Excerpts from November 2023 Letter

Matthew Costa, CPA, CFP®, MAcc

The introduction of the SECURE 2.0 Act marks a significant step forward in retirement planning for individuals and financial incentives for businesses. This legislation builds upon the foundations laid by the original SECURE Act.

Economic Update

As we approach the end of the year, it's an opportune time to reflect on the complex financial landscape that has evolved throughout 2023. This year has been marked by a series of contrasting economic signals—each carrying its own weight of opportunity and risk. From rising unemployment rates suggesting a possible slowing economy to technological innovations offering unprecedented growth potential, the pendulum of economic prospects has been in constant motion. As your trusted advisor, my mission is to help you navigate these turbulent waters with informed decisions. In this letter, I will delve into both the cautionary indicators and the promising trends.

Reasons to be Negative

  1. The Rising Unemployment Rate

The unemployment rate is announced on the first Friday of every month.  For September 2023, this flashed one of the first convincing slowdown signals of the year by crossing above its one-year moving average at 3.8%. The rate is now at 3.9% as of the start of November.  If the rate goes above the three-year moving average (which it is trending to do), then the risk of a recession increases.

The so-called “Sahm Rule,” another reliable recession indicator, has broken through. The rule, hatched by former Federal Reserve economist and now Bloomberg columnist Claudia Sahm, posits the start of a recession when the three-month moving average of the unemployment rate rises by a half-percentage point or more relative to its low during the previous 12 months.  The low for joblessness so far this year was 3.4%. October’s rate of 3.9% was the highest so far this year, following two readings at 3.8% in August and September. Hence, the Sahm Rule suggests current unemployment indicates a likely recession.

It should be noted, the unemployment rate rising is exactly according to plan.  The Federal Reserve’s interest rate hikes starting in 2022 have the intention of slowing down inflation by slowing the economy.  A tightening of credit and an increase in the unemployment rate is an expected, and frankly desired, secondary effect. It sounds callous (and perhaps it is), but the FED wants some unemployment as it helps secure the purchasing power of the dollar.  Their primary goal is controlling the inflation rate, while their secondary goal is to maintain a healthy job market.

  1. The Debt Situation

I will not use this letter to rehash some of the long-term debt issues.  If you have not yet read, please review my May 2023 letter and recent October 2023 Debt & Inflation Update.

One of the reasons the economy has been so good on paper this year is because the deficit has been so large.  If we all agree that GDP is about $26.5 trillion and that the U.S. government borrowed and infused another $1.3 trillion into the economy, then we can also all agree that we ran a deficit of about 5% of GDP.  If we were not running such a deficit to spur the economy, would the economy actually be contracting in a recession?  I think the answer is unfortunately yes.

  1. What if Interest Rates Continue to Rise?

There has been an overall decline in interest rates over the past 40 years. Most of us have only ever known a secular declining rate environment. What are the differences and unforeseen hurdles in a rising rate environment that people are discounting?

Borrowing is tough for individuals and businesses right now.  Approaching things from a business standpoint, the average rate for a small business to borrow is about 9% now vs. 4.5% two years ago.  This doubling, and potentially further increases, will further reduce business profits, reduce start-ups and innovation, and possibly other unforeseen consequences.

The residential real estate market is somewhat frozen now because of these interest rate moves.  The average rate on a new 30-year mortgage is now above 8%, or approximately 200% up from the 2021 lows.  Few people are going to give up a sub-3% mortgage in exchange for a greater-than-8% mortgage.  This means few are selling, and few can afford to buy.  In regards to affording to buy, here is a simple illustration of a $500,000 mortgage.

3% 30-Year – monthly payment of $2,108

8% 30-Year – monthly payment of $3,677

An extra $1,500 a month is no easy feat to manage for a borrower.  Over the long-term, this will naturally put negative pressure on home prices and lead to less savings for other investments.

Reasons to be Positive

  1. United States Economic Might
  • Reshoring

Reshoring manufacturing to the U.S., Mexico, and Canada is real.  Semiconductors are the foundation of modern life.  Samsung, the world’s largest semiconductor maker, announced it would build a $17 billion chip fabrication factory in Taylor, Texas.  For the last few decades, high-end semiconductors have been largely manufactured in Taiwan.  The increased tensions between China and Taiwan have led businesses operating in Taiwan to look elsewhere from fear of Chinese control in the future. Samsung is not alone; TSMC, Texas Instruments, and Intel are all reshoring their chip fabrication businesses as well.  Less skilled manufacturing is also growing immensely in some areas of the U.S. and Mexico.  It will be expensive to build out this productive capacity over the next few years, but, once the fixed-costs of production are incurred, it should lead to immense economic growth closer to home rather than the trajectory of the last 30 years of funding growth in Asia.

  • The Geography of the United States

The United States is the 4th largest country in the world by land mass with only China, Russia, and Canada being larger.  The difference is that the U.S. land quality is a lot more productive than the aforementioned larger countries.  A magical combination of geography also favors the United States over the rest of the world.

The Mississippi River System is the largest naturally navigable waterway in the world by far.  You can transport from Minnesota to the Gulf of Mexico all by water which is 10-30x cheaper than air, rail, or road.  The United States also has some of the best farmland in the world close to the Mississippi River and leads to the U.S. to be, by far, the world’s largest exporter of food.

U.S. Geography also leads to energy security.  The U.S. has abundant reserves of oil and natural gas and has the right land to be successful in wind and solar.  Countries like Germany may be well-ahead in terms of their solar setup, but Germany is not a sunny place like the American Southwest. The U.S. is well-positioned to leverage its own land for energy should the need arise, and it is well-suited to take advantage of progress in renewable energy.

The U.S. is capable of much more fluid production and distribution than in many other countries. Energy independence, food independence, natural navigable waterways and ports, and being surrounded by two oceans is tremendous for economic success and defense in turbulent times.

  1. Technology & Innovation

It feels almost cliché to mention artificial intelligence, but it is THAT impactful and relevant. It is a fairly well-known economic concept that prices fall to roughly the marginal cost of production over time.  What is the marginal cost of production of a line of code?  What is the marginal cost of production of a line of code created by other lines of code?

Manufacturing is another area robotics and AI can bolster the reshoring push.  All the ways this works could be its own blog post (it’s on my list), though it only leads to economic progress.  By now, we should not take for granted that AI is one of the biggest deflationary forces ever pondered.  The bigger questions will be societal reorganization and wealth transfers as technology inevitably impacts employability.

  1. The Debt Situation is Still Solvable

I am a CPA and we are naturally a financially conservative breed the is prone to react negatively to excess spending and borrowing.  The debt issue is solvable with some excess inflation, restructuring, and/or heightened growth that technology can bring.  The problem is that there is pain for those unprepared for volatility and not effectively managing cash flow and their portfolio.

Additional Thoughts on the “R” Word… Recession

The media likes to talk a lot about your 401(k) and recessions, but one point rarely gets made: the average return of the S&P 500 during a recession is still approximately +3.5%!

Yes, every recession will generate different returns, but history is the best partial guide we have.  The average returns ten years following a recession are over 250%. To that point, an investment plan should be created to capture market returns and not to avoid recessions.  Peter Lynch, the famous mutual fund manager, said (I’m paraphrasing) “People have lost more money trying to avoid market corrections than they have in actual market corrections.” He is obviously talking about the opportunity cost of not being in the market.

I’ve gotten a few questions in the last few months about if we should move to cash. Hopefully, this clears up my opinion on the matter. The ups and downs are the prerequisite for long-term returns, and long-term thinking should not concern itself greatly with shorter-term price fluctuations. The most important thing you can do is communicate with the Foundation Team as far in advance as possible for your cash flow needs. When we know you have a need of portfolio assets, we will adjust accordingly and allocate to the correct class of fixed income or money markets. We never want to be in a situation where you need to draw out 20% of your portfolio and you are over 80% invested in equities; that is the recipe to be selling assets at an inopportune time.

In summary, I could argue we are already in a recession, but that should not change long-term investment strategies. I look forward to meeting with all of you the next couple months to continue planning for the future and embracing the opportunities ahead of us.

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