September 2022 Client Letter
Here in Naples, we are already a month into the new school year. With our youngest son Jack now a freshman, we again have two kids in high school. Rick, a senior, has a study hall during first period, which allows him to stay at home until second period. This leaves me on morning-carpooling detail for Jack.
Jack and I leave the house around 6:40 a.m. Depending on the car line at Naples High, and on traffic, I am usually walking into the office by 7 a. m. After turning on the lights, I tune into Fox Business on the flat screen in our reception area. I listen to Maria Bartiromo for a few minutes to get a sense of what the national media is reporting about the global economy and financial markets.
Inflation, the Fed, and recession concerns have been much discussed this year. In April, Maria hosted a Harvard professor and former chief economist at the IMF for about a half hour. Typically, guests are on for less than a few minutes. He was pretty dour about the first-quarter GDP numbers, calling them “even below the worst” he imagined. He believed the chances of a recession to be 50-50 over the next year. More recently, a guest in the financial services industry told viewers that we are “technically in a recession.”
We are not yet convinced that the economy is in recession. The official arbiter of recessions in the U.S. is the National Bureau of Economic Research (NBER). NBER defines a recession as a significant decline in economic activity spread across the economy lasting for more than a few months. Factors the NBER uses to evaluate the economy include personal income, employment, consumer spending, and industrial production.
The NBER’s personal income measure is bordering on a new high. Employment is also at a high, and the labor market remains tight, with many more job openings than unemployed workers. Consumer spending remains relatively healthy, as does industrial production.
There are a couple of notable weak spots in the economy, including housing and some parts of the manufacturing economy, but perhaps we are simply seeing consumer demand shift from goods and houses to services as the pandemic economy subsides.
The recent ISM non-manufacturing survey on business seems to confirm this shift. The survey measures activity in the economy’s services sector. The July number improved from June and came in ahead of expectations. The details of the report appear to be positive. Business activity and new orders, two forward-looking components of the report, both increased to 59.9 from 56.1 and 55.6, respectively, in June. (Levels above 50 indicate expansion, and levels below indicate contraction.)
Dividends Can Provide a Cushion
Regardless of whether we are in a recession today or enter one in the future, a critical concept for investors to focus on is the fact that recessions end. During recessions, dividends are especially important because they can provide a cushion against falling stock prices. And, while waiting for the recession to end, dividends can be reinvested at lower share prices.
Traditional safe-haven sectors during a recession include consumer staples, drug stocks, and utilities. Many firms in each sector sell goods or services that consumers and businesses continue to purchase regardless of the economic environment. All three sectors are well represented in our Retirement Compounders portfolios. Procter & Gamble, Johnson & Johnson (JNJ), and Southern Company currently represent our largest position in each sector. We believe it unlikely that consumers would stop purchasing Pampers diapers, Tide detergent, Bounty paper towels, or Gillette razors in a recession. Nor do we believe JNJ would realize a significant slowing in sales of its top drugs or medical products. And while Southern Company may see some decrease in electricity demand from its business clients, consumers will likely use about the same amount of electricity and natural gas as when the economy is booming.
When I first got into the investment business, my dad would tell me, “If you want to know someone’s risk tolerance, talk to them during a bear market.” Successful long-term investing is an equation involving both risks and returns. Too often, investors ignore risk. When times are good and a rising tide is lifting all ships, risk can become an afterthought. The fear of missing out can cloud one’s judgment.
WSJ columnist Andy Kessler recently wrote an article titled You’d Be Stupid Not to Evaluate Risk. Andy warns his readers to be sure to assess future risk and be aware of the promise of especially high yields and guaranteed returns that “you’d be stupid not to take.” He correctly points out that “Risk is often nebulous, hazy, unmeasurable—so it is usually ignored. Years of zero interest rates have caused havoc, but with the Federal Reserve raising short-term rates, investors should be extra careful shuffling money around.”
At Richard C. Young & Co., Ltd., we seek to avoid the more risky and speculative elements of investing by pursuing a balanced approach. A mix of bonds, dividend-paying stocks, and precious metals has most often helped limit risk in our client’s portfolios while delivering an acceptable return. A well-diversified balanced portfolio will probably never earn the highest return in any single year, but it is also unlikely to deliver the worst return. And, with risk reduced, it can be easier to ride out down markets.
In my last letter, I included a bar chart titled Missing the Best Days Can Be Costly. The chart showed the potential missed opportunity to a portfolio’s value by sitting on the sidelines and missing market gains. I highlighted how Vanguard founder Jack Bogle did as much as anyone to help popularize the investing mindset of staying the course and not panicking during difficult times. In 1994, Bogle advised this in his book Bogle on Mutual Funds:
Think long-term. Do not let transitory changes in stock prices alter your investment program. There is a lot of noise in the daily volatility of the stock market, which too often is “a tale told by an idiot, full of sound and fury, signifying nothing.” Stocks may remain overvalued, or undervalued, for years. Patience and consistency are valuable assets for the intelligent investor. The best rule: stay the course.
A recent case in point to this advice is the markets’ runup since mid-June. Markets are up 10% in a short time. These are exactly the types of gains that you don’t want to miss.
Inflation remains the focus of many market participants today. The trend in inflation sets the tone for the Federal Reserve’s interest rate policy, which helps determine prices in both the stock and bond markets. Higher-than-expected inflation this year has hurt both. While we expect inflation to moderate from current levels in the months ahead, it is not yet clear if a higher level of inflation than we’ve experienced over the last decade will persist over the medium term.
If Inflation Does End Up Settling In at a Higher Level, What Can Investors Do?
Number one: Be invested. One of the biggest mistakes individual investors make is not being invested. Retirement is expensive, especially when factoring in the constant effects of inflation—whether moderate or otherwise. Your dollars will only keep up with inflation if given a chance. They have no chance if they’re sitting in your checking account.
Number two: include assets in your portfolio that can help hedge against inflation. Real assets, including industrial commodities or gold, can hedge against inflation; but over the long run, so can stocks. We especially like dividend stocks for this purpose.
Companies that make regular annual dividend increases exceeding the rate of inflation are effectively providing you with an inflation-adjusted income stream.
In our view, on a risk/reward basis, dividend-paying stocks make a lot of sense. Many of the companies we own are ones we consider to be blue-chip, and they possess the characteristics necessary to ride out the business cycle. Dividend-payers can also provide comfort and peace of mind during difficult stock market environments, given their relatively reliable income streams.
Our goal is to buy companies we believe will hold their value for the long term. We do not buy based on what we expect to happen next month or next quarter. We also do not sell just because an industry or a particular company goes through a tough period.
As interest rates rise, bond prices decline. As a result, it’s no surprise bonds have had a tough go this year. But it’s important to keep in mind that, except in the event of default, bond prices will gravitate upward, back toward par value as they approach maturity.
Also, because interest rates have increased, there have been more attractive yielding bonds for us to purchase during the last few months.
One of the bonds we purchased recently was an Apple issue with a 3.25% coupon rate due in seven years. With a AAA/AA+ credit rating, Apple has one of the highest ratings in the corporate bond market. We purchased the Apple bonds at a yield of approximately 3.25%.
Because interest rates have increased so rapidly this year, bonds with lower interest rates or coupons have much higher yields than the coupon rate implies. By example, we own a Waste Management bond for some clients. The bonds have a 1.50% coupon, and they are rated Baa1/A-. While the coupon is only 1.50%, the yield to maturity at current prices is 4.20%.
Speeding Toward Gridlock?
The 2022 midterm election is quickly approaching, and a divided Congress is a realistic possibility, with Republicans currently expected to take the House. Overall sentiment in the country appears to favor GOP candidates, with generic congressional ballots tight but currently favoring Republican candidates. The outcome of the races for positions in the Senate looks less encouraging for GOP candidates. Senate polls in battleground state races, including Pennsylvania, Georgia, Wisconsin, and Nevada, are not looking great for Republicans. Some early GOP targets for potential pickups in New Hampshire and Arizona are not looking so great either. Democrats are also outraising Republicans in key battleground races. The national mood could also shift, especially if voters associate Democratic Senate candidates with Joe Biden, whose polls are some of the worst ever at this point in the election cycle.
What happens next year if America finds itself with a divided government? One of the first things a divided government can accomplish is reducing government spending as a percentage of GDP. According to the Cato Institute’s Steven Hanke, “every instance of government shrinkage since World War II has occurred during a period of divided government.” But what about the stock market? According to a study by Bank of America Merrill Lynch, since 1936 the best stock market returns occurred under Democratic presidents with either complete or partial control of Congress by Republicans.
What Does a GOP House Mean for Taxes?
If Republicans are successful in taking the House, there could be a major shift in what taxpayers can expect from policymakers. In the past, Republicans have opposed Democrat priorities such as raising the regular income tax back to 39.6%, raising capital gains taxes, eliminating the step-up basis at death for investments’ cost basis, raising the corporate income tax, and raising the rate of taxation for carried interest.
Instead, the GOP has explained its plans for the tax code, which include:
- Making the 2017 tax reform (also known as the Trump tax cuts) permanent,
- Allowing for full and immediate expensing for investments in economic growth,
- Speeding up depreciation schedules for construction,
- Creating universal savings accounts,
- Raising the long-term capital gains tax bracket threshold to $75,000 to encourage investment among middle-income earners,
- Indexing capital gains taxes to inflation,
- Eliminating death taxes,
- Expanding net interest deductions,
- Reforming net operating loss deductions, and
- Introducing other measures to promote growth.
Many of these reforms are unlikely in a divided government, but their status as stated priorities for the GOP makes any tax increases seem unlikely.
Have a good month. As always, please call us at (800) 843-7273 if your financial situation has changed or if you have questions about your investment portfolio.
Matthew A. Young
President and Chief Executive Officer
P.S. Some good news. Yields on money markets have been on the rise. Your Fidelity Money Market fund now yields 1.8%, up from nearly zero percent at the beginning of the year. If the Fed follows through with its forecast for interest rate increases this year, we could see money market yields reach 3% by year-end.
P.P.S. I-bonds have received attention recently. We have nothing against I-bonds, but it is important to keep in mind some of their features: There is a maximum purchase amount of $10,000 annually using cash and $15,000 if you use a portion of your tax refund. I-bonds earn interest for 30 years unless you redeem them first. You can redeem them after one year; but if you redeem them before five years, you lose the previous three months of interest. I-bonds must be purchased directly from the Treasury website or via your tax return. Interest on I-bonds is a combination of a fixed rate that stays the same for the life of the bond and an inflation rate that resets twice a year. This means that your interest upon purchase most likely will change in future years.
P.P.P.S. We are not gold bugs, which is the financial sector’s nickname for an investor who is perpetually and extremely bullish on gold. We like to have gold in portfolios as an insurance policy for when things go bad. But we also realize gold’s limitations at times and its tendency to behave oddly. Take this year by example. With all the negative headlines about war and inflation, one’s inclination could have been to load up on gold. But rising interest rates and the potential for a stronger dollar indicated to us that gold might face headwinds in 2022. So far, that has been the case. Gold is an inflation hedge, but it also competes with other assets. Higher interest rates and a stronger dollar tend to be negative for gold, while higher inflation tends to be positive. YTD, we are looking at a stalemate in how these factors influence the price of gold.
P.P.P.P.S. As part of the Inflation Reduction Act, the IRS will receive $80 billion to help fund 87,000 new workers. Before you get too concerned about an auditor knocking on your front door, consider this. The hiring is to include all positions at the IRS over the next decade. Like most businesses, the IRS employs numerous customer service reps and tech workers along with its agents. Additionally, over the next ten years, the IRS is expected to retire 50,000 workers. Lastly, as reported in the WSJ, “It will take time for the IRS to staff up, especially in a tight labor market. By one estimate, new agents aren’t fully productive for three to five years. The Treasury Department has pledged to use the new funding to focus on tax underpayments by higher-income people. Their returns are often more complex than lower earners’ returns, and the IRS needs to devise new audit methods.” If I had to guess, I bet most of you reading this pay your taxes, have few itemized deductions, and do not file complicated returns. You are most likely not a top priority for the taxman.
P.P.P.P.P.S. Important Reminder – Fraudulent online activity continues to grow. Please remember to be vigilant in protecting your personal financial information. Please note, neither Richard C. Young & Co., Ltd. nor Fidelity Investments will ever send you a link (including via text message) asking you to verify the login information (username and password) to your financial account(s). Please contact us or Fidelity Investments immediately if you receive this type of request or if you believe your personal financial information may have been compromised. For your protection, we recommend that you implement multi-factor authentication for your online accounts. Other steps that you can take to protect yourself can be found at https://www.fidelity.com/security.