Shifting Back To The East ...

That chart at the bottom is from a recent Economist article. It’s interesting how economic power has shifted first from East to West and now back to the East. In the early centuries China and India were the largest economies, then Europe became preeminent. America’s turn came in the 1900s and with the exception of Japan’s surge in the 60’s and the 70’s, the twentieth Century was our time to shine. Now China is about to become the world’s largest economy and we will cede some influence to East Asia and possibly India.

The Middle Kingdom has pulled more people out of poverty since 1979 than any country has ever done in history. Now it has set its sights on bigger fish, its ‘Made in China 2025’ initiative. China wants the domestic content of “core materials,” that is the secret sauce of technology and pharmaceuticals, to increase dramatically. We are scared.

The tariff spat we are now in with China is only partly about dollars and cents. It is also about our fear of the inexorable rise of China. The current administration does not see the global economy as a win-win proposition but as win-lose. If they win then we must lose.

But remember the old adage, ‘everything is not lost that is in peril.’ Back in the 1980s the Japanese with their rigid organization and unbeatable quality were going to rule the world. That didn’t happen. China will continue to rise but don’t give up on America just yet. The Middle Kingdom has still not been seriously tested. It has been nearly 40 years since they experienced any real recession. The stimulus and borrowing required to keep its growth going today is getting more and more expensive. And 75% of middle and upper class Chinese net worth is tied up in housing. There is a lot of froth here. Some analysts estimate that there are more than 50 million unoccupied housing units in China held for speculative purposes. A big decline in housing prices would put the central government to a real test.

China is a threat but there is no need to get hysterical. Opening up China’s markets and stopping the extortion and theft of America’s technology must be a U.S. priority but even more important, America needs to take steps to keep our economy competitive. This includes more infrastructure spending, an emphasis on education, including workforce development, and a sensible immigration policy that allows us to keep the best and the brightest. The March to the East is not a done deal.

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Tax Talk...

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The new tax law is in effect and there are changes to be considered. Spoiler alert, tax discussions can be sleep - inducing. You are forewarned! The standard deduction – the amount that all tax filers can deduct from their income each year – was doubled to $12,000 for single filers and $24,000 for joint filers. Taxpayers age 65 and older get a higher deduction – single filers add $1,600 and joint filers can add $1,300 per spouse. People itemizing deductions are expected to fall by around 60% this year.

Qualified Charitable Donation (QCD) – Even if you take the standard deduction, the tax law still allows you to get some tax breaks for donations in the form of a Qualified Charitable Donation or QCD.

Individual Retirement Accounts (IRA) grow tax-free until retirement when distributions are included as taxable income that year. Regardless of whether funds from these accounts are needed or not, at age 70 ½ the IRS requires annual minimum distributions.

Regulations, however, allow those 70½ years or older to donate up to $100,000 tax-free from their IRA each year to a charity. The charity will not pay income tax on the donation and although there isn’t an income tax deduction for the donation, the amount is removed from adjusted gross income. This may mean a lower income tax bracket, potentially avoiding certain penalties that come with a higher adjusted gross income, such as higher Medicare premiums and the 3.8% tax on net investment income for taxable assets.

QCD’s may be appealing for those who do not need their full Required Minimum Distribution (RMD) for annual spending needs and who are interested in contributing to a charity. An important piece of advice, however, is if you are interested in having your RMD become a QCD, start the process now – it can be lengthy and the donation must be received by the charity no later than December 31st.

Capital Gains & Losses – The new tax law also changes how capital gains are taxed. Short-term gains – profit from sale of investments owned less than one year – will still be taxed as ordinary income. But for long-term gains – profit from investments owned more than a year – taxes are determined according to income thresholds. The difference will most likely not be earth - shattering, but still something to take note of.

The chart below shows the various income thresholds and the corresponding capital gains rate. A newly retired couple with taxable income of $60,000 could sell stocks at a gain up to $17,200 without paying tax on the appreciation of the stock. Any gain above the 0% threshold amount is taxed at the higher rate. For instance, if the same couple instead took $30,000 in capital gains then $17,200 of gains are tax-free and the remaining $12,800 is taxed at 15% or $1,935.

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Unfortunately not all stocks go up in value. Selling at a loss offsets capital gains on stocks that performed well. If losses are greater than gains in a tax year, one can use up to $3,000 to reduce taxable income and carry forward remaining losses for future tax years. This is “Tax Loss Harvesting” but beware of some stipulations, most notably, making sure to wait at least 30 days after selling the stock to buy it again.

So now you can wake up from your nap, the lecture is over. But go see your tax preparer… there are indeed benefits to be found in the new tax law.


Remember the Big Picture...

All seemed good when the S&P 500 reached an all-time high on September 20. But by October 29, we were 9.9% lower, with a lot of up and down in between. Gulp? Yikes?

If the market has been unnerving you, we understand. For one thing, before October, we enjoyed some pretty smooth sailing, and when things keep going in a certain way, we get used to it. That’s human nature. For another thing, the media switched the narrative on us pretty quickly. Not too long ago, we were reading about the longest bull market in history. Then the focus suddenly switched to all the things going awry in the world – trade tariffs, rising interest rates, China, emerging market woes, and potentially higher inflation among them.

But some perspective is in order here.

The first thing is to remember that while a 10% market drop doesn’t feel good, it is not uncommon. According to John Buckingham of asset manager AFAM and The Prudent Speculator newsletter, stock market corrections of 10% happen on average every 0.9 years, while bear market declines of 20% occur on average every 3.6 years. That means that stock investors should expect declines at some point. They’re inevitable.

On the positive side, for those who hold on, markets also can recover quickly. It doesn’t always happen, but it often does. Market strategist Ed Yardeni looked at the 29 U.S. stock market corrections that have taken place since 1968 (declines of 10% or more) and found that only six of them lasted more than a year. On the other hand, 21 of them lasted fewer than 105 days – a matter of months.

And think about how the longest bull market in history that we just mentioned actually played out. Starting in March 2009, it wasn’t straight up all the way with only feel-good moments. Just earlier this year, from late January through early February, the S&P 500 dropped 10%. The Dow fell 12% in two weeks. People were calling it “market insanity” and a “real roller coaster.” The New York Times wrote an article called “Stock Markets are Scary” in March. One trader in that article said, “We are seeing extreme volatility here.”

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But do you even remember any of this? Many people won’t. That’s human nature too. And we’re not even mentioning the Flash Crash, Grexit, European monetary crisis, Federal budget sequestration, Taper Tantrum, Brexit, or any of the other things we saw the past decade. We got through those things too. Each one of those correction blips in Yardeni’s chart shown on this page surely felt awful. But long-term investors who stayed the course did just fine.

This is not a plea for blind optimism. We are not saying that everything is fine or that things won’t get worse – because things could get worse. What we are saying is that we’ve been through a lot of stuff, and it’s turned out that the best way to stack the odds in your favor is to look beyond the short-term hurt and hold on for the long-term.

So, if you’ve recently realized you need more cash than you expected over the next few years, by all means sell your stocks to raise that cash. Or if you’ve realized that a 10% market decline is too much for you to handle, then reconsider whether you should be invested in stocks at all. But if neither of those apply to you, stay the course.

And remember what Warren Buffett wrote when he stepped up to buy U.S. stocks in 2008 and the world looked a lot worse than it does now. He acknowledged that “The financial world is a mess . . . business activity will falter and headlines will continue to be scary.” But he also wrote: “I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month – or a year from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

Rising Rates – The Good, The Bad and The Ugly…

Investors sitting on cash over the last several years finally have something to cheer about. Interest bearing deposits have inched up steadily over the last year with many today yielding over 2.0%. Unfortunately, these higher rates are not good news if you are the U.S. government, one of the biggest borrowers around. U.S. debt now totals $15.7 trillion. At 78% of GDP, today’s debt burden is at the highest level since the end of WWII.

Economists alarmed by our growing indebtedness are often criticized for instilling a false sense of panic. Debt levels have, after all, been rising for years. But there are at least three reasons why investors should pay more attention to this issue now.

Debt Levels Are Increasing at a Faster Rate: The Congressional Budget Office (CBO) estimates that in 10 years our outstanding debt will grow to $28.7 trillion or 96% of GDP. This could be a fairly conservative estimate as it excludes additional spending related to infrastructure needs or fiscal stimulus if the economy hits a speed bump. It also assumes that the most recent tax cuts are not extended. If these somewhat optimistic assumptions hold, federal debt per taxpayer would grow from $164,100 today to just over $250,000 by 2028.

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Government borrowing is not always a bad thing. But problems develop when the level of debt grows faster than the ability to support it. This is similar to saying you can carry a bigger mortgage as long as you have a bigger income. Unfortunately, for the U.S. this outcome is unlikely. According to the CBO, nominal annual GDP growth over the next decade is likely to clock in at 3%-4% while the combination of rising expenditures and slowing revenues should result in deficits growing closer to 5%.

The Cost of Carrying Debt is Rising: The upward creep in interest rates and sheer level of indebtedness will wreak havoc on the federal budget. Annual interest costs are expected to increase from their current $263 billion to $915 billion by 2028. At this point, the government will be spending more on interest than on all non-defense discretionary spending combined. Easy fixes like trimming back discretionary programs or tweaking benefits will not solve the problem.

Political Will to Act is Lacking: Federal debt levels have increased under both Republican and Democratic administrations. Today, neither party seems interested in tackling the debt problem. Caps placed on federal spending have been removed several times over the last three years, Medicare cost controls have been reversed and with the recent tax cuts, revenue decreased.

Former Treasury Secretary Robert Rubin suggests reducing debt must ultimately involve two things: compromise on Medicare and Medicaid cost growth and higher federal revenues (read taxes). Reaching a consensus, however, will require making painful choices today for benefits some time in the future – not an easy path for any politician.

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Years of low rates, a gradually improving economy and healthy investor demand has led to complacency regarding the nation’s growing debt. But this issue should not be ignored. Foreign investors own 30% of our outstanding debt. They will continue to have an appetite for it as long as long the dollar remains the world’s reserve currency and a safe harbor during periods of heightened risk. But to assume that their appetite is boundless would be foolish. And at some point in the not too distant future our debt will become a political problem as rising interest costs begin to crowd out spending on key government programs.