InSight

Market InSights:

There Is Too Much Money

You read that right, there is simply too much cash in the capital markets to not see a handful of effects that could impact your investments and plan. The supply of money floating around is massive right now. There is a lot of risk, COVID has us concerned about the economics of the coming year, but it’s getting harder and harder to ignore how much cash has been made available.

Even relative to itself, it’s a volume of cash in the money supply that will take at least a decade to settle into long term investments, or be recaptured by the Fed. At the beginning of the year there was roughly $15T in circulation held in cash and cash equivalents. We are in December and the number is closer to $19T of more highly liquid cash in the world. This $4T expansion in only 12 months is remarkable.

Here’s some history on money supply. It took until 1997 to reach the first $4T in circulation, the decade from 2009 to 2019 saw that supply double from $8T to almost $16T (the fastest doubling ever), resulting in a major part of the expansion of the stock market for that decade. Now, in twelve months we have seen a flood of almost 27% more money in the supply than there was at the beginning of the COVID-19 pandemic. 

One of the best leading indicators for where capital markets are headed, can be found in how much money, especially highly liquid money like cash, is available in the system. This is a reflection of how big the pie is. Usually in investments we are focused on cash flow, and a companies market share – or how effective a company is at capturing cash flow from a given size of market. That’s becoming less relevant as the sheer volume of cash has exploded. The pie is so big right now that there will have to be a a few notable adjustments to make:

InflationWhile I have heard that Jerome Powell has not registered an increase in inflation yet, it is hard to believe that as the newly introduced money will not have an expansive effect on the costs of goods and services. Many mark the inflation rate off the CPI, grievances with that benchmark aside, it would be irresponsible to assume that the basket of securities they mark to market does not see an above average increase as more money finds its way into the same number of consumer goods. Additionally, elements like rents will see a disproportionate increase in the coming decade because while supply of say consumer goods will increase quickly to capture this cash, construction of rental properties is a less reactive market and a slower roll out to correct the market. In the meantime expect rental costs and revenues to see above average inflation figures. 

Interest Rates – Permanently impaired. As I write this the current observation, the 10 year US Treasury is paying 0.9%, a third of where it was even 2 years ago. It is heard to believe that such a robust introduction of cash doesn’t become a permanent downward pressure on fixed income assets for the foreseeable future. Unless there is a formal and aggressive contraction of the money supply, it will take decades for the amount of cash in circulation to let up that downward pressure on bonds. Interest rates in short term assets will be particularly affected as the demand has become less appetizing in contrast to long term debt, and the supply of cash is chasing too small of demand. 

EquitiesThe real benefactor here. It is hard not to believe that over the course of the coming decade, this cash infusion doesn’t trickle its way up and into the stock market and other asset values. Generally the most “risky” part of the market is the historically the benefactor of excesses in cash. Companies will do what they do best and capture this supply of cash through normal operations, this will expand their revenues and ultimately the bottom line. Additionally, the compressed borrowing costs from low interest rates will lower their operating costs. Compound the poor risk reward ratio in bonds and you will see more of those investments seek out stocks, real estate, and other capital assets. This sector will see a virtuous combination of more revenue, and more demand for shares. Expect permanently elevated P/E reads for the time being. 

 

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Is a U.S. Housing Market Crash Inevitable?

It is almost inevitable that housing correction is coming. Most of the upswing nationally in housing prices is caused by low borrowing rates. A mortgage payment is mostly made up of three different columns 1) Principle 2) Interest 3) Other required costs of homeownership like insurance and taxes. The bulk of the payment comes from the first two.  Banks start the process by determining your “ability-to-repay” the debt. This comes to a given amount that they assume borrowers can repay, let’s say this number is $100 a month. This means you are approved if Principle, Interest, and Other Costs can come to less than $100 a month. So all of the “costs” combined need to stay below that mark, a zero-sum figure. Now as interest rates were low, the amount of the interest portion of the loan was low. Meaning more money could be freed up for the principal portion. And that principal portion is the rate at which the loan is being repaid. So if over a 360 payment loan $75 on average is getting paid in principle, the loan can retire $25,200 in debt. So the borrower can offer $25,200 for a home with faith from the bank that they will be able to repay. Thus, the buyer in the real estate auction can spend $25,200 max (and they will spend all of it).  Now if that same borrower, who can afford $100 a month in mortgage payments has to borrow in an interest rate environment that is 10% more costly than before, a rate change of borrowing from 2% to 2.2% the borrower will need to borrow from the principal repayment part of the pie. That means that the average payment they can afford to make comes down, and they will only be able to offer $21,600 when making an offer on the house. This is 14% less, after a 10% move up in borrowing costs.  This is where it will get interesting.  The “rates” that you may have heard are rising, are the percentages at which banks borrow. That money has cost banks 0.25%, since 2020. It’s made spending during the pandemic easier and lowered the cost of capital risk for banks in order to keep the money flowing. So, a bank borrowing at .25% or close to it can lend a 30-year mortgage at really low rates. Hence the sub 3% and 2% mortgage rates we saw in the last 2 years and on the heels of the 2009-2016 recovery cycle.   The by-product of this low-interest rate, high spending environment is inflation (the rising costs of goods and services). So if the cost to the bank to repay these loans increases, the cost for borrowers increases at a faster rate. So the rate of change is more than the 10% increase we discussed above. A borrower seeing their interest rate go from 2.2% to 4.4% (while still historically low) will see their capacity for repayment severely impacted. By just returning to normal lending rates the portion a borrower can repay is reduced. The borrower who could afford a $100 a month payment, now sees his buying power reduced to $9,000 over the course of the 360 mortgage payments in a 30-year mortgage. The borrower now has 41% of the buying capacity by doubling the borrowing rate, this change in the amount of borrowed capital buyers brought into the house buying equation, means that the bid sizes will invariably contract. Bringing the prices that a home clears the market down. Knock-on-effects: Inflation In the above scenario, the ignored part of the pie is the “Other.” This is mostly tax and insurance, but also includes power, water, HOA’s, and other required expenses for the ownership of a home. These costs are also climbing, and they too will erode the buying power of borrowers. This has been a largely understood space for some time, but as inflation continues to outpace wages, this will have a growing negative effect on the buyer’s ability to borrow. This is simply shifting payments from principle into insurance. What is missing from the “crash” in ‘08?: Leverage So just understanding that buyers are going to lose buying capacity in a given market doesn’t result in a crash, it just means that home prices will contract. What is still missing in this equation is selling pressures.  The housing crisis wasn’t just the rising cost of home prices, it was also the deterioration of credit quality borrowers, and excess leverage. As the housing market of the early 2000s looks eerily similar in growth, an important distinction is made between the two when we look at the leverage ratio of borrowers. This is a result of the bad actors in the housing crisis leveraging one house with another, and another, and another. This allowed the rampant contagion of home selling. One default in the leverage on leverage structure meant that a single default meant 2 or more defaults as a result. The low credit quality and poor borrowing strategies (adjustable rate mortgages, and subprime lending) meant that all borrowing became interconnected. Now while the current system has become somewhat lax on the underwriting standards again, the use of adjustable mortgages and equity requirements for vacation and second homes remains largely intact. Limiting the contagion of contraction to single borrowers. What is missing from the “crash” in ‘08?: Employment Employment is well below 4% and that is encouraging. That means that there is plenty of demand for workers and that if a borrower is qualified when they are employed, the risk of losing that employment is at its lowest point ever. Broadly speaking this means that it’s worth keeping an eye on, but will limit the amount of forced selling that could trigger a true “crash”. 

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529 College Planning: 102

Types of 529 plans This is one of the largest hang-ups for savers. A history of misinformation and contamination between different types of 529s has generated several misnomers. Simply put: 529 plans are usually categorized as “prepaid tuition” or “college savings plans.” Our favorite of the two is the college savings plan, and we find that several of the misconceptions that savers have come from the “prepaid” tuition plans.    For clarity, College Savings Plans work much like a Roth 401(k) or Roth IRA. They are investments made with post-tax dollars (that often carry tax benefits) and the accounts grow and earn income in a tax-free way. These accounts allow you to invest your after-tax contributions in mutual funds or similar investments. Most of the 529 college savings plans we work with offer several investment options from which to choose. The performance of the account will be tied to the investment options you chose, and you should consult a CFP® and your InSight-Full® to manage this risk, and coordinate it with your timing of needs. The other alternative, a Prepaid Tuition Plan,  lets you pre-pay all or part of the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges. The Private College 529 Plan is a separate prepaid plan for private colleges, sponsored by more than 250 private colleges. These programs are limited in scope, while they can support savers concerned with the rising costs of tuition, they are generally less flexible and have fewer payment and conversion options. They may also carry unique liquidity issues should you plan to change. It is an educational institution that can offer a prepaid tuition plan but not a college savings plan. What can’t I use my 529 plan for? The funds and the investments in a 529 plan are yours. You should be able to maneuver and control the funds in the account as you see fit and within your fiduciary scope. Also, you can always withdraw them for any purpose but should be mindful of the consequences. Chief among these is the earnings portion of a non-qualified distribution will be subject to ordinary income taxes and a 10% tax penalty, though there are exceptions and methods for managing this tax loss. At the college or post-secondary level, we discussed in “529: 101” the obviously covered costs of education and what the 529s have been expanded to include. Though you should be made aware that there are some costs that you may believe are necessary, but the IRS disagrees. For example, student health insurance and transportation costs are not qualified expenses, unless the college has lines out these associated costs in fees or services from the college. So, parking fees at Denver University campuses might be covered, but a space in a parking lot near campus might not be. Are 529 plan contributions tax-deductible? Unfortunately, the 529 is funded with post-tax dollars, and there is no federal tax relief yet. However, here in Colorado and in over 30 other states, they offer state income tax deductions for contributions to 529 plans. But it’s likely that like Colorado, you would be restricted to investing in your home state’s 529 plan in order to claim the state income tax benefit. (Consult a tax professional for more information) The tax advantage regarding federal taxes comes when the funds in a 529 plan grow. The growth in these plans is federally tax-free and will not be taxed when the money is withdrawn for qualified education expenses. Can I use a 529 plan to pay for rent? Yes, with some restrictions. Room and board is now a qualified expense for at least “half-time” or greater students. Consult with the institution for what constitutes a half-time student.  So for on-campus residents, qualified room-and-board expenses should not exceed the amount charged by the college for room and board. So in this case savers pay the room and board directly to the student housing authority to avoid mismanagement.  For students living off-campus, qualified room and board expenses are limited to the cost of attendance figures that vary from school to school. Contact the financial aid office for their reports on this figure. In these cases, try to find a 529 fund that supports payment directly to landlords. What happens if my child doesn’t use the 529 plan? There are always options for these funds. Hopefully, you are in this situation for a positive reason like a full-ride scholarship or attendance at a service academy. There are a few reasons to seek a waiver however, your earnings will still be subject to federal and sometimes state income tax. If this is the case the 10% penalty is waived if: The beneficiary receives a tax-free scholarship The beneficiary attends a U.S. Military Academy The beneficiary dies or becomes disabled If you want to avoid paying taxes completely you can resort to the following: Change the beneficiary to another qualifying family member (a parent, child, sibling etc.) Hold the funds in the account in case the beneficiary wants to attend grad school later Make yourself the beneficiary and further your own education Use a 529 ABLE account, a savings account specifically for people living with disabilities Since January 1, 2019, qualified distributions from a 529 plan can repay up to $10,000 in student loans per borrower over their lifetime for both the beneficiary and the beneficiary’s siblings As we said at the top of this article. you can withdraw any of the money in a 529 plan at any time for any reason. However, the earnings portion of a non-qualified withdrawal will be subject to taxes and a penalty. So in the absence of one of the exceptions listed above, we will usually coach our clients to find one of the other alternatives above and make these necessary changes to their InSight-Full® plan. If you are still contemplating a non-qualified distribution, be aware of the rules and possible tactics for reducing taxes owed.

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Taxmageddon
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What is ‘Taxmageddon’?

We’re currently looking for major overhauls in taxation for corporations and people in the coming years. General civil unrest, combined with decades-long examples of corporations and individuals paying no and very little taxes, is causing a groundswell of discussion in Washington regarding changes to the IRS practices, the rules for carried interest, and the tax bracketing system. Couple this with a massive infrastructure bill on the heels of the Jobs and Tax Cuts Act and the U.S. is finally feeling the pressure to pay for the spending it has racked up since 2008.  The easiest way to pay for this 13-year long spending spree will be to turn to the corporations and people who have seen their fortunes impacted the most. The “tax the rich” cries are ringing out from both parties and a need to bring taxes up to resolve debt is becoming more and more immediate.  The first pitch in this game has come from the Biden administration. With several proposed changes affecting inherited wealth, treatment of capital gains, and raising the corporate tax rate back to the 2010’s range. There will be huge shifts for the wealthiest Americans, and even for those who will dip into that range for a year or two as they sell property, their businesses, and begin shifting assets to the next generation. Taking steps to defer your federal income bill is usually a good idea, especially if you expect to be in the same or lower tax bracket in future years. If that assumption pans out, making moves that lower your current-year income will, at a minimum, put off the tax day of reckoning and leave you with more cash until the bill comes due. If your tax rate turns out to be lower in future years, deferring income into those years will cause the deferred amount(s) to be taxed at lower rates. Great. This confluence of historically high pent-up capital gains and what might be a purge of those positions in 2021 to avoid the tax consequences in the years to come has made for a major (albeit temporary) shift in the tenured financial advice many are used to. Some elements will still support the goals and efforts of workers, but many will be turned on their ear and are downright bad advice given these proposed changes. Additional Resources for ‘Taxmageddon’ Tax Mitigation Playbook Download Opportunity ZoneOverview

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