Inflation

Inflation

How to navigate a coming Worldwide recession

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Source: myownadvisor and https://www.thecanadianencyclopedia.ca/en/article/recession

By Mark Seed, myownadvisor

Special to Financial Independence Hub

According to the largest asset manager firm in the world (BlackRock), policymakers will no longer be able to support markets as much as they did during past recessions – so we have been warned – a team of BlackRock strategists led by vice chairman Philipp Hildebrand wrote in a report titled 2023 Global Outlook.

“Recession is foretold as central banks race to try to tame inflation. It’s the opposite of past recessions,” they said. “Central bankers won’t ride to the rescue when growth slows in this new regime, contrary to what investors have come to expect. Equity valuations don’t yet reflect the damage ahead.”

The report went on to say “The old playbook of simply ‘buying the dip’ doesn’t apply in this regime of sharper trade-offs and greater macro volatility. We don’t see a return to conditions that will sustain a joint bull market in stocks and bonds of the kind we experienced in the prior decade.”

I reflected on this report recently. How is an investor to cope?

Well, I think the “old playbook” is actually something I’ve already started to think about for the “new playbook” and maybe you have as well …

  1. Directionally, i.e., longer-term than one year or so, stay with equities. Lots of them. In fact, to be specific, consider infrastructure stocks in particular. BlackRock: “We see some opportunities in infrastructure. From roads to airports and energy infrastructure, these assets are essential to industry and households alike. Infrastructure has the potential to benefit from increased demand for capital over the long term, powered by structural trends such as the energy crunch and digitalization.”
  2. Tactically, i.e., within the next year, if you need that money balance, consider bonds. Yes, consider fixed income again. According to BlackRock: “In fixed income, the return of income and carry has boosted the allure of certain bonds, especially short term. We don’t think leaning into broad indexes or asset allocation blocks is the correct approach. We stay underweight long-term nominal bonds as we see term premium returning due to persistent inflation, high debt loads and thinning market liquidity.” Meaning, if you are going to own some bonds, stay short and own short-duration bonds.

I come back to Ben Carlson’s thesis (that I agree with) after reading this recent BlackRock global outlook report when it comes to bonds. There are absolutely good reasons to own bonds, but it’s more for the near-term variety:

  1. Bonds can help your investing behaviour – helping you ride out stock market volatility – including being strategic to buy more stocks soon.
  2. Bonds can be used to rebalance your portfolio – helping you keep your portfolio aligned to your investing risk tolerance and therefore asset allocation (mix of stocks and bonds).
  3. Bonds can be used for spending purposes – where some fixed income is “king” for major, upcoming, near-term spending.

The main reason I would keep any bonds (and I still don’t have any right now) is if I was saving for a major purchase in a few years (e.g., secondary residence?). Then, I would like rely on some form of fixed income between now and then to help secure that purchase. Otherwise, an interest savings account in the short-term will do that and/or some 1 or 2-year GICs are a great consideration as well as part of any bucket strategy.

Personally, I believe the main role of fixed income in your portfolio is essentially safety – not the investment returns and not the cash flow needs. In other words, if all else fails per se, if/when stocks crash, then bonds should historically speaking offer a flight to safety for preserving principal.

So, they are there for diversification purposes.

As Andrew Hallam, a Millionaire Teacher has so kindly put it over the years: when stocks fall hard, bonds act like parachutes for your portfolio. Bonds might not always rise when the equity markets drop. But broad bond market indexes don’t crash like stocks do.

Is that enough to own bonds in your portfolio? Maybe.

For now, I’m going to continue living with stocks: a mix of dividend-paying stocks (including infrastructure stocks that BlackRock likes for the year or so ahead) AND owning low-cost equity ETFs for growth.

I will also grow my cash wedge to my desired safety net by the end of 2023 too. That’s one year’s worth of spending/expenses held in cash that will form Bucket 1 below. That first bucket is an insulator from my dividend and growth equities.

Your mileage may vary. Continue Reading…

TFSA contribution is Job One in 2023 and other inflation-related tax changes to consider

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A belated Happy New Year to readers. Today I wanted to start with a reminder that your first Financial New Year’s Resolution should always be to top up your TFSA contribution to your TFSA (Tax-free savings account), which because of inflation has been bumped to $6,500 for 2023. I’ll also link to two useful columns by a financial blogger and prominent media tax expert.

A must read is Jamie Golombek’s article in Saturday’s Financial Post (Dec. 31/2022), titled 11 tax changes and new rules that will affect your finances in 2023. Golombek is of course the managing director, Tax & Estate planning for CIBC Private Wealth.

He doesn’t lead with the TFSA but does note that the cumulative TFSA limit is now $88,000 for someone who has never contributed to a TFSA. On Twitter there is a community of Canadian financial bloggers who often reveal their personal TFSA portfolios, which tend to be mostly high-yielding Canadian dividend-paying stocks. In some cases, their TFSA portfolios are spinning out as much as $1,000 a month in tax-free income.

On a personal note, my own TFSA was doing nicely until 2022, when it got dragged down a bit by US tech stocks and a token amount of cryptocurrency. Seeing as I turn 70 this year, I’ll be a lot more cautious going forward. I’ll let the existing stock positions run and hopefully recover but my new contribution yesterday was entirely in a 5-year GIC, even though I could find none paying more than 4.31% at RBC Direct, where our TFSAs are housed. (I’d been under the illusion they would by now be paying 5%. I believe it’s still possible to get 5% at independents like Oaken and EQ Bank.)

At my stage of life, TFSA space is too valuable to squander on speculative stocks, IPOs, SPACs or crypto currencies. Yes, if you knew for sure such flyers would yield a quick double or triple, it would be a nice play to “sell half on the double,” but it’s better to place such speculations in non-registered accounts, where you can at least offset capital gains with tax-loss selling. So for me and I’d suggest others in the Retirement Risk Zone, it’s interest income and Canadian dividend income in a TFSA and nothing else.

Inflation and Tax Brackets

Back to Golombek and inflation. Golombek notes that in November 2022, the Canada Revenue Agency said the the inflation rate for indexing 2023 tax brackets and amounts would be 6.3%:

“The new federal brackets are: zero to $53,359 (15 per cent); more than $53,359 to $106,717 (20.5 per cent); more than $106,717 to $165,430 (26 per cent); more than $165,430 to $235,675 (29 per cent); and anything above that is taxed at 33 per cent.”

Basic Personal Amount

The Basic Personal Amount (BPA) — which is the ‘tax-free’ zone that can be earned free of any federal tax — rises to $15,000 in 2023, as legislated in late 2019. Note Golombek’s caveat that higher-income earners may not get the full, increased BPA but will still get the “old” BPA, indexed to inflation, of $13,521 for 2023.

RRSP limit: The RRSP dollar limit for 2023 is $30,790, up from $29,210 in 2022.

OAS: Golombek notes that the Old Age Security threshold for 2023 is $86,912, beyond which it begins to get clawed back.

First Home Savings Accounts (FHSA). Golombek says legislation to create the new tax-free FHSA was recently passed, and it could be launched as soon as April 1, 2023. This new registered plan lets first-time homebuyers save $40,000 towards th purchase of a first home in Canada: contributions are tax deductible, like an RRSP. And it can be used in conjunction with the older Home Buyers’ Plan.

3 investing headlines to ignore this year

Meanwhile in the blogosphere, I enjoyed Robb Engen’s piece at Boomer & Echo, which ran on January 1st: 3 Investing Headlines To Ignore This Year. Continue Reading…

Preparing your Portfolio for Retirement? Income Is so Yesterday

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By Billy and Akaisha Kaderli, RetireEarlyLifestyle.com

Special to the Financial Independence Hub 

When preparing for retirement, designing your portfolio for income is over-rated. Oh, it feels good bragging about how much money you make each year, but then you also quiver about the taxes you owe each April.

What’s the point?

To make it – then give it back – makes no sense.

In today’s interest rate environment people are being forced to adjust their thinking.

Our approach 3 decades ago

When we retired over 32 years ago, having annual income was not on our minds. Knowing we had decades of life-sans-job ahead of us, we wanted to grow our nest egg to outpace inflation and our spending habits as they changed too. Therefore, we invested fully in the S&P 500 Index.

500 solid, well-managed companies

The S&P Index are 500 of the best-managed companies in the United States.

Our financial plan was based on the idea that these solid companies would survive calamities of all sorts and their values would be expressed in higher future stock prices outpacing inflation. After all, these companies are not going to sell their products at losses. Instead they would raise their prices as needed to cover the expenses of both rising resources and wages, thereby producing profits for their shareholders.

How long has Coca-Cola been around? Well over 100 years and the company went public in 1919 when a bottle of Coke cost five cents.

Inflation cannot take credit for all of their stock price growth as they created markets globally and expanded their product line.

This is just one example of the creativity involved in building the American Dream. The people running Coke had a vision and have executed it through the years. Yes, “New Coke” was a flop as well as others, but the point is that they didn’t stop trying to grow because of a setback.

Coca-Cola is just one illustration of thousands of companies adapting to current trends and expanding with a forward vision.

Look at Elon Musk. He has dreams larger than most of us can imagine.

Sell as needed

Another benefit we have in designing our portfolio in this manner, is that when we sell shares for “income,” they are taxed at a more favorable rate as a long-term capital gain. Dividend output is low, our tax liability is minimal, yet our net worth has grown.

We are in control of our income stream.

Our suggestion is not to base your retirement income on income-producing investments but rather to go for growth. You can always sell a few shares to cover your living expenses.

Money Never Sleeps

Just because you retire, your money doesn’t have to.

In the words of Gordon Gecko from the 1987 movie Wall Street, “money never sleeps.” And your money definitely won’t once you leave your job.

Reading financial articles about what if retirees run out of money, we get the impression that the authors do not understand that once retired, your money can – and should – continue to work for you.

Working smart not hard

Once you walk out of the 9-5 for the last time, that doesn’t mean your investments are frozen at that point. The stock market is still functioning and now your “job” is to become your own personal financial manager. Actually, you should have been doing this all along, but if not, start now.

You need to get control of your expenses by tracking your spending daily, as well as annually. This is so easy – only taking minutes a day – and this will open your eyes as to where your money is going. Not only that, but it will give you great confidence to manage your financial future. Every business tracks expenses and you need to do the same. You are the Chief Financial Officer of your retirement.

The day we retired the S&P 500 index closed at 312.49. This equates to a better than 10% annual return including dividends. We know that we have stated this before, but it’s important.

Chart of S&P Market Returns January, 1991 to September 2022

That’s pretty good for sitting on the beach working on my tan.

Making 10% on our portfolio annually while spending less than 4% of our net worth has allowed our finances to grow, while we continue to run around the globe searching for unique and unusual places.

But what if you’re fifty?

You need to take stock of your assets and determine what your net worth is, with and without the equity in your home. Selling the house and downsizing may be a windfall for you, again utilizing the tax code to your benefit. Continue Reading…

5 key themes that will shape the Canadian and global economy in 2023

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Vanguard Group

 

Vanguard has released its 2023 forecast. You can access it by clicking on this link to a PDF.

We first looked at this in this Hub blog on December 12: Vanguard says Balanced portfolios still offer best chance of success as Inflation gets beaten back.  

In this follow-up blog, we’re looking in more depth on the Canadian portion of the report, which begins on page 23. We have reproduced some of the text and charts from that section in the second half of this blog.

“Generally, we are calling for a global recession next year, including a milder recession for Canada with economic growth pegged at 0.7% (for Canada),” says Matthew Gierasimczuk, spokesperson for Vanguard Investments Canada Inc.

Vanguard expects five key themes will shape the Canadian and global economic environment as we move into 2023:

  1. Central banks’ vigilance in the fight against inflation
  2. Spillover effects of global economy, energy, and real estate markets on the Canadian economy
  3. Economic effects of the energy crisis in Europe
  4. China’s long-term structural challenges as it aims to end its zero-COVID policy
  5. Last, but not least, a more positive outlook for long-term investors across bonds and equities

 Fighting inflation: Central banks maintain vigilance

 Vanguard says 2022 has proven to be “one of the most rapidly evolving economic and financial market environments in history. Across the globe, central banks have responded with coordinated monetary policy changes that have outpaced anything we’ve seen for several decades.”

A globally coordinated monetary tightening regime

 “This is the greatest inflation threat we’ve seen since the 1980s,” it continues, “Central banks have a difficult path ahead that will require being more aggressive with policy, making additional rate hikes, and maintaining vigilance as the inflation situation shifts.In the U.S., the Federal Reserve has adopted the position that there is still work to be done, and it appears to have the resolve to stick with it.”

For the balance of this blog, we’ll drill down on the report’s prognosis for Canada, which starts on page 23 of the forecast. We’ve selected large chunks of text, which is as it appears in the report, with minor excisions such as references to some charts not reproduced here. Therefore, we are not using quotation marks. An ellipsis (3 dots as here: …) is used to indicate sections excised between passages. With one or two exceptions, most subheadings are from Vanguard. Readers who want the full report should of course click on the PDF link above.

Canada: Reining in an overheating economy

The year 2022 has seen persistent global inflation followed by rising policy rates as central banks across the world played catch-up. Over the course of 2022, inflation in Canada continued to tread higher driven by a combination of rising demand, tightening labor markets, and volatile energy and food prices as a result of ongoing supply constraints and geopolitical events. Heading into 2023, there are growing signs that inflation will moderate due to recovery in global commodity supply and slowing economic growth driven by tightening monetary policy.

In 2022 we discussed how policy tightening will be a crucial risk behind a lower growth environment among other factors such as high inflation, further supply disruptions, and new virus variants. Looking back most of these risks occurred throughout the course of 2022. The unexpected Russian invasion of Ukraine added to supply disruptions and pushed headline CPI inflation to its historically highest level of 7.9% YoY. Continue Reading…

Price, Value & the CAPE’d Crusade

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Image via Outcome/The Blue Diamond Gallery

By Noah Solomon

Special to the Financial Independence Hub

According to Warren Buffett, “Price is what you pay. Value is what you get.”

The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, is a valuation measure invented by Nobel Prize recipient Robert Shiller. It is calculated by taking the price of an index and dividing it by its average earnings over the past 10 years, adjusted for inflation. The ratio’s use of average earnings over the last decade helps to smooth out the impact of business cycles and other events and thus provides a better picture of a market’s sustainable earnings power.

The CAPE ratio is commonly used to gauge future returns over medium to long-term horizons. In theory, higher than average CAPE levels imply lower than average future returns, while their lower counterparts suggest that future returns will be relatively high.

In the following piece, I analyze historical data to determine if the CAPE ratio has been a useful predictor of future real (i.e., after inflation) returns. In my view, including real rather than nominal returns is appropriate given the recent resurgence of inflation. Investors must be mindful of inflation’s potential to erode a substantial portion of their portfolios’ purchasing power. Lastly, I comment on what investors can expect going forward given the current CAPE level.

The following table presents average real future returns following various CAPE ranges.

S&P 500 Index: Average Real Returns Sorted by CAPE Ratio (Jan. 1970 – Nov. 2022)

There has been an inverse relationship between CAPE ratios and future returns. When the CAPE ratio has been near the high end of its historical range, future returns have tended to be relatively low. Conversely, low CAPE ratios have tended to foreshadow higher returns. Whereas this relationship has not been statistically significant over shorter holding periods, it has been strong over the medium to long-term.

When CAPE ratios have been below their historical average of 21, annualized real returns over the subsequent five years have averaged 8.3%, as compared to only 3.3% when CAPE ratios have stood above this level. The corresponding numbers for 10 year holding periods have been 8.8% vs. 4.2%.

The difference in average returns cannot be understated. On a $10 million investment over 5 years, the difference in return equates to a real value of $14,922,900 vs. $11,754,768. Adding in the average inflation rate since 1970 of 4.04%, the corresponding nominal values have averaged $17,920,804 vs. $14,240,696.

Over ten-year holding periods, the average real values of a $10 million investment made when CAPE levels were below vs. above average were $23,290,712 and $15,137,096, respectively. After adding back the post-1970 average inflation levels of 4.04%, these figures rise to $33,533,809 and $22,140,747.

These differences, although significant, represent the divergence in average returns during times when CAPE ratios have been merely above or below average. As the table above demonstrates, the difference in returns following investments made in very low vs. very high CAPE environments has been far greater.

Explaining the Anomalous “Bump”: Where Behavior Confounds Theory

Although low CAPE levels have been associated with higher future returns, and vice versa, the relationship is far from perfect across different CAPE ranges. Specifically, there is an anomalous “bump” whereby future returns for the 20-25 CAPE range have been nearly as high or higher than those that have followed any other CAPE level.

My best guess is that this peculiarity relates to human psychology and behavior. Historically, when stocks have risen for an extended period following a bear market, investors have been increasingly willing to believe that “it’s different this time” and that the good times will continue indefinitely. At these times, FOMO (fear of missing out), greed, and momentum have taken center stage until valuations reached levels which all but guaranteed a catastrophe.

Greed, Fear, & Where we Stand Today

The above relationships are a powerful representation of investor psychology. Historically, when the crowd’s greed manifests in lofty stock valuations, future returns have tended to be anemic. On the other hand, when widespread skepticism and despondency have caused earnings to go on sale, above average returns have tended to ensue. Alternately stated, investors would be well-served to follow Buffett’s advice to be “fearful when others are greedy, and greedy when others are fearful.”

Recent market malaise notwithstanding, stocks remain overvalued by historical standards. Taking the most recent data available, the CAPE ratio currently stands at 27.42, which is 30% higher than its historical average since 1970. This CAPE level implies real annualized returns over the next five years of 3.6%, which is approximately 50% lower than the 6.9% average that has prevailed since 1970. Over the next ten years, the implied real rate of return is 4.3% as compared to a historical average of 6.6%.

When the Going Gets Tough, the Tough get Tactical and Seek Dividends

Over five decades spanning January 1970 to December 2019, the two worst periods for the S&P 500 Index were the 1970s and the 2000s. Continue Reading…