Third Quarter 2022 In Review

Market Overview

Well there isn’t any being cute about it anymore – 2022 continues to be a painful year for investors of any stripe. It has also been an atypically bad time for diversified and balanced investors. It is a rare market environment when stocks and bonds fall together, and a uniquely 2022 environment when the baseline yields for bonds were near zero when rates started to rise. As a result, stalwart “60/40” portfolios are taking it on the chin. The Vanguard Balanced Index, for example, is down -20.78% year to date through 9/30/22. Where bonds would normally help to materially offset stock market losses, we’ve gotten little reprieve this year. The broad bond market is off double digits in 2022, with the S&P Aggregate Bond Index down -13.45%.

Of course, I am here to say it again: this isn’t cause for panic. Losses happen in markets, they happen regularly, they happen unfortunately, but they also happen temporarily. Sometimes, investing is really easy. Actually it is pretty easy most of the time. We ignore these times because our brains hate us and want us to be miserable. No one reacts the same way to a +18% year as they do to a -18% year. Most of us aren’t thrilled by the fact that the market goes up the overwhelming majority of the time. But we are quick to be upset when we have a bad stretch.

My advice this round is simple: zoom out. If you need to, pull your performance reports from the last several years and note those gains. Recognize that this year we’re giving back some of those past gains. Pay attention to past years that you’ve had losses, and how quickly you minimize those in hindsight. The current time always feels bad, but not many of us are fixated on the temporary losses in 2020 or late 2018 or late 2015 (should I go on?).

3Q 2022 1 Year 3 Year 5 Year
Large Cap US Stocks -4.88%-15.47%8.16%9.24%
Small Cap US Stocks-2.19%-23.50%4.29%3.56%
International Equity-9.36%-27.09%-1.83%-0.84%
EM Equity-11.57%-28.11%-2.07%-1.81%
Aggregate Bonds-4.22%-13.54%-283%-0.11%

Index performance is provided as a benchmark. It is not illustrative of any particular investment. An investment cannot be made in an index. Past performance is not an indication of future of results. S&P 500, Russell 2000 Index, MSCI EAFE Index, MSCI EM Index, S&P US Agg Bond Index. Returns as of 9/30/2022.

Economic Update

There is plenty of economic data to build the case that a recession started earlier this year, and plenty that says we are hanging in there. The debate of what truly is a recession has been held elsewhere plenty in 2022, so I won’t bother. The lay of the land is: we have now had two quarters of negative GDP growth in 2022, but unemployment is still low by any measure. Inflation remains a major concern, and wages are working to keep pace. The housing market is absolutely cooling off, but there are no signs that most Americans are having any issues meeting their mortgage payments. Nothing like the 2008-2009 financial crisis is afoot. Instead what we have is serious supply-side inflation shocks as a result of production issues related to COVID-19, booming energy prices that are multifactorial but not exclusive of the Russian invasion of Ukraine, and central banks around the world in a frenzy to control inflation and put the brakes on (quite strongly) economic activity. Getting on top of inflation means slowing the flow of money, which typically does not come without some pain in some parts of the economy.

Below we can see that Real GDP growth was -0.6% in Q1 and initial measures are -0.1% for Q2 2022. Clearly, nothing like the wild swings in early 2020 from the pandemic and not even approaching the tumult of the financial crisis. Current expectations are for a positive (~+1.0%) Q3 GDP print.

CPI, our best measurement of inflation, started to boom as we exited pandemic lockdowns and put in a near-term peak recently this year. August measured an 8.2% increase over the previous twelve months.

The response of the Federal Reserve this year has been to rapidly increase short-term rates (another 0.75% at the most recent meeting) and continue “Quantitative Tightening” by selling off longer term bonds on the balance sheet. These actions, coupled with modestly higher inflation expectations, have pushed long-term rates up as well. US mortgage rates have more than doubled in the last 18 months and briefly topped 7% earlier last week.

Mortgage rates have a huge impact on home affordability. The combination of record high home prices and newly high mortgage rates has pushed this measure into territories not seen by this generation. Home prices are responding quickly, with the first drop in national average home prices in July since the financial crisis.

Of course, home prices are still much higher than pre-financial crisis levels:

But housing isn’t the whole economy, or the whole story. Employment measures are still strong, as initial jobless claims fell again in September. (Forgive my logarithmic chart axis, I needed to correct for the pandemic somehow!)

Tax & Policy Updates

On August 16th, 2022, President Biden sign the Inflation Reduction Act into law. While the provisions are many and widespread, there are a number that specifically address financial planning topics.

There will be big changes for Medicare recipients coming in 2023. Medicare will now negotiate prescription drug costs, which will affect those costs in 2026 and beyond. Medicare Part D out of pocket costs will be capped at $2,000 per year beginning in 2025. Prior to this, there was no out of pocket cap for prescription drug costs. Monthly out of pocket costs for insulin products will be capped at $35 with no deductibles. All future vaccines will be covered with no out of pocket costs for Part D recipients.

The bill includes $80 billion in additional funds to the IRS in an effort to increase staffing and tax enforcement. Treasury Secretary Janet Yellen specifically instructed the IRS to focus on “high end non-compliance” and not to increase audits of households earning under $400,000 per year.

The newly renamed Energy Efficient Home Improvement Credit was extended through 2032, and includes provisions for a 30% tax credit for expenses related to home energy efficiency. The former $500 lifetime cap has been replaced with a $1,200 annual cap. These projects include home energy audits, exterior doors and windows, home heating and cooling and heat pumps. Home renewable energy credits (for solar and similar projects) will receive a 30% credit for installations from 2022-2032 (not subject to the $1,200 annual cap).

There will also be a significant change to electric vehicle tax credits. The credit, which has a maximum value of $7,500, will now only be available to vehicles with 40% or more of materials sourced in North America and final assembly must happen with in the US. This effectively means that most EVs on the market prior to the legislation will no longer be eligible for the tax credit, resulting in a massive market shift ahead. The new EV credit is also only available for those with income under $150,000/$300,000 (single/married filers).

Subsequent to the Inflation Reduction Act, the Biden administration announced their Student Loan Debt Relief plan in late August. In broad strokes, this promised the forgiveness of $10,000 in student debt for Federal student loan borrowers, another $10,000 in forgiveness for Pell Grant recipients, a push to apply for the Public Student Loan Forgiveness program and changes to income-based repayment programs. Some of these provisions are coming up to sharp criticism from political foes and we may see some changes yet. In short – there is no 50 word summary of action needed here. If you or someone in your family has Federal student debt – reach out and ask questions about eligibility and action steps.

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