Perspective on Inflation, Recession, Stagflation, Deflation

To date, we’ve all seen price increases (inflation) and also shrinkflation (smaller content of a product for the same price) but so far no hyperinflation. As consumers and investors, we participate in this process but seldom acknowledge the interplay. For example, when we decide to spend freely at this point in the economic cycle, we are contributing to inflation but not spending at all can contribute towards deflation.

To me, recessions are a natural cleansing mechanism for the economy. Over the course of economic expansions, companies become flush with excess. Meaning that their processes loosen, they hire too many people, they accumulate too much inventory. Recessions are a business cycle’s ‘diet plan’ for companies that need to shed excess but do so reluctantly – with negative growth. Recessions are never fun (the pain will certainly be felt more by those without adequate resources or with less certain employment), but historically they tend to be short-term interruptions between economic expansions. It is accepted that the greater long-term risk to the economy is not recession, but stagflation (slow growth, increased unemployment, and inflation) or even deflation (drop in demand for goods).

Despite headlines to the contrary the ‘tightening’ of monetary policy by the Federal Reserve is essential to economic recovery, which means raising interest rates have to be tolerated to slow down inflation and hopefully without dramatic increase in unemployment.  With that, it is “quite likely” that the unemployment rate will rise “a fair bit” from  where it is now, at 3.6%. If it rises more than a ‘fair bit,’ we could see a period of stagflation.

You’ll likely see headlines through the next months about the last time the US experienced stagflation. Briefly, in the 1970s the onset of stagflation was blamed on the US Federal Reserve’s unsustainable economic policy during the boom years of the late ‘50s and ‘60s. At the time, the Fed moved to keep unemployment low and to boost overall business demand. However, the unnaturally low unemployment during the decade triggered something called a wage-price spiral and hyperinflation. The impact of inflation on our economy will depend on the differential between the inflation rate and wage growth. This is what the Fed is trying to control as it maneuvers for a ‘soft landing’. The higher the unemployment, the greater potential for stagflation.

Stagflation may happen if a recession sets in before inflation has gone down low enough. For example, if unemployment were to go up to about 5% and consumer price index inflation was also above 5%, then that would be a kind of stagflation, though nothing like the degree experienced in the ‘70s. In the near term, we expect the labor market will more likely just cool, resulting in fewer vacancies rather than unemployment. It is likely that we will enter a recession this year and/or in 2023 but hopefully not stagflation. Much depends on how the economy and businesses react to Fed rate hikes.

Before focusing on the unknown future, we should remind ourselves that in the last 20 years, we’ve seen declining interest rates and low inflation, which in turn caused a seemingly never-ending increase in housing prices. This put extra money into our pockets and drove prices of all assets up, which in turn boosted consumer confidence, as people felt wealthier and were encouraged to spend. In addition, during the last 20-plus years every time the economy stumbled, the Fed worked to bail it out – by lowering interest rates, injecting the market with liquidity. This caused the economy and equity market to recover quickly and without much pain. The pain we were spared was stored, metaphorically speaking, in a pain jar (represented in part as increased debt, income discrepancies) awaiting the next crisis. Today, to prevent inflation turning into hyperinflation, the Fed has no choice but to raise interest rates. We expect that this process will take time and likely be cyclical since the Fed only controls a couple of components. Consumers, by their purchases, will play a role in which companies survive this market cycle. The larger goal is for the business cycle to trim inefficient businesses while avoiding hyperinflation, stagflation, and deflation.

Though price drops are considered a good thing—at least when it comes to your favorite shopping destinations – price drops across the entire economy, however, is called deflation, and that’s a whole other ballgame. Large scale deflation can be really bad news.

While inflation means your dollar doesn’t stretch as far, it also reduces the value of debt, so borrowers keep borrowing and debtors keep paying their bills and the economy continues to grow. Modest inflation is a normal part of the economic cycle—the economy typically experiences inflation of 1% to 3% per year—and a small amount is generally viewed as a sign of healthy economic growth. You might have heard that 2% is the Fed’s target inflation rate.

Inflation is also something consumers with assets/resources can protect themselves against, to some extent. Investing in equity markets, for instance, grows your earnings faster than inflation, helping you retain and grow your purchasing power. Protecting yourself against deflation is trickier because debt becomes more expensive, leading people and businesses to avoid new debt. They instead payoff increasingly pricey variable rate debts from prior purchases and avoid new purchases, decreasing growth.

During periods of deflation, the best place for people to hold money is generally in cash investments, which don’t earn much. Other types of investments, like stocks, corporate bonds, and real estate investments, become riskier when there’s deflation because businesses (even businesses with good market performance but with high debt) can face very difficult times or fail entirely.

Overall, in the USA we’ve primarily experienced inflation, not deflation.

As consumers and investors, we don’t control these market components, so what might we do? We focus on what we can control and work to feed the economy while trimming our excess spending.

This is actually a really good time to revisit your financial fundamentals. Do you still have a reasonable emergency fund? Are you spending consciously and aligned with your values and budget? This is certainly a time to re-examine any adjustable-rate debt and determine how to best lock them in. It is also a great time to examine your career and ensure you are professionally valued and not likely in any potential layoff pool. Most importantly, this is a time to get comfortable with what you value and control.

Do not let fear derail what you do. Instead prepare your finances to take advantage of whatever situation presents itself.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Family Loans

Lending money to family is often intended to be a gift of love and to provide assistance, but it is also rife with perils, for both the lender and the borrower.  It goes without saying that lending money should only be considered when permitted by your financial plan. In other words, don’t give money away at the expense of your future cash flow.

If all goes well, the loan will be repaid in a timely manner and will be a win-win for the lender and the borrower. In our experience, this is not usually the case.

In fact, most family loans are forgiven and often turn into gifts. In some cases, family discord and financial stress derail the family relationship when the borrower is unable to repay, and the lender needs the funds for their financial well-being. At other times the loan repayment is not the issue, but other squabbles (like unequal lending to family members) arise which can cause defaults and family resentments.

Lending money to a family member in exchange for a promissory note must follow IRS rules. The IRS requirements are clear, the loan must charge a minimum interest rate, must document transactions, and require repayments. If it is instead a gift (no repayment expected), then it must be stated as such and recorded for gift tax purposes (and may require filing an IRS Gift Tax Form).

The recent highly publicized case of Bank of America independent director David Yost’s daughter’s divorce is an appropriate example. Yost appears to have made $8M in loans to the couple years earlier and on divorce demanded repayment from his soon to be ex-son-in-law. The ex- claimed they were not loans but gifts that Yost made to appear as loans to evade taxes. This landed both families in court with suits on both sides and the IRS watching from the sideline.

It is common for highly affluent families to make private loans with assets they do not need in their retirement. It is particularly beneficial when loans are used to purchase assets for the next generation without tax liability and to simultaneously reduce the size of the lender’s estate while avoiding future estate taxes (currently, this estate tax reduction strategy is relevant for families with estates greater than $12M).

My concern over family loans arise when the financial plan doesn’t comfortably cover the loan and yet the lender feels emotionally inclined to make the loan despite the projected shortfall in future cash flow. I find that lenders who are family members do not recognize that despite best intentions the possibility exists that the money will not be repaid, and money not market invested is missing out on gain that will be needed later in retirement. In addition, most are not aware that without proper documentation the IRS can label this transaction as a tax avoidance technique.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Manipulative Investment Products:  Politics and Emotion

The investment world frequently capitalizes on emotions by creating products (funds) that cater to the latest fads or emotionally charged topic. A recent trend has been to create funds that filter companies based on political views.

A recently concocted fund demonstrates this trend precisely. The adviser ostensibly boycotts certain companies in the S&P 500 perceived to be too liberal and calls it a new fund. The fund’s very name is designed to excite and exploit political passions, irrespective of what the client might need in their portfolio. In addition, defining one company as “left-leaning” or another as being “more Conservative” is not only arbitrary in practice, but also contrary to the entire idea of diversification, and the “rational investor.” The marketing pitch captures people who believe that filtering using personal conservative ideals, beliefs, and values will yield needed market returns while investing in companies they think fit with their political beliefs. This is not likely to have the expected outcome since markets seldom behave how we want or expect them. They are encouraged to invest dollars without regard to capital market behavior or diversification. Amazingly they do claim to be ‘diversified’ and not to compromise performance without much history.

Whether “pro Right” or “pro Left”, I consider this trend more insidious than other marketing techniques because it encourages investors to use politics and emotions to select investments for a retirement portfolio. Retirement portfolio allocation shouldn’t be derailed by fads or emotions but capture gains when others react emotionally.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Market Volatility – Panic has a Price

Market volatility is part of the deal when investing for the long-term. Currently, some of the volatility is due to inflation and the invasion of Ukraine but most of the volatility is from fear of the unknown (by market participants). We’ve had many periods that generated panic and each time an emotional reaction or seeking ‘safety’ had a price.

Since 1960, the markets have dropped more than 30% during seven crises.

Instead of seeking ‘safety’ during a crisis, we encourage you to let us do what we do best and make the most of these crises and instead focus on things that you directly control.  The best way to handle market volatility is to have a plan in place and let it be executed without ‘fear’.

So, what should you do during periods of volatility?

  1. Take care of your health by not over focusing on media hype – crises are a bonanza for media outlets. For example, CNN searches were up from 89% to 193% during March of 2020. ‘Googling’ trending topics only makes us more anxious. Online searches will not guide you to how your portfolio and your finances should be managed to get you to your goals.
  2. Do not check your portfolio every day but do evaluate your anxiety level – if you find that you are overly anxious then we need to re-examine your asset allocation once the market recovers. Keep in mind that unless you depend on the portfolio for cash support, what happens in the market today is not relevant.
  3. Monitor your cash flow – ensure that you have the cash flow you need and that you have the necessary emergency fund.
  4. If you have a long-term horizon (meaning that you are not planning to draw from your portfolio over the next 3 years) then view the volatility as dips that we will use to reallocate your portfolio.
  5. If you depend on the portfolio for ongoing cash flow and we developed a distribution plan for you then you have a withdrawal plan for the next 3-5 years regardless of the market dip. Stay within planned spending.

I don’t deny that there is good reason to be anxious about the war in Ukraine and the impact it will have on our lives and the economy. Even so, this is not the time to decide that you want to make your portfolio ‘safer’. ‘Safer’ often means going to cash or bonds but the time to move to cash is when markets are doing well not during a crisis. During a crisis the ideal action is to use cash to buy positions that will benefit your portfolio in the long-term even if they underperform in the short-term.

The graph below illustrates how a hypothetical “fearful” investor, who chose safety during market downturns of 30%, missed gains time and time again during market recoveries. This investor traded long-term results for short-term comfort likely because the constant drumbeat of negative news made it difficult to stay true to the investment plan.

But how about market timing? Research shows that market timing strategies do not work well for individual investors. Dalbar’s Quantitative Analysis of Investor Behavior measured the effects of individual investors moving into and out of mutual funds. They found that the average individual investor returns are less—in many cases, much less—than market indices return held through the crisis.

But how about, “it is different this time”? Of course, each crisis is different BUT the US has experienced 26 bear markets since 1929 and the markets recovered all 26 times though some took a long period of time to recover. The key to market recovery is that businesses must continue to make profits.
If you find that you are overly anxious about your portfolio, then record this in your Aikapa folder and let us seriously address your portfolio allocation and the tradeoff to your long-term goals once the market has recovered.

If you find you have unexpected/unplanned cash flow needs from your portfolio, then let’s talk about it and find ways to provide what you need today minimizing damage to your long-term plans.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Retiring early – A reality check

A letter published online by an ‘early’ retiree who encountered health difficulties has generated a lot of negative comments regarding early retirement. I thought it might be helpful to provide you with my perspective on the subject. Retiring early often means that there is NO paid work and that your assets are the only source of income for all living needs. The income from those assets needs to be able to support your chosen lifestyle for your entire life. For this reason, it is essential that this planning be completed with details based on your life and potential worse case scenarios. In this letter there seemed to have been little planning for healthcare, unexpected market changes, and potential disability which are essential in any retirement plan and particularly in one that would need to last 40+ years. The negative outcome for this early retiree might have been prevented with comprehensive retirement planning and annual adjustments.

Of course, the assets to support early retirement need to be much higher if retiring before age 65 when Medicare healthcare becomes available. In addition, retiring before age 59.5 needs to include significant non-retirement assets (or a willingness to annuitize retirement assets) to avoid a 10% early withdrawal penalty for retirement accounts. Early retirement must also account for retirement cash flow distributions over very long periods (longevity investment planning) which requires a careful combination of investment strategies to ensure that cash is available regardless of market behavior. A portfolio that needs to provide support for long periods of time must include sufficient growth potential with protections against the likely downturns.

If you are contemplating early retirement and have not yet discussed it with us, then let’s create planning scenarios for your situation and see how and if your assets will support your ideal ‘early’ retirement life.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Differences in Finances: Pre-retirement and Retirement

I am sometimes asked how our work differs as clients move from a period in which they are accumulating assets (pre-retirement savings) to a period in which they withdraw/distribute from their assets (retirement or financial independence). This becomes a critical question as individuals transition out of earning years and begin to implement their retirement plan. As a matter of fact, our tasks are very different in each case though our role remains the same. Our role is to provide financial guidance to help make the most of available assets given current realities and future goals.

To help you understand the various financial tasks that occur in these two distinct financial planning periods, I’ve outlined some of the major tasks that we perform in pre-retirement (accumulation phase) and in retirement (distribution phase).

During the accumulation period, our focus is to encourage you to integrate finances with all major decisions. We work with you to save as much as possible using tools or techniques that we know will likely be successful in your situation and come up with ways that work better for you. We also support you to define spending that is meaningful because we want spending to be sustainable and satisfying later in life. Annually, we help set spending and savings goals and ask you to hold yourself accountable because with accountability comes financial self-confidence. We also want you to experience the ups and downs of portfolio behavior over a significant period so that overtime you will learn to relinquish unproductive human emotions that are associated with daily monitoring and fretting over your portfolio total (which feeds fear and greed). We want you to internalize that what really matters is that the portfolio delivers as expected to meet your goals. It is therefore important that during accumulation (when you are not dependent on the portfolio), you can confirm that the returns used to create your financial plan are attainable by the average return of your own portfolio (not a model or generic return). Overall, we want you to identify how you can best work with finances and gain confidence in your own ability to make financial decisions regardless of the obstacles.

During retirement we are more involved with your cash flow management as we help you transition to financial independence by implementing your financial plan. This requires providing the needed cash flow from your accumulated portfolio. In retirement we annually setup monthly cash-flow distributions (or an annual lump sum distribution) from the portfolio and we internally estimate the tax liability so that we have the best after tax result for each distribution. We find that tax planning also helps prevent unexpected increases in future Medicare premiums, helps make Roth conversion decisions, and helps decide on the best timing for Social Security benefits. RMD (Required Minimum Distributions which begin at age 72) are also calculated and implemented based on what is best for your overall finances. We may recommend QCD (Qualified Charitable Distributions, only for those at age 70.5) or DAF (Donor Advised Funds which are available to anyone who wants to make significant or regular charitable donations) in some cases. Finally, we serve as your financial resource or partner to support you during major financial decisions.

Let us know if you have different questions or want more details on what is currently most important in your life, regardless of whether you are in pre-retirement or already enjoying your well-earned financial independence.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Inflation Expectations as of January

On Tuesday, January 11, 2022, Federal Reserve Chairman Jerome Powell called high inflation a “severe threat” to a full economic recovery and that the central bank was preparing to raise interest rates because the economy no longer needed emergency support. Powell further stated that he was optimistic that supply-chain bottlenecks would ease this year and help bring down inflation while the central bank begins removing the emergency support we’ve depended on for years.

The January inflation rate (CPI) is reported at 6.1%.

With U.S. debt approaching $30 trillion and growing at $2 trillion per year The Fed is in a tough spot, they must find ways to fight off inflation. Debt is often a drag on future growth unless the debt is used to increase GDP and stimulate the economy. With higher interest rates and without additional economic growth (GDP), the U.S. government will struggle to cover interest payments given that tax revenues are at about $1 trillion per year. So, I expect aggressive measures will be taken to check inflation.To be honest, there is little agreement on the likelihood that 2022 inflation will be permanent. Some believe that the current wave of inflation will prove to be transitory and expect, at worse, a slowing of the global economy in the first half of 2022. Others argue inflation is not temporary and will be devastating through 2023 (they usually use the 1970’s period as a painful reminder of extreme inflation).

I am cautiously optimistic and believe that in the long-term what matters is our ability to increase economic growth. I also believe that consumers have a lot more influence over inflation than they realize – inflation is not magical or something to be afraid of but rather a reaction to something we consumers encourage or discourage with our behavior. Every time we purchase something despite its excessive price, or we raise the price despite the actual cost, we contribute to inflation. Consumers can practice restraint over consumer discretionary purchases, but it becomes much more challenging when inflation impacts the essentials or basic spending. For example, if your rent increases at 4% (see the chart below), this is not optional so something else needs to be reduced or your income must increase thus fueling inflation.

Percent changes in CPI

In your portfolio we are continually monitoring and adjusting for expected inflationary pressures, volatility, and increased interest rates. Our belief is that with infrastructure funding we’ll reach a high GDP by year-end and a good portfolio outcome. Without economic stimulus we are likely to have a more volatile and less predictable performance this year. You may notice that we added tilts to the portfolio that increased commodities (primarily cereals, materials, energy) and digital/tech assets (like digital supply chain, traditional finance, and fin tech companies) which we expect to do better during inflationary periods. Fixed income is tilted to the short-term and should provide stability if the expected volatility in equity markets materializes.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Student Government Loan Repayments to Restart in May

The Department of Education has announced that it will restart student loan payments that were frozen at the start of the pandemic. This was intended to allow for increased cash flow and savings during the pandemic. So far, it does NOT appear that the government will create new student loan forgiveness programs. If you were able to save over the last two years, then let’s review if paying down your student loans is the best use of your additional savings.

Action for those with a federal government student loan:

  1. Review the terms and balance of your loan.
  2. Make sure that you understand if it falls under any of the existing (and not yet honored) forgiveness programs.
  3. Log on and update your contact information.
  4. Determine your new payment amount and if you can consider paying it earlier. We recommend that you start paying it sooner than May if your cash flow allows so that you lower the loan before May, but this may not be ideal for all.Let us know and we can go over your specific situation.
  5. If the loan repayment amount doesn’t work within your current budget, then let’s work on a different solution before the May due date.
  6. Don’t count on blanket loan forgiveness – although it may arrive, it is not likely – the current government goal appears to be focused on fulfilling existing forgiveness programs not creating new ones.
  7. Check with us BEFORE you accept loan forgiveness offers – they may not be legit – anyone offering that they can easily forgive your student loan without details should be suspect.

Finally, when working online to obtain information on your student loans (or other financial transactions) please err on the side of caution and check with us and your CPA to ensure that you avoid scammers. They get more sophisticated each day.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

A New Year – A New Opportunity

We’ve completed a second year in this pandemic that upended most of our habits and norms. Before we embrace a quasi-new normal and return to our old ways, we have an opportunity at the start of this year to pause, step back, and review what has and hasn’t worked in our lives.

It’s natural that we should want our financial life to be supportive and in concert with our values and life choices. I encourage you to identify and mobilize behaviors that add energy and positive feelings into your life. This year, prioritize those healthy behaviors and do your best to eliminate or minimize the negative ones.

The Milestones & Impressions notebook can help you create a personal record of what has added value and what makes you feel good each year. Over time, these notebooks will be a source of key events, patterns, and behaviors that mattered in your life. Possibly they will be a resource to help you identify what you wish to include in your ideal life.

Ultimately the process of taking time to reflect provides greater satisfaction and increases financial resiliency (readiness to handle unexpected financial issues in an efficient and streamlined manner). Financially resilient people focus on things they can control, such as meaningful spending, rather than the things that are beyond our control like market behavior. Recent studies suggest that acknowledging the events that bring joy to your life and recognizing from time to time just how fortunate we are will help to increase financial resiliency, and in-turn, well-being.

Be kind to yourself and take the New Year to reimagine yourself and your relationship with your finances.

Here is to a hopeful and happy 2022!

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

2022: Current Retirement Savings Limits

In 2022, 401K plan employee contribution maximums have increased by $1K to $20,500 and the catch-up (at age 50) remains at $6,500 (or a maximum of $27K). Total employer and employee contributions for 401K plans has increased to $61K. On the other hand, pension plan contributions are limited to $260K but the amounts are determined early in 2022. IRA contributions remain at $6K and for those over age 50 at $7K but tax deductibility is dependent on earnings and whether you’ve contributed to a 401K/403b plan. A Roth IRA contribution can be made instead of the IRA contribution, and it also has earning limits. Long-Term Capital Gain federal tax rates this year are still at 0%, 15%, and 20% dependent on taxable income levels but these are expected to increase in the new tax plan. Gifts can be made tax free to the recipient up to $16K in 2022 and for non-US citizen spouses this tax-free gift rises to $164K without additional paperwork. Keep in mind that these annual gifting exclusion limits are in addition to the currently huge lifetime tax-free gifting limit of $12.06M per person. The child tax credit and after-tax Roth conversion are part of the new tax plan under consideration.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com