Fed Does a 180

Does the most dramatic change in the Federal Reserve’s policy outlook indicate a change in the economy?

Prior to December 1, the Fed had widely broadcast that it intended to raise it benchmark rate 3 more times in 2019.   At the December meeting, they lowered that to 2 times in 2019.  In January after the horrid December stock market fall, the Fed changed once again, removing expectations of further rate increases.

The Fed has claimed to be data-dependent and the major economic data points have been indicating slowing growth for most of 2018, and more so since Q2 2018.   The Fed may have realized it overtightened, having raised the Wu-Xia Federal Funds Shadow Rate (Atlanta FRB) by more than 5%.  This was the fastest rate of increase in almost 40 years.

Now the Fed’s balance sheet normalization plan is being questioned and pundits are calling for an early cessation.   In November 2017 the median targeted estimate for the Fed’s balance sheet was just under $3 trillion.   The balance sheet peaked at $4.5 trillion and is currently a tick under $4T.  At the beginning of 2008 it was $800 billion.

So, from a target Fed Funds rate of 3% and Fed balance sheet of $2.75T, to a ‘normalized’ rate of 2.25% and a Fed balance sheet of $4 trillion.    The last few recessions we have seen the Fed raise rates right into economic weakness, only to cease then ease as the recession begins.   With that kind of track record its no wonder people believe the Fed to either be behind the ball, or the outright cause of recessions.

The irony is that the US may have crossed the Rubicon regarding diminishing returns from cheap credit (low rates) aka velocity of money.   While over the past 40 years we have lowered the cost of credit to induce consumption, each recession we must lower the rate below the previous recession lows.  And while we ramp up credit expansion to boost the economy (borrowing more and spending more today) each time, we are getting less and less growth for each dollar borrowed/spent (velocity continues to decrease).  And when there is low velocity, in order to create growth, exponentially larger amounts of money (credit) are required.

I have seen a few reports discussing the idea that low rates decrease future potential growth.  Essentially low rates fail to attract capital, reducing investment, reducing future productivity gains which reduces overall growth.

We have seen the Fed essentially stop tightening (balance sheet runoff should continue to at least this summer) the next step will be for the Fed to ease again, indicating a recession has begun.

Blame the Fed! (for following through on previously telegraphed guidance)

The Federal Reserve today reiterated it plans to continue what it has been doing and said it would continue to do, much to the chagrin of market participants.

While the last Fed minutes showed more dovishness, actual actions that are indeed ‘dovish’ have yet to occur.  Reducing expected rate increases from 3 to 2 in 2019 was widely interpreted as, ‘the Fed might stop raising rates’, for some reason.  History shows us that the Fed telegraphs well in advance what it intends to do.  Thanks to Alan Greenspan, this has been the case for more than 20 years now.

What has the Fed said it will do in 2019?  Raise rates two more times and continue to drain liquidity from the system via its bond roll-off program.  It is also expected that other nations’ central banks will also cease adding liquidity this year. China may not have gotten the memo though, as they just lower their Reserve Requirement Ratio by 1%, freeing up approximately $100 billion in bank liquidity.  This was announced on Friday, January 4, but was not even mentioned in the Saturday Wall Street Journal!

Here is a picture of global liquidity for 2019.  From adding more than any given year in 2017, to net withdrawal in 2019.   Adjust your expectations accordingly.

qt central bank 10 2018

 

The 1031 Roadmap

Advantages of a 1031 exchange include many things aside from the tax benefits. Investors can consolidate, diversify, move markets, or increase income potential on their current investment property. dst 2 black-01

Some people choose to do a 1031 exchange to acquire more income. For example, they can exchange vacant land for commercial or residential real estate. The investor is able to increase income potential by exchanging a property that is not generating any revenue, such as land, into real estate that has greater income potential like commercial and residential real estate.

Another advantage of doing a 1031 exchange is consolidation. Depending on the investor’s situation, they may not want to manage multiple properties. They can exchange their properties into one larger investment property that is easier to manage. Others are tired of managing properties and of being a landlord altogether. These investors can exchange from a residential or commercial property into a more manageable and less time consuming piece of land.

Some investors are looking to diversify. With a 1031 exchange they can exchange one property for multiple property types. For example, an investor can exchange their residential investment property into a commercial, residential, and vacant piece of land. This is one of the most attractive of the advantages of a 1031 exchange!

A 1031 exchange is great for investors who have multiple properties in other states or for investors who are moving markets. Instead of traveling from state to state to manage multiple properties, investors can exchange the out of state real estate into property that’s in one state. If the investor is moving markets, for example from one state to another, they can exchange their investment property in the current states for an investment property in another state.

Every situation is unique when considering the advantages of a 1031 exchange, and it is always advised that the taxpayer consult with his or her tax advisors before making any decisions!

For more information, visit www.DST.investments.

Winter Solstice

They say its always darkest before the dawn, which seems appropriate as we meet the Winter Solstice today, at the lows of 2018.

There is a lot of commentary out there right now about hos investors are ‘worried’ about certain things like Brexit, slowing economies in China and Europe and if that slowing will seep into the U.S.  All these areas of concern have been with us for most of the year.  I have pointed out the Chinese credit impulse (slowing) more than a few times.  Housing and auto sales have been slowing for months.  The only difference is now there is a market decline and all these issues are being discussed.   If the market had not been declining these issues would still be with us, only accompanied by the tag line: “Investors shrug at concerns in Europe”.

In past posts I have described the coming year over year comparisons, 2018 v 2019, regarding earnings and GDP growth.  Every time I have mentioned that 2019 will look much worse than the stellar numbers put up in 2018, thanks largely in part to the one time cut in taxes.   That gave markets a boost and it was hoped that business investment, and wages would go up as a result.  Well it’s the end of 2018 and were still waiting.

The Federal Reserve gave a modest tip of the hat towards global economic concerns by reducing its estimate of rate increases in 2019 from 3 to 2.   There were even rumors that the Fed would skip raising its rate on December 19th and guide to 0 rate increases in 2019.   The Fed NEVER overtly bows to market or political pressures outside of an official recession or panic.   The Fed is in the process (as usual) of raising rates into the beginning of a recession.   Besides the yield curve, there are several other indicators that make recession in 2019 likely.  These indicators have been leaning this way for several months, and finally have tipped far enough that the markets are now concerned and discounting this likelihood.

As this is likely the beginning of a bear market (average -33% post WW2 era), we should expect large rapid moves, both down AND up in the markets.  During the bull market, a 2-4% pullback was common and quickly bought.  Today we see 2-4% intraday moves that continue to fall to hold support.  I expect several more percentage points south before a significant rally in stocks in the first few months of the year.   This will be an opportune time to reassess one’s risk tolerance and goals over the next 1-3 years, as well as make sure that one’s portfolio is properly diversified across asset classes. When stocks go down there are often other asset classes that are performing better, the core idea behind diversification.

Keeping Pace with Inflation

Inflation has been called the silent killer of wealth. It’s rarely discussed and many dollar picretirement income strategies ignore it completely. But over time, the steady increase in the cost of living can have a profound negative effect on your standard of living in retirement.

How inflation destroys wealth

As this chart shows, even at a modest rate of inflation, your spending power could decline by nearly 40% over the next 20 years.inflationNo one knows what the future may hold for inflation, but we do know that the Federal Reserve aims to keep the rate between 1% and 3% per year, and it has reached double digits in the 1950s, 1970s and 1980s.

Happy Thanksgiving !

Please note our office will be closed on Thursday, November 22 and Friday, November 23, 2018 in observance of the Thanksgiving holiday.  Normal operating hours will resume on Monday, November 26, 2018.

Feel free to contact me should you have any questions or if you have specific needs that require special attention.  You can reach me at 239-287-3789 or via email at pmcintyre@namcoa.com.

Have a safe and happy holiday!

 

Was that the Top or the Bottom?

The Wall Street Journal had a very good article detailing one of the root causes of the February decline.  A classic ‘tail-wagging-the dog’ story about derivatives and how they can impact other markets that are seemingly unrelated.  While the outlook for global equities informs the level of the VIX, we have just seen an incident where forced trades of VIX futures impacted futures prices of equity markets.   Its as though the cost of insuring against market declines went up so much that it caused the event it was insuring against.

Even with that being known, the impact to market sentiment has been dramatic.  Most sentiment indices went from extremely optimistic to extreme fear in a matter of days.  This change in attitude by market participants may have a lasting impact.  A rapid decline like we saw in February will reduce optimism and confidence (which underpin a bull market rise), and increase fear and pessimism, which are the hallmarks of a bear market.   Short term indicators turned very negative and now are more neutral, but longer-term sentiment indicators will take a longer decline to move negative.

Often the end of a bull market is marked by a rise in volatility, with equity prices falling 5-10%, then climbing back up only to get knocked down again, until finally prices cease climbing back up.  This can take several weeks or months.  We can see this in the market tops in 2000 and 2007.  This may be occurring now.  Many of the market commentary I follows the approximate theme of ‘markets likely to test the 200-day moving average’.  This is the level the February decline found support.  This would be about 7% below current prices, and have the makings of a completed correction, finding support once and then retesting.

Since the market highs in late January the major stock indices fell 12%, then gained 6-10% depending on the index.  Since that bottom and top; markets moved down about 4.5%, then again up into yesterday (3/13/2018) gaining 4% to 7%.  Tech shares and small caps have outperformed large cap along the way, rising more, but falling the same during this series.   Recognizing the size of these moves and the time frame can help manage one’s risk and exposure without getting overly concerned with a 2-3% move in prices.  But if one is not aware of how the 3% moves are part of the larger moves, one might wait through a series of small declines and find themselves uncomfortable just as a decline is ending—contemplating selling at lower prices as opposed to looking to buy at lower prices.  Hedging is a process to dampen the markets impact on a portfolio in the short term while looking for larger longer-term trend turning points. The high in January and current decline and bounce are likely a turning point over the longer term and in the near term provide investors with parameters to determine if the bull trend is still intact.

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

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.