Cash Management In A Declining Interest Rate Environment

Over the last two years, interest rates have risen at a historic clip. As a result, Rockbridge has dedicated moretime helping clients manage cash reserves to take advantage of the current market environment. In previous years, “high yield” savings accounts were (and some still are) paying less than 1%. Now, it is easy to find money market funds earning in excess of 5% annually.

However, we know that this won’t remain the case forever, and given the most recent guidance by ChairmanPowell, we’ll almost certainly enter a declining interest rate environment at some point in 2024. With that being said, now is an important time to review the goals of your cash reserves. We would classify these “goals” into three major categories:

Emergency Fund / Short-Term Use

For cash earmarked for known expenses within the next year, or cash acting as an emergency reserve for those worst-case scenarios, we recommend maintaining safe, liquid investments such as a purchased money market fund or high-yield savings account. While the interest earned in these accounts will trickle down as the Fed starts to lower short-term rates, this is still the best option for short-term cash reserves. Still, it’s important to make sure the interest rate you receive on these monies is competitive relative to market rates.

Intermediate Term Use / Goal Funding

This is the bucket for which we’d allocate cash earmarked for major expenses or cash flow needs in the next 1-3 years. Given this timeframe, we’d caution investors against taking stock market levels of risk and volatility, but we also know that fully liquid options won’t be as attractive as interest rates come down. For these intermediate term cash goals, it may be a good time to purchase a Treasury bond or Certificate of Deposit (CD). This allows you to lock in an interest rate today and ensure that level of interest is earned throughout the duration of the investment. These investments can still be sold if you need the principal sooner than expected, however, you might be selling at a premium or discount from face value.

Long Term Goals

If you have cash on the sidelines that isn’t earmarked for a specific goal in the short or intermediate-term, we recommend putting a plan in place for getting this money invested in a diversified stock/bond portfolio. Shown below is a chart from J.P. Morgan’s Economic and Market Update as of 12/31/2023 that illustrates 12-month market performance following a peak period of 6-month CD rates:

While this doesn’t guarantee future market performance, this data is consistent with the correlation of positive stock market performance in declining interest rate environments.

Bottom Line

While earning 5% on cash reserves might feel like the best decision today, it’s important to consider the bigger picture. If you have questions about the status of your current cash reserves, a Rockbridge advisor would be happy to help develop a plan for you.

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Market Indifference: How Presidential Elections Impact Your Portfolio

With the 2024 presidential election coming up, many investors wonder how the outcome could affect their investment portfolios. Historically, there has been a perception that Republican presidents are better for the stock market, while Democratic presidents are better for the bond market. However, statistics shows that the market responds indifferently to which party wins the election.

Short-Term Market Reactions

In the short-term, the stock market may react based on investor expectations and uncertainties around the incoming president’s policies. Markets tend to favor continuity and predictability. Any unexpected outcomes can cause volatility as investors digest the news.

For example, there might be an increase in market volatility leading up to the election if the race is close and the outcome uncertain.  Conversely, the market may rise if the incumbent president wins re-election, indicating continuity. However, these initial reactions tend to be temporary. Within a few months, other factors like corporate earnings, inflation, and employment trends reassert themselves as the main drivers of market performance.

Long-Term Market Trends Not Driven by Politics

Numerous studies have shown that over longer periods of time, stock market performance does not reliably differ based on which party is in office. In the chart seen below, Vanguard found a marginal return differential for 60% stock and 40% bond portfolio under administrations of different parties.

This makes sense when you consider what really drives long-term market returns – corporate growth and profitability. Over the long run, corporate and industry fundamentals are far more impactful than who sits in the Oval Office. Presidents inherit these economic conditions and their policies take time to materialize.

Focus on Long-Term Goals

History shows that predicting market outcomes based solely on election results is futile. Market fluctuations surrounding elections are often minor and short-lived.

Rather than making any changes based on election predictions, we recommend sticking with a long-term investment strategy that aligns with your risk tolerance and goals. Some volatility around elections is expected, but markets are resilient and the underlying market fundamentals will persist.

Rest assured that the Rockbridge team will be monitoring conditions closely and we’re always available to discuss how political factors could affect your financial plan.

 

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Rockbridge Institutional – December 2023 Market Review

Year in Review

After plenty of ups and downs throughout the year, financial markets turned in reasonable results in 2023 – a globally diversified stock portfolio was up 16%, a reasonable proxy for bonds (Barclays Aggregated Bond Index) returned 6%. News on several fronts helps to explain this year’s results:

Interest Rates, Inflation and Prospects for a Soft Landing

Throughout 2023, all eyes were on the Fed’s effort to tamp down inflation without a recession. Much uncertainty was associated with its ability to pull this off. During the year, the Fed raised its Federal Funds Target Rate by 1% to 5.5%, which seemed to have the desired effect, as the annualized change in the Consumer Price Index (CPI) fell from almost 7% to 3% by the end of the year. Unemployment remained at historical lows in a growing economy suggesting a soft landing – not the conventional wisdom at the start of the year.

Stocks responded positively. The tech-ladened S&P 500 was up over 26%; domestic small company stocks (Russell 2000) up 17%; international developed markets (EAFE Index) returned 18% and emerging markets (MSCI Index) 10%.

Bond yields fell back in response to expectations that the Fed is done raising interest rates. The yield on the closely watched 10-year Treasury Note fell over 100 basis points (1%) from its October peak. Yields are now about where they were at the beginning of the year, producing returns for Treasury securities of about 4% across all maturities.

Artificial Intelligence and the Magnificent Seven

News on Artificial Intelligence (AI) impacted financial markets positively. Amid the short-term uncertainty, it is clear the impact of AI will be profound. Domestic tech companies expected to benefit from AI, termed the “Magnificent Seven” (Apple, Amazon, Google, Meta, Microsoft, Nvidia and Tesla) representing 30% of the value of the S&P 500, were up big in 2023. An equally weighted portfolio of these stocks more than doubled over the year.

Interest rate risk and bank failures

Rapidly rising interest rates from near zero means banks are susceptible to interest rate risk by funding long-term loans with short-term liabilities. This risk explains the failures of Signature Bank and Republic Banks, as well as increased concern for the banking system in early 2023.

Political upheaval

We have endured our share of political upheaval in 2023, including the ongoing fighting in Ukraine, the brutal attack by Hamas and Israel’s response, coupled with the ongoing dysfunction of our Congress. This political wrangling and global uncertainty, plus a three-year increase in the average price of goods in the CPI of 17%, helps to explain the public perception of the domestic economy generally being worse than what’s implied by the numbers.

What’s Ahead in 2024

The beginning of a year is when we are treated to various forecasts of what’s ahead. Don’t pay any attention – no one knows. A long history of market behavior does give us a sense of what’s expected, but what’s realized is driven by surprises, both positive and negative. Market prices are the best predictor – diversification is the best way to deal with uncertainty. Take advantage of the wonders of compound interest by maintaining established commitments to several markets and avoid getting caught up in anyone’s predictions.

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Qualified Charitable Distributions

Qualified Charitable Distributions (QCDs) allow taxpayers age 70 ½ or older with traditional IRAs (not including active SEP or SIMPLE IRAs) to make charitable contributions directly from their IRA to a qualified charity (not a donor advised fund or private foundation) that will be excluded from their taxable income. This is especially beneficial for those who have to take required minimum distributions (RMDs) since Qualified Charitable Distributions from an IRA will count towards a taxpayer’s RMD. Therefore, utilizing QCDs gives those at RMD age the opportunity to satisfy their RMD requirement without incurring a tax liability.

 

For individuals age 70 ½ and older, QCDs can provide greater tax savings than typical charitable contributions reported on Schedule A of their 1040 since the distributions are guaranteed to be excluded from income even if the taxpayer cannot itemize their deductions. Traditional charitable contributions, including contributions to donor advised funds, are only useful to taxpayers who itemize their deductions. Even then, deductions are limited to 30% to 60% of AGI depending on the type of contribution (cash vs. non-cash).

 

In order for QCDs to be eligible they must be contributed directly from the taxpayer’s IRA to the qualified charity. They are only excluded from a taxpayer’s income up to $100,000 for single taxpayers ($200,000 for MFJ) per year.

 

Important to note, QCDs are not indicated as such on a taxpayer’s 1099-R, so it is imperative that any Qualified Charitable Distributions made throughout the year are properly documented by the taxpayer and communicated to their tax preparer.

 

To summarize, the steps for making a Qualified Charitable Distribution are as follows:

 

  1. Request a QCD withdrawal form from your financial advisor.
  2. The custodian will then process and transfer the distribution to the charity indicated.
  3. You will receive your 1099-R in the mail after year end.
  4. Specify to your tax preparer the amount of distributions on your 1099-R that are attributable to QCDs.

 

Please be sure to reach out to your Rockbridge financial advisor if this is something you would like to pursue.

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Bonus Depreciation Phase Out

When businesses purchase eligible property such as equipment, there are two options available to allow them to accelerate book depreciation, rather than write the asset off over the useful life. Under Section 179 of the Internal Revenue Code (IRC), the business may expense the entire cost of that piece of property in the year of acquisition, up to $1,220,000 in 2024, thus lowering the business’ taxable income. However, Section 179 depreciation cannot be applied in a year the business incurs a taxable loss, and would require a carry-forward.

 

As an alternative, a business may elect what is known as “bonus depreciation.” Bonus depreciation is a product of the Tax Cuts and Jobs Act of 2017 and allows businesses to immediately deduct 100% of the cost of eligible property placed in service after September 27, 2017 and before January 1, 2023. This is known as 100% bonus depreciation, it differs from the 179 deduction since the business is still eligible if they are operating at a loss. In addition, there is no limit on the amount of bonus depreciation a business may take in a given year. While the 100% write-off expired at the end of 2022, the bonus depreciation incentive still exists in some capacity as scheduled below:

 

  • Property placed in service in 2023 is eligible for 80% bonus depreciation.
  • Property placed in service in 2024 is eligible for 60% bonus depreciation.
  • Property placed in service in 2025 is eligible for 40% bonus depreciation.
  • Property placed in service in 2026 is eligible for 20% bonus depreciation.

 

This is a great tax planning opportunity for individuals who are partners/shareholders in a business that typically operates at a loss and are planning significant fixed asset acquisitions over the next few years. These individuals should try to accelerate any major asset purchases in order to be able to receive the maximum amount of bonus depreciation as it continues to wind down each subsequent year. Business owners who typically take advantage of bonus depreciation should be aware of this phase-out in order to avoid oversight on projected loss calculations for the next few years. Examples of common industries that may be affected by these changes include the manufacturing, rental real estate, and the agricultural industry. In addition, be sure to verify with your tax professional in regards to your State’s conformity with the Tax Cuts and Jobs Act as it relates to bonus depreciation.

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Advisor-Managed vs Outside-Managed Accounts

Most clients have investment accounts in each of the three major tax buckets: tax-deferred (ex. 401(k)), tax-free (ex. Roth IRA), and after-tax (ex. Brokerage account). Due to the different tax statuses, each account type “behaves” differently.

When investors save adequately across these accounts, there are a myriad of benefits. From a tax management standpoint, a financial advisor can help design a tax efficient withdrawal strategy. With that in mind, there are also drawbacks to investing when there is a lack of coordination across these different accounts. This often happens when accounts are managed outside of one’s advisor-managed accounts.

Advisor-Managed Accounts

At a high level, advisors are licensed professionals with access to tools and services that the general public typically does not have. Financial advisors can create a consistent investment strategy that should be integrated across client accounts. At the individual level, this is just one less thing for each client to navigate on their own in the midst of their own personal and professional responsibilities.

At a more detailed level, fully integrated advisor-managed accounts allow for more accurate management of capital gains, including:

  • Realizing short-term losses used to offset income tax instead of capital gains tax.
  • Accurate management of realized gains to prevent unnecessary tax payments.
  • More efficient tax bill for Roth conversions due to proper management of realized gains when using brokerage assets to pay tax on conversions.

Outside-Managed Accounts 

While consolidating all of your investment accounts with one advisor can be time consuming, that process is largely offset by the potential lack of coordination between advisors which can complicate financial planning goals and prevent plans from being executed. As more and more investors are switching their investments to exchange traded funds (ETFs) from mutual funds, many still hold mutual fund shares in their accounts outside of Rockbridge.  Actively managed mutual funds tend to have higher expense ratios and are less tax efficient than exchange traded funds. For example, as mutual fund shares are redeemed (outflows) at a greater rate than shares are purchased (inflows), fund managers will realize gains inside the fund portfolio, which passes capital gain costs onto the investors.

Solutions

  • Consider consolidating accounts with one manager.
  • If mutual funds are held in qualified accounts, reinvest mutual fund shares into ETFs with no tax consequences.
  • Turn off “auto-reinvest” of dividends of mutual fund shares.
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