Election & Markets

11pm eastern on election night and it’s looking like we have ourselves another BrExit moment coming for the financial markets, with US futures down as much as 4.5% a few minutes ago. I wouldn’t be surprised to see that double by morning. I’m going to keep this short so as to stay out of the political side of the story. In my opinion, a Trump win is a threat to global trade (just like BrExit was) and that is a threat to global growth. Even if much of it wasn’t rhetoric to gain votes in the states that have bled manufacturing jobs over the past two decades, ironically, a Republican controlled Congress is probably a block to much of that type of movement. Just as the reaction to BrExit was to sell first and think later, it appears the same will prevail here if Trump does win (now a 90% chance in better markets). Fear is not a winning proposition. I’m confident the world won’t end from a Trump presidency either. More details to follow in the coming days regarding what to expect from a tax and economic point of view.

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Updated 2017 Tax Numbers

The IRS has released the key tax numbers that are updated annually for inflation, including tax rates, phaseouts, standard deduction, exemption amount, and contribution limits. Since inflation was low in 2016, only small changes have been made in most cases. Some notable callouts for those who don’t want to read all the way through the update:

· Social Security payments will increase by 0.3% in 2017. The Social Security Wage Base (the max amount of income subject to the 6.2% Social Security Tax) increases dramatically from $118,500 to $127,200 (it’s calculated based on wage increases and by law could not increase in 2016 since there was no SS COLA increase).

· Max contributions to 401k, 403b, and 457 retirement accounts remain unchanged at $18,000 (+$6000 catch-up if you’re at least age 50).

· Max contribution to a SIMPLE retirement account remains unchanged at $12,500 (+$3000 catch-up if you’re at least age 50).

· Max total contribution to most employer retirement plans (employee + employer contributions) increases from $53,000 to $54,000.

· Max contribution to an IRA remains unchanged at $5,500 (+$1,000 catch-up if you’re at least age 50).

· The phase out for being able to make a Roth IRA contribution is $196k (married) and $133k (single). Phase out begins at $186k (married) and $118k (single).

· The standard deduction increases by $100 to $12,700 (married) and by $50 to $6,350 (single) +$1,250 if you’re at least age 65.

· The personal exemption remains unchanged at $4,050 per family member. Remember that exemption amounts begin to be phased out if your income exceeds $313,800 (married) or $261,500 (single). The exemption is reduced by 2% for every $2500 of AGI over threshold until reduced to $0.

· Itemized deductions are reduced by 3% of the amount AGI is over $313,800 (married) or $261,500 (single).

· The annual gift tax exemption remains at $14,000 per giver per receiver.

· The maximum contribution to a Health Savings Account (HSA) remains at $6,750 (married) but increases by $50 to $3,400 (single).

· Note that mileage rates have not been updated yet for 2017.

2017 Key Tax Numbers

 

Q3 2016 Returns By Asset Class

At the end of Q2, I posted returns by asset class (by representative ETF), as well as year-to-date, last twelve months, and last five years. While there is still no predictive power in this data, I updated those charts as of the end of Q3 2016 for those of you that are interested (see below).

Q3 2016 Asset Class Returns

While Commodities and Real Estate Investment Trusts were down slightly during Q3, other asset classes were positive. All major asset classes are now positive year-to-date, and all except Commodities are positive for the past 52-weeks (this should turn around by the end of Q4 as the horrible Q4 2015 Commodity crash will roll off the 52-week chart by then).

Q2 2016 Returns By Asset Class

The link below shows Q2 2016 returns by asset class (by representative ETF), as well as year-to-date, last twelve months, and last five years.

Asset Class Returns

While I don’t think there is any predictive power in this information, some of you may still find it interesting. A few call outs:

1) Commodities overall (energy, metals, agricultural products) are down more than 50% in the past 5 years.

2) Emerging market stocks are down almost 20% over the past 5 years. In fact, they never fully recovered from the financial crisis and are still down more than 25% from their October 2007 peak.

3) Large Cap US stocks (think S&P 500) have been consistent strong performers. It makes sense that that the S&P 500 is near an all-time high.

4) Note the diverse returns by asset class, especially bonds vs. stocks and US stocks vs foreign stocks. This diversification is what we ultimately want in portfolios. It “feels” bad when your home country is outperforming as the S&P 500 has for the past 5 years. There is a temptation to want to just invest in the S&P 500 since it has done well for a particular period of time in the past, but there are no guarantees that will continue for the future. In fact, it may be starting to reverse course (see #5 below). Diversification works over the long-term, not over the arbitrarily defined term.

5) Some of the worst performers over the last 5 years are some of the best performers year-to-date (commodities, emerging market bonds, emerging market stocks).

6) Notice the low, but consistent returns of US bonds. That’s why they’re part of your portfolio. They have very little (and often negative) correlation to the rest of the portfolio. These are true diversifiers in that they have positive expected returns, but tend to do well when other parts of the portfolio are doing poorly. The addition of bonds to a portfolio smooths out the roller-coaster of stock returns. The more bonds, the smoother the ride, but the lower the overall return will be.

7) While cash has paid essentially no interest over the past five years, Aggregate US Bonds have returned 20%, and with a very smooth ride along the way. This is why we favor bonds strongly over cash (other than as an emergency fund and for known upcoming spending).

Brexit Follow-Up – One Ugly Day Later

Quick update on the financial impact of Brexit after one day of trading. Bad in the US, but terrible overseas, especially in financials. Vanguard’s Total World Market ETF was down 5.35%. I like to use that as a proxy for all the assets in the world, which are worth 5% less today than they were yesterday at this time (or, more optimistically, they’re 5% cheaper than they were yesterday). Again, no one knows if this is an over-reaction, if there will be a bounce in the short-term, or if this is the beginning of a big move down. Most importantly, no one knows what the long-term economic impact will be. The unwinding of positions just needs to play out in the market for a while in the short term and a LOT of negotiations, votes, and policy decisions need to be made in Europe over the long-term (likely several years). Here’s where things settled today, with all returns below by representative ETF, in US Dollars (captures market impact and currency impact together):

  • US Large Cap Stocks: -3.6%
  • US Small Cap Stocks: -3.8%
  • US Real Estate Investment Trusts: -0.9%
  • US High Yield “Junk” Bonds: -1.6%
  • Foreign Developed Country Stocks: -8.2%
    • Foreign Developed Value (includes a lot of banks): -9.8%
  • Foreign Emerging Market Stocks: -5.7%
  • Foreign Real Estate Investment Trusts: -6.0%
  • Emerging Market Bonds (Local Currency): -3.3%
  • Aggregate Commodities: -1.8%
    • Oil: -4.8%
    • Gold: +4.9%
  • US Aggregate Bonds: +0.6%
    • US Short-Term Investment Grade Bonds: +0.1%
    • US Medium-Term Corporate Bonds: +0.3%
    •  US Long-Term Treasuries: +2.7%

Brexit

As I type this message, the votes are being counted in the UK referendum on whether to remain in the Euro zone or exit (British Exit, “Brexit”). With approximately 2/3rds of the voting areas reporting, the result looks like a narrow victory for the exit camp. This comes as a total shock to the financial markets, which had been pricing in a win for the Remain side, based on recent poll data, and similar votes in other countries in recent years. Virtually all economists are in agreement that this will have a detrimental impact on UK GDP, at least in the short-term, and maybe in the long-term. It also signals a possible unraveling to the Euro zone if other countries reach similar decisions. The future impact is all based on speculation at this point. Is it better for the UK to extract itself from a potentially failed experiment in trying to combine countries in Europe that are too culturally different to be combined, even if there is some short-term economic pain? Might it even be better for the world if the countries of the Euro zone all return to their previous status as completely separate entities that are not as dependent on each other? Or does the obliteration of trade agreements, a common currency, and a determination to become more unified wind up hurting global growth irreparably? No one knows these answers.

What we do know is that when financial markets are shocked by an unexpected event that MAY have major economic implications for the future (MAY emphasized, because whether it does have those implications or not is irrelevant), volatility ensues. In this case, it is led by the currency markets as the value of a British Pound can change dramatically if the market in aggregate believes now that investments in the British economy will offer poorer returns in the coming years than they did yesterday. Major swings in one currency often trigger major swings in other currencies in a rush to safety (US Dollar) and away from riskier and higher yielding currencies. Currency swings impact the economies of the countries that use those currencies. Currencies that depreciate in value gain an export advantage over other countries, but the cost of imported goods can rise sharply and hurt more than the exports can stimulate growth. Stock market fluctuations follow from the economic impacts and volatility there can be self-fulfilling as leveraged losing bets cause additional forced selling via margin calls and fund liquidations. In financial markets, fear begets fear. As you might expect, the British pound is incurring substantial declines in overnight markets… currently down almost 10% vs the US dollar, back to levels not seen since 1985. World equity markets are also suffering, with US markets down 3-4%, the UK down 7.5%, and Asian markets down as well. US bonds are a bright spot, as is almost always the case in situations like this, which is the reason we include bonds in your portfolios even when interest rates are low. They are a source of stability and are negatively correlated with other assets.

While it’s always possible that there will be a quick snap back rally, events such as this tend to take a while to play out in the markets as bottom-pickers try to time their bets (exerting buying pressure and causing a rebound in prices), while funds with liquidation requests and leveraged bets that led to margin calls force additional selling (downward pressure) on the markets. As is usually the case, the market knows best what a fair price is given the current situation, so we don’t see this as a reason to panic and sell, or a particular “buying opportunity” beyond the investing of spare cash that you should always be doing and that’s part of your financial plan. It’s merely something that has now happened and is priced into the markets. Over the long-term, the economic impacts will play out, and prices will continue to adjust as those impacts are better understood.

The long and short of Brexit is this: tomorrow is likely to be a very ugly day in most financial markets. The gains of the last few months are likely to be wiped out (and then some). Will that change the fact that over the long-term, populations will continue to grow, people will continue to work, and productivity will continue to increase through process and technological advances? Call me skeptical, but I doubt it. The world’s economic output, in all likelihood, will continue to grow over time and we’ll look back on this as yet another event in the history of financial markets that caused a lot of headlines to be written and a lot of fear to swell over a temporary blip in overall growth. We have no idea whether the UK will benefit or be hurt by their democratic decision (if they even go through it). But the world as a whole will be just fine after some time to adjust to the new landscape. In other words, I sincerely doubt any of you will be telling your grandchildren that their lives would be so much different if only 2% more of the UK voted to stay in the EU on 6/23/16.

Q4 and Full Year 2015 Market Segment Performance

Just a quick snapshot of Q4 and 2015’s selected returns by segment of the market (returns are those of the segment’s representative ETF). It was a mostly flat to slightly down year with US Large Company stocks up slightly, but US Small down slightly more. Foreign Developed areas were up over 7%, but Foreign Emerging was down more (~15%). REITs were up a bit, but high-yield down a bit more. The noted exception area to the mostly flat to slightly down market was in Commodities. Led by oil (-46%), commodities in aggregate were down 28%, following their almost 19% drop in 2014

On the bright side, Q4 was mostly positive (again with the exception of Commodities). And inflation (as measured by the CPI) remains very low thanks mostly to the fall in commodity prices. The high correlation between your spending and commodity prices (esp. energy) is why we include commodities in investment portfolios. It’s ok if that portion of your portfolio falls in value if inflation is substantially lower than the 3% expectation we incorporate into most financial plans. The reverse is also true… If commodity prices rise sharply, your spending has a tendency to increase more than planned and the commodity portion of your portfolio is likely to rise along with it.

2015Q4-1

Stocks / REITs / High Yield / Commodities over the course of the year:2015Q4-2

Bonds over the course of the year:2015Q4-3

As a reminder, while it might not feel good, unless you are retired and no longer saving money, you are far better off with flat to down markets that rise later in life than you are with a market that moves steadily upward. It allows more investing at lower prices which results in a higher amount of total wealth assuming the same endpoint (see The Value Of Volatility). If you are retired and no longer saving, you’re likely to be in a much more conservative portfolio with lower expected returns factored into your financial plan so that the occasional down year in stocks doesn’t have a big impact on the plan overall.