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In Reading Recommendations

Gettin’ Chatty: Artificial Intelligence Gets Real

If you were lost in space, having artificial intelligence by your side would be helpful. Will Robinson’s robot, B9, was a form of chatty artificial intelligence imagined in the middle of the last century. B9 was a fiction brought to life by actor Bob May in the Lost in Space sitcom.

Artificial intelligence (AI) in the 21st century is real. For the analogue -inclined, developments in AI can be mind-bending. AI might seem worlds away and you might feel ‘lost in space’ if you’re trying to understand what it’s about.

ChatGPT, which went mainstream in December, provides a window into the world of AI – and is an application that’s available for anyone to use today.

McKInsey’s recent blog post What Is Generative AI? Is a helpful explainer. It describes AI through the lens of content creation, and the disruptive effects it’s likely to have.

Also the New York Times sponsored podcast Hard Fork provides an engaging discussion of the new technology in Can ChatGPT Make This Podcast?

Of course, seeing is believing. You might consider setting up a ChatGPT account and giving it a whirl. I was impressed by the amount of content the application generates in response to questions, as well as with its accuracy and speed.

If you decide to ChatGPT, or have other AI-related experiences, I’m interested to hear your impressions.

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In Financial Planning

The Taxman Cometh – Getting Ready to File Your Return

The IRS set January 23 as the official start to the 2023 tax filing season. Many of us are now busy gathering tax-related documents for tax preparation purposes. The filing deadline to submit 2022 tax returns or to submit an extension to file is Tuesday, April 18.

Even if you go on extension until October 16, you still have to pay any tax you expect to owe by April 18 or the IRS will add penalty and interest charges to the amount owed.

The IRS provides a useful reference page on their website, which includes ‘Tips to Help People with the 2023 Tax Season’ at irs.gov

Also, you might find this two-page reference sheet of important tax-related numbers for 2023 helpful. The data includes: 

  • Federal Income Tax Brackets
  • Capital Gains Rates
  • Medicare Premiums
  • IRMAA Surcharges
  • Retirement Plan Contribution Limits

Susan and I will also gladly address your tax planning questions.

Here’s wishing you many happy returns!

RK

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In Economy

US Debt Ceiling Developments

The debt ceiling is a cap on the total amount of money that the federal government is authorized to borrow. Congress last agreed to raise this cap to $31 trillion in late 2021.

Lifting the debt limit does not authorize any new spending, it simply allows the government to pay bills already incurred.

Some members of Congress are trying to tie an approval for an increase in the debt ceiling to an agreement for greater fiscal stringency.

In a letter to Congress on Thursday, January 19th, Treasury Secretary Janet Yellen said that the US had reached its debt limit and has begun taking “extraordinary measures” to enable the government to stay current on its bills.

The special measures include suspending investments in government benefits plans, such as the Civil Service Retirement Fund.

The actual moment when the federal government can no longer meet its obligations on time is a function of the Treasury Department’s cash flow, which could change depending on things such as the receipt of tax payments.

Yellen estimates that the government could run out of money, and may have to declare default, sometime in June 2023.

The US has reached inflection points regarding the debt ceiling in the past. In 2011, Congress engaged in a contentious stand-off over spending and the debt that got close to a default situation.

The brinkmanship a decade ago had a negative impact on the financial markets and resulted in a downgrade of America’s credit rating by Standard & Poor’s, one of the main US credit rating agencies.

Last week, Speaker of the House Kevin McCarthy and President Joe Biden held a meeting focused on the debt ceiling issue. The tone following that meeting was constructive, with McCarthy saying “I think, at the end of the day, we can find common ground.”

Given that the government appears to have enough flexibility to stay current on its obligations until June, it’s likely that we’re just at the ‘beginning of the day’ on this issue.

Investors will probably have to suffer through more political posturing, and possibly brinkmanship similar to what occurred in 2011, before the situation is resolved.

The stakes in this political game of chicken are high: Yellen has said that a US debt default would “cause irreparable harm to the US economy, the livelihoods of all Americans, and global financial stability.”

My sense is that cooler heads will prevail in Washington and the US will avert the worst outcome. But if the impasse on the debt ceiling persists into spring and summer, it will become more problematic for financial markets, and more likely cause bouts of volatility and downside for investment portfolios.

RK

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In Investment Strategy

The Real Deal on Real Yields and Bond Funds

By saving and investing today, most investors expect that they will be better off tomorrow. This is a reasonable premise. For this to happen, investments must, at a minimum, outpace inflation.

Stock returns have done a great job at outpacing the rate of inflation over time –generally speaking, by about 6 percentage points per year.

Bond returns also have outpaced inflation over time, but by a significantly smaller margin than stock returns. Treasury bond yields have exceeded inflation by about 2 percentage points, on average, going back to 1958.

Sometimes the relationship between inflation and bond yields gets thrown out of whack.

In high-inflation environments, it’s possible that bond yields might not keep pace with inflation. Today, we are in this type of abnormal environment – illustrated by the chart below, courtesy of JP Morgan Asset Management.

The blue line shows the yield history of the 10-year Treasury bond yield. The peak yield of nearly 16% was reached in 1981, which came during a period of very high inflation.

The average 10-year Treasury bond yield since 1958 has been 5.7% (blue line), and the yield at the end of January was 3.5%. This yield, referred to as the ‘Nominal yield’, is what the 10-year Treasury has paid bondholders in interest before taking inflation into account.

The grey line shows the same 10-year Treasury with its yield adjusted for inflation. The after-inflation yield is called the Real yield, and it has averaged about 2.1% over time.

However, with inflation running north of 5.6% today, and with the 10-year Treasury providing a Nominal yield of 3.5%, the Real (after-inflation) yield is negative, by about 2.1%.

This situation of bond yields failing to keep pace with inflation is unusual and unlikely to persist indefinitely.

Eventually, Nominal yields will move above the rate of inflation. But the adjustment process can be painful for bondholders.

This was apparent in 2022, when the US bond market fell by 13%. The steep decline was a function of the yield / price relationship for bonds. When interest rates move up quickly, bond prices and bond returns fall.

A significant course correction for bonds occurred last year. Even still, the bond markets and the path of inflation remain in flux today. It likely will take time to revert to a normal bond yield / inflation relationship.

Because of this uncertain environment, proceeding with caution in managing bond allocations is advised. 

Emphasizing short-term bond funds, which carry less interest rate risk than longer-term bond funds, and inflation protected bond funds, are two ways to mitigate the negative effects of higher inflation on the bond portion of a portfolio.

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In Economy

Course Correction Under Way for the US Economy

Inflation was a big problem last year and inflation-fighting policies had a big, negative effect on stock and bond prices in 2022. Inflation will continue to be a front-and-center Issue for investors this year. 

Course Correction Needed was the title of the second section of my September newsletter. In that section, I wrote: “Until market participants sense a course correction in the inflation / interest rates / Fed policy dynamic, stocks are likely to struggle”.

I’m pleased to report that a course correction is under way. Inflation gauges are generally improving, longer-term interest rates made a meaningful adjustment, and the Federal Reserve has slowed its pace of short-term interest rate increases.

On February 2, the Fed brought its target for short-term interest rates up to 4.75%, an increase of 0.25 percentage points. This follows a 0.5 percentage point increase in December, and a series of 0.75 percentage point increases last fall and summer.

This indicates we may be approaching the end of the ‘Fed tightening cycle’ that I discussed in my October 2022 newsletter.

Improvements in inflation and a ‘go-slower’ Fed have given a very significant lift to stock and bond prices so far this year. Can this course correction persist in 2023?

The answer is yes, but likely will require the labor market to come off the boil.

The jobs market was hot in 2022. There were 4.5 million new jobs created last year, and millions of job openings remained unfilled.

This supply / demand gap in the labor market was a key factor that drove wages higher, which in turn contributed to inflation.

The hot labor market persisted in January. US employers added 517,000 jobs and the unemployment rate declined to 3.4% – the lowest since 1969. This is good for workers and good for economic growth. But for inflation? Not so much.

We should recognize the improvement in the financial markets in the early weeks of 2023 as a benefit for portfolios.

But we should also realize that the process of course correction is more likely to look like a winding mountain path, with sections of rocky trail and switchbacks, than a straight, paved road back to satisfactory investment results. 

RK

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In Market Updates

January 2023 Market Recap: Winter Warmer

Punxsutawney Phil, the bushy Pennsylvanian, predicted six more weeks of winter cold by seeing his shadow on February 2 – and right on cue, New England fell into a deep freeze.

The financial markets, however, have been feeling quite summery. In January, bonds became a bit steamy, stocks were sultry, and some parts of the tech sector were a-sizzle.

For the month of January, the S&P 500 index of large company US stocks rose by 6.3%. Foreign stocks climbed even higher, up by 9.0%. The technology-heavy Nasdaq index advanced by 10.6%.

Bonds rose along with stocks. The Bloomberg US Aggregate Bond Index rose by 3.3% last month. 

Below is a summary of January returns.

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In Reading Recommendations

21 Lessons for the 21st Century

In my reading selection for this month, I go deep. That is, the author raises challenging questions. Having deep, distraction-free time to contemplate what he is saying is beneficial.

In 21 Lessons for the 21st Century, author Yuval Noah Harari says in his introduction: “I want to zoom in on the here and now, but without losing the long-term perspective.”

Harari then asks: “How can insights about the distant past and distant future help us make sense of current affairs and of the immediate dilemmas of human societies? What are today’s greatest challenges and most important choices?”

Chapter titles include: work, equality, nationalism, immigration, ignorance, justice and education.

Harari is an Israeli historian and professor in the Department of History at the Hebrew University in Jerusalem. Other books include Sapiens: A Brief History of Humankind and Homo Deus: A Brief History of Tomorrow.

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In Financial Planning

Secure 2.0 Becomes Law

Last month I wrote about Secure 2.0, the collection of provisions intended to build upon the retirement system improvements that were implemented under the Secure Act of 2019.

Secure 2.0 became law on December 29, 2022.

There are many provisions to this new law. I participated in a webinar led by a leading consultant to financial planners, who said that in Secure 1.0, there were twelve or so changes to the law. Secure 2.0 brings almost one hundred additional changes.

Susan and I will be digesting Secure 2.0 in the weeks ahead to better understand how these changes might affect you and your financial plan.

Here are a few of the key changes to be aware of:

Required Minimum Distributions (RMDs)

  • For individuals who turn 72 in 2023, RMDs will be pushed back one year compared to current rules and will begin at age 73
  • Age 73 will continue to be the age at which RMDs begin through 2032
  • Then, beginning in 2033, RMDs will be pushed back further to age 75
  • Beginning in 2024, surviving spouses can elect to be treated as the decedent for RMD purposes from an inherited retirement account. This is beneficial for older spouses inheriting retirement accounts from younger spouses.

 

Retirement Plan Catch Up Contributions

  • Effective in 2025 and in future years, Secure 2.0 adds a special catch-up contribution limit for employees aged 60, 61, 62, and 63: the greater of $10,000 or 150% of the regular catch-up contribution amount (indexed for inflation)
  • Starting in 2024, Secure 2.0 requires all catch-up contributions for workers with wages over $145,000 during the previous year to be deposited into a Roth

 

Qualified Charitable Distributions (QCDs)

  • The maximum annual QCD amount of $100,000 is now indexed for inflation
  • There is no change to the age for being able to make QCDs from your retirement accounts – you may start at age 70.5

 

529 Plans

  • For 529 plans that have been in existence for 15 years or longer, you are allowed to transfer them into a Roth IRA for the beneficiary, and it appears that you will be able to change the beneficiary of the 529 before transferring it to the Roth
  • Any contributions to the 529 plan within the last five years are ineligible to be moved to a Roth IRA
  • The maximum amount that can be moved from a 529 plan to a Roth IRA in an individual’s lifetime is $35,000

There are also a host of new rules for accessing retirement funds during times of need.

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In Investment Strategy

The Long-Term Outlook for Stocks and Bonds

The corollary to “What Comes Next?” is “What Happens Years from Now?”

This is not an academic question. Big banks and investment firms typically invest a lot of time and money when trying to figure this out.

JP Morgan Asset Management, for example, compiles a comprehensive set of forecasts each year. More than fifty researchers are tasked with this project, and the report they recently produced runs more than 120 pages

These forecasts are commonly referred to as “Long Term Capital Market Assumptions”. This is a mouthful. It translates to researchers’ best guess on how stocks and bonds will perform over the next ten to fifteen years.

The good news is that updated long-term forecasts for 2023 have improved very significantly compared to a year ago. This holds positive implications for long-term financial planning purposes.

I’ll share with you a snapshot of the changes, then use an example to illustrate why this development is so significant for individuals’ financial plans.

The table below compares long-term return expectations at the start of 2022 with long-term return expectations at the beginning of 2023, based on JP Morgan’s data.

At first glance, the percentage changes for the long-term assumptions might appear to be modest, at 3-ish percentage points for stocks and 2-ish percentage points for bonds.

But seeing how these adjustments play out, and how the higher return assumptions enhance wealth over the long-term, are noteworthy.

Here’s an example.

Say a family has $500,000 to invest in a well-diversified portfolio. They select 60% large company US stocks and 40% US Treasury bonds for their long-term asset allocation and decide to rebalance at the end of each year. They will neither make additional contributions nor take withdrawals during the next 10 years.

Under this framework, how much should they expect to have at the end of the 10-year period?

Using the 2022 return assumptions, they would expect to earn 3.3%, on average, per year. To keep things simple, let’s say they earn 3.3% each year for the next ten years. This translates to $692,000 at year 10—for a cumulative gain of $192,000.

Using the 2023 assumptions, annual return expectations rise by 2.9 percentage points to 6.2%. This higher annual return assumption means their portfolio would grow to $912,000—for a cumulative gain of $412,000.

The 2.9 percentage point difference means the family’s gain is more than twice as much in 10 years’ time.

While an actual financial plan has far more variables that what was presented above, you can see from my example that an upward adjustment in return assumptions (similar to changes JP Morgan has made for 2023) can have a very meaningful impact on total wealth over time. 

The Economist magazine summed up the situation well, in a non-statistical way, in the Leaders section of their December 8, 2022 issue:

“This year’s capital losses, however, have a silver lining. If the downside of higher asset prices was lower expected returns, then by symmetry, future real returns have now gone up…

The new regime of higher interest rates and scarcer capital may seem like a shock, but for much of history these were the normal conditions for investors. It was the era of cheap money (that is now behind us) that was weird.”

 

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In Economy

Inflation Watch

Inflation remains a front and center issue for many of us as we start the new year, including consumers, business owners, policy makers and investors. Inflation refers to a broad rise in the prices of goods and services across the economy over time.

For this first letter of 2023, I thought it would be helpful to dig into the inflation issue a bit deeper, and then share some recent good news on the subject.

Price stability is considered a hallmark of a healthy economy. Economists generally consider annual inflation in the range of two percentage points to be a desired inflation target.

There are positive effects of moderate, contained inflation. For instance, it can stimulate spending and spur demand and productivity. But inflation running significantly above target is considered a problem.

The main issue with too-high inflation – a feature of today’s economic environment – is that it is erosive. Inflation erodes the value of income, savings, and investments. It erodes purchasing power for consumers and businesses. In other words, elevated inflation means your dollar will not go as far tomorrow as it does today.

Statistical agencies measure inflation by first determining the current value of a ‘basket’ of various goods and services consumed by households, referred to as a price index, which can be tracked over time to give observers a sense of the path inflation is travelling.

Here’s a picture of how inflation has changed during the past 40 years, as measured by the Consumer Price Index, or CPI, which is calculated by the US Labor Department.

The grey line, labeled ‘Overall’ includes food and energy prices. Since food and energy are considered the most volatile items in the basket, they are excluded from the blue ‘Core’ measure.

Any way you slice it, inflation today is too high for comfort. The most recent CPI reading published in mid-December shows that consumer prices rose 7.1% in November from a year earlier. This is obviously quite far from the 2% target.

The good news is that inflation gauges are now headed in the right direction, and down meaningfully from the high point reached in June 2022 of 9.1%. I expect price indices to show further improvement in the early months of 2023.

Developments in the commodities markets are supportive of this expectation. The recent period of unseasonably warm weather in the northern hemisphere has had a dampening effect on oil and gas prices.

Also, China’s reopening is easing supply chains, which is likely to positively impact goods prices.

And last Friday, January 6th, the US Labor Department provided information that indicates wage growth, a key ingredient in demand for goods and services, seems to be slowing down, too. Wage growth eased to 4.6% from a near 6% annual growth rate at the beginning of 2022.

While a few months of data don’t seal the deal, inflation trends are encouraging.

If inflation continues to moderate, it will give the Federal Reserve, the country’s chief inflation fighter, some room to ease off the pace of interest rate hikes. This, in turn, would mean less pressure on the financial markets, and a backdrop more conducive to stock and bond price gains.

Case in point: following the release of the Labor Department data on Friday, stocks jumped by more than 2% and registered their best day since late November. The bond market got a lift, too, rising by 1% on Friday.

An improving inflation picture in 2023 will go a long way in helping to relieve anxiety associated with the financial markets that has carried over from 2022.

RK

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