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When is 1.5% greater than 5%?

Dividends, Interest, and More!

This is an important issue for clients, as markets have done well for them recently. The 1.5% figure is the current dividend rate on the Standard & Poor's 500 Index now. Standard & Poor's 500 Index is composed of some of the best run, rationally managed, best capitalized, profit-oriented companies on the planet.

The 5% interest rate is the amount that you could receive by lending money to these companies or lending money to the United States government. Of course, the interest rate that you receive by lending to these companies (by buying their bonds) or lending to the US government (by buying their bonds) is a fixed rate of return for a fixed period of time.

The dividend yield from the Standard & Poor's 500 is not guaranteed, and importantly, is not fixed. The Board of Directors of a Standard & Poor's 500 Company declares dividends and attempts to increase dividends on a regular basis. However, there is no guarantee that the Board will do so. There is also no guarantee that the dividend payments will be maintained. However, it is our belief that overall the history of dividend payments will be maintained. In fact, history has shown that dividends and dividend increases have been a characteristic of stock ownership for decades. Historically, the rate of increase in the dividends paid by the Standard & Poor's 500 companies has been more than inflation. Now we are starting to answer our question.

Although we do not know what the future will hold, the past is telling us something about the goals of corporate management. It tells us that the management of these companies will attempt to maintain and to increase the dividend rate over your lifetime.

We do not know the rate of dividend increases in these companies going forward. There is no way to know the rate of earnings increases that these companies will experience as they grow, as they attempt to reduce costs, or as they employ new technologies to reduce the cost of production and expand into new markets. We do not know how future interest rates will affect the cost of financing company operations. However, I believe that companies will continue to grow earnings and then their dividends. On balance, corporate America will succeed.

Importantly, when the 1.5% dividend yield grows beyond 5%, I believe that those dividends will continue to grow. Meanwhile, the 5% interest rate on a bond is fixed and will not be increased going forward.

When we make these calculations in a world of inflation, which is currently 4% (but the Federal Reserve is targeting 2%), we must realize that the value of the 5% interest rate payments are being reduced by this inflation. The dividend rate is fighting back against inflation. Our expectations are that the dividend rate will grow faster than inflation.

We accept that there are no promises on the dividend rate. Please consider the dividends in your accounts, as well as the growth of the dividends, in your accounts, as an important part of your decision to invest in equities. An important part of our service to you is advocating for equity. It is one reason why you are paying our fee, for us to relentlessly advocate for a substantial portion, an ever-increasing portion, of your investment program to be invested in equities.

Although we do not know when 1.5% will be greater than 5%, we are confident that it will. We will continue to have this conversation with you. As always, we are available to introduce this concept to your colleagues, your children and other family members.

The Duality of the Markets

Have you ever noticed how so many idioms refer to the duality of life?  Consider:  There are two sides to every coin.  Life is a double-edged sword.  You can see the glass as half-full or as half-empty.  Every cloud has a silver lining. 

Each of these sayings refers to the fact that almost everything in life can be seen as either good or bad; it’s all based on what we focus on. Sometimes, it can even depend on which “side” we see, hear, or learn about first.  Even science has found this to be true.  For example, in 2014, two psychologists named Angela Legg and Kate Sweeny ran an interesting study.  Two groups of people filled out a personality inventory.  The first group was told they would get feedback, some positive, some negative.  The second group learned that they would be the ones to give it. 

The study found that 78% of the people in the first group wanted to hear the negative stuff first.1  That’s because they believed that if they got the bad news out of the way, they could end on a good note, and their day wouldn’t be ruined. 

The second group – the ones giving the feedback – were divided.  Roughly half focused on what they thought the recipient would want to hear and decided to give the bad news first.  The other half focused on their own feelings and decided to give the good news first, because they felt it would be easier to start off with something positive.  Either way, just about everyone in the study was preoccupied with the order in which to face both sides of the situation.  It didn’t matter if both the good and bad were roughly equal.  What mattered was mindset.    

I was thinking about this recently while pondering my next market message.  The very message, in fact, that you are reading now.  You see, there is a real duality to the markets at the moment.  Storylines pulling the markets down, storylines pushing them back up.  But which to focus on?  Which to start with? 

Given what we learned from that study I mentioned, I think I’ll start with the “bad” news before sharing the “good.”  Then, I’ll explain why, when you think about it, it really doesn’t matter. 

Interest Rates and Bank Failures

Perhaps the biggest drag on the stock markets – not just now but over the last year – has been the steady rise of interest rates.  The most recent hike came on May 3rd, bringing rates to a 16-year high of 5.25%.2  Essentially, the Fed has spent the last year trying to combat inflation by cooling down the economy.  When rates are low, consumers and businesses are incentivized to borrow and spend.  But when rates are high, it’s meant to reward saving over spending.  If people spend less and demand for goods and services goes down, companies have little choice but to lower prices if they’re to attract new business.

Unfortunately, these rate hikes are very much a – wait for it – double-edged sword.  Because while they do serve as a deterrent against inflation, they can depress economic activity to the point of a recession.  This fear of a recession, accompanied by lower earnings from many companies as a result of higher interest rates, has triggered some of the volatility we’ve seen in recent months. 

But rising interest rates have done something else, too: Threaten the solvency of America’s banks.  

On March 10, federal regulators seized Silicon Valley Bank, the sixteenth largest in the country.  Two days later, New York’s Signature Bank collapsed.  And on May 1st, First Republic Bank in San Francisco was seized, too, with most of its assets promptly sold to JPMorgan Chase.  Given how suddenly – and consecutively – these regional banks fell, many investors have been gripped by fear of contagion spreading across the entire banking industry.

While none of these situations were exactly the same, all three banks had certain things in common.  For one, all made long-term investment bets that turned out to be far too risky.  In the case of Signature Bank, this was in cryptocurrency, the value of which has plummeted in recent months.  In the case of Silicon Valley and First Republic, it was placing far too much money in U.S. Treasury bonds.  When interest rates began rising, the value of these bonds fell.  Suddenly, these banks held most of their money – their depositors’ money – in assets that no one wanted.  Furthermore, all of these banks had an unusually high number of uninsured deposits.  As a result, customers began withdrawing their money in droves.  No bank can survive without deposits, forcing the government to step in and take over before everyone lost everything. 

Now, three banks – out of the thousands that exist in the U.S. – may not sound like much.  But since this started, investors have been combing the industry with a magnifying glass, trying to find which other firms might have hidden weaknesses.  This has caused many banks’ stock prices to fluctuate wildly in recent weeks, acting as a further drag on the markets as a whole.  It’s also added to recession fears.  That’s because regional banks like these play a vital role in helping families, local businesses, and startups participate in the broader economy.     

In each of these cases, the government has acted fairly quickly in order to prevent any contagion from spreading.  So, if all this banking turbulence stops with First Republic, well and good.  But if other regional banks experience more credit shocks, or a fire sale on their stock prices, this may well be a case of getting out of the frying pan only to fall into the fire.  Stay tuned. 

So, that’s the “bad news”.  Now, let’s turn to a new subject that could be seen as either good or bad, depending on how you look at it.

Inflation

Since 2021, inflation has been the root cause of almost every bit of economic uncertainty.  But the role inflation plays has changed over time.

The current spike in inflation started due to an explosion of economic activity after the COVID-19 lockdowns.  Buoyed by historically low interest rates, Americans were shopping again, and not just for distractions to keep them busy while they were stuck at home.  But this pent-up demand far exceeded supply, causing prices to skyrocket.  Later, inflation became more driven by snarls in global supply chains.  Then, it became exacerbated by the war in Ukraine.  All these factors simply made it very difficult – and expensive – to get goods where they needed to be. 

Lately, though, inflation has changed again.  Now, the single biggest factor is not the price of goods, but of services.  People aren’t just buying things again; they’re doing things again.  Eating out at restaurants, going to sporting events, putting their children in daycare, traveling.  Meanwhile, a strong labor market has led to extremely low unemployment and rising wages.  This has caused businesses to raise prices to compensate. 

For these reasons, inflation remains stubbornly high, even after a year of rising interest rates.  But here is where you can (cough) see the glass as either half full or half empty.  The half-empty view would be that inflation remains high, meaning the Fed could keep raising rates.  But the half-full view is that these same factors keeping inflation high are also keeping us out of a recession.  (More on this in a moment.)  Then, too, prices are coming down…just very, very slowly.  (Back in March, prices were up 5% compared to the same time last year; that’s down from the 6% mark we saw in February.3)

Finally, let’s get to the “good” news…unless, of course, you’re the Federal Reserve, proving that even good news can be a double-sided coin.  (Ahem.)  

Jobs

For months, analysts have predicted the labor market would slow down.  Because of higher interest rates, companies would stop hiring, or even lay off workers.  To be frank, this is what the Federal Reserve wants – at least to a degree.  Because it’s this sort of economic cooldown that will tamp down prices.  But it’s also been a main source of recession-based fears.  When unemployment starts rising, a recession is often not far behind. 

To date, however, it hasn’t happened.  In April alone, the economy added 253,000 jobs.  That’s far more than what most economists predicted.  In fact, it’s actually brought the unemployment rate even lower, to 3.4%.  That matches a 53-year low!4 

This is terrific news.  The more jobs there are, the more spending there is.  The more spending there is, the more the economy will grow…or at least, not contract to the point of a recession.  But unbelievable as it may seem, there is a counterargument.  These job numbers may prompt the Fed to keep raising rates if they believe the economy can handle it…thereby injecting more uncertainty into the stock market and bringing us closer to a recession.  Only time will tell which way investors decide to spin it.

The Takeaway

So, what are you thinking right now?  Are you feeling positive or negative about the markets?  On the one hand, I devoted more words to the “bad” news.  On the other, we finished with a (mostly) positive note, with lower inflation and higher employment. 

To be honest, however you react to all this says more about you – and more about how I wrote this message – than about the markets themselves.  And that is exactly the point.     

Positive and negative.  Good news and bad.  Yin and yang.  Jekyll and Hyde.  Dark side and light side.  Half-full and half-empty.  The fact is, there are two sides to almost every storyline impacting the markets right now.  And most investors are picking and choosing what they react to, and how they react, based on which side of that duality they fall on.  They choose one side of the coin, one edge of the sword.  They turn investing into one big psychology experiment. 

But we’re not most investors. 

Moving forward, we need to accept that there are forces pushing the markets up and forces pulling the markets down.  We can’t control which of those forces wins.  Nor can we predict, day to day, which force will prove stronger.  This is precisely why we have chosen a long-term strategy for investing.  We don’t have to decide whether the glass is half-full or half-empty.  We don’t have to stress over whether we hear the good news or the bad news first.  We acknowledge both as important…but neither as everything.  We don’t have to worry about guessing right because we never guess. 

As always, my team and I will keep watching all these storylines closely.  When we feel that any of them requires tweaking your portfolio, or your financial plan, we’ll let you know.  In the meantime, my advice is to not stress about whether tomorrow’s news will be good or bad.  We are always here to help you hope for the one and plan for the other…while remembering the words of one of my favorite idioms: Slow and steady wins the race. 

Have a great month! 

 

 

1 “Why Hearing Good News or Bad News First Really Matters,” PsychologyToday, June 3, 2014.  https://www.psychologytoday.com/us/blog/ulterior-motives/201406/why-hearing-good-news-or-bad-news-first-really-matters

2 “Fed increases rates a quarter point,” CNBC, May 4, 2023.  https://www.cnbc.com/2023/05/03/fed-rate-decision-may-2023-.html

3 “Inflation Cools Notably, but It’s a Long Road Back to Normal,” The NY Times, April 12, 2023.  https://www.nytimes.com/2023/04/12/business/inflation-fed-rates.html

4 “US labor market heats back up, adding 253,000 jobs in April,” CNN Business, May 5, 2023.  https://www.cnn.com/2023/05/05/business/april-jobs-report-final/index.html

Debt Ceiling Update

A Brief Update on the Debt Ceiling

On May 1, the Secretary of the Treasury informed Congress that the U.S. could default on its debt by June 1 if legislators do not raise the nation’s debt ceiling.1

This announcement was not a surprise.  The U.S. officially hit the debt ceiling in January but were able to stave off any immediate effects through the use of “extraordinary measures.”  (These are essentially accounting tools the government can use to pay its bills without authorizing any new debt.)  The Secretary’s recent message was to let Congress know those measures are close to being exhausted.  Without raising the debt ceiling, the U.S. will not have the money it needs to pay its debts.  And while the exact date this will happen is unknown, it could come by June 1 at the earliest.

Should a default actually happen, the economic consequences could be severe.  But even if Congress staves off the unthinkable, simply going down to the wire can have negative effects on the markets.  To explain why that is, it’s useful to first remind ourselves what the debt ceiling is.

The debt ceiling is “the total amount of money that the government is authorized to borrow to meet its existing legal obligations.”2  What are these obligations?  It’s a massive list.  Think Social Security and Medicare benefits, for starters.  Tax refunds, military salaries, and interest payments on Treasury bonds are hugely important, too.  The debt ceiling, then, is the limit to what the government can borrow to pay back what it has already spent.  (Or is legally obligated to spend.)

Normally, raising the debt ceiling requires a simple act of Congress.  But in some years, politicians disagree about whether the ceiling should be raised without an accompanying decrease in spending.  That’s the scenario we’re in right now.  Congressional Republicans do not want to raise the debt ceiling without enacting spending cuts at the same time.  Democrats, meanwhile, prefer a “clean” hike where the ceiling is raised without conditions.  In their view, any changes to federal spending should come separately, after the nation’s existing debts are addressed. 

In other words, the two sides of the political aisle are engaged in a game of fiscal “chicken.”  Each betting the other will blink first. 

The problem with this game is that at some point, if a resolution isn’t reached, everyone loses.  While no one is quite sure what will happen if the U.S. defaults – it’s never happened before – it’s not hard to guess, either.  Look at that list of obligations I mentioned earlier.  Now, imagine if they all just…stopped.  No Social Security checks.  No Medicare payments.  No tax refunds.  Tens of thousands of soldiers and government employees without income.  And don’t discount the importance of interest payments on Treasury bonds.  Without this, interest rates would skyrocket and probably lead to a major recession. 

Now, it’s important to note that this is not our country’s first rodeo with the debt ceiling.  This has actually happened several times over the past twelve years.  In each instance, Democrats and Republicans eventually came to an agreement and raised the ceiling.  Most experts expect the same thing to happen this time.

That said, the two sides are still very far apart.  While House Republicans have made a proposal on the cuts they want to see, most are measures that Democrats are unlikely to agree to.  (The bill would lift the debt ceiling by $1.5 trillion through March of 2024 while eliminating $130 billion in government funds.  But that’s not a very long time, and most of the cuts are to areas that the White House considers high priority.3) The two sides have agreed to a meeting on May 9, but it’s doubtful whether that will lead to anything. 

The closer we get to June, however, the more nervous Wall Street will get.  Given how much uncertainty already exists in the markets – thanks to rising interest rates and a recent spate of bank failures – a debt ceiling crisis is the last thing investors need.  To be sure, there are other possible outcomes to this situation.  Perhaps the most likely is that Congress enacts a short-term increase to the borrowing limit.  This would give themselves more time to pass something longer lasting.  It would also be seen as kicking the can further down the road…and not much further at that! 

If the U.S. does default, there may be ways to blunt the impact.  For instance, the government could prioritize its debt payments so that not everyone gets left out in the cold all at once.  Another possibility would be for the Federal Reserve to buy up more Treasury bonds.  This would at least stabilize the bond market.  But none of these options are ideal, and it would be best for everyone to avoid them.

So, that’s where things stand. In the coming weeks, I’ll send you more detailed information on what hitting the debt ceiling could mean for investors.  (Assuming Congress doesn’t get its act together before then.)  In the meantime, my team and I will continue to monitor the situation carefully.  Should we ever feel this issue requires a change to your portfolio, we’ll let you know immediately.          

As always, please let us know if you have any questions, or if there is anything we can do for you!

 

1 “Treasury’s Yellen says US could default as soon as June 1,” The Associated Press, May 1, 2023.  https://apnews.com/article/x-date-debt-ceiling-yellen-treasury-borrowing-f726fd88a9bb7f72e50f0b948731ac57

2 “Debt Limit,” U.S. Department of the Treasury, https://home.treasury.gov/policy-issues/financial-markets-financial-institutions-and-fiscal-service/debt-limit

3 “No Solution in the Senate,” Politico, May 1, 2023.  https://www.politico.com/news/2023/05/02/senate-parties-debt-00094873

 

How the Federal Deposit Insurance Corporation (FDIC) Works

Aftermath of Silicon Valley and Signature Bank

In the aftermath of Silicon Valley Bank/Signature Bank take over by the FDIC, I thought it would be a good time to review the FDIC rules for insurance on bank accounts.  All accounts for all depositors are covered up to $250,000. Should the FDIC take over a bank, the $250,000 coverage should provide for very quick access to your funds.  Let's look in the next few days to find out how quick the actual access is.  

  

FDIC is a government agency. The FDIC guarantee is backed up by the federal government. The FDIC insurance is federal backing of your account at a bank. Please be aware that we utilize in your investment account a government money market fund. Your cash deposits are invested in US federal government securities. There is essentially no limit to US government coverage because the US government securities are backed by the full faith and credit of the United States government.  

 

The Federal government has also announced that they will provide insurance coverage on amounts above $250,000 for the involved banks.  It is the intent of the Federal government to reimburse all depositors for the full amount. Again, we will watch to see how quickly the over $250,000 accounts are covered. The law is clear that $250,000 is the limit. The Federal government is using emergency powers to provide coverage over $250,000.  

 

To our knowledge, none of our clients have deposits with Silicon Valley Bank or any of the other banks that are named in the press reports on this matter.   

 

As part of our investment strategy and our overall investment plan with you, you may recall that we recommend that your cash reserves be held in a manner that you can get access to the funds immediately. We do not recommend CDs or any investment with a restriction on your access to the funds. Typically, we are concerned about financial emergencies such as repairs around the house, boilers breaking, cars dying, a family member needing financial support.  We should add to our list of concerns bank insolvency.   

 

We are going to watch closely and see how quickly the FDIC is able to provide access to funds for all the depositors at Silicon Valley or Signature Bank. We will continue to utilize US government money market funds, so our clients don't have to worry about the $250,000 limit and can get access to their funds on a same-day basis in an unlimited amount.   

 

As always, please contact us with any questions.  

Silicon Valley Bank – Run on a Bank Explained

For most of us, the words “bank failure” immediately trigger the same recent memory: the financial crisis of 2008. That was a year no investor could ever forget. The year some of the largest, most storied financial institutions in the world — think Lehman Brothers, Bear Stearns, and others — collapsed, never to return.

Similarly, for anyone who has studied history, the words “run on the bank” immediately trigger images of the early days of the Great Depression. For others, it’s perhaps scenes from It’s a Wonderful Life.  (Or Mary Poppins, if you prefer.Dramatic moments now consigned to the waste bin of time. Surely not something that could happen in this day and age.

But on Friday, March 10, all these words — bank failure, bank run – happened to the Silicon Valley Bank in northern California. It’s an event that has many investors, scarred by the memory of 2008, wondering if the same thing could happen to other banks.  An event that has only added to the fearful mood currently pervading the markets.

As you probably know, when the news broke on Friday morning, all three major indices immediately tumbled, capping off a rough week for the markets.  So, I want to briefly explain what’s going on with this semi-obscure bank and why it spooked investors.  Then, I want to go over what we can learn from it. 

Prior to collapsing, Silicon Valley Bank was the 16th largest in the country, holding approximately $209 billion in assets.1  If you’ve never heard of it before, it’s probably because the bank specialized in lending money to start-up companies; the kind of fledgling tech firms Silicon Valley breeds each year.  Now, it has the dubious distinction of being the largest bank to fail since 2008.1 

So how did a bank this large fail so suddenly?  Truth be told, it’s a tale that anyone who lived through 2008 also remembers well: The bank simply made too many bad decisions at precisely the wrong time.  During the pandemic, tech companies saw a surge in business.  This led to a host of new, hopeful tech companies popping up, each flush with venture capital.  As a result, banks that specialize in serving these types of companies enjoyed their own surge: A surge in deposits. 

Silicon Valley Bank (SVB) was one of these banks.  But while business was booming, this was also when the problems started.  You see, like most banks, SVB only keeps a fraction of its deposits in-house at any given time.  The rest is lent out or invested.  In this case, SVB purchased tens of billions of dollars in U.S. Treasury bonds. 

To be fair, there was a certain logic here.  Treasury bonds are historically seen as one of the safest investments in the world.  Given the market uncertainty we saw during the pandemic, the bank probably thought it was being prudent with customers’ money.  Unfortunately, the bank forgot one important detail: While Treasurys don’t usually see the kind of volatility that stocks or other securities do, they are vulnerable to a very specific kind of risk.  The risk of rising interest rates.

While this was going on, the economy started changing.  Inflation skyrocketed.  Interest rates, in turn, rose to the highest levels in decades.  That meant all those Treasurys purchased when interest rates were low were suddenly far less valuable.  (Newer government bonds pay far more in interest than those purchased before the rate hikes began.)  At the same time, those tech companies that profited during the pandemic saw business – and their stock prices – fall.  For SVB, that meant fewer and fewer deposits coming in.  Suddenly, SVB was faced with a nightmare scenario: A lack of liquidity and a lack of new funds. 

None of that might have mattered so long as customers didn’t start withdrawing their money.  Of course, that’s exactly what happened.  Faced with their own economic distress, all those tech companies – and their executives – started asking for their money back.  Given that they only kept a fraction of that money in reserve, SVB had no choice but to sell its investments at a major discount.  The result was a major loss of nearly $2 billion, which the bank revealed earlier in the week.1

When news of the situation got out, customers began panicking.  This led to a classic, seldom-seen-but-much-feared scenario: A run on the bank. 

In the days that followed, the bank was unable to stop the bleeding.  So, on Friday, the government stepped in and took control of the bank’s remaining $175 billion in customer deposits.2

Okay.  That’s the story.  But why the impact on the markets? 

Aside from being eerily similar to 2008 – a bank makes risky financial decisions at the exact wrong time and crumbles – the situation has investors wondering if there are other banks out there that might soon experience the same problem.  No surprise, then, that shares of banks with similar business models have fallen sharply over the last two days. 

But it’s more than that.  Right now, investors are gripped with fears of a recession.  On the surface, that may seem counterintuitive, as most areas of the economy remain in decent health.  But until the economy cools down, inflation will continue to run hot…which means the Federal Reserve will continue to raise interest rates.  (Indeed, the Fed chairman announced on March 8 that he expects rates to rise “higher than previously anticipated.”)3

With each rate hike, the threat of a recession grows larger. 

Right now, investors are hyper-sensitive to anything that looks like the first sign of a recession.  And the failure of a major bank certainly qualifies.  Hence the turmoil we’ve seen in the markets this week.  Hence the volatility we may keep seeing. 

So, what can we learn from this?  To my mind, there are a few lessons:

1.      When making investing decisions, always prioritize your long-term goals.  In the wake of the pandemic, SVB made too many short-term decisions that locked up its long-term options.  We will never do that.  Here at Vaughan & Co. Securities, Inc., our approach will always be to take the slower-but-surer path to your financial goals.  We will always emulate the tortoise, not the hare.

2.      Never forget the importance of liquidity.  We are not a bank.  We are human beings, and human beings must contend with the unexpected.  That means we sometimes need quick access to our money.  That’s why we will always invest, save, and plan accordingly. 

3.      Hold to our long-term strategy and never invest based on stories or emotions.  Right now, too many investors are trying to divine when a recession will strike.  They are overreacting to every headline.  We won’t do that, either.   

We are experiencing a time of uncertainty in the markets.  Such times are rarely fun, but they’re not unexpected.  The good news is that my team and I continue to have confidence in both our long-term strategy and the road you are taking toward your financial goals.  We will continue to monitor the markets very carefully and keep you updated on what’s going on.

In the meantime, please let me know if you have any questions or concerns.  We are always here for you.  Have a great month!

In addition to this blog post, we have released a podcast episode “Silicon Valley Bank – Market Minutes No. 2”. Click here to listen now.

 

1 “Silicon Valley Bank Closed by Regulators, FDIC Takes Control,” The Wall Street Journal, March 10, 2023.  https://www.wsj.com/articles/svb-financial-pulls-capital-raise-explores-alternatives-including-possible-sale-sources-say-11de7522

2 “Silicon Valley Bank Fails After Run by Venture Capital Customers,” The NY Times, March 10, 2023.  https://www.nytimes.com/2023/03/10/business/silicon-valley-bank-stock.html

3 “Fed Chair Powell says interest rates are ‘likely to be higher’ than previously anticipated,” CNBC, March 7, 2023.  https://www.cnbc.com/2023/03/07/fed-chair-powell-says-interest-rates-are-likely-to-be-higher-than-previously-anticipated.html

 

 

Return of the Debt Ceiling

Debt Ceiling Preview

“Here we go again.”  That’s a line from Return of the Jedi, delivered by C-3PO just before he and his friends prepare to go out on another harrowing adventure.  In the movie, poor 3PO was referring to taking down the Death Star, but he could have easily been referring to something else:  

The Debt Ceiling. 

Yes, it’s back.  And now, economists, pundits, politicians, and investors are all saying the same thing: “Here we go again.” 

On January 19, the United States officially hit the debt ceiling.1  Now, you probably didn’t notice anything different when you woke up that morning, and nor will you for a while.  But there is a chance that sometime this year, the effects will be very noticeable indeed.  This is a story that will likely dominate the news more and more in the coming months.  Furthermore, it may lead to volatility in the markets.  So, to help prepare you for the spate of headlines coming our way, here’s a quick preview on the debt ceiling fight brewing in Washington. 

First, let’s recap what the debt ceiling actually is.  Many people think the debt ceiling is a cap on how much total money our government can spend, but it’s not.  This is actually an important point.  In truth, the debt ceiling is “the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations.”1

Now, what are these obligations?  It’s a massive list, including everything from Social Security and Medicare benefits to tax refunds, military salaries, and interest payments on Treasury bonds.  The debt ceiling, then, is the limit to what the government can borrow to pay back what it has already spent.  (Or is legally obligated to spend.)

To better understand this, we must understand the difference between government spending and government borrowing.  The two are not interchangeable. You see, when Congress passes a law, the government must spend money to enact it.  There are two types of legislation used to get that money.  Sometimes Congress authorizes a law, but the authorization doesn’t contain provisions to fund the law.  A separate piece of legislation, known as an appropriations bill, is required.  This is where Congress separately appropriates money for the new law.  These appropriations must be renewed, usually on an annual basis, for the law to remain funded.  This sort of thing is known as discretionary spending, because Congress decides upon its own discretion whether to continue funding the law. 

Other laws fall under the umbrella of mandatory spending.  When a new law is enacted that does contain the authority for funding, then Congress is required to fund the law perpetually until the law expires (assuming the law has an expiration date).  Social Security and Medicare, for example, fall under mandatory spending. 

Now, here’s the important part.  Sometimes Congress doesn’t have the money to pay for the laws it previously enacted, especially the larger mandatory programs.  But Congress can’t simply not pay for them.  A law is a law, and Congress is legally obligated to find the money to fund them.  So, in those cases, Congress must borrow the money it is compelled to spend.  That’s the difference between borrowing and spending, and the debt ceiling only applies to the former.  It limits how much the government can borrow to cover what it has already spent.

Normally, raising the debt ceiling requires a simple act of Congress.  Some years, however, politicians in Congress disagree about whether the ceiling should be raised.  Or, if the ceiling should only be raised if it also comes with a decrease in government spending.  When this happens, we get a debt ceiling crisis, where the nation comes perilously close to defaulting on its debts.  The most nerve-racking of these crises occurred in 2011.  Back then, the U.S. came so close to a default, our nation’s credit rating was downgraded for the first time in history.  (More on that in a moment.) 

Unless things change very quickly, 2023 is setting up to be the most bare-knuckled fight since then.  Now, for all our sakes, I’m going to skip the political aspects of this and focus solely on the financial.   The most important being: What happens if the U.S. defaults on its debt?

The short answer: Nobody knows.  It’s never happened before. 

The long answer: Nobody knows for sure, but we have a good idea.  It isn’t pretty. 

For starters, seniors could stop receiving Social Security payments, or at least experience delays.  Families could stop receiving Child Tax Credit Payments.  Members of the US military would stop receiving paychecks, as would federal employees.  Veterans’ benefits would be delayed.  Food assistance for the hungry, homeless, poor, and malnourished could stop.  Medicare patients would have no means of getting healthcare.  You get the idea. 

Less gut-wrenching on a human level, but equally impactful on a financial, is what a default would mean for the bond market.  As you know, the U.S. issues Treasury bonds to pay for everything that taxes alone cannot.  In a default, bondholders would no longer be paid, and the value of their bonds would plummet.  This would lead to dramatically higher interest rates on any new debt issued in the future – which in turn would lead to higher rates for everyone.  Given that rates are already higher than they’ve been in years, this would likely plunge the economy into a deep recession.  And since Treasury bonds are historically the most stable investment in the world, it would probably disrupt international bond markets, too.  The result?  A global recession. 

Now, there are some possible steps the government could take to diminish the effects of a default.  The most likely option would be for the government to prioritize its debt payments.  In this scenario, bondholders would get paid first, since they literally own the country’s debt.  That might stabilize the bond market, but it could still lead to higher unemployment, lower consumer spending, and other problems.  In other words, still a recession. 

Another possibility would be for the Federal Reserve to buy a portion of those bonds so that bondholders aren’t left out in the cold.  But doing this would also increase the nation’s money supply, leading to lower interest rates and higher inflation.  That’s the very opposite of what the Fed is currently trying to do!

Other scenarios are either more far-fetched or come with a host of potential legal problems.  For example, some academics argue that President Biden could simply ignore the debt ceiling.  Other experts think this would be unconstitutional.  If the courts agreed with that interpretation, all payments the government makes after breaching the debt ceiling would be considered invalid.  This would also throw the bond market into turmoil.  For these reasons, most policymakers usually see raising the debt ceiling as the only viable option. 

At this point, you’re probably wondering why none of this has happened yet if we’ve technically already reached the debt ceiling. I can give you the answer in two words: Extraordinary Measures.

Now, let me give you the answer in a few more words.  These “extraordinary measures” are basically accounting tools that help the government pay its bills without authorizing new debt.  The good news is that these measures buy the government time.  The bad news is that it’s just like replacing a flat tire with a spare one.  It’ll get your car to the shop, but sooner or later, you’ll have to get a new tire. 

As far as the debt ceiling is concerned, no one is exactly sure when “sooner or later will be.”  In a recent letter to Congress, the Treasury Department estimated the clock will hit zero no earlier than June.1  So, the immediate question we need to ponder is what will happen before then. 

Up to this point, the markets have been fairly calm about the debt ceiling.  There are two reasons for this.  The first reason is that, right now, investors are more concerned about things like interest rates and inflation.  The second reason is due to the assumption that Washington will get its act together and raise the debt ceiling like it always has before. 

Whether this happens remains to be seen.  But, while history suggests the country will avoid a default, history also suggests the markets will get increasingly nervous the closer we get to the June deadline.  For proof of that, let’s rewind back to 2011. 

Back then, President Obama and House Republicans were locked in a fierce debate over the same issues Washington faces today.  As the clock got closer to zero, Wall Street began to truly come to grips with the possibility of a default.  At one point, things looked so dire that one of the major rating agencies actually downgraded the nation’s credit for the first time in history.  It didn’t last very long, but it certainly rattled investors.  The stock market fell sharply while the cost of borrowing rose.  The only upside was that these effects shocked Washington into action, and a deal was cut to raise the debt ceiling mere days before a potential default. 

For these reasons, my team and I are carefully watching the negotiations going on in the White House and on Capitol Hill.  For the moment, we don’t see a need to make major changes to your portfolio.  And we certainly don’t think you need to feel any stress about the subject right now.  However, should anything change, we will let you know immediately.  Furthermore, we’ll keep you up to date about the situation as we get closer to June.  While Congress may be in the habit of waiting to the last minute to get things done, that’s not how we work here at Vaughan & Co. Securities, Inc..  We are committed to being vigilant and proactive as the months go by.        

In the meantime, we’ll continue to monitor your investments daily.  It’s our job to stress about the markets so that you don’t have to!  Of course, please let me know if you ever have any questions, concerns, or just want to chat.  Because, while the Force may not be real, I can still give you my own version of another famous Star Wars quote: “Remember, my team and I will be with you…always.”

 

1 “Letter to the Speaker of the House,” Department of the Treasury, January 13, 2023.  https://home.treasury.gov/system/files/136/Debt-Limit-Letter-to-Congress-McCarthy-20230113.pdf

The Secure 2.0 Act

Breaking down SECURE Act 2.0

On December 23, Congress passed the Consolidated Appropriations Act of 2023.  This is what’s known as an “omnibus spending bill”.  (The word omnibus means that multiple measures were packaged into a single document.)  The bill authorizes $1.7 trillion in government spending on everything from disaster relief to supporting Ukraine to workplace protections for pregnant mothers. On December 29, President Biden signed the bill into law.1

As you can imagine, this was a massive bill.  In fact, it contained over four thousand pages.  That’s because, as an omnibus, it’s really multiple bills combined into one.  Among those many bills is one that will have a profound impact on retirement called SECURE Act 2.0.

Back in 2019, Congress passed a law known as the Setting Every Community Up for Retirement Act.  This was the original SECURE Act.  The law made important changes to IRAs and 401(k)s, among other things, and was designed to help more Americans save for retirement.

SECURE Act 2.0 widens the scope of several provisions from the original law.  It also comes with a variety of new ones.  To help you understand this law and how it may affect your finances, I’ve written this special letter.  Now, as you’ve probably guessed, I’ve sent the following information to all my clients.  So, while some of the information you’re about to read may not apply to you right now, it could apply to members of your family.  If so, feel free to share this letter with them!

There’s a lot to unpack here, so please take a few minutes to read about these new provisions.  Most are fairly simple, and I’ve done my best to explain them all in plain English.  But if you have any questions or concerns, please let me know.
In the meantime, I wish you a Happy New Year!  I hope the year 2023 is a great one!

Important Provisions of the SECURE Act

Before we dive in, understand that SECURE Act 2.0 is over 20,000 words long.  That means there isn’t room to cover every aspect of the law, and many won’t apply to you anyway.  So, what follows is a brief overview of the provisions that could affect your finances.

Are you ready?  Then take a deep breath as we go over…

Changes to RMDs2

One of the most notable changes from the original SECURE Act was raising the age at which retirees need to take required minimum distributions, or RMDs.  SECURE Act 2.0 raises the age again.  Beginning on January 1 of this year, retirees may now wait until age 73 (up from age 72).  This is important, because it gives retirees an additional year to benefit from the tax advantages that come with IRAs before making mandatory withdrawals.  (Note that anyone who turned 72 last year will still need to continue taking RMDs as previously scheduled.)

Per the new law, the RMD age will increase to 75 beginning in 2033.

Another noteworthy change is the penalty applied to those who fail to take their RMD, or don’t withdraw enough.  Previously, the penalty was 50% of what the retiree should have withdrawn.  Beginning this year, that penalty has now been reduced to 25%.  And if the mistake is corrected within the proper “Correction Window”, it will be reduced further to a mere 10%. The Correction Window is usually defined as beginning January 1st of the year following the year of the missed RMD and ending when a Notice of Deficiency is mailed to the taxpayer or penalty is assessed

Finally, the law eliminates the need to take RMDs for Roth IRAs that are inside qualified employer plans.  What does that mean in English?  It means that if a retiree owns a Roth IRA through their old employer, they need never make mandatory withdrawals during their lifetime.  This change begins in 2024.

(Note, of course, that regular Roth IRAs not part of an employer plan were never subject to RMDs to begin with, so this change does not apply.)

Changes to Catch-Up Contributions2

Under current law, employees aged fifty or older can make extra “catch-up” contributions of up to $7,500 per year to their 401(k) or 403(b).  Beginning in 2025, individuals aged 60 through 63 will be able to contribute up to $10,000 annually.  Furthermore, that amount will be indexed to inflation, meaning it will go up as inflation does.

For people who are 50 or older – but not between the ages of 60-63 – the catch-up limit will remain $7,500 per year.

People aged 50 and older who own IRAs can also make catch-up contributions, albeit at a smaller amount.  Currently, the catch-up contribution limit for IRAs is $1,000 per year.  In 2024, that number will be indexed to inflation, too.  Again, that means the limit could increase each year as cost-of-living expenses rise.

Other Provisions to Note2

Here’s an interesting provision: Starting in 2024, individuals may transfer money from a 529 plan into a Roth IRA.  This could be useful if you own a 529 plan that has more funds than you or your loved one needs to pay for an education.  Think of it as a way to add more flexibility to your long-term finances.

It’s important to note, however, that this provision comes with a lot of terms and conditions.  For example, the Roth IRA must be in the same name as the beneficiary of the 529 plan.  Furthermore, no transfers can be made until the 529 plan has been maintained for at least fifteen years.  There are also very specific limits on how much money can be rolled over.  So, if you ever intend to make use of this provision, my advice is to talk to me first so my team can help you through the process.

Let’s move on to another interesting provision.  As a financial advisor, I’ve long recommended that all investors have a Rainy-Day Fund.  But sometimes, even this isn’t enough to handle unexpected expenses, like a health crisis or loss of income.  Under SECURE Act 2.0, it’s now easier to make use of your retirement savings in an emergency.  Previously, there was a 10% penalty for withdrawing money from a retirement account prior to reaching age 59½.  (This was to prevent people from using their retirement savings for something other than retirement.)  However, there are some exceptions, such as when you need the money to pay for certain medical expenses.  The new law has expanded the list of exceptions.  Here are some examples where the 10% penalty no longer applies:

- Recovering from a natural disaster, like an earthquake or hurricane

- Dealing with a terminal illness

- Being the victim of domestic abuse

The law also allows for emergency withdrawals for any taxpayer who needs to meet “unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses.”2  Now, what the law does not do is specify what situations qualify as an emergency.  Instead, the law states that “the administrator of an…eligible retirement plan may rely on an employee’s written certification that the employee satisfies the conditions of the preceding sentence in determining whether any distribution is an emergency personal expense distribution.”2

I know, I know – that sentence is Washington legalese at its finest.  Basically, this means people just need to be reasonable at determining for themselves what qualifies as an emergency.  For example, if a loved one has been injured in an accident?  That’s an emergency.  Desperately want to buy the newest PlayStation before it goes out of stock?  Not an emergency.

Hopefully, you will never have to make use of this provision.  But it’s nice to know that it’s there in case you ever do!

The final provision I want to address in this letter involves qualified charitable distributions, or QCDs.  A QCD is a direct transfer of funds from your IRA to a qualified charity.  They are a popular tool for retirees who want to contribute to a worthy cause, because QCDs also double as RMDs under most situations.

Under SECURE Act 2.0, people age 70½ and older may use a QCD to gift up to $50,000 to a beneficiary.  This is a one-time deal, and several conditions must be met.  So, again, if you want to take advantage of this provision, talk to me and my team first so we can help you navigate the rules and restrictions.

Lastly, the law also links the maximum annual QCD amount to inflation rather than capping it at $100,000 like before.

Conclusion

As you can see, SECURE Act 2.0 is loaded with provisions for those saving for retirement.  So, again, if you have any questions or concerns, please don’t hesitate to contact me!

Of course, my team and I will continue pouring over these changes.  If there is anything else we feel you need to know, we’ll reach out to you, or go over them with you during our next review.

In the meantime, remember that I’m here to help you work toward your financial goals.  Please let me know if there’s ever anything I can do – in 2023 and beyond.

 

Sources

1 “Here’s what’s in the $1.7 trillion spending law,” CNN, December 29, 2022.
2 Text of “Consolidated Appropriations Act of 2023,” (beginning page 817), Congress.gov.  https://www.congress.gov/117/bills/hr2617/BILLS-117hr2617enr.pdf

Christmas Present from the Federal Reserve 2022

Have you ever gotten a present you didn’t really want but knew that you kinda sorta needed?  (For example, socks.)  Just before Christmas, that’s exactly what the Federal Reserve decided to give the country.  Except the present wasn’t socks, but another interest rate hike meant to combat inflation. 

Suddenly, socks don’t seem so bad, do they?   

The markets reacted predictably, with the Dow dropping over 750 points the following day.1  So, in this message, I want to ensure you know what’s currently going on during the last few weeks of this year and what’s potentially on the table for next.  I also want to assure you that my team and I have expected this.  That way, armed with both understanding and assurance, you can focus on enjoying the holidays and spending time with family. 

In short, all the things that matter. 

Understanding the Fed’s Most Recent Move

On December 14, the Federal Reserve announced their seventh and final interest rate hike of 2022, bringing the Federal Funds Rate to a range of 4.25% to 4.50%.1 

Now, what’s interesting about this move isn’t that it happened.  Everyone knew another rate increase was coming.  What’s interesting is the number the Fed chose: 0.50%.1 

It’s easy to forget, but less than twelve months ago, interest rates were barely above zero.  Back then, the Fed was still trying to stimulate the post-COVID economy by keeping rates low and buying billions of dollars in bonds every month.  Unfortunately, while this was going on, inflation was starting to ramp up, too.

Think of it like hitting the accelerator on your car…right before you hit that patch of ice.

The Fed began reversing course in March, but it wasn’t until June that they began hiking rates in earnest.  What followed was the fastest rise in interest rates since the 1980s, all designed to slow the economy and bring prices down.  Over the next several months, the Fed raised rates by 0.75% at a time.2  That may not sound like much on its own, but when you realize that rates have gone from 0% to over 4% in just nine months, the full scope becomes clear.    

The Fed’s latest increase, however, was only 0.50%, which we haven’t seen since all the way back in May.  It’s the first sign the Fed may now be moving to slow the pace of rate hikes – although there are no plans to end the hikes anytime soon.  (More on this in a minute.) 

Interest Rate Changes in 20222

Date

Rate Change

Federal Funds Rate

3/17/22

+0.25%

0.25% to 0.50%

5/2/22

+0.50%

0.75% to 1.00%

6/16/22

+0.75%

1.5% to 1.75%

7/27/22

+0.75%

2.25% to 2.5%

9/21/22

+0.75%

3% to 3.25%

11/2/22

+0.75%

3.75% to 4%

12/14/22

+0.50%

4.25% to 4.50%

So, why is the Fed exploring a slower pace of increases?  To answer that, imagine heating up a mug of hot cocoa.  You put the mug in the microwave for about a minute, only to find your drink is nowhere near warm enough.  So, what do you do?  One approach would be to heat it up for another minute – there’s no chance your cocoa won’t be hot after that.  But there is a chance your drink will end up curdling…or maybe even exploding all over the inside of your microwave!    

Instead, you’d probably continue heating your cocoa in ten-second bursts, checking the temperature after each increment.  It’s a bit more work, but it ensures your cocoa ends up exactly how you want it to be. 

That’s what the Fed is doing now by dialing back the pace of their rate hikes.  They’re giving themselves a chance to see what effect each “ten second burst” has on both prices and the overall economy.  The reason they feel comfortable with doing that now is because the rate of inflation is slowing, too. 

According to the latest data, inflation slid from 7.7% to 7.1% in November.3  That’s a positive sign – especially as it’s a sharper decrease than economists expected.  And it’s why the Fed feels a bit more comfortable with hiking interest rates at a slower pace. 

So, does that mean all these interest rate spikes are working?  The answer is yes – to an extent. 

You see, when the Fed raises rates, what they’re trying to do is decrease economic activity.  By making it costlier to borrow money, the Fed wants to decrease how much consumers spend money.  It seems counterintuitive – after all, we’re used to the idea of economic growth being a good thing!  The idea is that as spending goes down, companies have no choice but to lower their prices to attract new business.  Lower prices equal lower inflation. 

The issue right now is that while prices are starting to go down, they are not going down evenly.  Furthermore, not all these decreases can be directly tied to interest rates.  For example, there’s an obvious link between interest rates and home prices.  So, it should come as no surprise that the housing market has been falling for months.  Auto loans are pricier too, which is why used-car prices are starting to fall. 

But other areas of the economy aren’t quite so tied to interest rates.  For example, two of the major sources of inflation this year have been food and fuel.  Both have started to level off, but this is largely due to post-pandemic supply chains finally getting sorted out and the world adjusting to geopolitical issues like the war in Ukraine.  As far as inflation’s concerned, the effect is the same – but the cause isn’t always tied to interest rates. 

The reason that matters is because in other areas, higher rates are not having the effect you might expect.  For example, take the labor market.  Oftentimes, when rates go up, businesses cut back on hiring or delay giving raises to their employees.  So far, neither is really happening.  Unemployment is still near a 50-year low.  Wages continue to grow at an unusually fast rate.  Hiring is beginning to slow, but nowhere near what the Fed likely expected.

The result is that consumer spending continues to motor along.  With most Americans having jobs and extra savings, families continue to spend.  That’s the main reason we haven’t entered a recession yet.  But it’s also one of the reasons that prices – although cooling! – continue to run stubbornly hot.          

It also means that, while the Fed may be slowing the pace of their rate hikes, there are no plans to stop anytime soon. 

Looking Ahead

On December 14, the Fed also unveiled their projections for 2023.  That’s important, because these projections reveal the Fed’s intentions for the coming year, allowing us to plan ahead. 

Due to all the factors, we’ve just gone over, the Fed projects they will continue to raise rates throughout the New Year.  Most Fed officials predict rates will rise to 5.1% by the end of 2023 (up from 4.25% now), but that’s just the median.4  Five officials thought 5.25% was more likely, and two went as high as 5.6%.  That’s significantly higher than what the Fed predicted just a few months ago, when they projected rates rising to around 4.6% for 2023.     

The last time interest rates were over 5% was all the way back in 2006.2  As you can imagine, this would have a profound effect on the economy, and the Fed knows it.  In fact, the Fed forecasts that unemployment will rise to 4.6% next year – up from 3.7% right now – and remain near that level through 2024.4  As a result, they also project a meager 0.5% in economic growth for 2023.4  That’s not technically a recession, but it will probably still feel like one. 

Now, it’s important to remember that this is a forecast.  Anyone who watches the weather knows how often forecasts change.  Inflation could cool faster than anticipated, nixing the need for such high interest rates.  Alternatively, inflation could continue being stubborn.  Or, the Fed might raise rates exactly how they predict, only to find the economy remaining surprisingly resilient. 

What it means for the markets – and for us

In 2022, there has been a spike in market volatility before and after every hike.  Don’t be surprised if that continues in 2023.  At the same time, investors have been playing a game of chicken with the Fed all year long, seeming to bet that the central bank won’t keep raising interest rates as high as they say, or for as long as they say.  This balancing act of inflation slowly cooling off, and the economy only gradually slowing down, may be the best thing that could happen to the markets.  Either way, however, we need to be mentally, emotionally, and financially prepared for more volatility in 2023. 

The good news, is that we already are!  While dealing with volatility is never fun, it’s important to remember that your financial plan and investment strategy already accounts for this.  We expect there to be times when we need to hit “Pause” on our journey and have factored those times into our plans accordingly.  The most important thing now is that we keep focusing on our mug of cocoa – tasting and testing as we go, looking for opportunities when we can and holding course when we need to.

My advice is to focus on the season.  My team and I will take care of the rest!  So, from all of us here at Vaughan & Co. Securities, Inc., We wish you Merry Christmas, Happy Hanukkah, and a prosperous New Year!  Please let us know if there is ever anything we can do for you.  May your cocoa always be the right temperature, and your gifts never be socks.                                                                                                           

1 “Dow closes out its worst day in three months,” CNBC, December 15, 2022.  https://www.cnbc.com/2022/12/14/stock-market-futures-open-to-close-news.html

2 “Federal Funds Rate History 1990 to 2022,” Forbes Advisor, December 14, 2022.  https://www.forbes.com/advisor/investing/fed-funds-rate-history/

3 “Inflation Cooled Notably in November,” The NY Times, December 14, 2022.  https://www.nytimes.com/2022/12/13/business/economy/inflation-cpi-november.html

4 “Summary of Economic Projections,” Federal Open Market Committee, December 14, 2022.  https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20221214.htm

 

 

Stock Market Halloween Edition!

Frights and Delights of Investing

As Halloween approaches, our thoughts turn to carving jack-o’-lanterns, trick-or-treating, haunted houses, festive costumes, and scary movies.  Halloween is the only holiday that has the ability to both delight and fright.  Costumed children gleefully celebrate their plunder from a neighborhood trick-or-treat.  Others brave the ghoulish horrors of a haunted house or ghastly terrors of Halloween movies.

In a way, markets have the same ability:  to both delight and fright.  After the better part of the year in market turmoil, it is probably starting to feel like we’ve been locked in a haunted house too long!

A client recently shared with us that he appreciates the “pep talks” our letters provide, but he would like to see something more technical from time-to-time.  So, we’re going to do just that.

To make this a little fun, however, see if you can identify who said the headings of each section of this letter!  Just in case, we’ve included the answers at the end.

LIONS AND TIGERS AND BEARS, OH MY!

In the present environment, we can’t talk about inflation without talking about interest rates.  The US inflation rate has declined somewhat, reaching 8.2% in September.  This is the lowest level in the past seven months, falling from a high of 9.1% in June of this year.1

This has occurred amidst a series of interest rate hikes.  The Federal Reserve has raised rates five times so far this year, with a likelihood of at least one more in 2022.2  The cause-and-effect between declining inflation and rising interest rates is not coincidental; it’s consequential.  Simply put, the Fed is using interest rate increases to slow down consumer demand.  Companies and consumers tend to borrow and spend less when the cost of doing so goes up.  As borrowing and spending decline, inflation declines.

This isn’t the first time the Federal Reserve used this strategy.  In the early 1980s, the Fed used aggressive rate hikes to tame double-digit inflation and restore balance to the US economy and markets.3

So, is the strategy working today?  It appears to be.  Inflation is declining, slowly, but declining.

What is a “good” inflation rate?  The Federal Reserve would like inflation to recede to near 2%.2

How long will that take?  Like a hot car engine, inflation takes time to cool.  The important thing to remember is that steady progress toward lower inflation may be as important to Wall Street as reaching the goal.  Why?  Because steady progress is better than uncertainty, and we know Wall Street does not like uncertainty.

A final thought on rising interest rates.  While rising rates are currently pressuring bond values, increased rates are finally making bonds, treasuries, CDs, and other fixed income attractive again.  This is long overdue in our opinion.  Investment-grade fixed income is usually a helpful risk-management element of a portfolio.  It hasn’t been performing to its potential for some time because of the historically low interest rate environment.  Rising rates should ultimately be positive for fixed income.

DOUBLE, DOUBLE TOIL AND TROUBLE

When high inflation and rising interest rates come together, higher unemployment usually follows.  So far, however, this is not the case in the US economy.  The September unemployment rate was 3.5%, falling from a high of 4.0% in January.4  Recently revised projections by Goldman Sachs see a slight uptick to 3.7% by year-end and possibly 4.1% by the end of 2023.5

The number of job openings in the US shrank notably from 11.2 million in July to 10.1 million in August.  Layoffs remain historically low, and overall hiring is largely unchanged.  In essence, employers may be getting more selective about hiring, but they aren’t slashing jobs or refusing to add jobs.6

Add to these facts that business borrowing by US companies remains relatively healthy.  In other words, companies have a positive enough outlook to acquire the goods and services needed to respond to customer demand.7  If companies felt financial trouble was on the horizon, they would be cutting budgets and laying off employees.  That doesn’t seem to be happening, at least not yet.

I GOT A ROCK

That probably summarizes how most of us feel about investments right now.

However, when putting together all the things we just reviewed, it may mean that the Federal Reserve’s plan to slow down the economy without triggering a recession could be working.  That said, this chapter in the US economy is not yet at an end.  There are some hints suggesting that we’re moving in the right direction, but those hints need to turn into steady progress.  Until then, volatility will likely remain.

So, what does all of this mean for your investments?  We haven’t gotten out of the haunted house yet, but there are glimpses of light suggesting we might be moving closer to the exit.

JUST BECAUSE I CANNOT SEE IT, DOESN’T MEAN I CAN’T BELIEVE IT

We know what you’re thinking.  “Seriously, are you really going to tell us yet again to stay the course?!?”

We understand.  Fatigue and weariness are setting in while we wait for some signs of better markets ahead.  Truth is, we’ve been rather spoiled in the 14 years since the Great Recession of 2008.  Only two times since then did we experience a bear market.  Markets fell 27.62% between January and March 2009, but recovered in just 62 days.  The second bear market occurred during just 4 short weeks between February and March 2020.  Markets declined 33.92%, but speedily recovered in a mere 33 days.8  Markets rebounded so quickly, some probably never noticed these events.

You’re noticing now, however, and that’s simply because markets are taking longer to recover.

So, are markets going to recover?  We believe, yes.  Over the last 70 years of market history, there have been nine bear markets (defined as a 20% decline or more).  The average decline was 33%.  The average length was about 14 months.  Conversely, the average bull market return during that same period was 268%.  The average expansion lasted 70 months.9 Let’s think about those averages in the form of a question:  Is one year of market pain worth nearly six years of market gain?

This is why trying to time the market is so very tricky.  Between 1930 to 2020, the S&P 500 cumulatively returned 17,715%.  Yes, you read that figure correctly.  Now, let’s exclude the 10 best days per decade.  Some quick math tells us that’s just 90 days out of about 21,600 trading days.  Remove those 90 best days, and the cumulative return is 28%.10  Yes, you read that figure correctly, too!

Now, you might be thinking, “Why can’t you figure out something to at least save us from the worst days?”  We agree that would be great, except no one knows a “worst day” IS happening until it HAS actually happened.  The same applies to the market’s best days.  The “timing” trap gets more complicated when you know that the market’s best days most often follow closely after the market’s worst days.  In fact, over the past 30 years, ALL of the ten (10) best trading days in terms of percentage increase occurred during recessions.11

THINGS ARE NEVER QUITE AS SCARY WHEN YOU’VE GOT A BEST FRIEND

We may not be your best friends, but we are your trusted financial advisors!  And part of our job is to take the scary out of the markets.  Your investment strategies are tuned to your financial goals and objectives.  They are built with the expectation that we will experience good and bad markets.  Staying true to your strategy is what helps us and you meet your goals and objectives.

As Halloween approaches, we here at Vaughan & Co. Securities, Inc. encourage you to leave the fright, the dark, the scary, and the terrifying for the Halloween movies and haunted houses of the season.  The delight of good markets comes with the occasional fright of bad markets.  Savvy investors don’t let emotions of those occasions steer them away from time-tested strategies designed to achieve their goals and objectives.

As always, we are here for you.  If you have any questions or concerns, please call us.  Have a happy Halloween!

 

 

1 “United States Inflation Rate,” Trading Economics, https://tradingeconomics.com/united-states/inflation-cpi

2 “The Fed forecasts hiking rates as high as 4.6% before ending inflation fight,” CNBC, September 21, 2026.  https://www.cnbc.com/2022/09/21/the-fed-forecasts-hiking-rates-as-high-as-4point6percent-before-ending-inflation-fight.html

3 “Paul Volcker,” Wikipedia, https://en.wikipedia.org/wiki/Paul_Volcker

4 “United States Unemployment Rate,” Trading Economics, https://tradingeconomics.com/united-states/unemployment-rate

5 “Goldman Sachs cuts 2023 outlook for US growth,” Fox Business, https://www.foxbusiness.com/economy/goldman-sachs-cuts-2023-outlook-us-growth

6 “United States Job Openings,” Trading Economics, https://tradingeconomics.com/united-states/job-offers

7 “U.S. Business Borrowing for Equipment Rises 6% in September,” US News, https://money.usnews.com/investing/news/articles/2021-10-25/us-business-borrowing-for-equipment-rises-6-in-september-elfa

8 “The Complete History of Bear Markets,” Seeking Alpha, https://seekingalpha.com/article/4483348-bear-market-history

9 “Bear markets look less fierce with a long-term perspective,” Capital Group, https://www.capitalgroup.com/individual/insights/articles/bull-bear-history.html

10 “This chart shows why investors should never try to time the stock market,” CNBC, https://www.cnbc.com/2021/03/24/this-chart-shows-why-investors-should-never-try-to-time-the-stock-market.html

11 “The perils of trying to time volatile markets,” Wells Fargo, https://www.wellsfargo.com/investment-institute/sr-perils-time-volatile-markets/

 

QUOTES QUIZ ANSWERS:

“Lions and tigers and bears, oh my!” – Dorothy, The Wizard of Oz

“Double, double toil and trouble” – Three Witches, Macbeth, William Shakespeare

“I got a rock” – Charlie Brown, It’s the Great Pumpkin, Charlie Brown, George Shultz

“Just because I can’t see it, doesn’t mean I can’t believe it” – Jack Skellington, Nightmare Before Christmas

“Things are never quite as scary when you’ve got a best friend” – Calvin and Hobbes, Bill Watterson

 

 

The Recession Question 2022

If I wanted to see if it was raining in, say, Zimbabwe, all I’d have to do is load my favorite weather app and I’d know within seconds.  Similarly, if I wanted to find out if which baseballs team won last night, all I’d have to do is fire up Google.

But if I wanted to find out if we’re in a recession or not?  Well, that’s a little harder to get an answer to.

Ever since summer began, people have been wondering whether we’re in a recession.  Many of my clients have asked me lately, too.  Unfortunately, it’s not as simple a question as it seems.  Why?  Because the very act of defining a recession is not as easy as you might think.

The popular definition of a recession, oft repeated in the media, is two straight quarters of declining economic growth.  But most economists don’t think of recessions that way – it’s too simplistic and may not accurately describe what’s going on in the economy.  Meanwhile, the technical definition, per the National Bureau of Economic Research – more on them in a bit – is “a significant decline in economic activity spread across the market, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”1

But this word salad raises more questions than answers.  For starters, how do you define “significant?”  How many months is “a few?”  Two?  Three?  Four?  And finally, what if you see a decline in, say, GDP, but not in employment?  Is it still a recession?

There’s no question that there’s a ton of economic uncertainty in our country right now.  Skyrocketing inflation means we’re paying more on everything from gas to groceries.  To counter this, the Federal Reserve recently hiked interest rates for the third time in 2022.  When interest rates rise quickly, it often – but not always – triggers a recession.  So, there are good reasons to think a recession is in the cards.

But are we in one right now?  Let’s examine that question in a little more detail, before addressing what the answer means to us as investors.

The argument for a recession

The case for a recession is simple: The economy has shrunk for two straight quarters.  In this argument, the popular definition of a recession is the correct one.

When I say, “the economy,” what I really mean here is our nation’s gross domestic product, or GDP.  You probably remember hearing this term a lot in your college economics class, but in case you need a refresher, GDP measures the market value of all the goods and services a country produces in a specific period.  In this case, the U.S.’s GDP fell by 0.9% from April through June, the second quarter in a row in which that’s happened.2  (In the first quarter, GDP dropped by 1.6%.2)

There are many reasons GDP can decline.  Data shows, however, that this particular decline was for one main reason: a drop in business inventory levels.

Okay, bear with me here, because we’re about to get wonky.  One component of how GDP is measured is how much inventory businesses have of whatever it is they actually sell.  It’s a small component – usually less than 1% of GDP3 – but it’s an extremely important one.  That’s because changes to these inventories can be a very effective signal for what business activity will look like in the future.  For example, if businesses across the country stock up on their inventory, it often signals strong demand.  Consumers want these products, are likely to continue wanting these products, and are willing to pay for them.  In other words, there’s likely to be a lot of buying and selling – i.e., business activity – in the short term.

Between April and June, however, inventories dropped.  Businesses simply didn’t see a need to invest in their inventory.  They foresee supply outpacing demand – which is good for inflation, because it may bring prices down – but not for the overall economy.  It’s a signal of declining business activity, which is one of the hallmarks of a recession.  Hence, a decline in GDP.

(We’ll come back to this in a bit, because there’s an interesting counterargument to the inventory angle.)

Another piece of evidence that we’re in a recession is something called the inverted yield curve. 

Okay, before I break down this piece of financial jargon, my advice is to get comfortable.  If you’re reading this during the day, make yourself a nice glass of lemonade and head outside to the hammock if you have one.  If it’s nighttime, get your fluffiest slippers and put the kettle on.

Ready?  Okay, here we go.

A yield curve is a graph that depicts the relationship between long-term bond interest rates and short-term bond interest rates.  Typically, longer-term bonds come with higher rates than short-term bonds because the bondholder needs to be compensated for investing for longer.  (If I’m going to lend my money for ten years, as opposed to one, I expect to get extra compensation for it.)

Sometimes, however, the yield curve inverts, or flips over.  When this happens, it’s because interest rates for long-term bonds fall lower than those for short-term bonds.  What prompts the flip?  Investors getting nervous about what the immediate future holds.  If bond investors feel that it’s riskier to lend money in the short term than the long-term, then they start demanding higher interest rates.  Otherwise, they’d prefer to just sock their money away for ten or twenty years and forget about it, thank you very much.

Why does this matter?  Because almost every recession for the past sixty years has been preceded by an inverted yield curve.  It’s one of the major recession indicators that investors – and the media – watch for.

(We’re not to “The Case Against a Recession” yet, but I want to clear up something before we go any further: An inverted yield curve does not cause a recession.  It merely predates one.  Remember, correlation does not equal causation.  It’s also important to note that, historically, recessions have occurred anywhere from 6 to 24 months after the yield curve inverts.4  So, while such curves may have a Nostradamus-like reputation, they’re an imperfect indicator at best.)

Another predictor for a recession is rising interest rates.  Between June 2021 and June 2022, prices in the U.S. rose by 9.1%.5  That’s a level of inflation we haven’t seen in decades.  To bring prices under control, the Federal Reserve recently approved another interest rate hike.  While higher interest rates are a proven tool for tamping down on inflation, they can also trigger recessions.

The final argument for a recession is that most consumers already think we are in a recession.

Here in the U.S., consumer confidence has slipped for three straight months, and is now the lowest it’s been since early 2021.6  That’s important, because when people have low expectations about the economy, they tend to make recessions a self-fulfilling prophecy.  When consumer confidence is low, people spend less.  When people spend less, businesses sell less.  When businesses sell less, industries produce less.

Add it all up and you have a declining GDP, a shrinking economy…and a recession.

The argument against a recession

Whoo-boy!  That was a lot of words about why we’re in a recession, wasn’t it?  So much so that it might seem overwhelming.  But if you’re someone who prefers to look on the bright side, always finds a silver lining, and sees the glass as half-full, you’re in luck.  Because there’s evidence against a recession, too.

Let’s knock these out one by one.  First up, for every bit of data that suggests a recession, there’s data that suggests the economy is actually doing okay.  One of the most important is the labor market.  As of June, 98% of the jobs lost during the pandemic have been recovered.  The economy has added 2.2 million jobs since January.  And the unemployment level has remained steady at 3.6%, which is just above where we were before COVID became a thing.7  So while, yes, GDP has declined, it only tells half the story.  Normal recessions show a decline in economic activity across the board, including both GDP and unemployment.  So, while businesses may be reducing their inventories, they are still adding jobs.

There’s also a possibility that the GDP argument is overblown right now.  For one thing, remember how I said that GDP fell by 0.9% between April and June?  That may turn out to be inaccurate.  Quarterly GDP data is always revised several times as the relevant bureaus who gather and analyze said data – the Bureau of Labor Statistics and the Bureau of Economic Analysis – collect and refine more information.  Sometimes, it turns out that the economy will have actually grown in the previous quarter when at first it looked like it fell.  (The opposite is also true: It’s possible that Q2 GDP could end up looking worse than first thought.)

Some economists also believe the business inventory data I mentioned may be a bit of a misnomer.  You see, in 2021, many businesses ended up overstocking on goods they didn’t actually need.  Why?  Because they wanted to ensure that future issues with global supply chains didn’t leave them high and dry later.  Think of it like going to the grocery store just before a blizzard hits.  If you think it will be a while before you can get groceries again, you may end up buying more food than you can actually eat – food that will go to waste or sit unused in your pantry.  This is what many businesses did in 2021.

So, what’s an overstocked business to do?  Simple: Balance things out by investing less in their inventory.  There’s a possibility this is why inventory levels fell so much during the second quarter.  If so, it would suggest that the decline in GDP was largely artificial.  Especially because, if you take inventory data out of the equation, our GDP would have actually gone up in Q2!

Want more data about why our economy might be okay?  I can give you more. So far this summer, wages and salaries have increased along with jobs – hardly a sign of a recession.  And while consumer confidence is down, consumer spending is up, having grown 1.1% in June.7

Add all this evidence up, and you have a picture that looks more like an economic cooldown than an economic recession.  Which, of course, is exactly what the Federal Reserve hoped for when it started raising interest rates to bring down inflation.

Who decides whether it’s a recession, anyway?

Over the last decade or so, economic data has become weaponized by politicians hoping to win the next round of political football.  Every time there’s a slowdown in the economy, the party that holds power in Washington has an incentive to declare “Everything’s fine” so that they can stay in power.  And the party that wants to be in power has the incentive to say, “Everything’s falling apart.”

That’s what we’re seeing now.

So, after reading all the arguments for and against a recession, you’re probably wondering whose job it is to figure out the answer officially.  Early in this message, I mentioned an organization called the National Bureau of Economic Research.  (NBER for short.)  Inside the NBER is a small group of economists called the “Business Cycle Dating Committee.”  This is the body that officially declares a recession.

While this group is officially part of the government, they have a long history of nonpartisanship.  The proof of that is in how long they take to issue pronouncements.  You see, the committee does not analyze whether we’re in a recession or not in real time.  Instead, they take months to make the call, usually waiting until the evidence is overwhelming and undeniable.  (Clearly, we’re a long way from this.)  Sometimes, the recession may have already come and gone before the committee says anything.  While this can be frustrating, there’s a good reason for it: Their research is for the benefit of historians and economists who are seeking to learn from the past.  Not politicians and pundits who are looking for easy talking points.  So, it may be a long time before we officially know the answer to the question I posed at the beginning of this message.  That means we need to take everything we hear in the media, or out of Washington, with many grains of salt and not overreact to any one piece of data.

Why the question doesn’t matter as much as you might think

Make no mistake: Recessions are a big deal.  But as investors, the real danger is less about whether we’re in a recession or not, and more about whether we overreact or not.  To illustrate what I mean, I’d like to tell you a story.  This is an old fable that first appeared in magazines at least as far back as the 1950s, but it’s still relevant to us today.

There was once a man who sold hot dogs on the side of the road.  He was hard of hearing, so he had no radio.  He had trouble with his eyes, so he never watched television.  But he sold good hot dogs.

He put up a sign on the highway, telling people how good they were.  He stood by the side of the road and cried, “Buy a hotdog, mister!”  And people bought.

He increased his meat and bun order and bought a bigger stove so he could make more hot dogs.  Then he asked his son, who was home from college for the summer, to help him.  But then something happened.  His son said, “Dad, haven’t you been following the news?  There’s a recession coming.  The international situation is terrible, and the domestic situation is even worse.”

The man thought, “Well, my son is very smart.  He watches the news, so he ought to know.”  So, the man cut down on his bun order.  He took down his advertising signs.  He worked fewer hours. And he never cried, “Buy a hot dog!” because times were hard, and he figured nobody would or could.

His hot dog sales fell overnight.

“You were right, son,” the man said.  “We are certainly in the middle of a recession.”

The worst mistake an investor can make during times like these is to stop making decisions based on what they know in favor of what they don’t.  The man in the story knew how to make good hot dogs.  We, in turn, know how to make sound investment decisions.  Our investment strategy is designed to work over the long-term, in good times and bad, and so long as we stick to that – so long as we keep making good hot dogs – then we will keep moving forward to your long-term financial goals.

So, are we in a recession?  I’ll leave that for the economists to decide.  All I know is that I remain confident in the direction we are going, and I look forward to helping you continue in that direction for years to come.  As always, please let me know if you have any questions or concerns.  My team and I are always here for you.  Enjoy the rest of your summer!   

 

Sources

1 “Business Cycle Dating Committee Announcement,” National Bureau of Economic Research, January 7, 2008.  https://www.nber.org/news/business-cycle-dating-committee-announcement-january-7-2008

2 “U.S. economy shrank at annual rate of 0.9% in the second quarter,” CNBC, July 28, 2022.  https://www.cbsnews.com/news/gdp-us-economy-2022-q2/

3 “Changes in Inventories (from NIPA accounts),” NYU Stern School of Business.  https://pages.stern.nyu.edu/~nroubini/bci/Inventories.html

4 “Inversion of key U.S. yield curve slice is a recession alarm,” Reuters, March 30, 2022.  https://www.reuters.com/business/finance/us-2-year10-year-yield-curve-inverts-first-time-since-sept-2019-2022-03-29/

5 “Consumer prices up 9.1% over the year ended June 2022, largest increase in 40 years,” U.S. Bureau of Labor Statistics, July 18, 2022.  https://www.bls.gov/opub/ted/2022/consumer-prices-up-9-1-percent-over-the-year-ended-june-2022-largest-increase-in-40-years.htm

6 “US Consumer Confidence Drops to Lowest Since February 2021,” Bloomberg, July 26, 2022.  https://www.bloomberg.com/news/articles/2022-07-26/us-consumer-confidence-drops-to-lowest-since-february-2021

7 “So are we in a recession, or not?” CNN Business, July 29, 2022.  https://www.cnn.com/2022/07/29/economy/gdp-recession-fed/index.html