Author: Amanda Ahne
Asset Allocation Bi-Weekly – The Inflation Adjustment for Social Security Benefits in 2025 (October 28, 2024)
by the Asset Allocation Committee | PDF
Even for dedicated, successful investors who have built up a substantial nest egg, Social Security retirement and disability investments can be an important part of their financial security. For many Americans, Social Security benefits may be the only significant source of income in advanced age. On average, Social Security benefits account for approximately 30% of elderly people’s income and more than 5% of all personal income in the US. There is one aspect of Social Security that is especially important in the current period of higher price inflation: By law, Social Security benefits are adjusted annually to account for changes in the cost of living. In this report, we discuss the Social Security cost-of-living adjustment (COLA) for 2025 and what it implies for the economy.
In mid-October, the Social Security Administration announced that Social Security retirement and disability benefits will increase 2.5% in 2025, bringing the average retirement benefit to an estimated $1,976 per month (see chart below). The increase, much smaller than those during the last couple years of high inflation, will bump up the average recipient’s monthly benefit by approximately $49. The benefit increase was right in line with expectations, given that it is computed from a special version of the Consumer Price Index (CPI) that is widely available. The COLA process also affected some other aspects of Social Security, although not necessarily by the same 2.5% rate. For example, the maximum amount of earnings subject to the Social Security tax was raised to $176,100, up 4.4% from the maximum of $168,600 in 2024.
Media commentators often fret that the Social Security COLA could be “eaten up” by rising prices in the following year, or that the benefit boost could provide a windfall if price increases decelerate. In truth, COLA merely aims to compensate beneficiaries for price increases over the past year. It is designed to maintain the purchasing power of a recipient’s benefits given past price changes with price changes in the coming year being reflected in next year’s COLA.
For the overall economy, the inflation-adjusted nature of Social Security benefits is particularly important. Since so many members of the huge baby boomer generation have now retired, and since more and more people are drawing disability benefits than in the past, Social Security income has become a bigger part of the economy (see chart below). In 2023, Social Security retirement and disability benefits accounted for 4.9% of the US gross domestic product (GDP). Having such a large part of the economy subject to automatic cost-of-living adjustments helps ensure that a big part of demand is insulated from the ravages of inflation, albeit with some lag. In contrast, if Social Security income were fixed, a large part of the population would be seeing its purchasing power drop sharply, which might not only reduce demand, but could also spark political instability. Of course, the additional benefits in 2025 will help buoy demand and keep inflation somewhat higher than it otherwise would be.
Finally, it’s important to remember that an individual’s own Social Security retirement benefit isn’t just determined by inflation. The formula for computing an individual’s starting benefit is driven in part by a person’s wage and salary history. Higher compensation will boost a retiree’s initial retirement benefit, which will then be adjusted via the COLA process over time. As average worker productivity increases, average wages and salaries have tended to grow faster than inflation, and as a result, the average Social Security benefit has grown much faster than the CPI. Over the last two decades, the average Social Security retirement benefit has grown at an average annual rate of 3.5%, while the CPI has risen at an average rate of just 2.6%. In sum, Social Security benefits provide an important source of growing purchasing power that helps buoy demand and corporate profits in the economy.
On the bottom line in our view, this year’s COLA announcement will prove to be market neutral. Although recipients may experience initial disappointment with this adjustment relative to those of recent years, the adjustment is actually more in line with those that came before the recent period of heightened inflation.
Asset Allocation Quarterly (Fourth Quarter 2024)
by the Asset Allocation Committee | PDF
- Our three-year forecast includes balanced economic growth, albeit at a slower pace than recent experience, and inflation settling above the Fed’s target rate.
- The Fed is expected to continue easing at a measured pace over the next year.
- We initiated a position in long-duration, zero-coupon Treasurys as a stabilizer amid potential global policy uncertainty and default risks.
- We continue to favor small and mid-cap domestic equities which offer appealing valuations and growth prospects relative to large caps.
- International developed equities remain in the portfolios, but we avoid emerging markets due to heightened risks.
- We preserve an allocation to gold as a hedge against geopolitical risks, with an allocation to silver where risk appropriate.
ECONOMIC VIEWPOINTS
Recent economic growth has been bolstered by a strong labor market, fiscal stimulus, and resilient personal consumption. We expect fiscal spending and continued strong labor markets to sustain growth during the beginning of the forecast period, both of which would support the consumer. While the overall business spending and personal consumption sentiment has been generally optimistic, momentum is slowing at the margin. The latest GDP report highlights that a part of the recent expansion stems from drivers that may be short-term in nature, such as inventory build-up ahead of a potential port strike. As we look ahead, we expect the labor market and consumption to be supported by easing monetary policy and lower inflation. The heightened uncertainty surrounding immigration policy could lead to a scenario where labor markets remain tight, which would continue to bolster household incomes. However, toward the end of the forecast period, consumption could moderate and potentially lead to increased uncertainty in the labor markets.
This first chart shows that while civilian unemployment, shown in red, has remained subdued at 4.1%, we are seeing some weakness with part-time work for economic reasons, shown in blue, ticking higher. Wage growth momentum has moderated but remains elevated compared to the pre-pandemic decade. It is worth noting that job openings have fallen as companies anticipate slower expansion, and a notable increase occurred in the long-term unemployed (27 weeks or more), which we anticipate will also be a drag on the labor markets.
While the Fed’s 50 bps rate cut and expectations for further easing support the expansion, high prices and relatively low rates of savings have made consumers more frugal. Such economic uncertainty has the potential to lead firms to delay investment and households to postpone buying big-ticket items, actions which we have already seen to a degree. Consumer sentiment, shown in red on the second chart, has improved since inflation, in blue, receded from its cyclical peak in 2022. We expect consumption to moderate as households have depleted their stimulus-driven savings and have grown more concerned about future job prospects.
Additionally, the favorable tax treatments for individuals in the Tax Cuts and Jobs Act of 2017 are due to sunset at the end of 2025. While each of the presidential candidates has shown support for extending at least some part of the tax act for individuals, tax policy cannot be unilaterally controlled by the president. To extend these tax cuts, both houses of Congress must pass legislation. While individual tax breaks are set to expire, most of the favorable corporate tax treatments, including the reduction of corporate tax rates from 35% to 21%, do not sunset.
The US presidential election will take place this quarter, and while highly publicized, these elections generally have a limited long-term impact on financial markets. However, given the current political climate, we are taking precautionary measures. We maintain a position in gold as a hedge and have increased our exposure to long-dated Treasurys to mitigate potential risks. Either candidate is expected to govern alongside a divided Congress, which reduces the likelihood of abrupt policy changes.
STOCK MARKET OUTLOOK
We expect corporate profit margins to remain healthy during the forecast period but we’re closely monitoring earnings quality for signs of potential weakness. With moderate economic growth and stable margins, we are maintaining an even-weight position in equity risk. The record level of cash on the sidelines continues to support valuations as we’ve seen these funds flow into risk assets during market pullbacks. This suggests that investors remain generally comfortable with equity exposure but are mindful of valuation levels. Furthermore, as the Fed continues to ease, lower money market rates may drive more capital into equities.
We are even-weight on the growth versus value style bias. While we recognize the concentration risk in a few prominent growth stocks, we believe current economic conditions will support equities across the board. We’re overweight mid-cap equities due to attractive valuations. While small cap stocks also offer appealing valuations, many small caps face higher sensitivity to debt refinancing. To manage risk and focus on earnings quality, we hold a small cap quality factor position, screening for profitability, leverage, and free cash flow.
We also maintain an overweight in the Energy sector and uranium miners, driven by Middle Eastern geopolitical tensions and the global energy transition. Our exposure to military hardware and cyber-defense remains a strategic portfolio component.
International developed equities remain attractive due to valuation discounts. Many global market leaders in the developed world ETFs are trading at lower valuations compared to US large caps. However, due to concerns about European economic growth, we have reduced developed market exposure in some portfolios. We maintain targeted exposure to Japan, where ongoing shareholder-friendly reforms and continued capital inflows may drive multiple expansion. We continue to exclude emerging market equities despite steep valuation discounts as we believe the risks surrounding Chinese growth outweigh the potential returns.
BOND MARKET OUTLOOK
Expectations for fixed income markets largely depend on inflation trends. While we expect volatility of inflation to remain elevated, the likelihood of a spike to levels experienced in 2022-2023 is slim. Rather, we expect inflation to decline gradually but unevenly from those highs, though we find it unlikely that the Fed will achieve its 2% target level within our three-year forecast period. While this became the target during the period of zero rates of the past decade, we find that a level around 3% is much more likely.
Against the backdrop of inflation expectations, the Fed’s data dependency heralds the prospect for three-month rates to remain relatively elevated compared to two-year rates. This implies that, absent a significant economic shock or a deep recession, the yield curve is more than a year away from returning to a normal, positive slope across all maturities. Accordingly, we find a mix of maturities to be the appropriate exposures in the strategies as the process unwinds. Within sectors, we are underweight investment-grade corporates due to their historical tight spreads. However, we are overweight mortgage-backed securities (MBS), where low refinancing activity has created attractive pricing. Contrasted with investment-grade corporates, speculative grade corporates maintain an attractive spread of nearly +300 basis points. Nevertheless, some caution encourages our preference for the higher BB-rated bonds in this asset class.
Although the majority of the bond exposure in the strategies is in the short to intermediate section of the curve, the combination of heightened geopolitical risk, uncertainty surrounding the US legislative and presidential election outcomes, and resulting potential policy changes leads to the introduction of a modest exposure to long-term, zero-coupon Treasurys in most strategies, the intention of which is to act as a hedge against these risks. A long-duration bond may serve as a ballast against market volatility due to its inverse relationship with interest rates and its role as a stabilizing asset in a diversified portfolio.
OTHER MARKETS
We continue to hold a position in gold across all portfolios. Despite gold spot prices reaching record highs this year, we believe additional Fed interest rate cuts and continued central bank purchases could push gold prices higher. The gold position also offers a strategic layer of protection against volatility, given its historical role as a safe-haven asset during periods of geopolitical instability. In portfolios with higher risk tolerance, silver is retained as a complementary precious metal holding. While REIT valuations have improved and the prospect of lower interest rates should generally benefit the sector, we have ongoing concerns around debt refinancing challenges and property valuations that lead us to avoid this sector this quarter.
Keller Quarterly (October 2024)
Letter to Investors | PDF
“Will it play in Peoria?” That wonderfully alliterative question originated in the show business community. A show that might “knock ‘em dead” in New York might not be so popular in the rest of the country. We live in a big nation. While there is a commonality that binds us together, there are meaningful cultural differences. New York, Philly, Boston, and Miami all have their unique qualities, as do Houston, Denver, San Francisco, and LA. As I travel the country I’ve come to admire and enjoy all these mini cultures.
I’m thinking about Peoria, Illinois, because I’ll be visiting that town soon. I’ve been travelling there regularly for about 25 years because of the many friends and clients I have there. What gave rise to the idea that if a show does well in Peoria it will do well anywhere? Like much of the Midwest, Peoria is a place of easy-going, but hard-working and friendly people; people who don’t mind being characterized by words like calmness, perseverance, and normal. In a country where so many people seem to be lined up on the extremes of anything, Peoria provides a delightful middle. It’s neither too high nor too low. If the Peorians like it, mainstream America will love it!
What’s the point of this paean to a Midwestern disposition? I think it is the ideal temperament for successful long-term investing, and you don’t have to be from the Midwest to develop it. It’s important not to let oneself get too excited about something great or get too depressed about a negative development. I believe keeping one’s emotions in check is the single most important thing an investor can do. Investing should be a rational, thoughtful endeavor.
I’ve written before that the same emotions that make us human can be the enemies of successful investing. Emotional extremes generally lead to irrational decisions. There may be many reasons to get emotional about this year’s election, but, in my opinion, the impact on your portfolio should not be one of them. Neither party seems particularly interested in reducing federal spending or substantially increasing the tax burden on the US economy. Thus, we expect federal deficits to remain large no matter which party controls the purse. Both parties are likely to continue tariffs on a variety of Chinese goods destined for the US. Whatever their differences on non-economic issues, we expect that these economic policies, which we believe are inflationary, will remain in place.
As I discussed at length in my last letter (July 2024), the factors that have made the US an extraordinarily good place to invest are still in place and not likely to be affected by the national election. The recent Confluence Asset Allocation Bi-Weekly from September 30, 2024, exhibited data since 1930 indicating that stock market returns have shown virtually no preference for which party was in power.
I repeat what I wrote last quarter, quoting my letter from October 2020: The stock market is neither Republican nor Democrat but is solely interested in making money. In my opinion, the current environment is well-suited to doing just that, regardless of who wins the election.
As we’ve said for several years, we expect inflation rates to remain above the average of the last decade for the foreseeable future. In our opinion, this should be the investor’s primary concern. Our investment strategies, be they domestic equities, international equities, or asset allocation portfolios, have this expectation in mind: that inflation is likely to remain higher than investors expect. The professionals at Confluence Investment Management have experience investing in rising inflation environments. It’s not unknown to us, like Peoria.
We appreciate your confidence in us.
Gratefully,
Mark A. Keller, CFA
CEO and Chief Investment Officer
Bi-Weekly Geopolitical Podcast – #55 “Israel’s Pager Caper and Supply Chain Security” (Posted 10/21/24)
Bi-Weekly Geopolitical Report – Israel’s Pager Caper and Supply Chain Security (October 21, 2024)
by Bill O’Grady and Patrick Fearon-Hernandez, CFA | PDF
Can you trust your refrigerator? What if it could be weaponized against you, perhaps by being booby-trapped to explode, release poisonous gas, or just stop working on the command of some foreign enemy communicating with its computer chip? Just as important, if everyday products connected to the internet or communication networks could become that dangerous, what would you want your government to do to protect you? What could your government do to protect you?
These questions may sound strange, but they demand attention after hundreds of Hezbollah militants in Lebanon were maimed by simultaneously exploding pagers and walkie-talkies on September 17 and 18. Dozens of militants died in the attacks, which have been attributed to Israel. In this report, we explore how this groundbreaking attack has probably transformed national security requirements and will likely lead to big, costly changes in global supply chains in the coming years. We will also delve into the underlying philosophies that help explain why this could impact globalization. As always, we wrap up with a discussion of the implications for investors.
Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify
Asset Allocation Bi-Weekly – #127 “The Yield Curve Un-Inverts” (Posted 10/14/24)
Asset Allocation Bi-Weekly – The Yield Curve Un-Inverts (October 14, 2024)
by the Asset Allocation Committee | PDF
Although the financial press has failed to discuss it at length, the United States bond market has just exited a long period in which the yield curve (the range of bond yields across maturities) was inverted (longer-term yields were lower than shorter-term yields). One popular summary measure of the yield curve is the difference between the 10-year Treasury note’s yield and the yield on the two-year Treasury note. By that measure, based on month-end figures, the yield curve was inverted for 25 straight months from July 2022 through August 2024. At its nadir of -0.93% in July 2023, the 10-year Treasury yield was 3.90% and the two-year Treasury yield was 4.83%. At the end of September 2024, this measure of the yield curve had turned positive at 0.10%, with the 10-year Treasury yield falling 18 basis points to 3.72% and the two-year Treasury yield falling 121 basis points to 3.62% (see table below). Positive, upward-sloping yield curves are considered more normal.
The yield curve is closely tracked because inversions have often signaled an impending recession and falling values for risk assets. At this point, it appears that the latest inversion was a false signal of recession. It does appear that US economic growth has slowed, but there are only limited signs currently that the economy could be heading into a broad decline. Investment strategists have nevertheless begun to focus on the implications of the yield curve turning positive again. Many are urging investors to rotate into longer-maturity bonds, apparently on the conviction that longer-maturity bonds will see big price gains (implying big yield declines), while shorter-maturity bonds will see smaller price gains (implying smaller yield declines). Is this reasonable?
To get at that question, we analyzed the total return (yield plus price change) for both five-year and 10-year Treasury notes after each of the eight un-inversions of the yield curve since the early 1960s. We focused on the total return for Treasury notes at three months, six months, and 12 months after the end of each inversion. The results of our analysis are shown in the table below.
The table shows that in the 12 months after the un-inversions since the 1960s, the average total returns on five-year and 10-year Treasury notes have been positive but not spectacular. The table suggests that the key variable is what happens with the Federal Reserve’s benchmark fed funds interest rate in the year after the un-inversion. To the extent that the fed funds rate declines in the year after un-inversion, total returns for longer-maturity Treasury obligations are greater. If the fed funds rate is basically stable in the year after un-inversion, investors’ total returns from longer-maturity Treasurys have been similar to the yield on those obligations. But if the fed funds rate increases in the year after un-inversion, the total returns on longer-maturity Treasurys have typically been negative.
Looking out at the coming year, investors widely expect the Fed to keep cutting the fed funds rate, so today’s ubiquitous calls for longer-maturity Treasurys may make some sense. However, investors should also not forget the burgeoning bond issuance that could potentially outpace demand. In our view, in addition to lower policy rates, the Fed may need to end its balance sheet reduction program to help alleviate some of the liquidity concerns in the bond market. Policymakers could also decide to cut rates gradually over the coming year and only moderate the pace of balance sheet reduction. That’s especially so after the strong September employment report, which pointed toward rebounding demand for labor and increased wage pressures. More broadly, modest policy easing would be expected if US economic growth remains healthy and/or consumer price inflation doesn’t cool as much as anticipated. Based on the analysis presented here, the resulting “restrictive for longer” approach to monetary policy would likely limit the total returns for longer-dated Treasurys. An economic soft landing and modest monetary easing mean the maturity extension trade probably doesn’t work.
We also note that in the year after an un-inversion, the average total return on five-year Treasury notes is better than the total return on 10-year Treasurys, especially in cases where the fed funds rate increases. We see a similar implication from our bond model, which we use to predict fair value bond yields based on key economic indicators. When we plug a 3.25% fed funds rate into the model (roughly the level policymakers expect to reach by year-end 2025), we get a projected decline in the five-year Treasury yield from current levels but a rise to nearly 4.00% for the 10-year yield. (At today’s fed funds rate of 4.75% to 5.00%, the model estimates a fair value of 4.43% for the 10-year Treasury, as shown in the chart below.)
In sum, rotating into longer-maturity bonds to generate greater returns may not make sense right now, even if some observers are calling for it. Further normalization of the yield curve may indeed be in store as the Fed keeps cutting short-term interest rates, but those rate cuts may well prove modest if the US economy keeps growing. That could limit any price gains and total return opportunities in longer-dated fixed income. If the economy avoids a recession and reaccelerates, pushing up inflation again and potentially requiring renewed rate hikes, longer-maturity obligations could produce negative total returns. Keeping most bond exposure relatively short still seems to make sense today, even as it might be prudent to maintain some longer-maturity exposure to hedge against geopolitical risks.