To say the least, it was a rough quarter in the markets. All major asset classes continued to fall, and stocks officially entered into bear market territory. Inflation continues to be top of mind for both policymakers and the general public. Energy and food prices have generated most of the attention. Various market pundits are forecasting an imminent recession.
It’s during times like these that investors must maintain focus on the long-term. If you don’t have a plan already, get one and stick to it. If we allow ourselves to get swallowed up by the day-to-day chaos in the media/markets, we’ll go crazy.
Here are the asset class returns for the past quarter:
Economic situation
Inflation is the main problem in the economy right now. The underlying causes include:
COVID shutdowns continue to disrupt global supply chains
Commodity supply disruptions from the war in Ukraine
Stimulus efforts in the developed world that likely overshot the mark
Stable economic systems require a fine balance between supply and demand. Right now, demand significantly outweighs supply.
Managing inflation with interest rates
The Federal Reserve has taken steps to reduce demand. At the most recent meeting, officials raised short term interest rates by 0.75%, the largest one-time increase in a very long while. However, the leaders of the Fed better get comfortable with tough choices in the future. As Paul Volcker learned back in the 1970’s, getting a handle on inflation is much like wrestling a grizzly bear… scary and difficult.
Furthermore, the Fed’s power really only extends to the ‘demand’ side of the economy. There is not much they can do about the supply chain issues. For example, they cannot force China to reopen factories, or Russia to cease attacks in Ukraine.
However, there are actions that other policymakers can take to address some of the components of inflation. Here is an example:
Long Beach, California, hosts the largest container port in the United States. Given current supply chain issues, the port had a long backlog and considerable wait for container ships to unload. The City of Long Beach had a regulation that allowed the stacking of only two containers, designed to keep the containers from blocking residents’ view of the ocean. Realizing the bottleneck at their port was causing a national problem, the City of Long Beach changed the regulation, allowing four or five containers to be stacked. While inconvenient for citizens in the short term, the City of Long Beach did something to help the nation.
We are seeing the effects of higher interest rates in housing. Price growth has flat lined as prospective home buyers have paused their plans in the face of unprecedented affordability concerns. To wit:
Mortgage rates have essentially doubled in the space of six months. If you combine historically elevated real estate prices with much higher mortgage rates, you get a collapse in housing affordability:
While the Fed can slow down demand for housing, the only true solution to housing inflation will require more houses.
Energy prices
It’s hard to overstate the effect of energy prices on the economy. Energy flows through every component of modern economic systems. Just ask the citizens of Sri Lanka.
It remains to be seen whether energy producers will fill in any supply gaps caused by Russia. Once upon a time, management teams at US energy companies got paid largely based on production goals. That is, the more oil the company pulled out of the ground, the more money reached the executive team’s pockets. However, this created significant problems for investors.
Turns out, there is a LOT of oil out there, but not all of it can be profitably extracted.
But some management teams undertook a “drill baby, drill” approach and didn’t concern themselves too much with the economic profitability of each individual well. This approach left energy producers vulnerable when oil prices came down starting back in 2014.
Nowadays, investors in energy companies are demanding (and getting) more discipline around costs and profits. Investors are, in effect, saying, “If you want to drill a well, fine, but you better not lose money on it.” All of this means that nobody should rely on energy companies to turn on the spigot of new supplies. More than likely, the managers at Exxon, Chevron, etc. are happy to keep production levels steady even with current price levels.
Valuations and corporate earnings
One bright side of falling stock prices is more attractive valuations. The Schiller Cyclically Adjusted Price Earnings (CAPE) Ratio dropped from 38.3 to 28.7 so far this year. While still elevated compared to historical norms, this drop represents a drastic improvement for those investors still in the accumulation phase.
Bonds also now offer more attractive valuations. The 10-year Treasury Note yields about 3%, up about 1.5% from the beginning of the year. Credit spreads for corporate bonds have also increased:
Unfortunately, there is no guarantee that valuations won’t continue to fall. In addition, any reduction in corporate earnings growth could create a one-two punch to stock prices. Earnings headwinds include higher borrowing costs, commodity and input prices, and labor or wage costs. To some extent, companies have the ability to pass along costs to end consumers, but over time consumers may balk.
Planning updates
On the planning side of things, there is still hope that some version of the SECURE 2.0 bill will get through Congress. The House and Senate are ironing out the differences between their respective versions of the bill.
Major provisions include:
Increasing the RMD age for future retirees
Removing the RMD requirement for Roth 401(k) accounts
Increasing catch-up contribution amounts
Increasing participation in 401(k) plans
Implementing a national “lost and found” system for old retirement savings accounts
It’s likely, but not assured, that a final bill will get passed into law later this year.
Possible conversion from 529 to Roth IRA
The College Savings Recovery Act could implement a path to convert 529 education accounts to a Roth IRA without penalty. This bill is aimed at users of 529 accounts, who, for whatever reason, didn’t use the funds for educational costs. Those people would be allowed to transfer excess 529 funds into their Roth IRA account without penalty. If you have a large 529 account, keep an eye on this one.
New 401(k) rollover rule
The Department of Labor (DOL) implemented new rules for investment advisors who recommend “rollovers” or transfers out of employer retirement plans such as a 401(k). If an advisor’s compensation will increase if a client transfers assets from a 401(k) to an IRA, then that advisor must document the process and provide the client with the rationale for their recommendation.
This rule was created to bring more awareness to the costs and benefits of moving assets out of a 401(k) plan and into an IRA account. If you work with an advisor charging the typical 1%-of-assets, you’ll want to be sure that your advisor is adhering to this new rule.
For any clients of Noble Hill Planning, our compensation is not dependent on moving assets out of your 401(k) plan, so we are exempt from the documentation requirement. We are happy to discuss the benefits and drawbacks of any potential action, but we will never steer you towards an IRA because we stand to earn more money. Our sole focus is providing high quality advice and helping you make the best decision possible.
Matthew Jenkins is the Founder of Noble Hill Planning LLC. Matthew has over 15 years of experience working in both large and small financial services firms. Before starting his career in finance, Matthew served as a U.S. Army Ranger. Matthew values transparency and fair dealing and enjoys helping people prepare for a great retirement.
Market Commentary 2Q 2022
To say the least, it was a rough quarter in the markets. All major asset classes continued to fall, and stocks officially entered into bear market territory. Inflation continues to be top of mind for both policymakers and the general public. Energy and food prices have generated most of the attention. Various market pundits are forecasting an imminent recession.
It’s during times like these that investors must maintain focus on the long-term. If you don’t have a plan already, get one and stick to it. If we allow ourselves to get swallowed up by the day-to-day chaos in the media/markets, we’ll go crazy.
Here are the asset class returns for the past quarter:
Economic situation
Inflation is the main problem in the economy right now. The underlying causes include:
Stable economic systems require a fine balance between supply and demand. Right now, demand significantly outweighs supply.
Managing inflation with interest rates
The Federal Reserve has taken steps to reduce demand. At the most recent meeting, officials raised short term interest rates by 0.75%, the largest one-time increase in a very long while. However, the leaders of the Fed better get comfortable with tough choices in the future. As Paul Volcker learned back in the 1970’s, getting a handle on inflation is much like wrestling a grizzly bear… scary and difficult.
Furthermore, the Fed’s power really only extends to the ‘demand’ side of the economy. There is not much they can do about the supply chain issues. For example, they cannot force China to reopen factories, or Russia to cease attacks in Ukraine.
However, there are actions that other policymakers can take to address some of the components of inflation. Here is an example:
Housing prices
We are seeing the effects of higher interest rates in housing. Price growth has flat lined as prospective home buyers have paused their plans in the face of unprecedented affordability concerns. To wit:
Mortgage rates have essentially doubled in the space of six months. If you combine historically elevated real estate prices with much higher mortgage rates, you get a collapse in housing affordability:
While the Fed can slow down demand for housing, the only true solution to housing inflation will require more houses.
Energy prices
It’s hard to overstate the effect of energy prices on the economy. Energy flows through every component of modern economic systems. Just ask the citizens of Sri Lanka.
It remains to be seen whether energy producers will fill in any supply gaps caused by Russia. Once upon a time, management teams at US energy companies got paid largely based on production goals. That is, the more oil the company pulled out of the ground, the more money reached the executive team’s pockets. However, this created significant problems for investors.
Turns out, there is a LOT of oil out there, but not all of it can be profitably extracted.
But some management teams undertook a “drill baby, drill” approach and didn’t concern themselves too much with the economic profitability of each individual well. This approach left energy producers vulnerable when oil prices came down starting back in 2014.
Nowadays, investors in energy companies are demanding (and getting) more discipline around costs and profits. Investors are, in effect, saying, “If you want to drill a well, fine, but you better not lose money on it.” All of this means that nobody should rely on energy companies to turn on the spigot of new supplies. More than likely, the managers at Exxon, Chevron, etc. are happy to keep production levels steady even with current price levels.
Valuations and corporate earnings
One bright side of falling stock prices is more attractive valuations. The Schiller Cyclically Adjusted Price Earnings (CAPE) Ratio dropped from 38.3 to 28.7 so far this year. While still elevated compared to historical norms, this drop represents a drastic improvement for those investors still in the accumulation phase.
Bonds also now offer more attractive valuations. The 10-year Treasury Note yields about 3%, up about 1.5% from the beginning of the year. Credit spreads for corporate bonds have also increased:
Unfortunately, there is no guarantee that valuations won’t continue to fall. In addition, any reduction in corporate earnings growth could create a one-two punch to stock prices. Earnings headwinds include higher borrowing costs, commodity and input prices, and labor or wage costs. To some extent, companies have the ability to pass along costs to end consumers, but over time consumers may balk.
Planning updates
On the planning side of things, there is still hope that some version of the SECURE 2.0 bill will get through Congress. The House and Senate are ironing out the differences between their respective versions of the bill.
Major provisions include:
It’s likely, but not assured, that a final bill will get passed into law later this year.
Possible conversion from 529 to Roth IRA
The College Savings Recovery Act could implement a path to convert 529 education accounts to a Roth IRA without penalty. This bill is aimed at users of 529 accounts, who, for whatever reason, didn’t use the funds for educational costs. Those people would be allowed to transfer excess 529 funds into their Roth IRA account without penalty. If you have a large 529 account, keep an eye on this one.
New 401(k) rollover rule
The Department of Labor (DOL) implemented new rules for investment advisors who recommend “rollovers” or transfers out of employer retirement plans such as a 401(k). If an advisor’s compensation will increase if a client transfers assets from a 401(k) to an IRA, then that advisor must document the process and provide the client with the rationale for their recommendation.
This rule was created to bring more awareness to the costs and benefits of moving assets out of a 401(k) plan and into an IRA account. If you work with an advisor charging the typical 1%-of-assets, you’ll want to be sure that your advisor is adhering to this new rule.
For any clients of Noble Hill Planning, our compensation is not dependent on moving assets out of your 401(k) plan, so we are exempt from the documentation requirement. We are happy to discuss the benefits and drawbacks of any potential action, but we will never steer you towards an IRA because we stand to earn more money. Our sole focus is providing high quality advice and helping you make the best decision possible.
Matthew P. Jenkins, CFA, CFP®
Matthew Jenkins is the Founder of Noble Hill Planning LLC. Matthew has over 15 years of experience working in both large and small financial services firms. Before starting his career in finance, Matthew served as a U.S. Army Ranger. Matthew values transparency and fair dealing and enjoys helping people prepare for a great retirement.
Matthew is a CFA® Charterholder and CERTIFIED FINANCIAL PLANNER™ Professional. He is also a member of the National Association of Personal Financial Advisors (NAPFA) and the Fee Only Network.