“Good” Inflation: Rising rates and falling stocks

Over the past week, the Dow fell by 4%, more than halving its ytd gains through Friday 1/19 (all time high).   Bonds continued the decline started in mid-December, bringing losses during the current ‘bond rout’ to -5.7% year to date.  That is a one week decline in the Dow of 4% and a four-week decline in long-bond prices of 5.7%.  Balanced investors have seen stocks gain and bonds lose, putting most investors (moderately conservative to moderately aggressive) at a mild gain or loss so far this year.  Generally, diversification across asset classes reduces volatility when bonds go up, stocks generally are weaker and vice versa.    When the classes move together differentiation across risk profiles diminishes.  Stocks remain in a strong uptrend and given the substantial gains over the past few months, equity centric investors should be able to take this in stride (or they shouldn’t be equity-centric) as 4% is a small blip in a strong multi-quarter uptrend awash in investor optimism, all-time low cash levels, all-time high exposure to stocks and financial assets and expectations of higher wages, earnings and GDP growth.   In this light, a rebound, or ‘buy the dip’ would not be surprising.  The new feature though is that volatility has returned.

The ‘bond rout spilling into equities’ explaination has to do with relative attractiveness.  If rates keep rising, bond prices are hurt, while becoming more attractive (due to higher yields) to equity investors, putting pressure on equity prices.  At some point, earning safe interest attracts enough investors from stocks to weaken stock prices.  The S&P 500 dividend yield is now 1.8%, similar to what can be found offered on 18 month CD.

Rate have climbed due to rising inflation expectations.  Inflation is expected to, finally, exceed the 2% goal set by the Federal Reserve ‘in the coming months’.  Current thinking is that a tight labor market is pushing AHE (average hourly earnings, +2.9% Jan ’18 vs Jan ’17), combined with more take home pay (via tax reform), will result in more spending from consumers and investment from business.  This will take time but markets have already priced it all in.  Just like the stock market has priced in exceptional earnings growth to match its exceptional valuations.  The chart below shows us that we’ve been in a tightening labor market for years without being able to hold above 2.0% inflation but briefly.

infl vs unemplmnt

Given the new feedback loop between stocks and bonds, perhaps we shouldn’t be so excited about inflation, even if its ‘good’.  On the bright side, the past few years has seen 3.25% as a top in 30yr bond yields and perhaps a decline in rates near term may help both bond holders and stock investors alike.

Up, Up and Away – Why Not to Fear New Market Highs

2018 started off with NYE fireworks that have continued. It took only 3 trading days in the New Year for the Dow to surpass 25,000. It took another 8 trading days to close above 26,000.

Do you take your money off the table or do you say, laissez le bon temps rouler?

I’m not a soothsayer (more of a historian), so let’s step back and remember that a day or a month does not make a year.

Performance-wise, 2018 marks a phenomenal start for the Dow index. As of January 16th, the Dow was up ~ 5% YTD, on the heels of being up ~ 25% in 2017. The Dow jumping from 25k to 26k was the quickest 1,000 point move ever. Wow! The Dow is like the Golden State Warriors (as of recent) – we’re seeing some outstanding moves and records achieved.

It’s best to keep everything in check though. We only have to look back 2 years to the beginning of 2016 – the Dow had its worst 10 day start since 1897. The Dow lost 5.5% in January 2016 and 93% of investors lost money, if not more than the Dow that month, according to CNN_Money.

Back then, global economic worries pushed investors away from risky assets. Now an apparent synchronized global pick-up has investors jumping in and seeking risky assets, such as stocks, fearing they’re missing out on the next leg up. It’s a melt-up, the opposite of a market melt-down.

When people know that I’m a wealth manager, they often ask me what I think about the stock market. Often it’s along the lines of “I have cash that I could/should put to work but have been waiting for a pull back as the market is at an all-time high, so I just sit tight.”

I often proffer that “the best time to invest was yesterday and the second best time is today,” in addition to, “it’s about time in the market, not timing the market.”

We’ve been constantly hitting new highs since taking out the old high on the Dow back in October 2007 (Dow 14,093) in early 2013, a span of ~ 5 ½ years to be back in black. Now we’re close to another 5 years since then, and close to 9 years in on a really impressive bull market run.

For those old enough to remember the Nifty 50’s, the Dow climbed 240% during the decade of the 1950s. For me, I remember the Roaring 90’s and the spectacular run we had during that decade. In 1999 alone, the Nasdaq composite rose 86%, the biggest annual gain for a major market index in U.S. history, while the Dow gained 25%, a record 5th year in a row that the index posted a double-digit percentage gain. That’s what a market topping process looks like.

Historically, the stock market has had its share of peaks and troughs, from bull to bear back to bull again, taking out previous highs and setting new ones. How long does that take? It depends on many circumstances but I would say that while the past is no fortune teller, it does offer clues.

Wharton School Professor Jeremy Siegel studied the ‘Nifty 50’ stocks of the early 1970’s. These were much sought-after stocks that got to ‘nose bleed’ valuation levels and then had a melt-down. However, they ultimately turned around and by 1996, they had offered up annualized double digit returns. (you can read the full study here: https://www.aaii.com/journal/article/valuing-growth-stocks-revisiting-the-nifty-fifty)

So even if you believe you are purchasing stocks at high valuation metrics, over a long period of time those securities will reward investors (caveats of diversification, etc. are always warranted).

There will be bubbles – Dutch tulip bulbs, dot-com stocks, and now we’re in the throws of a cryptocurrency craze. And yes, many U.S. stocks are currently stretched, valuation-wise, and probably will be for a while longer as there’s momentum from investors adding to stocks and away from bonds.

As economist John Maynard Keynes stated back in the 1930s, “The market can stay irrational longer than you can stay solvent.” At this juncture, that means a tricky part of putting money into a bearish bet is the timing. You can be right that a market or sector is overvalued but wrong on the timing.

My best answer to investing near or at market highs is to stay steadfast – continue to invest or get started in doing so. Dollar-cost averaging helps as well. Investors with a long runway before they need to draw on their assets should hold a good amount in stocks in their overall asset allocation.

One should take a diversified investment approach and forgo timing entry points. One’s time and energy is better served on focusing on a factor that has been shown to have a greater impact on returns – one’s asset allocation. That should be based on one’s long-range financial goals and needs as well as knowing one’s limitations. A wealth manager who has an informed view of a client’s total financial picture can then position the client to best hew to his or her overall financial plan.

In financial literature we often speak of a “rational investor” but we all know that humans are emotional beings (we’re not Vulcans!). It’s really difficult for human beings to envision what might happen in the future. That’s why we have a very tough time taking money we earn today and saving or investing it for some far-off point. But doing exactly that is what’s required if you want to reach big financial goals.

If you want to get or stay on track to reach your long term goals, feel free to reach out to me (or a fellow Naples Asset Management advisor in your local area) about any adjustments your plan may need.

A creative man is motivated by the desire to achieve, not by the desire to beat others.” ~ Ayn Rand

What are Alternative Investments?

  • Real Estate: Tenancy-in-Common, LLC,  LLC Unit or Partnership Interests in Real Property investments, such as hotels, storage, retail and other real estate types.
  • Arbitrage: Simultaneously buying and selling related securities, sometimes in different markets, to exploit mis-priced relationships.
  • Hedging: Investing to offset the risk of price declines using methods such as buying or short selling.
  • Trend-following: Identifying price patterns with profit potential and implementing similar long/short positioning

IMPORTANT RISKS
Alternative investments do not guarantee a profit or protect against a loss.  Sophisticated techniques can magnify a gain or loss, for more information consult your financial adviser, prospectus or private placement memorandum.

Tax Cuts and Jobs Act May Help Investors

While investments in commercial real estate came away with some clear advantages relative to other industries and investment types, the law also generally takes away some tax benefits and deductions previously available to high-income individuals, and in most cases increases the tax burden on persons residing in states with high state and city taxes (since the deductions for those local taxes is now limited).  So investors will need to evaluate the law’s overall effect from the point of view of their individual tax situation.

Commercial Real Estate is a Clear Winner

In general, the law will have corporations, partnerships, and family-owned firms seeing tax cuts across the board.  In those areas where the law otherwise eliminates special breaks or imposes tighter standards, commercial real estate almost inevitably gets a pass.

As noted in a recent NY Times article, most businesses will be subjected to new limits on deductions for interest payments, but not real estate. Most industries will lose the ability to defer taxes on the exchange of similar kinds of property, but not real estate. Domestic manufacturers and pharmaceutical companies will lose some industry-specific breaks in exchange for lower tax rates, but the real estate industry will benefit from an even more generous depreciation timetable, allowing owners to shelter more income. And in a break from previous practice, REIT income qualifies for a lower tax rate, the kind of special treatment traditionally reserved for long-term capital gains and certain qualified dividends.

Such benefits do not necessarily extend to owners of residential real estate, however.  Residential realtors, for example, are among the biggest losers under the tax code overhaul, since decades-old perks that were designed to encourage home ownership will be wiped out. And by almost doubling the standard deductions for individual and joint tax filers, the legislation blunts the advantage of the mortgage interest deduction, which is often a key factor in home-buying decisions, particularly in pricey markets. The legislation also caps the deduction for state and local taxes at $10,000, a blow to homeowners in high-tax states.

20% Deduction for Pass-Through Income Benefits Real Estate Investors

The change that might most directly affect investors and sponsoring real estate companies is the 20% deduction in income received through pass-through entities like partnerships or limited liability companies.

Pass-through income is business income that is not subject to corporate or entity tax, but is rather taxed at the level of the ultimate business owner(s), at their individual rates.

Nearly 40 million taxpayers claimed pass-through income on their individual tax returns.

The 20% deduction differs from the House’s original proposal to simply lower the applicable tax rate on pass-through income.  Under the final law, 20% of pass-through income can be deducted, but the rest will be subject to tax at the regular rates, up to a new top rate of 37% (down from 39.6% under current law).  The bill includes some limits on who can take the deduction (medical, legal, and consulting practices won’t be eligible), and also limits the deduction further for people who make more than $157,500 (or $315,000 for married couples).

For those facing a limit on the 20% deduction, the deductible amount is capped at 50% of the wages paid by the business or 25% of wages paid plus 2.5% of the value of the business’s “qualified property,” whichever is greater. Qualified property is tangible, depreciable property that pass-through businesses use to produce income – a qualifier that, again, benefits real estate investors.

Shortened Depreciation Periods

Property investors may also benefit from the shortened depreciation schedules for buildings. Both residential and non-residential properties have had their depreciation schedules reduced to 25 years, from 27.5 years and 39 years, respectively.

The change is significant for residential property, but even more important for commercial real estate. The shortened depreciation schedules will allow investors to more quickly realize the tax benefits on property purchases and related capital expenditures.

Expanded Expense Treatment for Certain Costs

Some commercial real estate, especially non-residential, may benefit from the new law’s expanded treatment of deductions of the cost of certain types of property as expenses, rather than capitalizing such expenses into the cost of the property. The new provision includes certain depreciable tangible personal property “used predominantly to furnish lodging or in connection with furnishing lodging.” It’s as yet unclear whether this provision will be limited to the hotel sector or might be interpreted to extend to other properties.  The expanded definition covers a range of improvements to non-residential real property, including roofs, HVAC systems, fire protection and alarm systems, and security systems.  The provision should benefit many value-add commercial real estate projects.

Limitations on Sponsor Business Interest Deductions Are Also Avoided

The law generally limits the deduction for business interest expenses.  Because property loans make up a significant portion of a real estate project’s overall capitalization, such restrictions could have been very problematic for real estate companies.

Under the law, the ability of most businesses to deduct interest expense will be limited to deductions that are not greater than 30% of their earnings before interest and taxes (EBIT). But that limit will not apply to commercial real estate.

Limited Changes to Carried Interest Taxation

Real estate developers make much of their money from taking a “promote” interest in their projects – a portion of the profits beyond those otherwise attributable to their invested capital – which is treated similarly under the tax code as “carried interest,” a similar compensation mechanism used by hedge fund and private equity managers. This compensation has typically been taxed at a lower rate than ordinary income, and some observers (including, earlier, President Trump) had called for the elimination of that disparity.

The favorable tax treatment of carried interest generally survived in the new tax law, but now longer holding periods are required to take advantage of the lower rates.  Currently, to get taxed at the long-term capital gains rate, a fund must hold an investment for one year. The new law extends that to three years.

The effect of this change may be limited, since real estate sponsors tend to hold properties for several years anyway.  Sponsors involved with projects having a relatively short-term renovation and exit strategy, though, may look at slightly extending their investment hold periods in order to continue taking advantage of the lower tax rates on their “promote” interest.

REITs to be Taxed at Lower Rates

Real estate investment trusts (REITs) pay no separate business tax, instead passing through nearly all of their taxable income to their shareholders, who then pay tax when they file individual returns. Under the new tax law, the top income-tax rate of 39.6% on dividends received from REITs will drop to 29.6%.

That reduction may help to keep REITs on the same playing field as pass-through vehicles, which will enjoy the 20% deduction discussed above. The lower tax rates may also REITs’ appeal relative to other yield-oriented investments, particularly for those owning REITs in a taxable account.

No Changes to 1031 Like-Kind Exchange Tax Deferrals for Real Estate

Investors that re-invest the sales proceeds from investment properties into replacement investment properties have long benefitted from the tax deferrals on gains that qualify for “like-kind” exchanges under Section 1031 of the tax code.  While the bill eliminates such tax deferrals for personal property, it leaves the tax provision unchanged for real estate investments.

Alternative Minimum Tax Remains in Place

Originally a subject of repeal in the House version of proposed tax changes, the final law preserves the alternative minimum tax but implements increased exemptions and phase-out amounts until the end of 2025.

Individual Mortgage Deductions Will Be Capped

The tax law is not as kind to the residential real estate market, since it would reduce or eliminate some of the benefits of homeownership that Americans have come to expect.  Homeowners in areas with hefty property valuations and high property taxes will be most affected, but real estate agents, home builders, and housing industry groups also worry that the effects will be felt by a wide swath of homeowner borrowers.  This is because the tax bill could make existing homeowners less willing to move up to bigger homes, which in turn might make it harder for renters to enter the housing market.  Recent home ownership figures indicate that ownership rates are already near some of the lowest figures seen in the last few decades.

The tax bill will reduce the maximum available interest deduction available on owner-occupied mortgage debt from a $1 million cap to just $750,000. More expensive areas along the coasts will likely feel the pinch; the move will likely serve to raise the overall cost of buying a home in those areas, and perhaps discourage existing homeowners in those regions from moving.

The tax bill will also cap the deductibility of state, local, and property taxes at $10,000, another provision that could weigh on the construction and resale of more expensive homes in high-tax states like California and New York.

The potential advantage to commercial real estate investors, however, is that such changes may continue or accelerate the shift from home owners to renters.  If this is the case, then the commercial property sector that focuses on rental units may well benefit.

Jury is Still Out on the Plan’s Macroeconomic Effects

The anticipated cut in the corporate rate to 21 percent from 35 percent and other business perks are lifting the stock market to new heights; “animal spirits” have been revived. Over time, however, because of the deficit restrictions imposed on the majority-vote rules by which the tax law passed in Congress, most of the broad-based tax cuts for individuals will likely disappear.  The few of the richest Americans will continue to benefit, but most people who earn less than $100,000 will see their taxes later rise over time.  These increases could slow the economy’s primary engine – consumer spending.

Neither NAMCOA nor any of its affiliates, advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice, either express or implied.  Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.

Money for Nothing: from QE to QT

During the crisis, central banks lowered interest rates dramatically during the stock market crash.  The Fed Funds Rate went from 5.25% July 2007 to 3.0% March 2008 (when Bear Stearns failed, most people remember Lehman, which failed in September).   That summer Freddie Mac and Fannie Mae failed and the FFR was lowered to 2% and then 1% in September and finally 0% was the official rate in December 2008.  All the while financial asset prices kept falling and the economy was hemorrhaging.  Soon after hitting 0% as the cost of money to the banking system, the Federal Reserve started Quantitative Easing, where the Federal Reserve would buy mortgage backed securities (as well as other tax-payer insured instruments) to provide ‘liquidity’ to the markets.   The stated goal was to increase the prices of assets (stocks, real estate, bonds) so that the “wealth effect” would spur people to spend money rather than save it.  Given the anemic pace of economic expansion, the primary effect QE has had has been to push up stock prices well beyond normal valuations.

While the US has ceased QE, raised interest rates off the 0% mark, and laid out a plan to shrink its balance sheet (taking liquidity away from the market); the European and Japanese central banks continue to buy assets. The Europeans buy corporate bonds and the Japanese buy everything including equities.  The ECB has expressed a desire to cease its purchases (stopping new liquidity into the market) starting in 2018, but have not committed to a schedule.  The chart above combines all the central bank’s asset purchases and projections into 2019 overlaid with global equities.  On the chart below, notice how the EM (emerging markets withdrew liquidity late 2015 to 2017—emerging market stock indices (EEM) fell 39% from Sept 2014 through Jan 2016).  Additionally we can observe the effect central bank purchases have had on interest rate spreads, giving investors the most meager additional interest for taking on additional risk.

The chart shows the Fed’s net reductions in liquidity and the Swiss, Japanese and Europeans declining levels of new liquidity to the marketplace.   Given that adding liquidity boosted asset prices, as additional liquidity slows and possibly reverses, it is not unreasonable to assume markets will become much more volatile as we approach that time.  We will likely see the effects of Quantitative Tightening (QT) beginning in, and throughout 2018.  One way to counteract this, would be for private investors to save/invest rather than spend this difference (approx. $1.2 trillion), but a reduction in consumer spending would bring its own problems.

central bank purchases 2019