What to Know About T Plus 1 Trade Settlement
On May 28, 2024, settlement cycles on U.S. stocks and other securities will shift from two business days to one. For most investors, this shift will have little or no impact. But it will affect some investors and certain types of transactions. It may be helpful to understand the basics of this important change.
T+1 vs. T+2
The trade date (T) is the day your order to buy or sell a security is executed. The settlement date is the day your order is finalized, and when the funds used to purchase the security and any sold securities must be delivered. Put simply, T+1 means most transactions will settle on the next business day after the trade.
For example, under the current T+2 protocol, if you sell shares of a stock on a Monday, the transaction will settle in two business days on Wednesday. Beginning on May 28, 2024, if you sell shares of a stock on a Monday, the transaction will settle in one business day on Tuesday.
Who will T+1 affect?
T+1 will have minimal or no impact on most investors because most brokerage firms require cash or sufficient margin in an account prior to the investor entering any orders to purchase securities in the account. However, if your brokerage firm allows you to make a purchase without sufficient funds in the account, under T+1 you will need to deliver a check or initiate a funds transfer so that the funds are deposited in your brokerage account no later than the next business day.
Another potential effect of T+1 on some investors may be the tighter timeframe to deliver paper certificates for securities that are sold. This is rare today, because investors typically hold securities in their accounts electronically, and the shorter timeframe should not affect electronic transfers. However, if you do wish to sell a security for which you hold a paper certificate, you should be prepared to deliver it to the brokerage firm no later than the next business day after the trade is executed.
Securities affected include stocks, bonds, exchange-traded funds, certain mutual funds, municipal securities, real estate investment trusts, and master limited partnerships traded on U.S. exchanges. This change will not affect government bonds and options as their settlement is already set at T+1.
Establishing accurate cost basis
When selling a security, any capital gains taxes are calculated using the security’s cost basis, which is the initial amount invested plus any commissions or fees and reinvested dividends and distributions. Under most circumstances, the change to T+1 will have no effect on figuring cost basis. However, if you purchased a security through more than one brokerage firm, you would have one less day to provide information on the previous purchase(s) to your current firm. Once settlement is complete, your cost basis is established for tax purposes. The best practice is to make sure your current brokerage has full cost-basis information on any securities purchased at previous brokerages.
For more information, see IRS Publication 550, which offers detailed guidance on how to calculate cost basis under different circumstances.
Convenience and close attention
For some investors, one-day settlement may mean greater convenience. In effect, an investor will fully own a security one day sooner than under the current system. This could be helpful for an investor who wants to trade the security quickly or wants to participate in a proxy vote. However, T+1 will also require some investors to pay closer attention to how the shorter settlement time could affect investment, trading, or tax decisions.
All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy will be successful.
2023 Charitable Giving
There is still time in 2023 for year-end planning. Your planning may include charitable giving. The tax benefits associated with charitable giving could potentially enhance your ability to give and should be considered as part of your year-end tax planning.
There may be tax benefits for making charitable gifts
If you itemize deductions on your federal income tax return, you can generally deduct your gifts to qualified charities. This may also help increase your gift.
Example: Assume you want to make a charitable gift of $1,000. One way to potentially enhance the gift is to increase it by the amount of any income taxes you save with the charitable deduction for the gift. At a 24% tax rate, you might be able to give $1,316 to charity [$1,000 ÷ (1 – 24%) = $1,316; $1,316 x 24% = $316 taxes saved]. On the other hand, at a 32% tax rate, you might be able to give $1,471 to charity [$1,000 ÷ (1 – 32%) = $1,471; $1,471 x 32% = $471 taxes saved].
Tax benefits may be limited to certain percentages of your adjusted gross income (AGI). Your deduction for gifts to charity is limited to 50% (currently increased to 60% for cash contributions to public charities), 30%, or 20% of your AGI, depending on the type of property you give and the type of organization to which you contribute. Charitable deductions that exceed the AGI limits may generally be carried over and deducted over the next five years, subject to the income percentage limits in those years.
Make sure to retain proper substantiation of your charitable contributions. To claim a charitable deduction for any contribution of cash, a check, or other monetary gift, you must maintain a record of such contributions through a bank record (such as a cancelled check, a bank or credit union statement, or a credit-card statement) or a written communication (such as a receipt or letter) from the charity showing the name of the charity, the date of the contribution, and the amount of the contribution. If you claim a charitable deduction for any contribution of $250 or more, you must substantiate the contribution with a contemporaneous written acknowledgment of the contribution from the charity. If you make any noncash contributions, there are additional requirements.
Year-end tax planning
When making charitable gifts at the end of the year, you should consider them as part of your year-end tax planning. Typically, you have a certain amount of control over the timing of income and expenses. You generally want to time your recognition of income so that it will be taxed at the lowest rate possible, and time your deductible expenses so they can be claimed in years when you are in a higher tax bracket.
For example, if you expect to be in a higher tax bracket next year, it may make sense to wait and make the charitable contribution in January so that you can take the deduction next year when the deduction results in a greater tax benefit. Or you might shift the charitable contribution, along with other deductions, into a year when your itemized deductions would be greater than the standard deduction amount. And if the income percentage limits above are a concern in one year, you might consider ways to shift income into that year or shift deductions out of that year, so that a larger charitable deduction is available for that year. A tax professional can help you evaluate your individual tax situation.
There are other methods of making charitable gifts. These generally are subject to additional documentation and other complexities.
Using appreciated securities that have been held for more than year allows the appreciation (gains) to be included in the amount of the contribution without paying tax on the gains.
Making Qualified Charitable Distributions (QCD) is another technique. If you or your spouse are over 70 ½ the first $100,000 of each your required minimum distributions (RMD) will reduce the taxable amount of you RMD.
Caution
When making charitable contributions, be sure to deal with recognized charities and be wary of charities with names that sound like reputable charitable organizations. It is common for scam artists to impersonate reputable charities using bogus websites as well as misleading email, phone, social media, and in-person solicitations. Check out the charity on the IRS website, irs.gov, using the Tax-Exempt Organization Search tool. And remember, don’t send cash; contribute by check or credit card.
Jason Zweig view of Benjamin Graham’s approach to investing
Jason Zweig is a journalist at the Wall Street Journal. I have consistently found his column, “The Intelligent Investor” to be clear and insightful. His March 21 column, “The Risk That Come With Rescuing Banks” is followed by “Money Mailbag”. He was asked for a comparison of “The Intelligent Investor” and “Security Analysis” both written by Benjamin Graham.
Following are excerpts from his answer.
“ Benjamin Graham (1894-1976) was one of the greatest investors of the 20th century, as well as Warren Buffett’s boss and mentor.”
“He understood that markets are dynamic and that investors should be flexible.”
“The guidelines Graham laid down in the final edition …(1973) differ significantly from those he set in the previous, 1965 edition.”
“What Graham never changed is the emotional framework he built. Whether you are a professional or an individual investor…”
“If he were around today, he would have yet another set of rules.”
- “cultivate the seven investing virtues of curiosity, skepticism, discipline, independence, humility, patience and courage;
- regard a stock as a stake in an underlying business, not as a ticker symbol or a lottery ticket;
- recognize that the stock market is often insane;
- think not only about how much you will make if you are right, but how much you will lose if you are wrong;
- trade as seldom as possible.”
He provides much to think about, even if you do not agree with him.
Is the Yield Curve Signaling a Recession?
Long-term bonds generally provide higher yields than short-term bonds because investors demand higher returns to compensate for the risk of lending money over a longer period. Occasionally, however, this relationship flips, and investors are willing to accept lower yields in return for the relative safety of longer-term bonds. This is called a yield curve inversion because a graph showing bond yields in relation to maturity is essentially turned upside down (see chart).
A yield curve could apply to any bonds that carry similar risk, but the most studied curve is for U.S. Treasury securities, and the most common focal point is the relationship between the two-year and 10-year Treasury notes. The two-year yield has been higher than the 10-year yield since July 2022, and beginning in late November, the difference has been at levels not seen since 1981. The biggest separation in 2022 came on December 7, when the two-year was 4.26% and the 10-year was 3.42%, a difference of 0.84%. Other short-term Treasuries have also offered higher yields; the highest yields in early 2023 were for the six-month and one-year Treasury bills.1 (Although Treasuries are often referred to as bonds, maturities up to one year are bills, while maturities of two to 10 years are notes. Only 20- and 30-year Treasuries are officially called bonds.)
Predicting Recessions
An inversion of the two-year and 10-year Treasury notes has preceded each recession over the past 50 years, reliably predicting a recession within the next one to two years.2 A 2018 Federal Reserve study suggested that an inversion of the three-month and 10-year Treasuries may be an even more reliable indicator, predicting a recession within about 12 months.3 The three-month and 10-year Treasuries have been inverted since late October, and in December and early January the difference was often greater than the inversion of the two- and 10-year notes.4
Weakness or Inflation Control?
Yield curve inversions do not cause a recession; rather they indicate a shift in investor sentiment that may reflect underlying economic weakness. A normal yield curve suggests that investors believe the economy will continue to grow, and that interest rates are likely to rise with the growth. In this scenario, an investor typically would want a premium to tie up capital in long-term bonds and potentially miss out on other opportunities in the future.
Conversely, an inversion suggests that investors see economic challenges that are likely to push interest rates down and typically would rather invest in longer-term bonds at today’s yields. This increases demand for long-term bonds, driving prices up and yields down. (Bond prices and yields move in opposite directions; the more you pay for a bond that pays a given coupon interest rate, the lower the yield will be.)
The current situation is not so simple. The Federal Reserve has rapidly raised the benchmark federal funds rate to combat inflation, increasing it from near 0% in March 2022 to 4.25%–4.50% in December. As the rate for overnight loans within the Federal Reserve System, the funds rate directly affects other short-term rates, which is why yields on short-term Treasuries have increased so rapidly. The fact that 10-year Treasuries have lagged the increase in the funds rate may indeed mean that investors believe a recession is coming. But it could also reflect confidence that the Fed is winning the battle against inflation and will lower rates over the next few years. This is in line with the Fed’s projections, which see the funds rate peaking at 5.0%–5.25% by the end of 2023, and then dropping to 4.0%–4.25% in 2024 and 3.0%–3.25% in 2025.5
Inflation slowed somewhat in October and November, but there is a long way to go to reach the Fed’s target of 2% inflation for a healthy economy.6 The fundamental question remains the same as it has been since the Fed launched its aggressive rate increases: Will it require a recession to control inflation, or can it be controlled without shifting the economy into reverse?
Other Indicators and Forecasts
The yield curve is one of many indicators that economists consider when making economic projections. Among the most closely watched are the 10 leading economic indicators published by the Conference Board, with data on employment, interest rates, manufacturing, stock prices, housing, and consumer sentiment. The Leading Economic Index, which includes all 10 indicators, fell for nine consecutive months through November 2022, and Conference Board economists predict a recession beginning around the end of 2022 and lasting until mid-2023.7 Recessions are not officially declared by the National Bureau of Economic Research until they are underway, and the Conference Board view would suggest the United States may already be in a recession.
In The Wall Street Journal’s October 2022 Economic Forecasting Survey, most economists believed the United States would enter a recession within the next 12 months, with an average expectation of a relatively mild 8-month downturn.8 More recent surveys of economists for the Securities Industry and Financial Markets Association and Wolters Kluwer Blue Chip Economic Indicators also found a consensus for a mild recession in 2023.9–10
For now, the economy appears fairly strong despite high inflation, with a low November unemployment rate of 3.7% and an estimated 3.8% Q4 growth rate for real gross domestic product.11–12 Unfortunately, the indicators and surveys discussed above suggest an economic downturn in the next year or so. This would probably cause some job losses and other temporary financial hardship, but a brief recession may be the necessary price to tame inflation and put the U.S. economy on a more stable track for future growth.
U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. The principal value of Treasury securities fluctuates with market conditions. If not held to maturity, they could be worth more or less than the original amount paid. Forecasts are based on current conditions, are subject to change, and may not happen.
1, 4) U.S. Treasury, 2023
2) Financial Times, December 7, 2022
3) Federal Reserve Bank of San Francisco, August 27, 2018
5) Federal Reserve, 2022
6, 11) U.S. Bureau of Labor Statistics, 2022
7) The Conference Board, December 22, 2022
8)The Wall Street Journal, October 16, 2022
9) SIFMA, December 2022
10) USA Today, December 15, 2022
12) Federal Reserve Bank of Atlanta, January 5, 2023
Are we in a Recession?
A common definition is that a recession occurs when there are two consecutive quarters of declining in gross domestic product (GDP). The GDP is the total of all the goods and services produced in a country. The National Bureau of Economic Research (NBER) determines when the United States (U.S.) is in a recession. It is a private nonpartisan organization that began dating business cycles in 1929. The committee, which was formed in 1978, includes eight economists who specialize in macroeconomic and business cycle research.1 The NBER defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” The committee looks at the big picture and makes exceptions as appropriate. For example, the economic decline of March and April 2020 was so extreme that it was declared a recession even though it lasted only two months.2
The committee studies a range of monthly economic data, with special emphasis on six indicators: personal income, consumer spending, wholesale-retail sales, industrial production, and two measures of employment. Because official data is typically reported with a delay of a month or two — and patterns may be clear only in hindsight — it generally takes some time before the committee can identify a peak or trough. Some short recessions (including the 2020 downturn) were over by the time they were officially announced.3
Public Opinion
Consumer sentiment is a significant factor. It is a powerful factor in consumer spending. Consumer spending is a substantial part of GDP. An early July poll, 58% of Americans said they thought the U.S. economy was in a recession, up from 53% in June and 48% in May.4 Yet many economic indicators, notably employment, remain strong. The current situation is unusual, and there is little consensus among economists as to whether a recession has begun or may be coming soon.5
GDP
Real (inflation-adjusted) GDP dropped at an annual rate of 1.6% in the first quarter of 2022 and by 0.9% in the second quarter.6
Since 1948, the U.S. economy has never experienced two consecutive quarters of negative GDP growth without a recession being declared. However, the current situation could be an exception, due to the strong employment market and some anomalies in the GDP data.7
Negative first-quarter GDP was largely due to a record U.S. trade deficit, as businesses and consumers bought more imported goods to satisfy demand. This was a sign of economic strength rather than weakness. Consumer spending and business investment — the two most important components of GDP — both increased for the quarter.8
Initial second-quarter GDP data showed a strong positive trade balance but slower growth in consumer spending, with an increase in spending on services and a decrease in spending on goods. The biggest negative factors were a slowdown in residential construction and a substantial cutback in growth of business inventories.9 Although inventory reductions can precede a recession, it’s too early to tell whether they signal trouble or are simply a return to more appropriate levels.10 Economists may not know whether the economy is contracting until there is additional monthly data.7
Employment
Economic data has been mixed recently. Consumer spending declined in May when adjusted for inflation, but bounced back in June.11 Retail sales were strong in June, but manufacturing output dropped for a second month.12 The strongest and most consistent data has been employment. The economy added 372,000 jobs in June, the third consecutive month of gains in that range. Total nonfarm employment is now just 0.3% below the pre-pandemic level, and private-sector employment is actually higher (offset by losses in government employment).13
The unemployment rate has been 3.6% for four straight months, essentially the same as before the pandemic (3.5%), which was the lowest rate since 1969.9 Initial unemployment claims ticked up slightly in mid-July but remained near historic lows.14 In the 12 recessions since World War II, the unemployment rate has always risen, with a median increase of 3.5 percentage points.16
With employment at such high levels, it may be questionable to characterize the current economic situation as a recession. However, the employment market could change, and recessions can be driven by fear as well as by fundamental economic weakness.
Inflation
The fear factor is inflation which ran at an annual rate of 9.1% in June, the highest since 1981.17 Wages have increased, but not enough to make up for the erosion of spending power, making many consumers more cautious despite the strong job market.18 If consumer spending slows significantly, a recession is certainly possible, even if it is not already under way. Inflation has forced the Federal Reserve to raise interest rates aggressively, with a 0.50% increase in the benchmark federal funds rate in May, followed by 0.75% increases in June and July.18 It takes time for the effect of higher rates to filter through the economy, and it remains to be seen whether there will be a “soft landing” or a more jarring stop that throws the economy into a recession.
Among the factors driving inflation are: Covid-19, Russian Invasion of Ukraine, supply chain disruptions, CARES ACTs 1, 2 and 3, fewer homes for sale than buyers, limited supply of semiconductors .
Unfortunately, no one knows the future, and economic forecasts vary significantly. Forecast range from remote chance of a recession to an imminent downturn with a moderate recession in 2023.19 If that turns out to be the case, or if a recession arrives sooner, it’s important to remember that recessions are generally short-lived, lasting an average of just 10 months since World War II. By contrast, economic expansions have lasted 64 months.20 To put it simply: The good times typically last longer than the bad.
Projections are based on current conditions, are subject to change, and may not happen.
1-3) National Bureau of Economic Research, 2021
4) Investor’s Business Daily, July 12, 2022
5) The Wall Street Journal, July 17, 2022
6) U.S. Bureau of Labor Statistics, 2022
7-8) MarketWatch, July 5, 2022
6,9,11,21) U.S. Bureau of Economic Analysis, 2022
10) The Wall Street Journal, July 28, 2022
12) Reuters, July 15, 2022
13–14, 17–18) U.S. Bureau of Labor Statistics, 2022
15) The Wall Street Journal, July 14, 2022
16) The Wall Street Journal, July 4, 2022
19) Federal Reserve, 2022
20) The New York Times, July 1, 2022
Roth Conversions are getting a lot of attention
Some consider the drop in the markets maybe a good time for some to consider converting traditional IRAs to Roth IRAs. The withdrawal of the assets from the traditional IRA would be taxed currently. The resulting tax would be lower as the value of the investment would be lower. The future growth of the assets would not be taxable in the Roth or to the beneficiaries of the Roth. There are many assumptions and conditions to achieve the desired benefits.
Tax rate assumptions
One assumption is that you will be in a lower tax bracket when you retire. A related assumption is that the tax laws will not change when the funds are distributed from the Roth. One approach would be to calculate your tax based on various assumptions. Depending on your current tax bracket and assumed future tax brackets to see how much to convert now.
Future values
There is a risk that the value of the investment will not grow or will drop in value.
Two five-year tests
To qualify for tax-free and penalty-free withdrawal of earnings, including earnings on converted amounts, a Roth account must meet a five-year holding period beginning January 1 of the year your first Roth account was opened, and the withdrawal must take place after age 59½ or meet an IRS exception. If you have had a Roth IRA for some time, this may not be an issue, but it could come into play if you open your first Roth IRA for the conversion.
Assets converted to a Roth IRA can be withdrawn free of ordinary income tax at any time, because you paid taxes at the time of the conversion. However, a 10% penalty may apply if you withdraw the assets before the end of a different five-year period, which begins January 1 of the year of each conversion, unless you are age 59½ or another exception applies.
Roth account are not subject to Required Minimum Distributions (RMD)
Roth IRAs are not required to minimum distributions. Distributions are tax-free to the original owner of the Roth IRA and spouse beneficiaries who treat a Roth IRA as their own. Other beneficiaries inheriting a Roth IRA are subject to the RMD rules. The longer your investments can pursue growth, the more advantageous it may be for you and your beneficiaries to have tax-free income.
There are many considerations and assumption in determining if a Roth Conversion is appropriate for anyone. The above is not intended as a complete discussion of the subject. A trusted advisor should be consulted to see if a conversion should be considered .
All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy will be successful.
Turmoil and the Bear Market
Where we go from here is unknown. There have been many times the stock market and the economy have recovered from worse. The following is intended to be a general discussion. How to proceed will depend on each person’s circumstances (it depends). There are numerous technical issues not included in this discussion.
During the intensely volatile first 100 trading days of 2022, the Stocks of companies in the S&P 500 index delivered their worst performance since 1970 .1 The S&P 500 continued to tumble, and the benchmark index descended into a bear market — typically defined as a sustained drop in stock prices of at least 20% — on June 13, 2022. When the market closed, the S&P 500 had dropped 21.8% from its January 3 peak, and the tech-heavy NASDAQ, already in bear territory, had plunged 32.7% from its November 19, 2021 peak.2
Some investors who are nervous about the future and their portfolios seem to have taken a defensive stance by selling riskier assets, including investments in growth-oriented technology stocks.
What’s causing market volatility?
Throughout 2021, U.S. businesses dealt with unpredictable demand shifts and supply shocks related to the pandemic, but near-zero interest rates and trillions of dollars in pandemic relief supported consumer spending, boosted economic growth, and drove record corporate profits. Companies in the S&P 500 posted profits in 2021 that were 70% higher than in 2020 and 33% higher than in 2019, which helped fuel a stock market total return of nearly 29%.3-4
But in the first months of 2022, investors began to worry that the anticipated tightening of monetary policies by the Federal Reserve — intended to cool off stubbornly high inflation — would stifle economic growth and cause a recession. Prices began rising in the spring of 2021 due to high demand, supply-chain issues, and a labor shortage that pushed up wages. Inflation picked up speed in the first quarter of 2022 when China’s COVID-19 lockdowns impacted the supply of goods, and Russia’s invasion of Ukraine sent already high global food and fuel prices through the roof. In May 2022, the Consumer Price Index rose at an annual rate of 8.6%, a 40-year high.5
The relentless acceleration of price increases puts pressure on the Federal Open Market Committee (FOMC), which meets on June 15 and 16, to act aggressively to tame inflation. At the beginning of May, the FOMC raised the benchmark federal funds rate by 0.5% (to a range of 0.75%–1.00%). This was the first half-percent increase since May 2000, and Fed projections suggest there will be more to come.6
Rising interest rates push bond yields upward, and the opportunity for higher returns from lower-risk bond investments makes higher-risk stock investments less attractive. Moreover, stock investors are buying a portion of a company’s future cash flows, which become less valuable in an inflationary environment. Higher borrowing costs can also crimp consumers’ spending power and cut into the profits of companies that rely on debt.
The problem with one sector dominating the market
Stocks tracked by the S&P Information Technology Sector Index, which fell 29.2% from a January 3 high, have been hit harder than the S&P 500. Plus, like many benchmark indexes, the S&P 500 is weighted by market capitalization (the value of a company’s outstanding shares). This gives the largest companies, most of which are in the tech sector, an outsized role in index performance. As of May 31, the information technology sector still accounted for 27.1% of the market cap of the S&P 500, compared with weightings of 14.4% for health care and 11.2% for financials, the next-largest sectors. Apple, Microsoft, Alphabet, and Amazon, respectively, are the four most-valuable companies in the index; Nvidia is ranked ninth and Meta has fallen to number 11.7
For the past several years, tech stock gains drove the market to new heights, but when their share values began to plunge, they dragged the broader stock indexes down with them. A Wall Street Journal analysis of market data through May 17 found that just eight of the largest U.S. companies — the six previously mentioned, plus Netflix and Tesla (in the consumer discretionary sector) — were responsible for an astounding 46% of the S&P 500’s 2022 losses (on a total return basis).8
These well-known technology companies have grown into massive multinational businesses that have a major influence on everyday life. Some dominate their respective business spaces — social media, smartphones, online search and advertising, e-commerce, and cloud computing — enough to spark antitrust investigations and calls for stricter regulations in the United States and abroad. They also have plenty of cash on hand, which means they may be in better shape to withstand an economic slowdown than their smaller competitors.9
Takeaways
Spreading investments among the 11 sectors of the S&P 500 is a common way to diversify stock holdings. But over time, a stock portfolio that was once diversified can become overconcentrated in a sector that has outperformed the broader market. Tech-sector stocks notched huge total returns of about 50% in 2019, 44% in 2020, and 35% in 2021, so you may want to look closely at the composition of your portfolio and consider rebalancing if you find yourself overexposed to this highly volatile sector. (Rebalancing involves selling some investments to buy others. Keep in mind that selling investments in a taxable account could result in a tax liability.) 10
If you feel shell-shocked after more than five months of market turbulence, try to regain some perspective. Some market analysts view recent price declines as a painful but long overdue repricing of stocks with valuations that had grown excessive, as well as a reality check brought on by waning growth expectations. The forward price-to-earnings (P/E) ratio of companies in the S&P 500 has fallen from 23.3 at the end of 2021 to 17.8 in May 2022, much closer to the 10-year average of 16.9.11-12
It could be a while before investors can better assess how the economy and corporate profits will ultimately fare against fast-rising inflation and higher borrowing costs — and the stock market is no fan of uncertainty. Disappointing economic data and company earnings reports could continue to spark volatility in the coming months.
It may not be easy to take troubling headlines in stride, but if you have a sufficiently diversified, all-weather investment strategy, sticking to it is often the wisest course of action. If you panic and flee the market during a downturn, you won’t be able to benefit from upward swings on its better days. And if you continue investing regularly for a long-term goal such as retirement, a down market may be an opportunity to buy more shares at lower prices.
The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Investments seeking a higher return tend to involve greater risk. Diversification is a method used to help manage risk. It does not guarantee a profit or protect against investment loss. The S&P 500 is an unmanaged group of securities that is considered representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is not a guarantee of future results. Actual results will vary. Dollar-cost averaging does not ensure a profit or prevent a loss. Such plans involve continuous investments in securities regardless of fluctuating prices. You should consider your financial ability to continue making purchases during periods of low and high price levels. However, this can be an effective way for investors to accumulate shares to help meet long-term goals.
1) SIFMA, 2022
2) Yahoo! Finance, 2022
3) The New York Times, May 31, 2022
4, 7, 10-11) S&P Dow Jones Indices, 2022
5) U.S. Bureau of Labor Statistics, 2022
6) Federal Reserve, 2022
8) The Wall Street Journal, May 19, 2022
9) The New York Times, May 20, 2022
12) FactSet, 2022
For the past several years, tech stock gains drove the market to new heights, but when their share values began to plunge, they dragged the broader stock indexes
The Question is How Long High Inflation Will Last?
at an annual rate of 8.5% in March 2022. That is the highest level since December 1981.1 A Gallup poll at the end of March found that one out of six Americans considers inflation to be the most important problem facing the United States.2 The Consumer Price Index for All Urban Consumers (CPI-U), the most common measure of inflation, rose
Many economists, including policymakers at the Federal Reserve, believed the increase would be transitory and subside over a period of months when inflation began rising in the spring of 2021. Inflation has proven to be more stubborn than expected. There are many reasons for the rising prices. The Fed has a plan to deal with the situation.
Russia and China contributed to the situation.
Among the cause of rising inflation are the growing pains of a rapidly opening economy, pent-up consumer demand, supply-chain slowdowns, and not enough workers to fill open jobs. Significant government stimulus and the Federal Reserve monetary policies helped prevent a deeper recession but contributed to an increase in inflation.
Russian invasion of Ukraine increased the already high global fuel and food prices.3 China’s response to the reappearance of COVID’s was strict lockdowns, which closed factories and increased already struggling supply chains for Chinese goods. The volume of cargo handled by the port of Shanghai, the world’s busiest port, dropped by an estimated 40% in early April.4
Behind the Headlines
8.5% year-over-year “headline” inflation in March was high. However, monthly numbers provide a clearer picture of the current trend. The month-over-month increase of 1.2% was extremely high, but more than half of it was due to gasoline prices, which rose 18.3% in March alone.5 Despite the Russia-Ukraine conflict and increased seasonal demand, U.S. gas prices dropped in April, but the trend was moving upward by the end of the month.6 The federal government’s decision to release one million barrels of oil per day from the Strategic Petroleum Reserve for the next six months and allow summer sales of higher-ethanol gasoline may help moderate prices.7
Core inflation, which strips out volatile food and energy prices, rose 6.5% year-over-year in March, the highest rate since 1982. However, the month-over-month increase from February to March was just 0.3%, the slowest pace in six months. Another positive sign was the price of used cars and trucks, which rose more than 35% over the last 12 months (a prime driver of general inflation) but dropped 3.8% in March.8
Wages and Consumer Demand
For the 12 months ended in March, average hourly earnings increased 5.6%. This was not enough to keep up with inflation, although it was enough to dulled some of the effects. Lower-paid service workers received higher increases, with wages jumping by almost 15% for nonmanagement employees in the leisure and hospitality industry. Although inflation has cut deeply into wage gains over the last year, wages have increased at about the same rate as inflation over the two-year period of the pandemic.9
One of the big questions going forward is whether rising wages will enable consumers to continue to pay higher prices, which can lead to an inflationary spiral of ever-increasing wages and prices. Recent signals are mixed. The official measure of consumer spending increased 1.1% in March, but an early April poll found that two out of three Americans had cut back on spending due to inflation.10-11
Soft or Hard Landing?
The Federal Open Market Committee (FOMC) of the Federal Reserve has laid out a plan to fight inflation by raising interest rates and tightening the money supply. After dropping the benchmark federal funds rate to near zero in order to stimulate the economy at the onset of the pandemic, the FOMC raised the rate by 0.25% at its March 2022 meeting and projected the equivalent of six more quarter-percent increases by the end of the year and three or four more in 2024.12 This would bring the rate to around 2.75%, just above what the FOMC considers a “neutral rate” that will neither stimulate nor restrain the economy.13
These moves were projected to bring the Fed’s preferred measure of inflation, the Personal Consumption Expenditures (PCE) Price Index, down to 4.3% by the end of 2022, 2.7% by the end of 2023, and 2.3% by the end of 2024.14 PCE inflation was 6.6% in March. this tends to run below CPI, so even if the Fed achieves these goals, CPI inflation will likely remain somewhat higher.15
Fed policymakers have signaled a willingness to be more aggressive, if necessary, and the FOMC raised the funds rate by 0.5% at its May meeting, as opposed to the more common 0.25% increase. This was the first half-percent increase since May 2000, and there may be more to come. The FOMC also began reducing the Fed’s bond holdings to tighten the money supply. New projections to be released in June will provide an updated picture of the Fed’s intentions for the federal funds rate.16
The question facing the FOMC is how fast it can raise interest rates and tighten the money supply while maintaining optimal employment and economic growth. The ideal is a “soft landing,” like what occurred in the 1990s, when inflation was tamed without damaging the economy. At the other extreme is the “hard landing” of the early 1980s, when the Fed raised the funds rate to almost 20% to control runaway double-digit inflation, throwing the economy into a recession.18
Fed Chair Jerome Powell acknowledges that a soft landing will be difficult to achieve, but he believes the strong job market may help the economy withstand aggressive monetary policies. Supply chains are expected to improve over time, and workers who have not yet returned to the labor force might fill open jobs without increasing wage and price pressures.19
The next few months will be a key period to reveal the future direction of inflation and monetary policy. The hope is that March represented the peak and inflation will begin to trend downward. But even if that proves to be true, it could be a painfully slow descent.
Projections are based on current conditions, are subject to change, and may not happen.
1, 5, 8-9) U.S. Bureau of Labor Statistics, 2022
2) Gallup, March 29, 2022
3, 7) The New York Times, April 12, 2022
4) CNBC, April 7, 2022
6) AAA, April 25 & 29, 2022
10, 15) U.S. Bureau of Economic Analysis, 2022
11) CBS News, April 11, 2022
12, 14, 16) Federal Reserve, 2022
13, 17) The Wall Street Journal, April 18, 2022
18) The New York Times, March 21, 2022
Managing Bond Risks When Interest Rates Rise
After dropping the benchmark federal funds rate to a rock-bottom range of 0%–0.25% early in the pandemic, the Federal Open Market Committee has begun raising the rate toward more typical historical levels in response to high inflation. At its March 2022 meeting, the Committee raised the funds rate to 0.25%–0.50% and projected the equivalent of six more quarter-percentage-point increases in 2022 and three or four more in 2023.1
Raising the federal funds rate places upward pressure on a wide range of interest rates, including the cost of borrowing through bond issues. Regardless of the rate environment, however, bonds are a mainstay for investors who want to generate income or dampen the effects of stock market volatility on their portfolios. You may have questions about how higher rates could affect your fixed-income investments and what you can do to help mitigate the effect in your portfolio.
Rate sensitivity
When interest rates rise, the value of existing bonds typically falls, because investors would prefer to buy new bonds with higher yields. In a rising rate environment, investors may be hesitant to tie up funds for a lengthy period, so bonds with longer maturity dates are generally more sensitive to rate changes than shorter-dated bonds. Thus, one way to address interest-rate sensitivity in your portfolio is to hold short- and medium-term bonds. However, keep in mind that although these bonds may be less sensitive to rate changes, they will generally offer a lower yield than longer-term bonds.
A more specific measure of interest-rate sensitivity is called duration. A bond’s duration is derived from a complex calculation that includes the maturity date, the present value of principal and interest to be received in the future, and other factors. To estimate the impact of a rate change on a bond investment, multiply the duration by the expected percentage change in interest rates. For example, if interest rates rise by 1%, a bond or bond fund with a three-year duration might be expected to lose roughly 3% in value; one with a seven-year duration might fall by about 7%. Your investment professional or brokerage firm can provide information about the duration of your bond investments.
If two bonds have the same maturity, the bond with the higher yield will typically have a shorter duration. For this reason, U.S. Treasuries tend to be more rate sensitive than corporate bonds of similar maturities. Treasury securities, which are backed by the federal government as to the timely payment of principal and interest, are considered lower risk and thus can pay lower rates of interest than corporate bonds. A five-year Treasury bond has a duration of less than five years, reflecting income payments received prior to maturity. However, a five-year corporate bond with a higher yield has an even shorter duration.
When a bond is held to maturity, the bond owner would receive the face value and interest, unless the issuer defaults. However, bonds redeemed prior to maturity may be worth more or less than their original value. Thus, rising interest rates should not affect the return on a bond you hold to maturity, but may affect the price of a bond you want to sell on the secondary market before it reaches maturity.
Bond ladders
Owning a diversified mix of bond types and maturities can help reduce the level of risk in the fixed-income portion of your portfolio. One structured way to take this risk management approach is to construct a bond ladder, a portfolio of bonds with maturities that are spaced at regular intervals over a certain number of years. For example, a five-year ladder might have 20% of the bonds mature each year.
Bond ladders may vary in size and structure, and could include several types of bonds depending on an investor’s time horizon, risk tolerance, and goals. As bonds in the lowest rung of the ladder mature, the funds are often reinvested at the long end of the ladder. By doing so, investors may be able to increase their cash flow by capturing higher yields on new issues. A ladder might also be part of a withdrawal strategy in which the returned principal from maturing bonds provides retirement income.
In the current situation, with rates projected to rise over a two- to three-year period, it might make sense to create a short bond ladder now and a longer ladder when rates appear to have stabilized. Keep in mind that the anticipated path of the federal funds rate is only a projection, based on current conditions, and may not happen. The actual direction of interest rates might change.
Laddering ETFs and UITs
Building a ladder with individual bonds provides certainty if the bonds are held to maturity, but it can be expensive. Individual bonds typically require a minimum purchase of at least $5,000 in face value, so creating a diversified bond ladder might require a sizable investment. Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss.
A similar approach involves laddering bond exchange-traded funds (ETFs) that have defined maturity dates. These funds, typically called target-maturity funds, generally hold many bonds that mature in the same year the ETF will liquidate and return assets to shareholders. Target maturity ETFs may enhance diversification and provide liquidity, but unlike individual bonds, the income payments and final distribution rate are not fully predictable.
Another option is to purchase unit investment trusts (UITs) with staggered termination dates. Bond-based UITs typically hold a varied portfolio of bonds with maturity dates that coincide with the trust termination date, at which point you could reinvest the proceeds as you wish. The UIT sponsor may offer investors the opportunity to roll over the proceeds to a new UIT, which typically incurs an additional sales charge.
Bond funds
Bond funds — mutual funds and ETFs composed mostly of bonds and other debt instruments — are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds. Thus, falling bond prices due to rising rates can adversely affect a bond fund’s performance. Because longer-term bonds are generally more sensitive to rising rates, funds that hold short- or medium-term bonds may be more stable as rates increase.
Bond funds do not have set maturity dates (except for the target maturity ETFs discussed above), because they typically hold bonds with varying maturities, and they can buy and sell bonds before they mature. So, you might consider the fund’s duration, which considers the durations of the underlying bonds. The longer the duration, the more sensitive a fund is to changes in interest rates. You can usually find duration with other information about a bond fund. Although helpful as a general guideline, duration is best used when comparing funds with similar types of underlying bonds.
A fund’s sensitivity to interest rates is only one aspect of its value — fund performance can be driven by a variety of dynamics in the market and the broader economy. Moreover, as underlying bonds mature and are replaced by higher-yielding bonds in a rising interest rate environment, the fund’s yield and/or share value could potentially increase over the long term. Even in the short term, interest paid by the fund could help moderate any losses in share value.
It’s also important to remember that fund managers might respond differently if falling bond prices adversely affect a fund’s performance. Some might try to preserve the fund’s asset value at the expense of its yield by reducing interest payments. Others might emphasize preserving a fund’s yield at the expense of its asset value by investing in bonds of longer duration or lower credit quality that pay higher interest but carry greater risk. Information on a fund’s management, objectives, and flexibility in meeting those objectives is spelled out in the prospectus and may be available with other fund information online.
The return and principal value of individual bonds, UIT units, and mutual fund and ETF shares fluctuate with changes in market conditions. Fund shares and UIT units, when sold, and bonds redeemed prior to maturity may be worth more or less than their original cost. ETFs typically have lower expense ratios than mutual funds, but you may pay a brokerage commission whenever you buy or sell ETFs, so your overall costs could be higher, especially if you trade frequently. Supply and demand for ETF shares may cause them to trade at a premium or a discount relative to the value of the underlying shares. UITs may carry additional risks, including the potential for a downturn in the financial condition of the issuers of the underlying securities. There may be tax consequences associated with the termination of the UIT and rolling over an investment into a successive UIT. There is no assurance that collaborating with a financial professional will improve investment results.
1) Federal Reserve, March 16, 2022
What Do Rising Interest Rates Mean for You?
On March 16, 2022, the Federal Open Market Committee (FOMC) of the Federal Reserve raised the benchmark federal funds rate by 0.25% to a target range of 0.25% to 0.50%. This is the beginning of a series of increases that the FOMC expects to conduct over the next two years to combat high inflation.1
The FOMC released economic projections that suggest the equivalent of six additional 0.25% increases in 2022, followed by three or four more increases in 2023 when it announced the current increase, 2 These are only projections, based on current conditions, and may not happen. However, they provide a helpful picture of the potential direction of U.S. interest rates.
What is the federal funds rate?
The federal funds rate is the interest rate at which banks lend funds to each other overnight to maintain legally required reserves within the Federal Reserve System. The FOMC sets a target range, usually a 0.25% spread, and then sets two specific rates that function as a floor and a ceiling to push the funds rate into that target range. The rate may vary slightly from day to day, but it generally stays within the target range.
Although the federal funds rate is an internal rate within the Federal Reserve System, it serves as a benchmark for many short-term rates set by banks and can influence longer-term rates as well.
Why does the Fed adjust the federal funds rate?
The Federal Reserve and the FOMC operate under a dual mandate to conduct monetary policies that foster maximum employment and price stability. Adjusting the federal funds rate is the Fed’s primary tool to influence economic growth and inflation.
The FOMC lowers the federal funds rate to stimulate the economy by making it easier for businesses and consumers to borrow, and raises the rate to combat inflation by making borrowing more expensive. In March 2020, when the U.S. economy was devastated by the pandemic, the Committee quickly dropped the rate to its rock-bottom level of 0.00%–0.25% and has kept it there for two years as the economy recovered.
The FOMC has set a 2% annual inflation goal as consistent with healthy economic growth. The Committee considered it appropriate for inflation to run above 2% for some time to balance the extended period when it ran below 2% and give the economy more time to grow in a low-rate environment. However, the steadily increasing inflation levels over the last year — with no sign of easing — have forced the Fed to change course and tighten monetary policy.
How will consumer interest rates be affected?
The prime rate, which commercial banks charge their best customers, is tied directly to the federal funds rate, and generally runs about 3% above it. Though actual rates can vary widely, small-business loans, adjustable-rate mortgages, home-equity lines of credit, auto loans, credit cards, and other forms of consumer credit are often linked to the prime rate, so the rates on these types of loans typically increase with the federal funds rate. Fixed-rate home mortgages are not tied directly to the federal funds rate or the prime rate. Although Fed rate hikes may put upward pressure on new mortgage rates.
Rising interest rates make it more expensive for consumers and businesses to borrow. Although, retirees and others who seek income could eventually benefit from higher yields on savings accounts and certificates of deposit (CDs). Banks typically raise rates charged on loans more quickly than they raise rates paid on deposits, but an extended series of rate increases should filter down to savers over time.
What about bond investments?
Interest-rate changes can have a broad effect on investments, but the impact tends to be more pronounced in the short term as markets adjust to the new level.
When interest rates rise, the value of existing bonds typically falls. Put simply, investors would prefer a newer bond paying a higher interest rate than an existing bond paying a lower rate. Longer-term bonds tend to fluctuate more than those with shorter maturities because investors may be reluctant to tie up their money for an extended period if they anticipate higher yields in the future.
Bonds redeemed prior to maturity may be worth more or less than their original value, but when a bond is held to maturity, the bond owner would receive the face value and interest, unless the issuer defaults. Thus, rising interest rates should not affect the return on a bond you hold to maturity, but may affect the price of a bond you want to sell on the secondary market before it reaches maturity.
Although the rising-rate environment may have a negative impact on bonds you currently hold and want to sell, it might also offer more appealing rates for future bond purchases.
Bond funds are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds. Thus, falling bond values due to rising rates can adversely affect a bond fund’s performance. However, as underlying bonds mature and are replaced by higher-yielding bonds within a rising interest-rate environment, the fund’s yield and/or share value could potentially increase over the long term.
How will the stock market react?
Equities may also be affected by rising rates, though not as directly as bonds. Stock prices are closely tied to earnings growth, so many corporations stand to benefit from a more robust economy, even with higher interest rates. On the other hand, companies that rely on heavy borrowing will likely face higher costs going forward, which could affect their bottom lines.
The stock market reacted positively to the initial rate hike and the projected path forward, but investors will be watching closely to see how the economy performs as interest rates adjust — and whether the increases are working to tame inflation.3
The market may continue to react, positively or negatively, to the government’s inflation reports or the Fed’s interest-rate decisions, but any reaction is typically temporary. As always, it’s important to maintain a long-term perspective and make sound investment decisions based on your own financial goals, time horizon, and risk tolerance.
The FDIC insures CDs and bank savings accounts, which generally provide a fixed rate of return, up to $250,000 per depositor, per insured institution. The return and principal value of stocks and investment funds fluctuate with market conditions. Shares, when sold, may be worth more or less than their original cost. Investments offering the potential for higher rates of return also involve higher risk.
Investment funds are sold by prospectus. Please consider the fund’s objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
1–2) Federal Reserve, March 16, 2022
3) The Wall Street Journal, March 17, 2022
