2024 – Financial Opportunities and Challenges

In 2024 we are expecting recoveries in some real estate categories, a settling of interest rates, and dramatic growth in the AI (Artificial Intelligence) space. It is the latter that could help businesses improve efficiencies and deal with headwinds from labor costs/shortages though it is still at its infancy. In addition, we are seeing growth in capital invested to deal with the expected scarcity in rare earth metals. If we have limited supplies then price volatility will greatly impact data, electronics, alternative energy, and agriculture investment sectors (new sources for these metals are from mining of asteroids and other stellar bodies).

The less predictable potential for volatility, in the USA, will come from our ability to deal with the destabilizing forces all around us from climate change and the election. I suspect that the US consumer will continue to spend through volatility and reward companies that meet the consumer demands (as they did in 2023).

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Looks like consumers are doing well but banks are entering a ‘credit crunch’

Shrinking the money supply has helped the Feds reduce high inflation.  Monetary and fiscal indicators continued to tighten significantly in the second quarter, pointing towards a slowdown in the U.S. economy. Negative money growth, increasing fiscal deficit, rising real interest rates, and central banking guidance of higher short-term interest rates are creating a classic ‘credit crunch.’ This credit crunch comes as the economy progresses further down the current financial cycle, slowing growth and limiting upward pressures on inflation.

While money supply and real interest rates reflect a traditional tightening financial cycle, as is the case now, a contraction in real bank credit is not usual when GDP is rising. Usually, money supply leads bank credit but the latest 12-, 24- and 36-month rates of change in real bank credit are all negative instead of the historical average of 3.4%/yr.

As the second quarter ended, the contraction in bank credit showed the potential for a credit crunch if not enough cash is available. During this time those holding sufficient cash for their needs will not be impacted if the bank credit crunch is widespread.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Last Friday’s message from Fed Chairman

Speaking from Jackson Hole, Fed Chairman Powell said, “Inflation is too high,” adding that they are prepared to raise interest rates further. The inflation rate in June/July has been around 3%.

The Feds effort to dampen inflation is working as the latest data shows a continued shrinkage of money supply.  The conundrum is that nominal GDP is up 6.3% from a year ago so somehow, the broader economy is growing despite less money circulating.

A side effect of all that additional money supply was a rise in stock prices. Excess money tends to end up with consumer spending or investing. However, the money supply is shrinking so this trend may reverse for a time unless we see good financials from companies this fall.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

What we heard at the July Fed meeting

The latest Federal Reserve meeting (July 26th) increased the interest rate another 25 basis points to 5.375%. We have another three upcoming meetings (September 20th, November 1st, and December 13th) left in 2023.

The current focus is now on fall corporate financial reports and the impact of existing debt payments on corporate profits to see if additional interest rate hikes are needed. GDP numbers out by July 27th showed an economy that is growing and consumers who are still spending (particularly in services rather than material goods) indicating that we are not in a recession. The CORE inflation measure (which strips out food and energy) used by the Federal Reserve in their evaluation actually dropped from 4.6 to 4.1% from May to June.

The new increase resulted in mortgage rates that though high (around 7%), compared to recent extremely low mortgage rates, are not historically the highest. It may be surprising to see that in areas with low housing supply (most people don’t want to sell a house with a mortgage below 3%) we are expecting house prices to actually increase 5%-10%. In areas with excess supply the story is different, and prices are dropping in the short-term. Similarly, the increased mortgage rates and abundant supply appear to be negatively impacting the commercial property market.

What does all this mean? Though your home and real estate may be impacted by this rate increase, we are not seeing a similar impact on your portfolio. If you feel strongly that commercial real estate will recover significantly this would be a time to invest in commercial REITs. Though we see promise in undervalued commercial real estate, we have more confidence that residential (not commercial) will outperform in the long-term despite additional potential interest rate increases.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

US credit downgrade by Fitch

As you have no doubt heard, Fitch downgraded US credit to double A plus from triple A. Many reasons have been given for their decision though I think only one is at the core of the downgrade — “the increasing failure of politicians to tackle pressing reforms” and demonstrate a stable process for making long-term country-wide financial decisions. I can’t argue with that . . . the debt ceiling crisis demonstrated that our politicians are disinterested in an orderly financial decision process.

A bit of history to provide perspective on these credit rating companies:
Fitch Ratings Inc., Moody’s, and Standard & Poor’s are the “Big Three” credit rating agencies nationally recognized to evaluate financial products/companies by the Securities and Exchange Commission (SEC) since 1975.

In 2011, the S&P Global Rating was the first to drop US credit to double A. The market mostly ignored this downgrade since this is the same credit rating company that continued to sustain a AAA rating for Lehmann Brothers even as LB filed for bankruptcy. Making matters worse, when the dust settled, this credit agency was found to have benefited from providing high credit ratings to packaged subprime mortgages (i.e., those with no-job, no income) that were then sold to unwary investors.

Moody’s is the remaining credit agency that still believes that the US will pay off its bills and deserves the AAA rating.

Though the remaining countries with triple A credit ratings from all three agencies have stable financial process around debt management many of them have high national debt levels. The countries are Germany, Denmark, Netherlands, Sweden, Norway, Luxemburg, Singapore, and Australia.

What does this downgrade mean? For now, not too much since the US dollar remains the go-to currency and US Treasuries are still considered the risk-free asset to have, particularly during a crisis. Unfortunately, this downgrade does mean that the debt service payments will increase and erode faith in the US dollar.

To resolve this issue, the US needs to deal with long-term fiscal issues in an organized and responsible manner.

What does this mean for your portfolio? Not much in the short-term. It does though remind us to maintain a globally allocated portfolio.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

What to expect from the next Fed meeting

The Federal Reserve System’s US Federal Open Market Committee (FOMC) meets 8 times each year to decide on the short-term interest rate – the next meeting is July 26th. We’ve seen market volatility prior to and following each of these rate increases. The table below shows the last ten increases out of the last twelve meetings. Most pundits expect a small rate increase either in July or/and September and we expect market volatility.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Volatility (Bear & Bull Markets) and Market Behavior

Since this year’s market is expected to continue to be volatile, I want to remind you that in times of market volatility, going to safer alternatives is tempting but can be costly. Safer alternatives should only be used for money that you want to use in the short-term and not as a response to potential market downturn fears.

We would all like to miss market drops (Bear market) but avoiding short-term declines by exiting the market often results in missing large market increases (Bull market). In fact, if you missed the market’s 10 best days over the past 30 years, your returns would have been cut in half. And missing the best 30 days would have reduced your returns by an astonishing 83%.

S&P 500 Index Average Annual Total Returns: 1993–2022*

*Past performance does not guarantee future results. [Data Source: Morningstar 2/23].

The bottom line – “Good Days Happen in Bad Markets” and exiting to safer allocations due to fear usually results in significant losses.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

The Market and Commentary on US Debt

So far this year, we’ve seen improvements with increased investment opportunities as businesses appear to be recovering and new ventures are obtaining needed capital. We are expecting that portfolio recovery will continue in parallel with improving inflation and business growth rather than the current politically created debt ceiling crisis.

This debt ceiling extension (currently at $31.5T) crisis is causing the US irreparable damage in the eyes of those who buy our debt. For many it is a demonstration that the US debt is no longer a low-risk investment of choice.  Hopefully this deadlock will be resolved without further damage to our financial standing. According to Yellen, it needs to be approved by June 5th.

The current agreement caps military spending at $886B and nonmilitary discretionary spending at $704B and would only allow increases of $9B and $7B respectively in the following year. This means a claw-back of the unspent COVID relief ($28B) and shift of $20B to nondefense items. Also elimination of at least $1.4B funding for the IRS. There are increased work requirements for some recipients of Medicaid, Temporary Assistance for Needy Families (TANF) and the Supplemental Nutrition Assistance Program (SNAP). A requirement to streamline permitting in the National Environmental Policy Act was also added to the list. These are some of the requirements to extend the Debt limit beyond the next election.  So far the agreement has no impact on Medicare/Social Security/climate change and promotion of clean energy.

As soon as this crisis is resolved we will refocus on economic activity and inflation to prepare for the next Federal Reserve meeting on June 14th. On June 2nd we expect the employment report and June 13th the CPI (Consumer Price Index). Together this information will guide the Federal Reserve on whether to implement the current expected ¼% interest increase.

Finally, it is hard to understand how we willingly accept debt accumulation levels for the US that we wouldn’t accept for ourselves. As you know from your own finances, if you take on too much debt then you may not have a lender for additional debt. In the same manner as we saw recently with the runs on the SVB and First Republic Bank, when the US debt exceeds the amount that willing buyers want to buy, then central banks do not have anyone to provide us with liquidity, so they have to increase interest rates or print dollars. This crisis would be worth the turmoil if it actually generated actions that deal with the long-term accumulation of US Debt regardless of who is in government. The last time we attempted to deal with US Debt was in 2010-11 with the Simpson-Bowles plan under Obama and yet our debt accumulation has continued to grow.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Silicon Valley Bank (SVB) failure and the FDIC

As many of you are aware, the FDIC placed a California bank (SVB) under receivership. The FDIC took this action to protect depositors in the face of unsustainable withdrawals (a “run on the bank”). SVB is a regional bank best known for supporting new venture businesses (in technology and biotechnology) and with assets worldwide. An additional small regional bank located in New York (Signature Bank or SBNY) was also placed into FDIC receivership just two days later.

What happened? SVB sold assets (long term bonds) at a significant loss just to cover deposit outflows which triggered more outflows.

What impact does an FDIC takeover have on your deposited money? None, if the account is FDIC insured and the balance is under $250K, though there may be a delay to access this cash. This is why we recommend that you retain an emergency account in an FDIC savings account at a separate bank.

In this case, the Federal government also stepped in and guaranteed all deposits to ensure accounts were made whole. The timing was particularly important since mid-month liquidity was needed to make business payroll and loan payments. Except in the Venture Capital space, SVB and SBNY are not household names, so why was prompt action required? The concern was that fear would spread to other institutions even though most other financial institutions are well capitalized, highly liquid, diversified, and risk compliant. In fact, we did see contagion to banks like First Republic Bank (FRB—which, incidentally, is popular with several of our clients) which had to obtain additional liquidity from the Federal Reserve and JP Morgan. In our view this failure was isolated and is nothing like the 2008 bank crisis. It was a result of regulatory exemptions (approved by the US Senate which was extensively lobbied by the CEO of SVB) and poor Risk Management at SVB.

As a consequence, the regulatory environment will likely tighten for regional banks and the Federal government will expect a fixed Balance Sheet within a year. In the meantime, the Justice Department has already launched an inquiry into the collapse of SVB and the actions of its executives who sold bank shares just prior to the collapse.

What long-term and short-term impact will this collapse have on your portfolio? We do not expect any long-term negative effects. In the short-term, we are expecting more volatility and a delayed recovery for technology, financial services, and fixed income sectors. It is also worth noting that this crisis affords a long-term opportunity to buy into this downturn ahead of the recovery.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Fed Action and Your Portfolio

The last Jackson Hole meeting was hugely anticipated, and Federal Reserve Chairman Jerome Powell reiterated that he would stay true to the current approach to tame inflation. The market reacted with a sharp sell off. Why? Because some were expecting the Fed to return to a loose monetary policy at the slightest economic weakening. January 4th, we heard from the Feds that any pivot prediction is misguided.

It is important to recognize that there are more important factors that drive stock prices than Fed policy – corporate earnings and greed actually impact prices far more!

While I agree that the Fed policy can and does impact economic activity, it is company earnings, economic growth, geopolitics, sentiment, innovation, and global economic trends that will certainly play a bigger role in our economic future and support higher lasting market valuations.

It appears that the media and market participants are fixating on every Fed utterance. Do not follow their lead. We are expecting a cool market over the next months, but inflation appears to be responding. If we stay the course and not return to easy money, we may recover without stagflation and the economic downturn associated with it.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com