The Markets	09/30/22 Close	06/30/22 Close	3rd Qtr. Change	09/30/21 Close	12 Mo. Change	YTD Change
Dow	28,725	30,775	-6.66%	33,844	-15.13%	-20.95%
NASDAQ	10,576	11,029	-4.11%	14,449	-26.80%	-32.40%
S&P 500	3,586	3,786	-5.28%	4,308	-16.76%	-24.76%
MSCI EAFE	1,661	1,846	-10.02%	2,281	-27.18%	-28.90%
10-yr Treas. yield	3.80%	2.97%	+0.83%	1.48%	+2.32%	+2.29%
Fed funds rate	3.0-3.25%	1.5-1.75%	+1.50%	0-0.25%	+3.0%	+3.0%

(stock indices are before dividends; yield and rate changes are absolute changes)

The US stock market had a strong rally through mid-quarter before falling steadily to end the quarter at multi-year lows. There really was no place for investors to hide, other than cash, which is now paying a decent return. The Fed raised rates 0.75% at each of their meetings, as expected. The benchmark 10-year Treasury touched 4% before drifting lower, adding more pain to an historically bad year for bond prices. The yield curve not only remained inverted (2-year Treasuries with a higher yield than the 10-year) but the inversion grew steeper as the 2-year hit a 15-year high. The US dollar hit 20-year highs against a basket of currencies, speeding the decline of international stocks struggling with weakening economies. Fittingly, the quarter ended with massive Hurricane Ian severely damaging the SE Florida coast.

Real estate began to feel the heat from higher interest rates, with 30-year fixed mortgage flirting with 7% at 15-year highs. Added financing costs and higher prices led to existing home sales falling for seven months in a row, and while the median price rose 7.7% from the year prior it had dropped from its record high in June. Housing affordability hit its lowest mark since 1989 and despite lack of housing supply and rental vacancies at a 38-year low, building permits declined. Consumer confidence somehow still exceeded projections, and consumer expectations hit a 6-month high.

Other governments were active in both monetary and fiscal policy, partly in reaction to US interest rates and the strong dollar and partly to address their own issues. The euro is now worth less than one dollar for the first time in 20 years and the British pound hit an all-time low (since 1792!!) against the dollar. Most foreign central banks except China raised rates and Japan bought yen and sold Treasuries to support the yen. New British prime minister Liz Truss announced tax cuts and more spending to offset higher energy prices; the market for British government debt plummeted, the government had to step in and buy bonds to support the market, and the next day the government backed off their tax and spending plans.

Despite softening indicators, the Fed remained steadfast in its rate-raising, citing “modest growth”, but its third 0.75% increase in a row is unprecedented. Projected rates through 2023 actually went up from prior forecasts, to 4.6% from 3.8%. In September, the $95 billion/month reduction in the Fed balance sheet began, eliminating what had for years been pressure to keep rates low. The Fed’s preferred inflation measure continued to increase slightly in August from July, but the producer price index fell in both August and July. There are now more people working than pre-COVID, labor participation crept up and the unemployment rate went up slightly to 3.7% due to people entering the workforce.

Services remain strong but manufacturing growth is slowing. Productivity for the second quarter was down 4.1% following the biggest decline in 74 years in the first quarter, likely due to training new workers and restarting various supply chains. This lower productivity increase costs and adds inflationary pressure, and labor costs jumped over 10%. Consumer spending recovered in August after a July decline, supported by higher incomes and a drop in the savings rate. Oil hit a low for the year before OPEC+ announced production cuts. The announced forgiveness of $10k of student loan debt for many borrowers, and $20k for a smaller group, generated much discussion but no final enactment. Second quarter GDP was down 0.9%, the second decline in a row, but there has been no official announcement that these two consecutive declines constitute a recession.

Looking Forward

The Fed has been quite clear in their resolve to combat inflation. As Fed chairman Powell said in September, “We have always understood that restoring price stability while achieving a relatively modest increase in unemployment and a soft landing would be very challenging.” In other words, beating inflation takes precedence over the Fed’s other goal of stable employment, and to be even more clear Powell has acknowledged that interest rate increases could cause economic pain.

Recently, however, there has been enough backlash to the rate increases that many are looking for signals that the Fed may “pivot” to raising rates less than expected or ending the increases earlier than expected. The UN issued a report that “imprudent monetary policy” (read: US rate increases and the strong US dollar) could lead to a global recession, which would impact developing countries more than developed economies and could also lead to political instability in those developing countries. The US gross national debt hit $31 trillion at the start of the new fiscal year in October, and the costs of servicing that debt will increase significantly with higher rates, growing the debt even further.

That balance between inflation and the labor market has become the focus for the market. When August job openings dropped by over a million, it was seen as a sign that the job market was softening, even though the total openings of 10.1 million was still high. The next day, another report showed that 208k jobs were added in September, greater than expected, and that was seen as a sign the job market was still hot. The full September jobs report, due on Oct. 7, will be closely scrutinized.

But are we not willing to undergo some short-term pain for the long-term advantages of wringing out inflation? Is the treatment worse than the disease? Or could the cost and pain of tackling inflation be higher down the road if it is not handled now?

Both inflation and unemployment were rising in 1970, leading to the coining of “stagflation”, or inflation with no or little growth. President Nixon was more concerned with political consequences than economic factors, so he imposed short-term price controls and took the US dollar off the gold standard. The oil embargo and global food shortages sent inflation higher. Inflation hung around and soared to 13.5% in 1980 until Paul Volcker raised short-term interest rates as high as 20%, with inflation falling to 3.2% by 1983.

The big difference between now and then is that unemployment had been high for years (remember in the depths of the recent Great Recession, unemployment was the “highest since 1983”?) so the public figured they had little to lose. Now, with employment strong and some people still trying to normalize after the pandemic, it seems like there is much more to lose if the Fed pushes the economy into a recession. We’ll see how well the Fed can handle the balancing act.

Our Portfolios

Given the stock market roller coaster this quarter and the steady pain of the bond market, our comments from the Second Quarter Review on how we deal with market declines remain particularly valid. Of course, the other critical player in portfolio management is the portfolio owner/investor, and the relationship between the investor, the portfolio manager and the portfolio itself is, like all relationships, largely dependent on expectations.

Vanguard conducted a research survey in 2021 with 1,500 investors on investor expectations and perceptions. Granted, 2021 was the third year of exceptional stock market returns, so the overall findings were tinged with optimism. And the objective of the research was to demonstrate the value of working with financial advisors versus “DIY” with a “robo-advisor”. But the results were still telling.

Not surprisingly, investors who used robo-advisors were more than twice as likely as investors with human advisors to agree that they have the time, willingness, and ability to fill in the gaps of a robo-adviser. However, across age and wealth levels, robo-advisors were preferred for tasks that can be automated, while the preference for human advisors went up significantly with the complexity and emotional content of investors’ situations. Similarly, investors with human advisors believe they are 16% closer to their goals, compared to only 5% closer for robo-advisors.

The most telling results were in how investors view their portfolio performance. Not only did robo-advisor clients feel their own returns for the prior three years were exceptional (21%, clearly an overstatement), they felt the robo-advisor added only an additional 3%. Clients with human advisors were more realistic about their core returns, at 10%, but they felt the human advisor added an additional 5%. Part of the human-advised results were undoubtedly due to advisors helping investors stay the course through difficult market periods, but the “added returns” for both human and robo-advisors are probably also due to the advisors simply telling clients that they are better off with the advisor, or claiming some magical investing genius.

Our portfolio management and our client relationships reflect these overall findings. We educate clients to be realistic about investment returns, we educate them regarding risk and return, we make no claims to “beat the market” and we spend a great deal of time coordinating the portfolio with their goals. If you want excitement from a portfolio, we are not the right place; we would much rather help you sleep better at night.

Carried Away?

In the negotiations for the Inflation Reduction Act, the special tax treatment for “carried interest” was initially eliminated but ultimately retained after objections from Sen. Sinema of Arizona. Carried interest has repeatedly surfaced as a target for change by both parties but has managed to survive all the criticism and legislative attacks. What is carried interest, and is the special treatment warranted?

The managers of hedge funds or private equity funds typically receive a fixed percentage (2% or so) of the assets being managed to cover management and operating expenses. Carried interest is an additional portion of the fund’s profits, if any, that the general partners receive as part of their compensation. Carried interest can be as much as 20% of the profits after the fund has surpassed a target return, known as the hurdle rate. If the fund has shortfalls after surpassing the hurdle rate, some of the carried interest may be “clawed back” or eliminated. The special treatment is that carried interest is taxed at lower capital gains rates rather than as income, even though the general partner did not invest any funds to earn the carried interest. (General partners often do invest in their own funds, but for that investment they are treated the same as other investors.)

Proponents of carried interest contend that since the goal of these funds is to generate high returns for investors, top fund managers need to be highly compensated. Further, these general partners are similar to other entrepreneurs who start and grow a business and get to treat part of their return from the business as capital gains, not income. Taxing these returns at higher income tax rates would discourage managers and potentially impact the flow of capital into these funds if fewer talented managers are available.

Detractors of carried interest argue that many other highly compensated financial careers, like investment bankers, receive their compensation as wages, including their bonuses, and all that compensation is taxed as ordinary income. Carried interest fees are high and result in lower returns for investors. As for those investors, most of their gains are taxed as capital gains because they have put capital at risk, and the fund managers are always able to put their own money at risk and earn the same favored capital gains as the investors.

It is instructive to look at other types of compensation that is usually available only highly compensated people. Grants of company stock are taxed as income at the fair market value of the stock when it is fully owned by the employee; if the employee holds the stock and later sells it at a higher price, that difference is taxed as a capital gain. Stock options enable an employee to purchase stock at a set price, and the taxation of various types of stock options is pretty complicated. But essentially the difference between the option price and the fair market of the stock when the option is exercised (that is, when the employee buys the stock) is taxed as ordinary income. And the employee often has to come up with funds to buy the stock at the option price. Tax on any subsequent capital gains is determined by the increase in value over the fair market price when the stock was acquired and the period the stock was held. Deferred compensation is not taxed when given but goes into a separate fund that is owned by the company and is taxed as ordinary income when the employee withdraws the funds.

The complicated tax rules aside, carried interest is the only compensation that is taxed entirely as a capital gain. It benefits a small group of people who, by any standard, would still be highly compensated after taxes even if carried interest were taxed as income. It is hard to justify the special treatment and changing the rules on carried interest would seem to be an easy fix. This debate is likely not settled yet.