Broker Check

The Splash and the Ripples

May 30, 2020

The stock market has been nothing if not durable over the Covid-19 pandemic and its attendant lock-down. From the all-time high reached in mid-February to the recent bottom in mid-March, the S&P 500 stands at 3,000 as of this writing. Down only about 10%.

I say "only" because, approximately 37 million Americans have already lost their jobs due to the Covid-19 lock-down. Experts predict that number will increase significantly before the economy begins a lasting rebound.

Air travel has halted almost completely, vehicle travel and gasoline sales have fallen off a cliff and new home sales are down markedly. Additionally, we have not yet seen what is likely to be a total decimation of summer vacation travel and the seasonal revenue it produces. The regions of our country and the industries that have come to rely on the three-month summer updraft could be in for a brutal year.

How will this all play out? Let’s ask the experts.

Arguably, the two most prominent investment houses in the world are JP Morgan and Goldman Sachs. A few weeks ago, Goldman claimed that the bottom was in and it was time to buy US stocks. Within hours of that article, JP Morgan said that they believed the market would drop significantly and at least retest the lows seen in March. One of them will end up being "right." But what will that mean?

What does it tell us when two of the largest and most respected financial institutions that have ever existed are viewing the same data and reaching precisely opposite conclusions?

It tells me no one really has a clue.

I have heard solid rationale for why the market has already seen the bottom and we can expect a V shaped recovery. I have also heard compelling arguments as to why the market will retest the lows in a W shaped recovery.

What I have not heard from anyone is that in aggregate, money does not leave the markets as much as it rotates between the various asset classes. Now the stock market, then fixed income, next precious metals, a quick stop in cash and cash equivalents, real estate, etc.

I believe that one reason the stock market has not fallen much farther than it might otherwise have done during this calamity is that this process has been arrested to a large extent because of two related factors, the national debt and interest rates.

The US Government has three main levers to pull when it needs or wants money.

-Raising taxes
-Cutting services
-Borrowing by issuing government debt

The government is made up of politicians. Politicians are people who get elected and if they remain popular, reelected. Raising taxes and/or cutting services are bound to be unpopular with a good number of folks who vote. Creating a lot of unhappy voters makes getting reelected much less likely.

Borrowing is the preferred method. The way the government borrows money is by issuing Treasury Bonds. Those bonds can be purchased by the Federal Reserve. The Federal Reserve oversees our currency and prints the money it uses to purchase the bonds.

Did you follow that? The Federal Reserve does not actually need to have the money, because it can just print it.

Politicians prefer borrowing because they get to appear generous by giving voters free stuff. They hope the voters will say thank you at the polls.
We American taxpayers should not prefer it because as new money is created from thin air, existing money, the money we have earned and prudently saved, loses buying power. This is known as inflation.

The Nobel winning economist Milton Friedman once said that "inflation, is taxation, without legislation." Inflation has also been called "a stealth tax." We can see how right Friedman was given that prices have increased faster than wages for the best part of the last 5 decades.

Many middle-aged people like me often question how their parents were able to raise large families, own a home and perhaps even two cars, on only one modest income. Yet they struggle to do the same today while seeming to make much more than their parents ever did. In large part, inflation is the answer.

Now if you are like me, you probably think that being able to print money whenever you need it would be a pretty sweet piece of cake. Well here is the icing on that cake.

Through the Federal Reserve, the government can also choose what interest rate it pays on that debt. Though our national debt is at an all-time high, as you could probably guess, they are choosing a rate that is historically low. The 30-year T-bond currently pays an interest rate of 1.25% (before ordinary income taxes.)

This has the effect of lowering fixed income rates across the board and that represents an enormous potential problem for retirees and those approaching retirement. Because our retirement savings are supposed to last our whole lives, we cannot afford to take on much risk with those assets.

The generally accepted formula is to take your age minus 100 and the resulting number should be your maximum percentage of equity (stocks.) So, if you are 65, only 35 percent of your portfolio should be invested in stocks.

However, because interest rates are so low, it has encouraged normally intelligent and sensible people, who are retired or near retirement, to maintain equity percentages of 80-90 percent or more. As little as a decade ago this might charitably have been described as reckless. 20 years ago, it might have been described as just plain nuts.

But here we are.

Because US debt is issued in, and most importantly, paid in US dollars, there is not much chance of default. We can simply print the money we need to pay our debts. Our debt is not a default problem, it is a dollar problem. The problem is that our dollars will continue to buy less and less of the things we need and want.

Moreover, because of the trillions being spent to combat the current Covid-19 crisis, income taxes will almost certainly have to rise and soon. This will be a serious challenge for anyone who is not extremely wealthy.

For the unemployed, folks on a fixed income and retirees, it could be devastating. For middle and upper middle class Americans looking forward to a certain lifestyle in their golden years, it might be equally so. If this plays out as expected, people will find themselves caught between the hammer of higher taxes and the anvil of higher prices. In plain English, people will keep less of their money and what is left over will buy them less than it will today.

The Coronavirus has struck American society and our economy like a meteor. In many ways, our lives will likely never be the same. I believe we will turn the corner on Covid-19 in the not very distant future.

It is not so much the splash that concerns me, it is the ripples. Some significant financial consequences of the current crisis are predictable and can be planned for.

The good news is there are steps that we can still take today to mitigate, marginalize and possibly even avert those results entirely. It will require planning, action and perhaps most importantly, an open mind.

If you like, work with a financial planner who has earned your trust to help you navigate the treacherous waters ahead.

Scott R. McGimpsey May 30th, 2020

This material was prepared by Scott McGimpsey and does not necessarily represent the views of the presenting party, nor their affiliates. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Neither Cetera Advisor Networks LLC nor Scott McGimpsey is engaged in rendering legal, accounting, or other professionally services. If such assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any federal, state, or municipal tax penalty. Moreover, a diversified portfolio does not assure a profit or assure protection against loss in a declining market. UNIFIED PLANNING GROUP is an independent firm. Securities offered through Cetera Advisor Networks LLC, Member FINRA/SIPC. Advisory services offered through Summit Financial Group, Inc., a Registered Investment Advisor. Summit and Cetera are affiliated and under separate ownership from any other named entity.