Wealth Management

The New Vigilantes

By:  Thomas Steffanci, PhD, Senior Portfolio Manager

The markets are all aflutter as the Federal Reserve (the “Fed”) plans to reduce and then eliminate their purchases of government securities which are supposed to follow their first increase in the Fed Funds rate in March. That is estimated to be a 25-basis point (maybe 50-basis point) rise. If you believe the latest estimates of the members of the Federal Open Market Committee (FOMC), by the end of 2024 the rate would be up to 2 1/8%. And their “longer-term” estimate is 2 1/2%.

All this is in connection with the switch by the Fed from their pipe-dream estimates of last year that the burst of inflation was “transitory”. Now, apparently, it is judged to be not. So, they are going to tame inflation by raising the Federal funds rate to 2+% and at the same time reduce the size of their $9T balance sheet by not reinvesting the maturing bonds that they hold. 

In a Goldilocks scenario, this should take care of the inflation threat by year’s end. All the while, economists see 10-year bond yields reaching 2.5% – 3%. With inflation still likely lingering about 4%, where are the bond market vigilantes of old, that forced interest rates high enough to choke off inflation (and in the process caused the two recessions of 1980 and 1982)? With inflation likely two times the level of the estimated Fed Funds rate, what mechanism will tame the inflation?

Well, ironically, oil prices reaching $100/barrel are likely to be the new “vigilantes”. With oil production being penalized by Western governments via taxation or regulation to limit oil drilling, and at the same time global economic growth is expanding as the Covid pandemic becomes endemic, oil prices could continue to rise toward $100/bbl. While there is nothing magic about that price level, it can do two things: 1) keep overall inflation rising above expectations, and more importantly, 2) depress economic growth enough to take the word “recession” out of the closet. That’s all the Fed will need (especially in an election year and their history of overdoing it) to “blink” and reverse course, especially if markets continue to be under pressure and politicians need to be re-elected.  

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

Providing Better Returns by Managing Taxes

Focus on What You Can Control

By:  Paul Horn, CFP®, CPWA®, Senior Financial Planner

The goal of every investor is to get the best returns possible per unit of risk based on your risk tolerance (the “optimal portfolio”). No matter how much research you do or the investment philosophy you use, at the end of the day there are many variables that you cannot predict or control for when you are making investment decisions. So much time is spent by the financial gurus discussing how to try and create alpha (i.e., excess returns above the market benchmark return), but it is very difficult to do so consistently. What is often overlooked in these conversations, is focusing on the variables that you can control, like costs and taxes.

What you keep as an investor is returns after fees and taxes. Fees are relatively easy to control as you can compare similar investments and see what the net expense ratio is for the Exchange Traded Fund (ETF) or mutual fund. For example, if two S&P 500 index funds have similar characteristics, low tracking errors, and return profiles, it would typically be best to choose the fund with lower fees. You can use tools like Morningstar.com to easily compare fees. 

The harder factor to control and the least understood is taxes. Let’s start with the basics of understanding long-term capital gains (LTCG) vs. short-term capital gains (STCG).

Any investment that is held for less than 12 months (this is always the case with options) will pay taxes at ordinary income tax rates.

Short term gains (positions held 12 months or less) taxed as ordinary income tax rates

  •  The max federal tax rate is 37% plus a 3.8% Net Investment Income Tax (NIIT)*

* If your Adjusted Gross Income (AGI) > $200,000 Single; or AGI > $250,000 Married Filing Jointly

When you purchase the investment and if you hold it for more than 12 months, then it is considered a long-term capital gain and the investment receives preferential tax treatment.

Below is a chart summarizing long term gain tax rates for 2022.

You will notice in both scenarios (short-term or long-term gains), there is an additional tax you may pay called Net Investment Income Tax (NIIT) if your income is greater than $200,000 single or $250,000 married filing jointly (MFJ). There is no way to get around this surtax, but it is important to understand.

Let’s take a closer look at the drastic impact taxes can have.  Let assume a married couple makes $400,000 per year and bought ten shares of XYZ stock for $100 per share on January 1, 2021. Now assume the shares are sold on December 1st of 2021 at $180 per share. This results in a gain of $80 per share, that would be taxed at short-term capital gains at a tax rate of 35.8% based on this hypothetical couple’s income (32% MFJ ordinary income tax rate + 3.8% NIIT).

However, if the shares are held a month and a day longer and sold on January 2nd, the shares would have been taxed as long-term capital gains. This is a more favorable tax rate of 18.80% for the couple (NIIT applied in this example).

Below is a summary to help clarify:

Tax Rate Short Term Capital Gain (w/ NIIT)35.8%
Tax Rate Long Term Capital Gain (w/ NIIT)18.8%
Taxes per share paid at STCG $    28.64
Taxes paid at LTCG $    15.04

You can see here with proper planning you can easily make an additional $13.60 per share by getting a long-term capital gains tax rate. This is just a simple example of how tax planning can increase the return on your investments.

With tax planning, another strategy to use is called tax location. The idea here is to keep your investments in the proper account to limit tax drag. For example, interest from bonds is normally taxed as ordinary income. It may seem counterintuitive, but it is best to keep bonds in a tax-deferred account. This will save you on your annual taxes, since in the tax-deferred account you only pay taxes at the time of withdrawal. Remember withdrawals from tax-deferred accounts are always taxed as ordinary income just like how the bond interest is taxed. Stocks on the other hand, should usually be held in either Roth retirement accounts or a taxable brokerage account. This will allow the best growth potential* to occur in the Roth account, which is favorable because the Roth account grows tax-free, and distributions are also tax-free (*stocks typically have higher reward potential based on their risk compared to bonds). The taxable brokerage account allows you to take advantage of preferential tax rates (long-term capital gains) since stock gains are treated as capital gains (as long as held the position for longer than a year). That is why in accounts for BFSG clients we strive to use this tax location method to try and reduce tax drag in portfolios.

These strategies do not guarantee returns, but certainly give you the best chance of future outperformance. To be successful with investments, as with anything in life, focus on what you can control. By using a disciplined approach, these strategies should help your investments grow at a higher rate of return to help you achieve financial independence sooner. If you would like to discuss this in further detail or how this applies to your situation, please contact us at financialplanning@bfsg.com

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

The Fed & Inflation

By:  Thomas Steffanci, PhD, Senior Portfolio Manager

Source: Realinvestmentadvice.com

Has the Federal Reserve (the “Fed”) caused the burst in inflation over the past year? Not Likely.

While the Fed can influence money supply (M1) growth, they can’t control how fast it is spent. Money velocity measures how many times a dollar of money supply circulates. If M1 growth rises but it is saved (a decrease in velocity), GDP and prices will stagnate. In the 1970’s (circle) both M1 and velocity rose, causing rapid inflation. Contrast that to today, where the Fed caused an historic expansion in M1 to counter the pandemic/recession. But until recently, inflation was quiet as households and businesses hoarded cash and velocity plummeted. The supply chain wreck caused by the pandemic have been the major factors in elevating inflation, not “excessive” M1 growth.

But this speaks of the Fed’s policy impact on inflation. If/when velocity rises as Covid subsides and lockdowns end, economic activity is likely to rise, lifting velocity, and that may frustrate the Fed’s attempts to control inflation. It would largely be out of their hands at that point.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

Understanding Washington State’s New Long-Term Care Program

Back in 2019, the state of Washington passed the “Long-Term Services and Support Trust Act” to provide long-term care benefits. The benefit would be $100 per day with a lifetime maximum of $36,500 and the benefits can be used for long-term care services including professional care at home or nursing facilities, dementia support, or adaptive medical equipment. The benefits will not start until January 1, 2025.

This act will be paid for through an additional tax the employer will deduct from your payroll for 0.58% of the employee’s wages and there is no cap. For example, an employee making $100,000 will pay $580 annually for this tax.  Independent contractors and self-employed are not required to participate. Currently, there is no option to be excluded from this new tax.

Employers were set to begin the new payroll tax on January 1st, 2022, but this has been delayed until March 2022. Governor Jay Inslee has temporarily halted the collection of the payroll tax to allow the Legislature to have more time to review and potentially make some changes. There may be potential changes and we will keep you updated as things progress.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

Is Our Democracy in Trouble?

By:  Michael Allbee, CFP®, Senior Portfolio Manager

“What we’ve got here is failure to communicate. Some men you just can’t reach.”

– Captain (Strother Martin) from the movie “Cool Hand Luke”

Barron’s recently interviewed hedge fund giant Ray Dalio, who manages Bridgewater Associates, the world’s largest hedge fund with around $150 billion in assets. During the interview, he discussed how social division and polarization could lead to some form of domestic civil war and that we are at a critical juncture.

Is Mr. Dalio out of left field? Could we have a constitutional crisis in 2024 similar to the presidential election of 1876? The election of 1876 and the present day have many similarities, with the relentless anger and even hatred building up in our political system. The history of ancient Greece showed that, in a democracy, emotion dominates reason to a greater extent than in any other political system.1

Our democracy is fragile and can only survive if most citizens feel the system is fair and legitimate.2 “Good words and spirit aren’t enough,” Dalio said. “People will have to agree on both how to grow the pie and how to divide it well. That will require revolutionary change.” I don’t know about “revolutionary change”, but bipartisan government and legislation are absolutely essential for the health of our democracy. With an evenly divided Senate and a near-even split in the House, lawmakers have an unprecedented opportunity to truly come together with a plan to restore truth and respect in governance, putting the nation’s business ahead of partisan loyalties. “History bears the scars of our civil wars”, but history also justifies such moderate hopes.  “I don’t need your civil war”!3

As we enter mid-year elections, there will be lots of headlines but that should not sway you from following the financial plan we created for you. Of course, elections hold great importance in upholding the U.S. tradition of democratic, representative government. However, their impact on market returns has historically proven to be negligible.4

How do we counter today’s political climate? We focus on the things that we can control. At least when it comes to investing, we focus on diversification, strive to position portfolios to generate stable returns after inflation and taxes, and disciplined rebalancing in times of market volatility to capitalize opportunistically on dislocations. Even though bonds and other “safe haven” assets (i.e., gold, reserve currencies, some alternatives) don’t provide much income today and may face near-term headwinds with rising interest rates, these assets remain a critical component of a diversified portfolio.

References:

  1. Hart, Liddell B.H. Why Don’t We Learn from History? Sophron, 1944.
  2. Marks, Howard. The Winds of Change. Oaktree Capital Management, L.P, 2021.
  3. Guns N’ Roses. “Civil War”. Use Your Illusion II. Universal Music Group, 1991.
  4. Source: Vanguard, based on data from Global Financial Data as of December 31, 2019. Data represents the 60% GFD US-100 Index and 40% GFD US Bond Index, as calculated by historical data provider Global Financial Data.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.