If not now, when? That is what Bloomberg economists are asking themselves after forecasting a 100% chance of a recession within one year of October 2022. With GDP figures consistently above 2% and with 79% of the S&P 500 beating their earnings estimates in Q2, the United States economy has proven resilient. However, several headwinds were present in August and September, leaving most asset classes negative in Q3 as investors began to brace themselves.
The Fed raised interest rates in July for the eleventh straight time, but left rates unchanged in the September meeting. Inflation is stubbornly hovering between 3-4%, but not quite down to the Fed’s long-term target of 2%. Oil and gas prices are 12% higher than they were at this time last year: American companies have increased production to take advantage, while Russian and Saudi Arabian companies have cut production, keeping the prices high.
It is looking more likely that we are near the peak of the interest rate hike cycle. With payroll gains trending down each month, the labor participation rates getting back to pre-pandemic levels, and federal stimulus unlikely due to a rising national debt, the case for robust inflation is a hard one to find. The Fed currently projects two small interest rate cuts in 2024.
Investors are flocking to money market funds and 3-month US Treasuries, yielding 5.0% and 5.5% respectively. However, history tells us that over the last six interest rate hike peaks, the best performing asset class over the next 12 months was in fact the S&P 500 in four of those instances! The other two resulted in aggregate bonds outperforming, typically with 5–6-year durations. Thus, while cash may feel safe right now, long term investors will be asked again to do what feels counterintuitive: stay the course with stocks and add duration to their bond portfolios despite an inverted yield curve.
The pullback in Q3 has left valuations about 9% cheaper since July. Compared to their 25-year averages, the most appealing asset classes from a valuation perspective are Treasuries, bonds, all international stocks, and U.S. small caps. High yield bonds and growth stocks are still expensive, but significantly cheaper than 12/31/21. The top 10 stocks in the S&P 500 accounted for 96% of its 12% return YTD, repeating a phenomenon seen in 2021 and emphasizing the need for rebalancing portfolios in Q4.
While exceptional returns may require patience, one positive of our current situation can be found in the 60% stock and 40% bond portfolios that many retirees use. Not since before the 2008 recession have interest rates been this high. Recessions bring stocks down, but lower interest rates also tend to follow, which increases bond values and stabilizes an overall portfolio. We will continue to review the allocation of your investments to ensure they line up with your financial plan.
Year End Tax Strategies
With three months to go until 2023, we want to encourage clients to consider strategies to mitigate taxes. There is an old saying “Don’t let the tax tail wag the dog.” In other words, don’t implement a tax avoidance/minimization strategy that could be detrimental to your comprehensive, long-term financial strategy. Having said that, here are a few quick reminders to consider as you close out the year:
- Max out your 401(k) or 403(b) at $22,500 ($30,000 if you are over the age of 50). If you are not sure what that requires, ask for a recent paystub and work backwards to contribute the necessary amount each pay period to max out the plan.
- Open or fund an individual 401(k) if you are self-employed. The deferral deadline has changed this year to your tax filing deadline in 2024.
- Max out your Health Savings Account (HSA) if you have a high deductible health insurance plan. Spend down your Flexible Spending Account (FSA).
- Perform Roth conversions by 12/31 if you are in a low-income tax bracket due to job loss or early retirement. We anticipate a higher tax environment in the future. A Roth conversion now could save you in the long run.
- Required Minimum Distributions (RMDs) are required for those who turn 73 this year. Consider qualified charitable distributions which are tax-free IRA distributions if you are over age 70 1/2. Donor advised funds may also still be used to bunch up charitable contributions for a tax deduction in 2023.
- For clients with large estates, family-owned businesses, etc. explore using your lifetime estate tax exemption to gift assets to beneficiaries (outright or in trust) in 2023-25, before the exemption comes down by half in 2026. It may also make sense to convert IRA’s to Roth IRA’s in 2023 to get both tax-free future growth and reduce the size of your taxable estate. The income tax paid now will reduce the size of your taxable estate.
Projected Contribution Limits for 2024
The following chart is a projection from Mercer for several contribution limits in 2024, based on 2023 inflation data:
Tax Loss Harvesting
Finally, we will spend much of the fourth quarter rebalancing portfolios to account for the recent volatility. In doing so, we will look for opportunities to harvest losses in your taxable investment accounts. These realized losses would first offset realized capital gains and mutual funds distributions from this year. Any excess losses harvested this year could be used to offset up to $3K of ordinary income and then carried forward to offset capital gains in future years. If you have outside gains or losses that you have realized in 2023, please let us know.
Massachusetts Tax Changes
On October 4th, Governor Healey signed a tax cut legislation that includes savings for seniors, businesses, renters, and an expanded child and family tax credit. Relevant to investors, the bill also lowers the short-term capital gains tax rate from 12% to 8.5%.
Most of the measures do not require any new financial planning. However, the Massachusetts estate tax has been relevant for many of our clients. The previous exemption was just $1 million in assets. With rising home prices and retirement account balances, one could easily be subject to the estate tax.
The new bill lifts the exemption to $2 million. It also eliminates the “cliff” of the Massachusetts estate tax, which resulted I residents with taxable estates in excess of $1 million paying estate taxes on all of their assets, not merely the portion in excess of $1 million. Under the new bill, only the portion of the estate that exceeds $2 million will be taxed. Assets in excess of $2 million will be taxed at a graduated rate between 8% and 16%.
Note that the exemption is NOT portable between spouses, which is different from how federal estate tax legislation works. This means that after the death of one spouse, assuming the surviving spouse inherits their assets, they will only be able to exempt $2 million in assets.
Proper estate planning techniques can ensure that a combined $4 million of assets are exempt from estate planning, but it does require the creation of a trust to do so. If you would like to review your estate plan and/or receive a referral to an estate attorney, please do not hesitate to reach out to your advisor.
Comings and Goings
The pending tax cuts in Massachusetts are not enough to entice Mike & Maureen to stay as residents of the Commonwealth. They recently purchased a home in Punta Gorda FL and are pointing the UHaul trailer south on October 28th. It is estimated by the MA Taxpayers Alliance that over 1100 residents per week have been moving our of Massachusetts since April of 2000. Mike will be working full-time remotely from Florida for the duration of the winter. At age 54 and with a daughter in college and pointing toward PA school, he has no intention of retiring anytime soon!
With 62 of our clients either permanently or seasonally in Florida last winter, and many more there for just a week or two, he is eager to schedule in-person financial reviews. If you plan to be in FL between Dec 1st and April 15th, please reach out to Mike to schedule a meeting. Of course, if you don’t plan to be in FL this winter, Mike is always willing to schedule online reviews as well. You can continue to call the office at 781-878-7757 and your calls will be routed to Mike in FL.
We are also pleased to welcome a new addition to the firm! Joe Curran is a resident of Hanson, MA and recent graduate of Bentley College with both a BS and MS in Finance. He will join us as a trader and research analyst initially with the goal of getting licensed to become an Associate Advisor. He will be pursuing a Certified Financial Planning designation over the next couple of years. Many of you will have the opportunity to meet Joe as he joins us on client meetings and calls while learning the business. He is eager to build relationships with our clients and we are certain he’ll become a great resource as he adds to his already impressive resume.