Economy

Source: The Economist

From the perspective of the possible impact on personal finances, tax policy marks one of the bigger gaps between Democrats and Republicans.

Many provisions in the 2017 tax law, which reduced taxes, are scheduled to expire in 2026 if Congress takes no action.

Candidate Trump wants the 2017 law made permanent, while Candidate Harris has pledged no tax hikes on those making less than $400,000.

Below are other tax ideas that Harris supports (source is The Kiplinger Tax Letter):

Tax ideas for individuals, supported by Harris:

• Bring back the top 39.6% income tax rate for people making $400,000 or more (currently the top tax bracket is 37%)
• Hike the 3.8% net investment income surtax to 5% for $400,000 earners
• For taxpayers filing Jointly with incomes over $1,000,000, long-term capital gains tax would be imposed at ordinary tax rates up to 39.6% (44.6% with the 5% Net Investment Income tax added in); for separate filers, the income breakpoint is $500,000
• Tax unrealized gains upon death, with capital gains and losses reported on the decedent’s final income tax return, with a $5 million lifetime gain exclusion
• Apply a 25% minimum income tax on the ultrarich (those with $100 million in wealth); this tax would apply to unrealized capital gains
• Bring back expansions to the child credit: boost to $3,600 per child (from current $2,000), with monthly payments and full refundability
• A new one-time credit of $6,000 per child claimed in the first year of the child’s life
• Give first-time home buyers a credit of up to $10,000
• Allow more people to get credits for buying health insurance through the Health Insurance Marketplace
• Make tipped income tax free

Tax ideas for businesses, supported by Harris:

• Raise the 21% corporate tax rate to 28%
• Increase the 15% alternative minimum tax on large corporations to 21%
• Quadruple the 1% excise tax on stock buybacks by publicly held firms

It’s likely that additional tax ideas will be floated by both campaigns in the weeks ahead.

It’s also important to recognize that, regardless of who becomes 47^th US President, the composition of the House and Senate will be critical in determining which policy proposals actually become law.

-RK

In poker, the “showdown” is a situation where, if more than one player remains after the last betting round, remaining players expose and compare their hands to determine the winner.

The showdown for interest rates occurred on August 23 in Wyoming – absent horses, cowboy hats, pistols, and booze.

The Jackson Hole Economic Symposium is an annual three-day international conference hosted by the Federal Reserve Bank of Kansas City at Jackson Hole, Wyoming.

The keynote speaker is the Chair of the Federal Reserve Board of Governors (the leader of the Fed), whose comments typically focus on the US economy and monetary policy.

This year, Fed Chair Powell played the interest rate showdown during his Jackson Hole speech, when he said:

• “my confidence has grown that inflation is on a sustainable path back to 2%”
• “we (the Fed) do not seek or welcome further cooling in the labor market”
• “the time has come for (interest rate) policy to adjust”

What gives the Fed Chair such confidence? Pandemic-driven inflation peaked at 9% in 2022, but has declined since, and recent readings show inflation has dropped below 3%.

The chart below shows the Consumer Price Index since 1965. According to this data series, inflation had ticked down to 2.9% in July.

Source: New York Times

Along with inflation, the jobs market has cooled, too – meaning jobs are still available, but harder to find now than a year ago.

Borrowing costs at their current level may be unnecessarily high, pressing down too much on the economy and inflation. Concerns about the possibility of an economic slowdown are likely behind the Fed’s signaling of future interest rate reductions.

So, the parlor game played by Wall Street people, where prognosticators pontificated and professionals speculated on the direction of interest rates, ended with the Jackson Hole speech.

What’s important to bear in mind is that the Fed has direct control over the overnight cost of funding for big banks (the Fed Funds rate) which is a very short-term interest rate.

The Fed Funds rate then affects other interest rates, such as the Prime Rate, which sets the cost of borrowing for consumers.

Currently, the Fed Funds target rate is 5.25% – 5.5%, and the Prime rate, which is usually about 3 percentage points higher than the Fed Funds target rate, is 8.5%.

The decline in short-term interest rates will begin soon, and most likely on September 18, when the Federal Reserve concludes its next board meeting.

Fed Funds futures contracts are financial instruments which allow Wall Street traders to speculate on what the Fed Funds target rate will be next month, or next year.

Fed Fund futures now anticipate a steady decline in short-term interest rates during the next 15 months.

These contracts currently anticipate Fed Funds declining in September, continuing to fall during the next sixteen months, and dropping by 2 percentage points from today’s level, to around 3.5% by the end of 2025.

What does this mean for Main Street people?

1. It will get cheaper to borrow money (mortgage rates have already started to drop)
2. “Safe” returns from CDs and High Yield savings accounts will start to come down
3. Lower interest rates should provide a tailwind for stocks

Fixed rate mortgages have already begun to decline. The average 30-year mortgage was over 8% in late 2023. Today the mortgage rate sits at 6.5%. As short-term rates and the Prime Rate fall, it’s reasonable to expect that mortgage rates will continue to decline, too.

For savers, there is likely limited time to earn 5%+ yields on CDs, High Yield savings, and Money Market accounts. If you’re counting on that income to meet expenses, you should expect to receive less of it in the months ahead.

Since short-term rate declines should proceed at a measured pace, short-term yields above 4% should be around for a bit longer. But expect those yields to fall below 4% by the end of 2025.

For stockholders, the impending interest rate declines should be beneficial. Typically, a Fed easing cycle is a tailwind for stocks when the economy is growing (no recession, like today’s environment) at the time of the first rate cut.

The chart below shows that on average, stocks have significant gains during the year after the Federal Reserve reduces interest rates.

Source: Edward Jones

The chart measures time along the horizontal axis in weeks prior to and following the first “Fed cut”, or reduction in short-term interest rates by the Federal Reserve.

Stock market performance has been much less satisfactory when interest rates are declining during recessionary times.

-RK

With hostilities raging in the Middle East and Eastern Europe, the resultant humanitarian tragedies weigh heavily on caring individuals, even for those of us fortunate enough not to have loved ones directly affected by the strife.

As investors, our minds may also turn to the potential financial market impact of the conflicts.

I participated in a conference call recently on geopolitics hosted by Goldman Sachs. The guest speaker was Retired General Sir Nick Carter, whose last assignment was chief of the Defense Staff for the United Kingdom (the US analog is the Chair of the Joint Chiefs of Staff).

The first message for investors: geopolitical tensions are rising, and with higher tension comes higher risk.

General Clark examined the situations in Gaza / Israel / Iran; Ukraine / Russia; China / Taiwan; and North Korea – through the lens of current or potential future military engagement.

The flashpoint that concerned Clark most was Iran’s recent drone and missile attack on Israel, following the Israeli attack on the Iranian consulate in Damascus on April 1.

Clark stated that this was the first time since the founding of the Islamic Republic of Iran in 1979 that Iran has mounted a direct attack on Israel. In Clark’s words, “we’ve reached another level in terms of escalation.”

Additionally, Clark sees the Israeli / Hamas situation as near unsolvable; the Russia / Ukraine war as intractable; China’s objective of gaining control of Taiwan unmovable; and North Korea’s desire for nuclear weapons insatiable.

Clark concluded by wondering if the system of rules-based international order, put in place after World War II, will survive; and if not, what might replace it.

This was clearly a heavy report with a discouraging prognosis.

The second message for investors: bad geopolitical outcomes infrequently bring about extended stock market declines.

While far from uplifting, past experiences may serve to allay the worst fears related to the potential market impact of escalating geopolitical risk.

The table below from Goldman Sachs presents twelve hostile geopolitical events and stock market performance over three subsequent periods: the next day, 30 days later, and low point in the market following the event (which may have occurred before or after the 30-day mark).

The key take-away from this chart: adjusting portfolio positions in anticipation of a bad geopolitical outcome is a hit-or-miss strategy. In six of the twelve instances, stocks were in positive territory one month after the event.

Stock market drops concurrent with negative geopolitical events are often significant, as the low point in the chart above depicts, but the duration of the impact is impossible to know, and other influences and countervailing events can affect stock prices, too.

Also, the negative stock market impact of geopolitical events tends to be in line with normal stock market declines experienced in years that did not include a hostile geopolitical event.

Since 1980, the average intra-year stock market drop has been 14.2% (see the first chart in the previous section of this letter).

It is understandable if you are troubled by geopolitical risk and worry about how it might affect your investments. Recent events have been distressing, violent, and cause a strong emotional response for many of us.

However, from an investment perspective, remaining dispassionate is recommended. Sticking to your investment approach and your financial plan will serve you well in the long term.

-RK

The race to win the White House in November 2024 is now in full gear. For anyone who’s accustomed to reading the news, watching TV, or engaging with social media platforms, the font of information on this topic will overflow as we approach November.

At this point, the Presidential election seems to be headed toward a 2020 rematch. The outcome likely will be consequential in many areas, including for the tax and investment environment for individuals and businesses.

Recently, I had the opportunity to participate in a conference call hosted by Goldman Sachs, which featured a leader in the bank’s Office of Government Affairs.

Key takeaways on the current political situation ahead of the November elections:

• The race for the Republican nomination will continue if Nikki Haley wins a plurality of the votes in the New Hampshire primary on 1/23; otherwise the race is “pretty much over”
• In a Biden-Trump rematch, the third-party element is important; currently Robert F. Kennedy Jr, Jill Stein, and Cornell West cumulatively are polling in the mid-teens to low-twenties in the percentage of the popular vote
• Third party candidate support tends to pivot toward the established candidates as election day approaches
• In 2016, third-party candidates accounted for 3-6% of voters in battleground states; in 2020, support for third-party candidates collapsed to about 1.5% of the vote in battleground states
• Third-party voters who pivot have tended to favor Democrats, so if third-party support stays strong, Republicans will likely be the beneficiaries
• In the electoral college, Biden will start with 226 “highly likely” votes and Trump with 219, with 270 required to take office
• There are seven states in the “up for grabs” category: Arizona, Georgia, Michigan, Nevada, North Carolina, Pennsylvania, and Wisconsin
• In 2016, Trump won all seven of these swing states
• In 2020, Biden won 6 of the 7, losing only in North Carolina
• States which had the tightest margins in 2020 were Arizona, Georgia, and Wisconsin, where the cumulative margin of victory was 44,000 votes
• The House of Representatives is down to a 2-seat Republican majority due to recent departures
• Congressional districts are being redrawn in some areas as a result of court challenges from 2020-21, which will likely favor Democrats
• Three Senate seats in “super-red territory” are coming up for re-election which are currently held by Democrats: in Montana, Ohio, and West Virginia
• It seems possible that Democrats could win a majority of seats in the House, and probable that Republicans will win a majority of seats in the Senate
• With a Trump victory, a sweep of the House and Senate is possible, which would put Republicans in control of both houses of Congress and the Presidency
• With a Biden victory, divided government is the likely outcome
• Presidential election years typically correspond with weaker stock market returns

RK

Unlike other commodities, we are constantly reminded of the direction in which the price of oil is headed when we fill up our gas tanks (for those of us who are still driving combustion-engine automobiles). Higher oil prices have a direct effect on our personal budgets and can be a source of financial anxiety when the oil price climbs quickly.

The chart below illustrates the recent oil price climb – up more than 25% during the last three months, which has pushed the price of gas at the pump to well over $4.25 per gallon, for mid-grade fuel, in Massachusetts.

The recent oil price climb may be acting as an anxiety accelerant for some, so taking a closer look at oil market dynamics might help alleviate these concerns. The information presented below comes by way of Clearnomics, an economic research firm.

Rising energy prices are a direct burden on consumers and businesses who spend more on gasoline and other fuels, putting upward pressure on headline inflation. This also indirectly raises prices on all goods and services as production and transportation costs rise, potentially impacting core inflation.

Thus, higher oil prices effectively function as a tax which can slow economic growth and impact corporate profitability.

Why have oil prices risen in recent months?

First, the U.S. economy has been much steadier than expected. Weakness in oil prices earlier this year partly reflected fears around an imminent recession. The fact that a recession has not materialized has helped to propel oil prices higher.

Second, Saudi Arabia and Russia recently announced that oil production cuts of 1.3 million barrels per day would be extended until December. This amounts to 1.3% of global production – not an insignificant sum – and adds to previous cuts.

The two countries are among the largest in OPEC+ and have led other cuts in order to prop up oil prices, as well as in response to slower GDP growth and weakness in China. Some economists estimate that this could result in a global deficit of more than 1.5 million barrels per day in the fourth quarter of 2023.

It’s important to maintain perspective around these cuts. The relevance of OPEC as a price-setting cartel has declined over the past decade, partly because cuts by each country are voluntary and difficult to enforce, and because the U.S. has become the top producer of oil in the world.

U.S. oil production is nearly back to its pre-pandemic level of 13 million barrels per day. While there are many nuances in terms of the types of oil produced and consumed in the U.S., Europe, and elsewhere, the fact that the U.S. has been a “swing producer” has shifted the dynamics of the energy markets considerably.

Another tailwind for oil prices is declining oil inventories. For instance, the Strategic Petroleum Reserve (SPR), a large emergency supply of oil in the US, is at its lowest level since the mid-1980s.

This is primarily because oil was drawn from the SPR to offset high prices last year when gasoline was averaging more than $5 per gallon nationwide. The federal government would need to purchase 376 million barrels of oil to restore the SPR to its 2010 peak level. While there is no set timeline for doing so, this deficit naturally places upward pressure on oil prices.

So it seems like events are conspiring to keep the price of oil higher for longer. How worried should we be about higher oil prices?

According to David Kelly, Chief Global Strategist at JP Morgan Asset Management, “investors should probably not worry too much about the recent spike in oil.”

Kelly, who presents his research team’s findings frequently to the advisor community, contends that, barring some further shock, there should be limited upside to energy prices from here.

The main reason: signs of slower economic activity around the world, according to JP Morgan. The global composite purchasing managers index (calculated from regular surveys filled out by big businesses) hit its lowest level in seven months in August, with outright declines in manufacturing and a moderation in services growth.

Both China and Europe are seeing very sluggish growth, offsetting strength in India and Japan. And JP Morgan is expecting the pace of economic growth to slow in the US as we move into 2024. All of this should dampen the demand for oil and gas, as should longer-term investment in energy transition.

So for those among us who experience oil-related anxiety, taking a few deep breaths, and anticipating less acute pressure on oil-market dynamics in the months ahead, may help.

-RK

In my April letter, I discussed the turmoil in the banking sector resulting from risk management shortcomings that led to failures of several sizable US deposit-taking institutions.

I concluded with the following statement: “if summer arrives without additional failures, I’ll feel comfortable calling “all clear”. Summer has arrived, and I’ll stand by that “all clear” claim.

As part of their regulatory responsibilities, officials at the Federal Reserve conduct an annual stress test for the largest US banks, designed to evaluate the resiliency of the banking system under challenging economic conditions.

The process is similar to an exercise stress test for humans. The regulators’ treadmill for banks include the following assumptions:

• severe global recession
• US unemployment rate rising to 10%
• commercial real estate prices declining by 40%
• house prices declining by 38%

The bank stress test was developed after the global financial crisis and was first applied in 2011. The assumptions are severe. For some time after 2011, large lenders struggled to earn passing grades.

But good news: all twenty-three large US banks that were recently evaluated passed their stress tests. This means balance sheets remain strong enough for the banks to continue to lend to households and businesses for the duration of a downturn.

You can read the details of the test on the Federal Reserve’s website at: Dodd-Frank Act Stress Tests 2023.

Although this news is unlikely to translate to large stock price gains, it does indicate that the financial market plumbing is in good working order and that the bank problems from earlier this year likely have been contained.

RK

Congressional leaders came to an agreement in late May to suspend the debt ceiling until January 1, 2025 – removing the near-term risk of a US default and sparing the American people political wrangling on the issue for the next 18 months or so.

According to projections made by the Congressional Budget Office, the Fiscal Responsibility Act of 2023 reduces budget deficits by $1.5 trillion over the next 10 years, mainly by imposing caps on discretionary spending.

In terms of the Federal budget, roughly 1/3 is discretionary and funded though the annual appropriations process, where Congress must pass bills to provide money to carry out the programs.

The other two-thirds of the Federal budget comprises mandatory spending, such as Social Security, Medicare, and interest on the federal debt. Mandatory spending is ongoing and occurs each year absent a change in an underlying law that provides funding.

The debt ceiling deal does little to put our federal finances on a path of long-term sustainability, since the budget is far from balanced. But it does ensure our federal obligations will be met.

And thankfully a government-induced, calamitous outcome for the financial markets has been avoided.

RK

The debt clock is ticking louder.

The nonpartisan Congressional Budget Office recently revised its projections for federal revenues and expenses.

According to the CBO there is now “significantly greater risk that the Treasury will run out of funds in early June”.

Treasury Secretary Janet Yellen said on May 1 that the US government could become unable to pay its bills as soon as June 1 if Congress doesn’t raise the debt limit soon.

These new estimates set a shorter timeline than many experts previously had been forecasting.

House Republicans approved legislation last week that would raise the borrowing limit for about a year, but parts of the legislation are unpalatable to Democrats.

In other comments she’s made recently, Treasury Secretary Yellen is not mincing words: “A default on our debt would produce an economic and financial catastrophe. A default would raise the cost of borrowing into perpetuity.”

President Biden has called top lawmakers from both sides of the isle to the White House for a meeting on May 9 to try to forge an agreement for a debt limit increase.

The situation remains tenuous, with extremely high stakes. As investors, how should we think about this?

The bond fund manager PIMCO has a group of researchers dedicated to understanding how public policy impacts financial markets, and they recently shared their thinking on the debt ceiling.

Here are some takeaways on the debt ceiling issue from a recent PIMCO note:

• More than 70% of Americans support avoiding a default, even without spending cuts – according to a recent CBS News / YouGov poll
• Because popular sentiment supports raising the debt ceiling, default is not a political winner, and leadership on both sides of the aisle know this
• If past is prologue, a resolution will likely happen at the eleventh hour and only after some brinksmanship
• The average peak-to-trough performance of the S&P 500 in the month before a debt ceiling resolution over the past dozen years has been about -6.5%
• A debt ceiling deal is the most likely outcome

From my perspective, it is inadvisable to significantly alter long-term investment strategies designed to support long-term financial plans, in anticipation of political events, especially those that have a low likelihood of transpiring.

The key to managing through possible larger-than-normal stock and bond price swings is to hold enough in liquid reserves (cash and short-term investments like money markets and short-term bond funds) to meet your near-term cash needs.

RK

Turmoil in the banking sector persisted throughout April and continues into May.

As deposit flight persisted at First Republic Bank, the pressure on the bank’s financial situation proved untenable. During the last trading day of April, the bank’s stock price cratered.

Over the weekend, regulators seized First Republic, and after a short bidding process, sold the lender to JP Morgan before the markets opened on Monday, May 1.

Three of the four largest-ever U.S. bank failures have occurred in the past two months. First Republic, which had more than $250 billion in assets at the end of the first quarter, ranks just behind the 2008 collapse of Washington Mutual Inc. Rounding out the top four are Silicon Valley Bank and Signature Bank, both of which failed in March.

While the immediate crisis may be over for the largest US banks, trouble still seems to be bubbling for mid-sized and smaller regional lenders. Los Angeles-based PacWest Bancorp, which had over $40 billion in assets at year-end 2022, experienced a precipitous stock price drop in the past week and is said to be ‘exploring strategic options’.

Persistent problems in the financial sector can be a source of concern for everyone. For folks who’ve been saving and investing for a while, worry about a 2008 financial crisis re-run in 2023 is understandable.

Key points to keep in mind, and reasons to believe that the US financial system is on firmer footing today, are:

• The biggest US banks are better fortified compared to fifteen years ago, with significant liquidity and healthy balance sheets
• Regulatory and private sector action has helped contain damage through swift wind downs of troubled institutions
• Shareholders of the failed banks have borne losses
• Most importantly, depositors have been protected

For a more in-depth explanation of what’s going on in the financial sector, I found the most recent memo from Howard Marks, Lessons from Silicon Valley Bank, to be helpful.

Marks has been investing in the credit markets for decades and is a sort of ‘Warren Buffet of Bonds’. He believes that another widespread banking crisis, a-la-2008, is unlikely.

In addition to gaining a degree of reassurance from his analysis, I found Marks’ perspective on the psychology of what’s going on to be particularly insightful. He concludes his memo by saying:

“When psychology swings in the direction of hopelessness, it becomes reasonable to believe that bargain hunters and providers of capital (i.e., investors with a long-term perspective) will be holding the better cards and will have opportunities for better returns.”

RK

The turmoil from the mid-March banking crisis seems to have calmed down in early April.

To get a better understanding of what’s going on and how concerned we should be, it can be helpful to hear an insider’s point of view.

It just so happens that the nation’s preeminent banker, Jamie Dimon, at the country’s largest bank, JP Morgan, discussed the matter in his latest letter sent last week to shareholders.

I’ve found Dimon’s communications to be refreshingly plain-spoken for a big-deal financial person, and he has the respect of his peers, as he was Treasury Secretary Janet Yellen’s first call when problems surfaced in mid-March.

Here are key points on the current banking crisis from the JP Morgan Annual Report, penned by Dimon, that provide a degree of comfort that the March tempest is unlikely to be a precursor to a 2008-style tsunami:

• The current crisis was the result of regulatory shortcomings and risk-management failures at a handful of banks
• The most prominent risks were hiding in plain sight, including interest rate exposure and uninsured deposits
• The current crisis is not yet over, and there will be repercussions from it for years to come (tighter regulation likely will follow)
• However, recent events are nothing like what occurred in the 2008 global financial crisis (which barely affected smaller banks)
• Back then, the trigger was $1 trillion of consumer mortgages that went bad, held by many financial institutions, and included the accelerant of enormous leverage (excess debt)
• Today’s crisis involves far fewer players and fewer issues that need to be resolved

If you’re interested in hearing his take on the recent bank issues, you can watch Dimon’s CNN interview.

From my perspective, to be confident that a banking crises has been resolved, we typically need to see three conditions met:

1. Government support
2. Resolution of failed entities
3. Passage of time (with no additional failures)

We have seen significant government support through a new Federal Reserve lending program and the swift resolution of three of the failed entities – Silvergate Bank, Signature Bank, and Silicon Valley Bank. Also a large foreign bank, Credit Suisse, was taken over by its main competitor, UBS, following governmental intervention.

As for the third condition: if summer arrives without additional failures, I’ll feel comfortable calling “all clear”.