Helocs

With high interest rates driving up the cost of borrowing money, more people are tapping the equity in their homes. The most common way to access it is through a home-equity lines of credit, or Helocs.

A Heloc works like a credit card, but since it is backed by your property it generally offers a much more favorable interest rate. The average Heloc rate is 7.7 percent, according to Bankrate.com (via the Wall Street Journal), compared with the average 19 percent on a credit card or a 10-plus percent average personal loan rate. Owners get a credit line based on their home equity, but don’t have to use all or even any of available funds. 

The ready access to money that Helocs provide can be particularly appealing during a time of economic uncertainty—as long as borrowers refrain from treating their home as an ATM. Lenders tend to tighten credit standards during a downturn so it may be wise to apply for a Heloc now if you’re worried about needing the funds later.

A Heloc is different from a home-equity loan, which typically has a fixed rate and gives borrowers a lump sum upfront. The interest rates on Helocs are typically variable, meaning they will fluctuate as interest raises change more broadly. Other factors go into the rate, including your credit score, debt-to-income ratio, and the amount you are seeking to borrow.

One of the most common uses for Helocs is to fund home-improvement projects, which have the added benefit of potentially increasing your home’s value. Interest payed for home improvements has the added benefit of being tax-deductible.

Social Security as an Inflation Hedge

What we are experiencing now between the markets and inflation brings home the importance of delaying Social Security until age 70. This past month's announcement of an 8.7 percent cost-of-living increase for 2023 underscores the true value that delaying brings to a retirement plan. It's not simply the income payments, but also the strong built-in inflation protection of these payments.

It is very hard to get this protection elsewhere. We have an allocation to Treasury Inflation-Protection Securities (inflation bonds) in client portfolios, but when the bond market has a historic collapse, we find that these securities are bonds first and inflation-protection second.

Stocks and real estate have historically proven to be long-term inflation hedges, but in the short to medium term, a sudden spike in inflation can have a serious negative effect on equity values, falling just as your expenses are increasing.

Social Security is not always about maximizing payments through one's lifetime. Sometimes it's used as a tool to minimize bad outcomes. While you get the inflation protection no matter what age you start collecting, by delaying, the cost of living adjustments are being applied to a higher base income. Even if health issues come into play, be aware that for a 65-year-old couple, there's a 50 percent probability that one of them reaches age 89. That fact isn't taken into consideration by most online calculators.

Carnage in the Bond Market

Bonds have always had a very important role in portfolio construction. While most investors think the reason for that is the income they provide, the more crucial element is the ballast that they offer to dampen volatility of an overall portfolio. Because they are less volatile than equities, and tend to move in the opposite direction of equites, they dampen the swings, allowing investors to stay the course. For instance, when stocks fell 50 percent during the Great Financial Crises, bonds actually rose 15 percent. A portfolio comprised of a 50/50 mix of stocks and bonds was therefore only down 19 percent. That’s the free lunch of diversification.

Not in 2022.

And for a few reasons.

First, rates were as low as they could go. Once you get to 0 percent, your upside to bond prices is gone (economic textbooks will have to be rewritten as interest rates did go negative in some parts of the world the past few years-but not in the U.S.)

Secondly, the Treasury issued massive amounts of bonds to finance the myriad of stimulus programs in response to the pandemic. From 1980 to 2019, the federal debt increased at an annual average rate of 5.6 percent. In 2020, it increased 18 percent compared with the year before as federal COVID-19 spending peaked. There are a lot more bonds that need to be sold, and to attract buyers you need higher rates.

Lastly, I don’t need to tell anyone that inflation is back in a big way. Inflation has a particularly negative effect on bonds because it erodes purchasing power. Bonds offer a fixed payment over time, and if those future payments have less spending power because prices are going up, investors will demand higher rates to be compensated for that.

So now we are in a negative feedback loop. It is because interest rates are going up that bond prices are falling. And stocks are falling because higher rates remove liquidity, which causes stock prices to fall. As bonds fall, they become more attractive for investors because the return is higher, and it is deemed less risky than stocks.

TINA (there is no alternative) has been the lament, since the financial crises really, that because bonds were paying so little investors had little choice but to up their allocation to equities to get some kind of return. As painful as 2022 has been, having rates rise to levels that really do provide a steady, positive return is welcome.

Just a side note from looking at the chart. I was working on the bond desk at HSBC in 1994, the now dethroned year of what was called the great bond massacre. It looks quaint in relation to what we’re experiencing now. In a case of history repeating, it began when the Fed surprised the market with an interest rate increase in response to a rise in inflation. The big difference between then and now however is the overall level of rates. 1994 ended with the benchmark 10 year bond at 7.8 percent. A 3 percent loss for the year would be recovered by interest payments in less than 6 months. Now, the 10 year is under 4 percent, so multiple years to be made whole. For reference, the Dow Jones finished at 3834.

Go Green

Americans looking to make energy-efficient home improvements are poised to receive millions of dollars in tax breaks with the passage of the Inflation Reduction Act of 2022.

The legislation has a $1,200 annual tax credit for green remodeling, up from what had been a $500 lifetime cap.

The potential tax savings for homeowners, thanks to the expanded credit under the energy bill, would be an estimated $1.6 billion in 2023 alone, up from an estimated $253 million in 2022 for the old credit, according to Congressional Budget Office estimates.

The $500 tax credit, which expired at the end of 2021, is reinstated for 2022. The new revamped tax credit would then be effective January 1, 2023 through 2032. There is a higher $2,000 credit limit for heat pumps and biomass stoves.

By making it annual, homeowners can budget out different energy-efficient upgrades over a 10-year period. For example, insulation one year and windows and doors another.

A credit, unlike a deduction, reduces your tax bill dollar-for-dollar. Taxpayers can’t carry over unused credits to future years. The improvements have to be made to a primary residence, not a second home.

Medicare Under the Inflation Reduction Act

The climate and healthcare bill that President Joe Biden signed into law this week marks the most significant changes to Medicare since the Part D prescription drug benefit was enacted in 2003.

Mark Miller of Morningstar has a great breakdown of the changes here. But the major implication is that the Inflation Reduction Act of 2022 aims, in part, to address the skyrocketing cost of prescription drugs—and in some respects, it is a do-over that fixes the flaws in the Medicare Modernization Act of 2003.

That law contained a controversial provision that prohibited Medicare from using its huge purchasing clout to negotiate drug prices with pharmaceutical makers. It’s therefore no surprise that the big headline on the Inflation Reduction Act is that it will finally empower Medicare to negotiate with pharmaceutical companies on the prices of a shortlist of the most expensive drugs, starting in 2026.

But for me, and a fair number of my clients, the biggest impact is this: Starting in 2025, the maximum Part D out-of-pocket liability will be $2,000. That's the change that may contribute even more to protecting enrollees from soaring costs.

To paraphrase Donald Rumsfeld, healthcare costs are one of the "known unknowns" of retirement planning. We know that there will be expenses, but the range of outcomes from one person to the next can be astronomical. The new generation of drugs for conditions such as cancer, multiple sclerosis, or rheumatoid arthritis have put tremendous cost pressures on the Part D program.

Parts of the Inflation Reduction Act aims to tackle drug costs along several fronts—and several important provisions would take effect in 2023:

• Halt the soaring cost of insulin: The new law caps monthly costs for Medicare enrollees at $35 per month.

• Drugmakers will be penalized in the form of “rebates” that they would be forced to pay to the government if they impose price increases that exceed general inflation. This provision gives drugmakers a powerful disincentive to raise prices sharply.

• Cost sharing will be eliminated for adult vaccines covered under Medicare Part D. That will help more than 4 million Medicare beneficiaries annually, according to the Kaiser Family Foundation.

A core problem in Medicare Part D is that there has been no total cap on the amounts beneficiaries pay out of pocket after deductibles are met.

The Inflation Reduction Act addresses out-of-pocket costs in two phases.

In 2024, Medicare’s current requirement that enrollees pay a 5 percent coinsurance above the Part D “catastrophic threshold” will be eliminated. This will provide critical help to beneficiaries who now pay 5 percent of the cost of very expensive drugs.

And then in 2025, the maximum Part D out-of-pocket liability will be $2,000.

According to the New York Times, the new law will save many Medicare beneficiaries hundreds, if not thousands of dollars a year. Its best-known provision would empower Medicare to negotiate prices with drug makers with the goal of driving down costs — a move the pharmaceutical industry has fought for years, and one that experts said would help lower costs for beneficiaries.

Nearly 49 million people, most of them older Americans, get prescription drug coverage through Medicare. Low-income people qualify for government subsidies, so those in the middle class are hit hardest by high drug costs.

Nowhere to Hide in the First Half of 2022

As we limp into the end of the first half of 2022, we’ve witnessed one of the worst yearly starts in the markets since 1962. With a decline of about 20 percent in the S&P 500, 25 percent in the small-cap index, and 30 percent in the Nasdaq, it makes this year the third worst start in market history.

Stocks are now firmly in bear market territory but that is a fraction of the pain being felt in stocks and other risky assets. Stocks are now down 11 of the last 12 weeks but the pain was concentrated in June.

Adding insult to injury, this has also been one of the worst starts for the bond markets in more than 40 years. Long used to add ballast to portfolios as a haven from the stock market storms, the Barclays Aggregate Bond Index is down 10 percent year-to-date, with long-term treasuries down more than 20 percent. Even short-term treasury notes are down almost four percent, making even the safest and shortest of duration government bonds not immune from the carnage. Of course, when bond prices decline, their yields increase, so they become more attractive for new investments. Savers will finally get some return on capital.

Mid-term election years have historically been lackluster for markets, but that doesn’t entirely explain why this year has been so awful. The same issues we've been talking about this year remain front and center:

The war in the Ukraine

Rising inflation

Higher interest rates

The Fed draining liquidity out of the system

You can add recession risk, which seems to be front page financial news on a daily basis. A resolution to any of these issues would go a long way to releasing the selling pressure overhanging the markets.

To OAM's credit, we were very concerned in 2021 with the excesses we saw taking place. I have worked in the financial industry since 1987 and have seen all kinds of market environments. The crypto/NFT/SPAC/meme stock craze of the last few years was truly stunning and I think easily surpassed the excesses of the dot com era. That led us to bring risk levels below target, and hold higher allocations in cash and cash-like investments than ever before. While it's never pleasant to experience any drawdown, it did certainly mitigate the damage.

A question I'm getting asked a lot is, where is the money from all this selling going? How can everything go down at once? It's not going anywhere. It's telling us that the era of zero percent interest rates is over.

Zero rates allowed corporations to borrow money and buy back their own stock. It allowed hedge funds and investment banks the chance to lever up their books at minimal cost. For example, the U.S. 10-year treasury bond has yielded a miniscule 1.5 percent for the past few years. But if you can borrow at zero percent and then leverage up 10x or 20x, you're talking real money. Those types of trades are now gone, and are either being unwound by choice or by margin calls. That's also why the selling has been so consistent and unrelenting across all markets.

So what does that mean for the second half of the year? We know the US economy – the global economy – is slowing. That isn’t news anymore. But I'm seeing it being presented as if a recession is a forgone conclusion. That I'm not so sure about. Banks, which were clearly the biggest source of concern in 2008, are in much better shape than they were then. Right now, anyone who wants a job can get one. And while I'm having a lot of conversations regarding recession, no one I'm talking to is being impacted by the slowdown. To the contrary, business-owner clients are full-out, and everyone seems to be taking vacations.

With so many moving parts, I don't expect things to be resolved right away, so expect a bumpy ride for a bit. We are still about 10 percent higher than we were right before Covid hit, and back then we had low inflation, cheap oil, functioning supply chains, and easy money policies.

On the plus side, the vast majority of the fall in stocks this year had nothing to do with fears of a slowing economy. In fact, the drop was much more about the rise in interest rates which was driven by inflation fears. Now inflation fears are fading rapidly as commodity prices drop. This is also being confirmed by interest rates moving lower, a positive sign.

Historically, of the 14 other worst yearly starts since 1931, 10 of them went on to turn in positive returns for the second half of the year, although only 5 of those 14 years turned things around and closed with positive returns for the entire year.

Lastly, here's an updated chart from J.P. Morgan that I've shared over the years. Stocks and bonds have positive returns over time, but on a year-by-year basis, especially with stocks, it is an almost 50-50 chance that they will be up or down. This is normal market behavior, and this uncertainty is the reason stocks return so much more than bonds over time.

As the holding period extends, the chance of a negative result goes to zero. That's the reason we keep five years worth of spending outside of the portfolio, to avoid having to sell an underwater position.

What Happened the Past 3 Years Using 2 Stocks

Nothing epitomizes what we've experienced in the market and the economy from 2020 until now quite like this chart. It compares the price of Zoom (ZM) stock, the poster child of the work-from-home movement, with that of ExxonMobile (XOM).

ZM entered 2020 with a market capitalization of under $20bn, but ended the year valued at about $100bn. At its absolute peak in the autumn of 2020 it was worth more than $160bn, surpassing even XOM, an old-economy titan that traces its roots back to John Rockefeller’s Standard Oil.

At the same time, XOM headed the other way, as the pandemic brought the global economy to a standstill. The price of a barrel of oil briefly went negative as there was no place to put it.

XOM’s market recovery first began when Pfizer, et al, announced that they had developed a strong slate of anti-Covid vaccines in November 2020. This also signaled that it was time for workers to head back to the office, lessening the need for every meeting to be held on Zoom. But it is the supply-chain disruptions and Russia’s invasion of Ukraine that has really sent oil prices and Exxon’s shares soaring, putting us in the situation we're in now. (h/t Financial Times).

Series I Bonds

In a normally quiet corner of the bond market, individual investors can purchase government bonds directly from the Treasury via the TreasuryDirect website. Quiet, at least until this year.

The spike in inflation as led to a spike in activity in Series I Bonds. I Bonds are inflation-adjusted U.S. savings bonds. Americans snatched up nearly $11 billion in these bonds over the past six months, compared with around $1.2 billion during the same period in 2020 and 2021, according to Treasury Department records.

The I Bond interest rate is based on a calculation tied to the consumer-price index and we all know what prices have been doing. Therefore the rate on I Bonds is currently 7.12 percent and will rise to about 9.6 percent beginning in May. In a world where the benchmark Barclays Aggregate Bond Index is yielding right around 2 percent that's a no brainer.

Now before you sell everything to pile into these bonds, there are a few caveats to be aware of. First of all, you can only invest $10,000 per year per social security number so there is that limitation. Secondly, you are restricted from selling them within a year, and you do sacrifice three months of interest if you sell within five years. So not for short term money. And finally, the rate resets twice a year, so if inflation turns out to be transitory like many still predict, the interest rate will come back down with it.

More Inflation in the Nation

Inflation has been a focal point of client conversations for the past year. And the problem has gotten worse over that time, not better. That has taken on added importance because the longer and more persistent it is, the Fed will be forced to use stronger tools to combat it.

Since the pandemic, most of the inflation we experienced was demand side inflation. We all know the story. The stimulus thrown at the economy by the Federal government along with the Federal Reserve, coupled with the unforeseen ability of U.S. corporations and businesses to pivot seamlessly to a remote work environment kept everyone at work. And because of shutdowns, spending shifted almost entirely to goods, not services. This overwhelmed (and still is) the global supply chain causing prices to move higher.

Demand side inflation can be looked at as a "good" problem. It means people have jobs and money and are spending, so the economy can tolerate it. This, along with the supply chain disruptions being seen as a temporary situation, kept the Fed in a wait and see mode rather than acting to change policy sooner.

Because it has now gone on for so long, coupled with the heartbreaking situation in Ukraine, it has become a supply side inflation problem as well. Additionally, we now have covid shutdowns in China again.

The main tool in the Fed's arsenal is interest rates. Fed officials are signaling that they will take a more aggressive approach to fighting high inflation in the coming months — actions that will make borrowing sharply more expensive for consumers and businesses and heighten risks to the economy.

Raising rates is a ham-fisted approach. It's impossible to know ahead of time what rates should be set at to slow the economy enough to quell inflation without stymieing growth leaving open the possibility of a hard landing. And they have already moved up fairly dramatically.

For instance, mortgage rates have gone from 3.5 percent to 5 percent in just six months, the fastest increase of that magnitude ever. That means the monthly payment on a median U.S. home has gone up 20 percent. Or looked at another way, if the payment were to stay the same amount it was six months ago, that same median home would need to be 16 percent cheaper. How this plays out will have broad implications.

Lastly, the Fed's policies can only effect the demand side of inflation. There is obviously nothing they can do to lower the price of copper or wheat. They can't print oil. So all eyes will be on prices in 2022, especially of commodities. And because they are very volatile, I would expect that the volatility in all markets we've been experiencing this year to continue.

Double Whammy

It's been a tough start to the year for investors as this month's chart from Sundial Capital Research makes clear. The overwhelming majority of investment wealth in the U.S. is tied to stocks and bonds, and both have been broadly hit. Neither asset class has provided ballast to the other.

It's extremely rare to see both stocks and bonds in a pullback at the same time, defined as a 5 percent decline from a 52-week high. Starting late last week, the total return in the S&P 500 and Bloomberg U.S. Aggregate Bond Index were both more than 5 percent off their highs.

That's why rising inflation is seen as such a problem. As the Fed raises rates to slow the economy and thwart price increases, bond prices fall. At the same time, corporations are getting their margins squeezed by the increasing cost of inputs and wages, as well as the new higher cost of capital, so their prices fall. Double whammy.