Financial Markets and the Economy
Stock markets pulled back in the second quarter of 2022. In the U.S., the S&P 500 was down 16.1% in the second quarter, and down 18.5% year to date. While globally, the MSCI EAFE was down 15% in the 2nd quarter and 21% for the first half of the year. Small company indexes trailed larger companies and the Russell 2000 was down 17.2% for the quarter, and 22.3% so far in 2022. Treasury yields rose as the 10-year U.S. treasury bond was yielding 2.9% at the end of June from 1.5% at the end of 2021. Continued rising interest rates pressured bond indexes, leading to a further decline in the 4 to 5% for the quarter and 10% year to date.
As we have written in previous commentary, the prospect for higher interest rates would be a negative for stocks and bonds. Inflation is currently well ahead of what the Federal Reserve was forecasting just six (6) months ago. Markets are forecasting continued increases in interest rates, generally. As the Federal Reserve has shifted to its inflation fighting mandate from targeting full employment, financial markets have and likely will continue to show some volatility. In our last commentary we wrote that it was likely we would “be reading and hearing about, hoping for a soft landing, possible stagflation, maybe a recession, before inflation subsides to a more desirable level.” It seems from the current news headlines that we are somewhere along that timeline. While there are some signs of easing prices here and there, no considerable evidence of a lessening of inflation measures is evident. The word “recession” has now become the watchword in economic and business commentary.
“Why would there be a recession?” While recessions come and go, the reason so many feel it is inevitable that the Federal Reserve’s action will trigger a recession is twofold. First, most agree that the Federal Reserve has made a mistake taking too long to raise interest rates, letting future inflation expectations by the public get too high. Simply put many consumers think they will need a hefty wage raise in the future to keep up with the rising prices of gas, groceries, rent etc. This in turn could start a dreaded price/wage spiral. Historically, this is hard to quell and has required aggressive action on the part of the Federal Reserve. Secondly, as the monetary authority of the world’s reserve currency, the US dollar, the Federal Reserve now has a credibility problem. Viewed as too accommodative and making the inflation situation worse. They now need to reestablish credibility and stop an inflation spiral. This requires bold and perhaps painful steps, possibly pushing the country into an economic recession. It is a tough spot to be in as not doing enough to slow price rises might lead to runaway inflation.
What can the investor do during declining markets? We know the economy grows long term but has cycles. Stock markets also grow over the long term but have cycles. Predicting these cycles is not a strategy. Assessing long term cash flow needs and building a portfolio that captures that growth and compounds over time achieves the goals of an investment plan. The cash flow analysis we do with you to define and determine your goals allow us to build a portfolio to help you achieve those goals. Our analysis takes the cyclical nature of investing into account. A good financial plan is one that can “ride out the storm” without abandoning it. We know difficult markets are unsettling, and we are here to talk through your questions and make any course corrections that may be warranted.
In addition to taking advantage of a volatile/down stock market to harvest losses for future income tax savings, we’re looking for other planning opportunities to take advantage of in this environment. One such opportunity would be transitioning pre-tax assets to tax free assets through a Roth IRA conversion. This could be appropriate if you expect to have a lower-than-normal income year and have IRA assets that have been negatively impacted by the current market. The strategy is to convert a portion or all of the IRA or other qualified assets (which are subject to ordinary income tax when withdrawn) to a Roth IRA (which is tax free). You would pay income tax now based on your current income tax situation and the value of the assets converted. The idea being that you withdrawal the assets at a depressed value and at a lower income tax rate. Once converted to the Roth IRA, all future growth will be captured income tax free. We can help you think through the pros and cons of this strategy and whether it matches with your goals and objectives.
Another consideration in this type of market is to fund your retirement plans, college savings (529 accounts), and possibly Custodial Roth IRAs for kids. Given a sufficient time horizon, investing now at lower prices should benefit the long-term growth of these assets. For younger children that are earning income over the summer, they can contribute to a Roth IRA. The limit is the lesser of $6,000 or their actual earned income. An idea to consider is to help them by “matching” their earnings through a gift/contribution to their Roth IRA. Not only is this a great way to get them an early start on retirement savings, but it also is an opportunity to get them interested and learning about investing.
Finally, a strategy that could be useful for those that are focused on advanced estate tax planning would be to reposition assets to entities outside of your taxable estate. For example, if you’ve created an Intentionally Defective Grantor Trust or other entity and gifted assets to it to use some of your estate tax exemption, you may have the ability to “swap assets” between your taxable estate and that entity without incurring any income or estate tax. The idea would be to opportunistically move assets that are depressed in value and have the potential to rebound when the market/economy recovers into the estate tax free trust now while the values are low.
As always planning should start with your high-level goals and objectives in mind vs. with a clever strategy to save taxes. We’re here to help you think through these and other planning opportunities regardless of what stock market or economic environment we find ourselves in! Please do not hesitate to reach out as you have questions or concerns related to your portfolio, planning, or anything else.
Waypoint Capital Advisors