencing “rolling recessions” already, saying “many of thebusinesses that launched us out of the Covid recession have since gone into their own recession.” To her point, technology and financial companies have been belt-tightening and laying off employees for close to a year now as revenue floundered. Today healthcare companies, like hospitals, and real estate firms, particularly in the commercial space, are experiencing extreme stress on their cash flow, profitability and future viability.

In all we are somewhere between the sun and the rain. Keep the umbrella close but it does not need to be open.

On the Markets

Since January of 2020, publicly-traded markets have cratered (during the world-wide pandemic explosion), roared back to new all-time highs (thanks to government handouts/stimulus) then plunged again into a grumpy bear market. Stocks this spring have been positive again, running mostly on the thrill of a singular theme, Artificial Intelligence (AI). Overall stock market levels are now somewhere in between the lows of March 2020 and the highs of November 2021.

The most recent positive action comes against the backdrop of mixed economic data. This bounce has been called a “baby bubble”. The term “baby” refers to the concentration of strong returns amongst only a handful of stocks but there is nothing baby about these mega-companies. These seven mostly technology-focused companies are responsible for roughly 60% of the total stock market gains, as measured by the S&P 500. It is possible for this “bubble” to be sustainable and not burst-able if the rally can spread out. Value companies lagged this year, as well as mid and small-capitalization stocks, which have lost money as a group. The upcoming earnings announcements this month will give companies airtime and investors will see if these areas are worth another look, especially now as certain sectors and companies’ valuations are getting silly expensive.

Bonds have continued their fluctuations, not as pronounced as in 2022, but still unusual and sharp for the normally staid fixed income sector. Bond prices have an inverse relationship with yields; when yields rise, prices drop. Take a look at these charts to see how investors have been whipsawed. A look back over three years of the two-year U.S. Treasury Note shows that prices were steady until 2022 when rates began rising; the two-year is especially sensitive to Fed Rate changes. The two-year yield has been consistently higher than the 10-year U.S. Treasury note, which is one of the most closely followed as it is a proxy, or floor, for mortgage rates and other loans.

When short-term yields are higher than longer-term yields, economists generally forecast a recession will occur more often than not. Morningstar analysts have another viewpoint. When comparing the lower, roughly 4% 10-year Treasury yield to the higher Federal Funds rate, the difference becomes “stimulative.” If a corporation can borrow in the capital markets by issuing a bond paying 4% instead of borrowing from a bank at a higher premium, that is a win for the business.

With companies about to announce earnings for the second quarter, the focus will be on expectations for future earnings and less on what already happened between April and June. Earnings and margins are expected to be lower going forward. If the stock market momentum is to continue, it needs to be on some actual good, solid financial news and it must broaden out to more sectors. At that juncture, it will suggest better times ahead for our economic landscape.

On Personal Finance

Aretha Franklin, the Queen of Soul and one of the world’s best-selling musical artists ever, died in 2018. She left behind four sons, an $80 million estate and two handwritten wills - one in a cabinet and the other under her couch cushions. The will from 2010 is signed and notarized; the 2014 will is not and looks more like an unfinished revision to the family members who prefer the earlier document. The sons head to court on Monday to get it sorted out, five years after her death. In the meantime, the Internal Revenue Service, which had already been trying to collect back-taxes while Aretha was still alive, has received $8.1 million, having been given legal priority on their claims. Ah, death and taxes.

Sadly the Franklin estate debacle is all too familiar, notably with celebrities who had the means and opportunity to get it figured out before their deaths, like James Brown, James Gandolfini, Prince, Casey Kasem and even Howard Hughes, whose $2.5 billion fortune was split amongst 22 cousins and not given to medical research as he had intended, but never put in writing.

The story is familiar with everyday people, regardless of whether they have money. Putting together a will, or a trust, is time-consuming, can be expensive and is often emotional. Many do not want to think about death, especially when day-to-day life keeps us on our toes. In fact, if you do nothing and you die intestate without any written plan in place, your home state will enact one for you. Easy!

So why bother? Because your heirs will be spared much time, money and certain stress and sorrow while settling your affairs without your guidance. And the less obvious reason is that doing so may ensure access to government benefits, like nursing home payments, while you are alive via Medicaid. This is too difficult, and often impossible, if your estate appears too ample on paper.

Over the last decade, families have been setting up irrevocable trusts (“Medicaid trusts”) to purposely reduce the value of their estates. It is donethrough a process called a spend-down, although there is no spending. “Grantors” retitle their assets, effectively removing them from their estate. On paper the family will then appear to have hardly any assets. Meanwhile the grantor can receive income and dividends generated by the trust assets and when the grantor dies, the heirs can still receive the trust assets.

When it comes time for long-term care, like a nursing home, Medicaid will pick up the bill and the family can be assured that the agency cannot claw back payment from assets in an irrevocable trust, like a house or brokerage account, down the road.

Medicaid, typically for the poorest of families who need healthcare, is more generous with long-term care benefits than Medicare, which is usually the primary healthcare for those aged 65 and better. For those who qualify, Medicaid pays for long-term care stays, which currently average $250 a day or $7,500 a month. This is much more expensive than most families can or want to afford, especially if an aging couple and not just one needs this type of assistance.

Recent headlines accuse the IRS of “quietly” changing the rules on taxation of irrevocable trusts by disallowing “step ups”. The IRS now excludes any property held in an irrevocable trust with the intent to deliberately exclude it from a taxable estate from “stepping-up the cost basis” at death. This affects heirs who will be selling highly appreciated assets in the trust and thus have to pay tax on the total gain, not just the gain from the date of the grantor’s death. This change will not stop families from using an irrevocable trust, but it will likely disappoint some heirs in the future.

If you have any questions about this, or any other personal finance questions, please do not hesitate to get in touch. We are always happy to help where we can and make referrals to legal and tax experts as needed.