| 4th Qtr.
| 12 Mo.
|10-yr Treas. yield||1.92%||1.675%||+0.245%||2.69%||-0.77%||-0.77%|
|Fed funds rate||1.5-1.75%||1.75-2.0%||-0.25%||2.0 – 2.25%||-0.75%||-0.75%|
(stock indices are before dividends; yield and rate changes are absolute changes)
It was, simply put, a great year to be an investor and the fourth quarter contributed across the board. The same large technology companies which have led the market for most of the decade boosted the US stock market to its best year since 2013. The overall technology sector was up over 47% for the year and all but one of the other sectors were up from 18% to 30%; energy was the laggard and was also positive at 7%. International stocks still lagged but their return of over 18%, with little currency benefit, was very welcome. With three interest rate cuts, the US investment grade bond market was up over 8.5%, high yield bonds jumped 14% and international bonds over 7.5%. Even gold had its best annual performance in a decade.
Trade tensions eased as both China and the US signaled that an initial agreement is near at hand. Boris Johnson, in something of a surprise, received a clear mandate to finally exit the EU, which could happen as soon as the end of January. The US trade deficit lessened slightly as the deficit with China fell but the EU increased, and oil trade was a surplus for the first time in 40 years. President Trump was impeached by the House, but the Senate trial is on hold and there is practically no chance he will be convicted, so the market has shrugged off any impact.
Consumer confidence remained strong, although expectations weakened in favor of strong present sentiment. The savings rate stayed relatively high at 7.9% as consumers did not spend all their increased wages, with earnings up 3.1% YOY, although retail sales were still up 2.9% from the prior year. All inflation measures are well within the Fed’s target range and services activity stayed strong. November job growth was quite strong, boosted by the end of the 40-day GM strike, and the labor participation rate hit a six-year high.
One area of concern is manufacturing, with some activity gauges slipping below the “expansion” level but staying well above “recession” level. Core business investment was volatile and increased only 0.7% YOY. Third quarter productivity fell for the first time in four years and was up only 2/3 of the long-term average for the prior year. All told, third quarter GDP was revised to an increase of 2.1% from an initial 1.9% and Social Security recipients will see a 1.6% increase in benefits for 2020.
After its third rate cut in October, which had two dissenting votes in favor of no cut, the Fed held rates steady in December and confirmed that its “current stance is appropriate to support expansion”. Consistent with continued economic growth, the Fed removed its “uncertainties” language and suggested it may not make changes in 2020 as long as the labor market stayed strong. The yield curve returned to a normal, albeit mostly flat, slope and the benchmark 10-year Treasury yield ended the year exactly where it started after adjusting for the three rate cuts.
It is tempting to get sucked into focusing on politics for the immediate future, such as impeachment, Brexit (still, because even though it looks like the uncertainty of Brexit is resolved, the exact method and implications are not) and the ongoing protests in many countries. And we could easily get bogged down in the 2020 Democratic primary and eventual general election but those will work themselves out. This is, after all, intended to be an economic and market review.
Let’s look instead at the housing market. Demand for new housing has been driven by low mortgage rates, low unemployment and wage growth, albeit sluggish. Affordability measures have improved slowly but steadily. Single-family housing starts rose for 10 straight months, housing permits hit a 12-year high and home builder confidence for single-family homes hit a 20-year high. For home builders, current sales, sales expectations and buyer traffic are all up. Median prices of new homes have not gone up dramatically as the tight supply might suggest, up 7.2% YOY, as builders try to meet demand for lower-priced homes.
At the same time, there are constraints such as availability of skilled labor and buildable land that are constricting supply. Supply of existing homes for sale is stuck around five months’ worth of sales and new homes are below six months. While younger workers are beginning to return to home ownership, many are willing to rent instead for the long term. Relocating workers have a positive ripple effect in housing as relocating workers sell their former house and buy another, but the mobility rate in 2019 fell below 10%, the lowest since World War II. In the boom housing decades of the 1950’s and 1960’s, the mobility rate was over 20%.
Perhaps most ominously, the pendulum of home building usually swings too wide, with overbuilding and overconfidence coming just before a slowdown. Institutional buyers are far more active in existing single-family homes than ever before, and how they will react if there is a slowdown is untested. The rate of increase in permits compared to new home sales has not diverged as dramatically as before prior slumps, so perhaps home builders will be able to better navigate the ups and downs of the economy and housing demand.
A new annual ritual will be to look back at the topics covered in the prior four “Looking Forward” sections.
• 4Q 2018 (January 2019) – Wage growth has lagged low unemployment, and sluggish wage growth has persisted through 2019 with only slight improvement.
• 1Q 2019 (April 2019) – The yield curve was flat in April and inverted in mid-May (the 3-month Treasury rate was higher than the 10-year rate). The inversion reached its steepest level in August, then reversed dramatically and was positive again by mid-October.
• 2Q 2019 (July 2019) – The US dollar continued to strengthen through mid-October against a basket of foreign currencies but then weakened through the year and ended up almost exactly where it was at the end of the second quarter.
• 3Q 2019 (October 2019) – The Fed cut rates a third time in October but signaled no further cuts unless there is clear evidence the economy has worsened.
S&P Dow Jones Indices issues a “Persistence Scorecard” twice a year which measures how actively manag
ed mutual funds perform compared to their peers over time. (Note that performance is measured against other actively managed funds with similar objectives, not against an index.) The Scorecard shows how funds that performed in the top 25% in one year performed in subsequent years.
Mark Hulbert of Hulbert Ratings points that purely random results would predict that each year, 25% of the strong-performing funds would land in the top 25% the next year, and so on. Actual results for large-cap US funds, though, were worse than random, with fewer funds remaining in the top 25% than pure chance would suggest. Small- and mid-cap funds did show some persistence over the short term (two and three years). But ZERO large-, mid-, or multi-cap stocks stayed in the top 25% of their peers over a five-year period.
Even worse, “top performing funds were more likely to become the worst-performing funds than vice versa”. The Scorecard looked at two five-year periods that did not overlap and found that over 50% of all top 25% funds became bottom-half funds, with over 30% falling all the way to the bottom 25%. So much for using past outperformance as a guide for future results. And taking the contrarian approach by betting on a poor performing fund to turn around is no more certain. Over 15% of funds from the bottom 25% moved into the top 25%, but over 26% of the poor performing funds were either merged or liquidated, eliminating their performance record. Over 9% of the poor-performing funds changed their investment style, another way of throwing in the towel.
This kind of analysis supports the use of index funds for part of a portfolio, unless chasing performance seems like a good idea. We use both broad index funds and several managed funds in our portfolios and we monitor the active funds for consistency in management, investment philosophy and approach and consistent, not stellar, performance. The objective remains to create a portfolio that, as a sum of all its parts, offers a reasonable combination of growth potential and protection from volatile markets.
The SECURE Act
As part of the mid-December government spending bill, Congress passed a retirement savings bill known as the SECURE (“Setting Every Community Up for Retirement Enhancement”, catchy) Act. The SECURE Act raises the age at which individuals must begin taking distributions from their retirement accounts to 72 from 70 ½ for those turning age 70 ½ after December 31, 2019. It allows workers of any age to contribute to an IRA, which was prohibited after age 70 ½. It allows more part-time workers to participate in 401k plans and makes it easier for small businesses to offer retirement plans to their employees The Act allows withdrawals for $5,000 from retirement plans without penalty for birth or adoption expenses and allows the use of up to $10,000 from 529 plans to repay student loans.
The above are generally seen as positive changes to help Americans save more for retirement and to eliminate some of the barriers to saving. There are two other provisions, however, that are drawing a lot of attention.
The first controversial change is a revision of rules which will make it easier for, and encourage, 401k plans to offer annuities to employees who are participating in the 401k. The stated goal is to make it easier for an employee to receive guaranteed payments for life and create something like a pension. The problem is that some types of annuities are put in place long before the employee retires and is ready to create those lifetime payments, and these types of annuities can have high costs and can reduce investment returns. An individual has always been able to roll the 401k money into an IRA at retirement and then purchase an income annuity, but along the way the individual can be susceptible to questionable annuity sales practices.
An annuity purchase should not be based solely on the desire to have retirement income but should consider factors such as other sources of income, overall financial circumstances, other assets and resources, family and estate issues and the specific features and cost of the annuity. For those who understand the complex world of annuities or are fortunate enough to have access to some objective advice, the change may provide some new and acceptable options. Otherwise, this change benefits annuity issuers and will sow confusion among unsuspecting 401k participants.
The second change is to reduce the period during which a non-spouse beneficiary must withdraw inherited IRA assets. (None of this applies if a spouse is the beneficiary.) Until 2020, a non-spouse could withdraw IRA assets annually based on the beneficiary’s life expectancy, which allowed IRA owners to name grandchildren and other younger beneficiaries and thus “stretch” the tax advantages of the IRA. The withdrawals are taxed as income to the beneficiary but by stretching the withdrawals over their life, the tax burden is spread over time and most of the IRA assets can continue to grow. This “stretch IRA” had become very popular as IRA accounts grew, and the government recognized that a program designed to enable retirement savings had become an estate-planning tool and a way to reduce taxes.
Beginning in 2020, any non-spouse who inherits an IRA must withdraw the entire balance within 10 years. There is no requirement that withdrawals be made annually or on any schedule, as long as the entire amount is withdrawn, so the beneficiary could choose to let the IRA continue to grow and withdraw the entire balance at the end.
Many pundits are up in arms over this change, upset that the government would “change the rules” after they had taken steps to create a stretch IRA, in some cases converting the IRA to a Roth IRA and paying taxes now so their beneficiaries could have tax-free withdrawals over a long period. In practice, whether this change really matters depends on how the current IRA owner plans to use the IRA during his lifetime, the financial circumstances of the beneficiaries, the other assets in the IRA owners’ estate and whether the IRA owner has a charitable intent in his estate plan. All these factors should be considered before hastily making changes to beneficiary designations based solely on the death of the stretch IRA. The worst case is that beneficiaries inherit a lot of money and have to pay taxes on it, which was always the intent of IRA’s and the price to pay for receiving a tax deduction for the contributions and deferral of taxes on any growth.