This Week in Review:

Focus on Data, Not D.C. Drama

Continued recession concerns and Washington rancor drive mood swings on Wall Street.

Polaris Investment Team | www.polariswealth.com

THIS WEEK:

While continued recession concerns and their potential impact on corporate earnings prompted a mood swing on Wall Street Wednesday, on Thursday the debt-ceiling drama in a divided Washington made headlines yet again.

We have more to say about that below, but here’s what else we’ve been watching this week and why:

Good news on the inflation front: Prices paid by suppliers in December rose at the slowest annual pace since March 2021. With last week’s headline consumer inflation number coming in at 6.5%, though, we’re still far from the Federal Reserve’s 2% inflation target, and we expect central bankers to raise interest rates again (albeit by just 0.25% this time) at their next meeting in two weeks.
Additionally, wage pressures (which can lead to higher prices) are showing possible signs of retreat. According to job website Indeed, positions promising a signing bonus recently fell to 5.1%, down from 5.6% in August.
The Fed’s “Beige Book,” a collection of anecdotal reports from around the country, supports the notion that inflation is slowing: Supply chain disruptions are being ironed out in the manufacturing sector, and housing sales and construction both continue to decline nationwide.
And there may be a light at the end of the tunnel for a housing market crushed by aggressive Fed rate hikes. Mortgage rates have fallen a bit, and according to a survey released this week, homebuilders’ confidence rose in January for the first time in 12 months, a hopeful sign that we may have reached a low point in permits and housing starts.

Chart of the Week: Can Foreign Currency Changes Boost Investment Returns?

Foreign stocks are off to a roaring start in 2023, continuing momentum built during last year’s final weeks. Over the past three months, the MSCI All-Country World ex-U.S. Index, a measure of non-U.S. shares, has returned nearly 21%. By contrast the S&P 500 has gained about 9%.

Wall Street has noticed: A recent Reuters poll of portfolio managers who oversee global strategies found that six out of 10 overweight foreign investments compared to their U.S. counterparts—the highest percentage since 2005.

After a decade of underperformance, is the stage being set for a sustained rally in overseas markets? We think so—in part because a weakening dollar is making foreign stocks more attractive than they’ve been in quite a long time.

Why is the dollar such an important factor in foreign stock performance? When the dollar is strengthening, American investors tend to keep their capital at home because investing overseas will likely lead to losses in currency exchanges. While the dollar will buy more euros or francs or pounds when investing, if it continues to rise, translating those foreign currencies back into dollars will yield less when foreign investments are sold.

To be clear, currency exchange rates are far from the only factor driving the relative performance of U.S. and foreign markets. But the currency issue is certainly a tailwind. The greater the dollar’s value relative to other currencies, the less attractive foreign stock holdings are for U.S. investors. The opposite is true when the U.S. dollar is weakening against other currencies—and that’s just what’s happening now.

Our chart of the week helps demonstrate the relationship. The blue line charts the relative performance of foreign stocks vs. U.S. stocks. When the line is rising, U.S. shares are performing better. The opposite is true when the line is dropping. You can see that the pink line, representing the U.S. Dollar Index, moves in near correlation. Over the past 25-plus years, a clear relationship has developed: As the dollar rises, U.S. markets outperform, indicated by the rising blue line. In periods of dollar weakness, we can also observe the inverse—foreign stocks begin to outpace their counterparts.

The Debt Ceiling Dilemma...

By Research Analyst Jen Yousif

The din from the debt-ceiling debate is almost deafening, and it’s likely to get worse. Though the reality may not seem quite so bad when you understand the nuances.

The U.S. government has two primary sources of money to meet its spending obligations: Taxes and sales of bonds like Treasurys (issuing debt). But it can only issue so much debt before it hits the debt ceiling, a limit imposed by Congress. Congress also controls how much the government spends. When our obligations outpace the money raised from taxes and bond issuance, something must give. Unfortunately, in today’s very partisan government, no one wants to blink first.

And so here we are, once again hitting the limit on borrowing. But there’s a caveat that keeps getting lost: The government can likely maintain enough wiggle room to meet its obligations until sometime this summer by using financial chicanery the Treasury Department describes as “extraordinary measures.” If that sounds familiar, well, yes, we’ve been here before.

When the debt ceiling comes into view, Congress is called upon to raise the debt limit, and it has always ultimately done so. Since 1960, Congress has raised, extended or refined the definition of the debt limit 78 times—49 times under a Republican administration and 29 times under Democrats.

So why all the handwringing now?

The debt ceiling is being leveraged as a bargaining chip between the two major parties. Republicans want to secure spending cuts before agreeing to raise the debt ceiling, while Democrats prefer the limit be raised without major spending concessions. If an agreement is not reached, there’s a fear that the U.S. will be unable to pay interest on its bonds sometime in the second half of the year and hence default.

Amid the rhetoric and finger-pointing, it should be acknowledged that both Democrats and Republicans have been responsible for the tax cuts and budget hikes that got us where we are today. Neither party is innocent in this debate.

But the result of a continued standoff could be disastrous. A first-ever U.S. default would shake investor confidence in what has been one of the safest securities in the world and “cause irreparable harm to the U.S. economy,” according to Treasury Secretary Janet Yellen.

I do not see that occurring.

In 2011, the debt-ceiling drama resulted in a political standoff on the floor of Congress and an eventual ratings downgrade of U.S. Treasurys by Standard & Poor’s, from AAA to AA. In my mind, that’s likely the very worst case we’re up against today—a possible downgrade as opposed to a default. The headlines are eye-catching, but the government always ends up increasing the debt ceiling.

Odds are high that it will come down to the wire before one side blinks. Bargaining chip or not, leaders in both parties have historically recognized that raising the debt ceiling is a necessity.

…and a Potential Government Shutdown

By Portfolio Manager Jeff DeMaso

If concessions can’t be made in the near term to raise the debt limit, we could see a potential government shutdown later in the year, wherein federal agencies are forced to cease all nonessential functions.

A government shutdown is nothing new and isn’t necessarily bad for the stock market. The government most recently shut down for 35 days—the longest pause in operations in history—starting in December 2018. Over those 35 days, the S&P 500 returned 10%.

Since the mid-1970s, the government has shut down 20 times. The S&P 500 was positive during half of the shutdowns. The index was flat on average during shutdowns—returning 0.04%. (Exclude the big 10% return during the 2018–2019 shutdown and the S&P fell 0.5% on average.)

Although unlikely, a U.S. government default could have far-reaching implications. But a government shutdown is less harmful to portfolios. Don’t let it deter you from your long-term financial plan.

What Secure 2.0 Missed

By Wealth Adviser Diana Linn

There’s been mega media attention surrounding the Secure Act. And why not? Between the original Secure Act of 2019 and the so-called 2.0 provisions, the rules usher in some major updates to the U.S. retirement system.

Perhaps just as notable are the measures that didn’t make the cut this round. While Secure 2.0 contains over 100 modifications, none rise to the level of its predecessor, and many changes will be phased in slowly. Here are the top items I expected to see in Secure 2.0 that were omitted.

No new limitations on Roth IRAs. Rumors that backdoor and mega backdoor Roth IRAs are slated for the chopping block have been circling for quite some time, yet they evaded elimination once again. This means that even high-income earners can continue to receive the tax-free benefits of a Roth IRA. Likewise, there were no new limits placed on who can make routine Roth conversions. And with required minimum distributions (RMDs) being pushed back to age 75 over the next decade, this may present an opportunity to grow your money tax-free for longer.

In some ways, Secure 2.0 expanded access to Roth IRAs by allowing unused funds from qualified college savings plans (529 accounts) to be transferred to a Roth IRA free of tax or penalties if certain conditions are met.

Qualified charitable contributions remain unchanged. I thought the age requirements for making qualified charitable contributions would change, but we dodged that one, too. This means gifts to eligible charities made directly from a retirement account don’t count as taxable income beginning at age 70½. No change.

No additional guidance on the 10-year rule. The biggest Secure Act surprise, in my opinion, was the lack of clarifying language surrounding the 10-year inheritance rule for noneligible designated beneficiaries.

Here’s what we know: The Secure Act of 2019 put an end to the stretch IRA, whereby individual retirement accounts could be passed along from one generation to the next, growing tax-free. Instead, the 2019 bill implemented a 10-year rule requiring the entire IRA account to be disbursed by the end of the 10th year following the original IRA owner’s death. More recently, the IRS said it was waiving penalties on missed 2021 and 2022 required payouts within the 10-year window. And it left it at that.

Unfortunately, Secure 2.0 doesn’t provide additional clarification. We’ll be on the lookout for clear guidance on the 10-year rule. In the meantime, contact your wealth management team with specific questions or to discuss your distribution strategy within the context of your overall financial plan—we’re here to help!

Looking Ahead

Next week brings useful reads on leading economic indicators, manufacturing and the service sector, durable goods orders, new and pending home sales, consumer sentiment, income and spending, and the first estimate of fourth-quarter 2022 GDP.

If you’d like to learn more about our tactical or fundamental strategies, please contact our team at 800-268-9046 or info@polariswealth.com.

Please note: This update was prepared on Friday, January 20, 2022, prior to the market’s close.

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