October 14th, 2022
The Dow Jones Industrial Average launched a historic turnaround on Thursday, surging 1,500 points from its low to its high, before closing +2.83% for the day. Markets had been treading water during the early part of the week in anticipation of the late week release of the CPI report. When September’s CPI report came in hotter than expected, it prompted an immediate selloff when markets opened on Thursday morning. The report’s strength all but assures the Federal Reserve will remain aggressive and raise rates by another 0.75% in early November. As the day unfolded, however, a number of alternative narratives and technical factors unleashed a flood of bullishness, resulting in a paradoxically strong outcome to what was – by all accounts – a very bad CPI reading. Markets gave back some of those gains on Friday, in part due to mixed earnings reports from the banking sector as well as some profit-taking, but the Dow Jones Industrial Average still managed to finish in the green by 1.20% for its second consecutive weekly gain.
Inflationary pressures remained elevated and broad-based in September. The CPI Index rose 8.20% year-over-year (yoy), in line with August’s 8.30% rate. Core inflation which strips out food and energy costs, and which is more indicative of future inflationary trends, continued to move higher. The core reading came in at 6.60% from the year ago period – its highest reading since 1982. On a month-to-month basis, overall inflation accelerated 0.40% relative to August’s 0.10% rise. Meanwhile, the monthly core CPI index rose 0.60%, matching August’s 0.60% increase. The monthly gains in CPI were primarily fueled by rising food, housing, and medical care costs. Food prices were higher by 0.80% for the month and 11.2% from the year ago period. Housing rose 0.70% on the month and 6.60% from the prior year. Medical bills were up 1.0% month-to-month, bringing their yoy gain to 6.50%. Although the market chorus has grown louder that inflation has peaked, that was not reflected in this report, and it is likely to remain elevated as a number of converging supply and demand forces are making the Fed’s job more difficult. One of those is the avian flu and its arrival in the U.S. with the fall migration. 47 million farmed birds have already been affected, topping the record set in 2014-2015 according to the New York Times. The UK is also facing a significant outbreak, which could force poultry producers into their second “flockdown” of the year by requiring all poultry and captive birds be kept indoors to prevent bird flu from spreading. Elsewhere, while Hurricane Ian has moved on, its wrath is still being felt by Floridians. Strong demand for shelter and cars will push on prices for building materials, new and used cars, appliances, and home furnishings, while OPEC+ oil cuts may impact gas prices. Additional inflationary pressures are in the pipeline as well. U.S. supplier prices increased 0.40% in September, bringing the yoy rise to 8.50%. In totality, the inflationary picture remains elevated, and while many of these readings are backwards looking, it seems too early to be comfortable claiming a peak.
Retail Sales Fall Flat
High inflation and rising interest rates are forcing consumers to make trade-offs between spending on goods or services. While consumers continue to prioritize services spending, retail sales, which comprise spending on goods like vehicles and groceries, were unchanged last month while August’s sales were revised 0.40% higher. Excluding gas and autos, retail sales grew 0.30% month-to-month. The flat top line was attributed to a -1.40% decline in sales at gasoline stations, which brought much needed price relief to drivers but is not expected to last given recent production cuts. That savings at the pump didn’t encourage consumers to buy more goods, and sales at appliance and furniture stores declined -0.80% and -0.70%, respectively. Consumers maintained an active social calendar in September, however, with spending at restaurants and bars up 0.50%. With inflation and interest rates continuing to percolate through the economy, it remains to be seen just how consumers will behave as we head into the busy holiday season.
Markets continue to swing in unexpected ways. Last week, markets jumped after weakening in a minor jobs report gave hopes that the Fed’s work might soon be done. This week, the market’s rally was likely more technical in nature rather than a response to a change in fundamentals. The CPI report, retail sales report and indications from bank earnings calls were not positive. In fact, they were just the opposite. Core CPI is still rising. Retail sales, while flat, are still elevated and bank earnings reflect an industry preparing for a downturn. Investment banking revenue, a proxy for overall business activity, was down sharply. Bank loans are increasing. This is great for banks because they earn higher interest, but ask yourself, “Why are loans increasing in a rising interest rate environment?” There are only two scenarios that come to mind. The first is that business is so brisk, companies need to borrow no matter the cost (bad for inflation) or companies are starting to lock in liquidity now to insulate themselves to a downturn (looming recession). Add to this, consumer credit card debt is rising, and banks are starting to reserve for potential loan losses, and it doesn’t paint a picture of confidence. So, what did markets see on Thursday to result in the fifth largest intraday rally in the S&P 500’s history? No one knows for sure, but here are the most likely explanations. The first is simply technical. The early morning sell-off resulted in markets having given back half of the gains made from the March 2020 lows. In touching that level, this set off a wave of profit taking (buying) on short and put positions, which then cascaded with other trend following algorithms to amplify the surge. We’re not technicians, and algorithms seem to get blamed on everything these days, but there is no question that trading did turn on a dime around the time when those levels were reached. Next, overnight Wednesday, rumors emerged that UK Prime Minister Liz Truss would ditch her controversial tax cuts and sack her finance minister over the handling of the UK’s debt crisis that has been rattling markets for weeks. This doesn’t resolve concerns with the UK entirely, but the policy reset and a sacrificial firing at least gave markets hope that Truss is not entirely tone deaf. Lastly, many traders interpreted the poor CPI report as an indicator that we are near a peak. Let’s call this the Peak Inflation Theory – which if true -means the worst is behind us. At some point, a CPI release will be bad. It will be the peak level, and since reports are backwards measuring, the storm will have passed. We just can’t say that we see anything in the most recent report to suggest that this was the one. None of these explanations are particularly satisfying and the magnitude of the rally doesn’t foretell that a page has been turned. In all likelihood Thursday’s rally was just another volatile day in a volatile market, and while the positive outcome was certainly appreciated, it was simply a headscratcher.
The Week Ahead
Big banks kicked off the Q3 earnings season on a mixed note. With more results to come next week, markets could rally on strong reports indicating healthy margins and 2023 guidance. U.S. economic news turns to the housing market just as the popular 30-year mortgage rate soared above 7.00% this past week. Higher borrowing costs will prove a formidable headwind to September existing home sales and housing starts. We’ll also check in on the global economy as China is the first of the major economies to release Q3 GDP numbers. The country’s Covid zero playbook has hammered domestic consumption while global inflationary pressures have slowed demand for goods. Current forecasts are calling for Q3 GDP of 3.50%.
Clarification by IRS Eliminates IRA Confusion
When the SECURE Act was passed in 2019 and signed by former President Trump, it had been a century since the introduction of tax incentives for employer-sponsored retirement plans in the IRS tax code. The SECURE Act, which stands for Setting Every Community Up for a Secure Retirement, was the largest retirement planning legislation in more than a decade. This year, it’s looking like we might see additional legislation out of Capitol Hill that further refines retirement savings for American workers. It is being referred to as SECURE Act 2.0. The provisions that will make the final bill are still to be determined, but last week, the IRS provided clarification on one of the provisions of the SECURE Act that affects taxpayers with inherited IRAs.
The SECURE Act of 2019 removed the stretch provision for Required Minimum Distributions (RMDs) from most Inherited IRAs. RMDs are congressionally mandated distributions from a qualified retirement plan, such as a traditional IRA or Simplified Employee Pension (SEP) plan. Contributions to these types of accounts are not taxed until money is withdrawn, and assets in the plan grow tax-free as well. The funds are taxed at the owner’s income tax rate when they are distributed. Prior to the SECURE Act, beneficiaries of an inherited IRA could “stretch” distributions from the inherited account over the course of his or her lifetime, thus delaying taxes and benefiting from tax-deferred growth. Under the new law, certain beneficiaries are now required to take all RMDs of a retirement account within a 10-year period. This is known as the “10-year-rule” and it applies to “non-eligible designated beneficiaries” which includes heirs who aren’t a spouse, minor child, disabled, chronically ill, or certain trusts with accounts inherited after December 31, 2020. In cases where inherited retirement plans were particularly large, beneficiaries were left with a huge tax bill.
Earlier this year, the IRS indicated that a number of heirs incurred penalties for not taking distributions that they didn’t know they were required to take from inherited IRAs under the new legislation. Many beneficiaries believed they would have ten years to deplete the assets in the account. However, the IRS has since announced that if the original owner of an IRA had already reached their “required beginning date” when they needed to begin taking RMDs, the “non-eligible designated beneficiaries” were expected to start taking RMDs immediately. A lot of individuals were not aware of this fact and expressed confusion about the timeline to the IRS and about the missed 2021 and 2022 RMDs. Furthermore, there was concern about the 50% penalty that gets applied to any amounts that were supposed to have been distributed.
Last week, the IRS said it would waive the distributions and the penalties for 2021 and 2022. The announcement by the IRS means that retirement plan heirs won’t get hit with a huge tax bill, and the money in the plan can continue to grow. It also gives advisors and their clients more time to create or modify retirement plans. The distributions must begin in 2023, however. There is an overwhelming amount of complexity surrounding inherited IRAs and the tax impact of leaving IRAs and 401(k)s to beneficiaries, and we anticipate further legislation and clarification on these issues. In the meantime, please feel free to call our office at (214) 891-8131 or contact your tax advisor with any questions.