We can ignore reality, but we cannot ignore the consequences of ignoring reality.
~ Ayn Rand, author of The Fountainhead and Atlas Shrugged
It's a crazy world out there. Be curious.
~ Stephen Hawking, physicist (speaking on space and our existence but could just as easily be applied to every aspect of life today)
On the economy
Three themes are running through the economy that have a massive impact on inflation and interest rates as they touch all of the corners of our economy – the U.S. dollar, housing and jobs. The dollar has been strengthening due to rising rates, housing has been falling due to rising rates, and job growth has been resilient in spite of rising rates. But some economists believe that we are getting close to a tipping point after the historic increases in the Federal Funds rate this year.
The dollar has been on a tear since it became clear in February that the Federal Reserve was really serious this time about hiking rates. Up some 16% as measured against six other currencies, the strength has been helping Americans traveling and spending money abroad. Buying imports is also cheaper for us at home. But the losers seem to outnumber the winners. As U.S. Treasury John Connelly said at a G-10 meeting in Rome in 1971, “The dollar is our currency, but it is your problem”.The comment did not go over well then - and would not now. The dollar’s strength has been causing considerable economic pain for global markets and calls from sovereign banks are coming in with pleas for the Fed to stop raising rates.
We are effectively exporting inflation to the rest of the world. Amongst those hurt are emerging markets, which borrow in dollars and buy commodities like oil and food with dollars, and international companies with headquarters in the U.S. (More on the stocks of those international companies below.) The Fed may be listening to those callers as a global recession will have considerable blowback on the U.S. too. When rates do peak, it is expected that the dollar will too.
Housing may be the sector most interlaced with interest rates. Affordability, or the percentage of income required for home expenses, is sinking while the median sales price of homes in America rises. Prices have moved from $320,000 in 2019 to $436k this year. Comparing the 30-year fixed rate from 2019 of 3.94%, and the current rate of 6.9%, today’s mortgage payment is nearly 90% higher for a 2022 homebuyer. Using income as a guide, it is as expensive today to buy a home as it was in the heady wild days of 2007, and reminiscent of the 1980s with soaring rates and home prices that rose 70% that decade.
Ivy Zelman, who earned the nick
name “Poison” in 2005 when she warned of a coming housing crash, has predicted nationwide prices will decline by as much as 9% by 2024. Economists are mixed on how steep a drop may be coming but note that mortgage applications have fallen to the lowest level in 25 years and existing home sales continue to decline (see chart at right).
It seems like more than two years ago when Covid-19 devastated the labor markets. To think of how different today’s picture is risks whiplash. The unemployment number rose from a decade low of 3.5% in January 2020 to 14.5% and back down to 3.5% today. Roughly the same number of people are employed in the US now as three years ago but cracks are starting to form. Job openings are falling and not by just a little. The August JOLTS data out this week showed a near record drop for a single month at 10%. Workers with more than one job and less than 40 hours worked a week are growing, a leading indicator for a downturn. Wages continue to rise 5% annually; this is above normal growth of 3%, but when adjusted for inflation, real earnings remain negative.
All of these metrics play into the Federal Reserve’s decision on rates. There is not enough “pain” yet, the latest overused Fed word, which can be translated to “recessionary data”, to convince policymakers to stop raising rates. However, we could be near the end of the raising cycle. Per Professor Jeremy Siegel of the Wharton School of the University of Pennsylvania, the pendulum has swung too far in the wrong direction and most of the inflation is now behind us. To that end, he also believes that the data is lagging on home sales and payrolls, which are worse than they appear.
On the markets
Being able to rely on market correlations between assets is a foundation of investing. A positive correlation between securities indicates that the asset classes move in tandem with each other. All U.S. stocks, large and small, are highly correlated with each other compared to say investment grade bonds. Amongst sectors, industrials and consumer discretionary businesses are highly correlated; when economic times are good, consumers are comfortable spending on higher-end goods, and industrial companies, the engine of creating and delivering goods, prosper. One of the most dependable relationships is between stocks and bonds. Generally when stocks go down, bonds go up; if bonds fall also, it is by a negligible amount. Stocks and bonds have a low correlation - most of the time.
2022 has been a painful year, to use that word again, in part because the usual correlations have broken down. The bond market, as measured by using Bloomberg’s Aggregated Bond Index is down 14.6% year-to-date through September 30th with the S&P 500 down 25%, signifying an unusual strong correlation this year.
As investors have been selling bonds all year, primarily the shorter duration securities, they have pushed down prices and in turn raising yields, given their inverse relationship. This has set up an inverted yield curve as the markets anticipate and react to the Fed’s interest rate increases. Today a bond buyer could earn a higher annual yield on a three year U.S. treasury note than on a 30-year bond.
The downward spiral in both U.S. and international stocks has been at times emotional, both to the up and downside. It has been rational on other fronts, such as with recognition of the strong dollar and its negative consequences on U.S. based companies with foreign earnings. Revenue earned in weaker foreign currencies shrinks when converted into fewer greenbacks.
Stocks of companies with predominantly U.S. revenues have outperformed year-to-date. This is another broken correlation which started back at the beginning of the pandemic. If we look back at 10 years of performance, companies with more foreign revenue had been the winners. But in the case of a rich dollar, every increase in the dollar index, DXY, has translated to a loss of 0.5% in earnings for the revenue heavy businesses.
As we roll into the weeks-long earnings season for stocks, nerves are on edge. Investors are anticipating losses in every sector other than energy and utilities. Excluding energy, Zacks Investment Research says Q3 earnings are expected to be -6.0% for the period running July through September. While the overall S&P 500 looks like it could be still priced high given expectations, trading at 16 times earnings (P/E), over the average of 15.4, the typical stock is not as expensive. Remember that the S&P 500 gives big companies more influence on the overall value.
For over a decade now the largest have been technology companies which trade at higher multiples. Apple is nearly 7% of the entire S&P 500’s performance and trades at a P/E of 23. Microsoft is 6% and a 24 P/E, Amazon is 3.4% with a 104 P/E and Tesla is 2% with a 83 P/E. But a look at the equal-weighted S&P 500 index, which gives each component the same weighting and influence, and the P/E falls to 13, below the 20-year average.
Looking out to next year, investors are hopeful for a turnaround. Morningstar is optimistic and sees many more attractive investment opportunities than at the beginning of the year. The washout or capitulation that often comes at or towards the bottom of the market is upon us. For long-term investors that have been sitting on cash, this is looking like an opportunistic time to buy.
Recessions, for all of their damage, do have silver linings. Companies, and people, take stock of what is important to their bottom lines and overall health. Businesses give credence to what works, fix what does not and tighten their belts. It is a reset for many and for some an ending if there is no path forward. Given how flush consumers and businesses were coming into this year, a downturn economically and in the markets may just deliver bruises, not permanent scars.
On personal finance
The two largest threats to wealth creation are inflation and taxes. Both may seem out of one’s control but that is rarely true. Sometimes it is the small steps taken that can make a big difference.
To understand how and where inflation may be affecting you, calculate your own personal rate. If you budget, look at your spending numbers from a year ago and calculate the change. (Current expenses minus previous expenses; divide the result by previous expenses.) If you do not budget, use old credit card statements to compare to current statements. While current inflation is running at 8%, many find that their personal inflation differs quite a bit.
If you are finding that, overall, you are spending substantially more without obvious changes in your situation, look for ways to cut unnecessary fees and services. If you do not budget, give it a try. We offer lots of advice on the subject and have tools on our website to help you get started.
Taxes may seem more difficult to avoid but all households can probably do one or two things to lower the bill. Where you live often has the biggest impact on your taxes. If you are considering a move to another city, county or state, do the math on the impacts. If you are looking at retirement, consider low or no income states; Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming do not tax income. Additionally Illinois, Mississippi, Pennsylvania, New Hampshire andSouth Dakota do not tax distributions from retirement accounts. If you like where you live, look to reduce your income by saving it in one of the following ways.
Savings with retirement accounts are the most common way to defer taxes. Avoid federal and state taxes by saving in with employer-sponsored retirement plan or traditional IRA. Married couples can also save for a spouse who is not working and receiving a 1099 or W-2; spousal IRA contributions can be made for up to $6,000 in 2022.
Health savings accounts (HSA) are the only triple-tax free options in the U.S. Put away money before-tax, grow and withdraw it tax-free. These accounts are available for individuals and families using a high-deductible healthcare plan in a calendar year. Even adult children on a parent’s healthcare plan, an option for those up to age 26, can make the full HSA annual contribution, $7,300 in 2022, without jeopardizing their parents’ ability to contribute. Please let us know if you would like more information about this option, which is one of our favorite ways to get a leg up on socking away dollars.
Some highly compensated employees working for large corporations may have access to a Deferred Income Plan (DCP). These are options for workers to delay recognizing income that is above and beyond what they or their families need at the current time. These are ideal for families with multiple streams of income and ample savings. Income is often then set for payout at retirement or at a time when income from wages would be less. These plans require annual enrollment so deferral of income in one year requires an employee to re-enroll the following. One consideration is that DCPs are by design unsecured liabilities of the business so having confidence in your employer’s finances is a must.
If you have questions about any of these options, please let us know. It is our great privilege to be able to help you with your personal financial goals.