The Financial Advocate: Winter 2023
Goodbye, TINA and FOMO
It has been a busy start to 2023. After a dismal 2022, the markets took off with a bang! Stocks Up, Bonds Up! Surely, we are out of the woods…
Well, not really. Over the past 15 years, since the financial crisis of 2008, the Federal Reserve had a “put” under the stock market. Every time the stock markets headed in a negative direction, the Fed came to the rescue with lower interest rates. (This happened during periods of economic stress: the Financial Crisis and the pandemic). Low interest rates spur stock investments higher. Investors view earnings of corporations as more valuable when there are dismal returns on savings and money market accounts. Stock investors fell into two mindsets: TINA and FOMO. (The feeling that There Is No Alternative to stock investing followed by the Fear Of Missing Out). As conservative investors saw their equity-oriented, aggressive counterparts prosper, they changed direction and money flowed into risk assets like stocks.
TINA & FOMO
So, what makes a sustained move in the equity markets challenging? For one thing … there is an alternative! With interest rates up, investors can lock in favorable bond investments with higher rates. Even cash investments will get you a risk-free yield in the high 3% range. Some Johnny Come Lately (FOMO) stock market investors of the past few years will be happy to lock in “safe” returns rather than watch their investments have volatile or negative returns as they did in 2022. And there is another problem…
“Welcome to “the Club!”
Usually, this greeting is associated with a pleasant experience of joining a golf, tennis, swim, or social club. But for our purposes, we are going to discuss Federal Reserve policy.
During the pandemic, the Fed flooded the financial markets with liquidity. How much? $5,000,000,000,000! Yes, $5 trillion. Remember, before the pandemic the Fed was trying to work off the previous $4 trillion on their balance sheet from the financial crisis. At its peak, the Fed’s balance sheet totaled just under $9 trillion. Then, the Trump and Biden administrations added trillions in fiscal stimulus. So, with all this money sloshing around and supply chains in disorder, inflation set in.
The Fed hates runaway inflation just as it hates deflation. The organization has two official mandates: full employment and price stability. The inflation we experienced in 2022 was anything but “price stability.” So now the Federal Reserve is headed in exactly the opposite direction they were pursuing during the pandemic: drain money from the system, hike interest rates, slow the economy, and kill inflation. The goal is for there to be a sharp drop in demand which ultimately leads to a slower economy with a more “normal” inflation rate.
Back to “the Club.” Federal Reserve officials frequently talk in terms of how sophisticated their monetary tools are and how adroitly they can yield them. The team at the Fed is undoubtedly comprised of some of the best economists in the world. But the tools which they use to influence the American economy look much more like the caveman’s club than the surgeon’s scalpel.
The club is simply this: drain liquidity and raise interest rates. Not very sophisticated, is it? Profits go down, earnings go down, stocks go down, interest rates soar, and there are few (if any) “safe” places to hide. Doesn’t that feel a lot like 2022?! The Fed’s club is a blunt tool, and its outcomes can be just as sloppy.
Today, markets are rallying because the general perception is that the Federal Reserve has nearly finished its interest rate hiking agenda. That may or may not be true. Housing went from blistering hot to very cool. Tech companies, the darlings during Covid, have announced layoffs and weaker demand. Yet, the overall labor market is robust, the consumer continues to spend, and GDP looks firm enough. These conditions create crosswinds. So, we remain cautious and are studying the corporate earnings picture closely. If earnings hold up, then the elusive “soft landing” for the markets and economy becomes a possibility. However, if earnings crack lower markets will likely follow. We remain cautious in many of our holdings, concentrating in companies with strong balance sheets, niche markets with wide moats, good dividend policies, and adroit management teams.
China’s reopening should be greeted warmly by economies around the world. Supply chain disruption is already improving and will likely get even better. Middle class demand from Chinese citizens is good for many industries. The emerging markets should do better as they supply a “restarted” world. Even Europe looks like it is muddling through without severe recession. (The warm winter has helped keep energy inflation caused by the war in check). If the US can successfully drive down inflation (it looks like that is happening right now) without plunging into a deep recession, we can all breathe a collective sigh of relief. Housing markets will rebound, tech spending will pick up, and reshoring activities around the globe should keep industrial demand strong.
While it felt like everything went wrong in 2022, a lot of things did not. Investment markets were very volatile. There were points during the year where analysts were calling for a 20% decline in corporate earnings. Earnings will likely finish 2022 higher by a margin of 9%. That’s pretty good! Inflation is taking significant steps lower. The likelihood of a “soft landing” is increasing while the odds of a severe recession are decreasing. We will be mindful of weakness in jobs figures, wages, retail sales, and purchasing manager indices. But, the Atlanta Fed’s “GDP Now” reading is showing annualized expansion of 2.2% for the US economy in the first quarter. That’s not “gloom and doom.”
|The likelihood of a “soft landing” is increasing while the odds of a severe recession are decreasing. We will be mindful of weakness in jobs figures, wages, retail sales, and purchasing manager indices. But, the Atlanta Fed’s “GDP Now” reading is showing annualized expansion of 2.2% for the US economy in the first quarter. That’s not “gloom and doom.”|
It is worth noting that this type of market action has occurred six times since the 1970’s. Here are the dates: 1973-74, 1980-82, 1987, 2000-02, 2007-09, 2022. Most of our clients have invested through at least two of these episodes and some have seen all six. The significance is that by avoiding panic and applying discipline to remain thoughtfully invested, investors have prospered tremendously over the past six decades. We believe that we are stuck in a grinding recovery. We expect interest rates to stay higher for longer. But we have been here before! Stay the course. For actively managed, discretionary portfolios, we do not just endure – we adapt portfolios to be reflective of the overall investment environment. In actively managed, discretionary accounts, when world class companies were down 40-80%, as your portfolio managers, we took the opportunity to accumulate. We do not expect the economy to crater, but it is not off to the races either. Price increases should moderate or even drift lower, earnings may be OK, demand should cool. If 2023 becomes a “reset” year, that will be a good outcome. The Fed will eventually loosen its policy and rates will fall. Investments in both stocks and bonds will weather that storm and set up for the next expansion.
Economist’s Corner by Roger Klein, PhD
Thus far, through January and the start of February, it has been a pleasant time for investors. Why this favorable change? Of course, nobody really knows. But after the fact we can point to some obvious factors. Sentiment was extremely negative. At the beginning of the year, almost every commentator and pundit were negative about the outlook for monetary policy, inflation, and the possibility of recession. Measures of investor sentiment were as negative as they can get. When investor sentiment is leaning extremely negative that means that investors are holding a lot of cash, while hedge funds and other speculations are short stocks. If the things that investors worry about become less worrisome, markets can shift quickly and violently to the upside.
Many concerns remain. Monetary policy is on a tightening path. The Fed promises to continue to increase its target interest rate. The Federal Open Market Committee will meet again in March and another 0.25% increase in the target federal funds rate is expected. In addition, the Fed is using quantitative tightening (QT). Liquidity is drying up. Year-over-year growth in the M2 money supply was zero in November and was negative 1.31% in December. We almost never experience negative money growth.
The Fed has a 2% inflation target and believes that it must use its policy tools to achieve it. The inflation data are the numbers to watch. An upward tick in the inflation indexes will be bad news for the financial markets. My expectation is that the Fed will stop raising its target interest rate at the March meeting and keep its target rate at 5% for an extended time.
Managed Model Strategy
The Global Alpha model continues to “muddle through” with a mix of growth companies balanced with more traditional, early cycle industrial and energy complex holdings. These two focus areas are on either side of the equity risk spectrum. Some days the growth stocks take the lead, other days the value/traditional stocks behave as a haven. Volatility is alive and well – even if somewhat muted at the moment. We see opportunities coming to fruition in emerging markets, small and mid cap domestic equities and international markets. We maintain that our focus on high-quality companies should lead to successful results over time.
Global Balanced has made notable changes in the past several months. In the fixed income component, we have begun the process of making bond holdings more aggressive after a long period where this sleeve focused on conservative issues. This includes initiating positions in longer term bonds, emerging market debt, and high-yield bonds. The alternatives sleeve of the portfolio has seen a slight reduction in the allocation to commodities. Several positions in the domestic equity bucket had appreciated rapidly in the first few weeks of the year warranting profit taking. Lastly, in the international equity sleeve of the portfolio, we expanded exposure into Mexico and Canada as we believe the USMCA (NAFTA) economic zone is relatively well-positioned. A strong rebound in China could justify increased allocations to emerging market stocks.
As we enter the new year, we are using some of the cash balances in the Moderate Allocation portfolio to increase fixed income holdings. The Federal Reserve is closer to the end of this tightening cycle and inflation has definitively decelerated. We will use weakness in bond prices to further increase the asset class, as well as lengthen the duration of the holdings. We recently closed out a tactical trade in the Vanguard Total Stock Market ETF for a profit and will redeploy these funds judiciously. We have also begun to take positions in overseas holdings as we believe the valuations are compelling and expect such companies to benefit from the “reopening” of the Chinese economy. We also expect volatility in domestic markets to remain higher than usual in the coming months as the outcome of monetary tightening plays out. We intend to use substantial weakness in equity prices opportunistically.
Important Note: Across all internally managed, discretionary models at VWM there was extensive tax-loss harvesting at the close of 2022. Accounts were examined at both the individual and household levels in an effort to minimize capital gains. In some instances, we purposely created “banks” of capital losses that may be used in future years to offset capital gains. (While 2022 was a lousy year for investors, realizing these losses and putting them in the proverbial bank is a positive outcome). As your portfolio managers, we balanced the risk and reward of taking these actions without seriously impacting portfolio performance. It’s a delicate dance with meaningful outcomes come Tax Day.
This quarter’s Milestone360 topic is the Secure Act 2.0. Recently passed into law, the Secure Act 2.0 has notable implications. There are over 90 components of the law – some take effect immediately, some rolling out over the next several years. Here are a few key points:
- There are new contribution limits to 401(k) and 403(b) plans. The normal contribution amount is now $22,500. Employees 50 and older can contribute an extra $7,500 as a “catch up.” If you are considering increasing your deferral, please contact your employer’s HR department.
- The initial Required Minimum Distribution (RMD) age from retirement accounts was increased from 72 to 73. If you turned 72 in 2022, you must still take your RMD by April 1st.
- Starting in 2024, there will no longer be RMDs for Roth 401(k) accounts.
- People with terminal illness can now take distributions from retirement accounts without incurring the 10% penalty if they are younger than 59.5.
- If you live in a federally declared disaster zone, you can withdraw $22,000 from retirement plans without incurring the 10% penalty if you are younger than 59.5.
- Starting in 2024, a portion of unused 529 monies can be rolled into a Roth IRA without incurring taxes or penalties. There is a $35,000 lifetime cap per child.
As always, we appreciate your continued support. If you have questions or concerns about your portfolio or financial plan, please do not hesitate to reach out to a member of the team. We are happy to help.
Nick Ventura, CFP® CPWA®
President / CEO