At its March 2^nd Federal Open Market Committee (FOMC), the Federal Reserve board voted to raise short-term rates another 25 basis points—the second such increase this year. It was the ninth rate hike since March 22, 2022, in an all-out effort to tame rising inflation, which had surged to its highest levels in 40 years.

The number of rate hikes is not unprecedented—the Fed increased rates 17 times between 2004 and 2006 to cool a bubbling housing market. What is unprecedented is the velocity of the rate hikes, taking the short-term rate from near zero to nearly 5.0% in a relatively short period of time. That period included four increases of 75 basis points and two 50-point hikes. Such steep increases have been unheard of in the last three decades.

By some measures, inflation appears to be cooling somewhat though prices of many essential items remain at record high levels. Where the Fed goes from here is not entirely clear. Since its initial burst of rate hikes last year, the Fed has been walking a tightrope in trying to curb rising inflation without tipping the economy into a deep recession.

Recent Events Increasing Fed Challenges

In an ideal world, the Fed would be able to gradually moderate inflation by closely calibrating its rate hikes until demand and supply are balanced while allowing the economy to grow. But the events of the first quarter of 2023 have reaffirmed that this isn’t an ideal world, which complicates the Fed’s job and notches up the tension on the tightrope.

Though the stock market rebounded nicely in the first quarter, it wasn’t without significant economic and geopolitical drama, creating a wall of worry for the market to climb. In just three months, we’ve experienced several remarkable and potentially cataclysmic events, including:

• Rising tensions between the U.S. and China punctuated by the downing of a Chinese spy balloon that was allowed to traverse most of the U.S.
• The U.S. inching closer to a “hot war” with Russia as it escalates its military aid to Ukraine.
• The second largest bank failure in U.S. history with fears of more to come.
• Brazil and Saudi Arabia joining China, Russia, and a dozen other countries in replacing the U.S. dollar as their primary trading currency.
• An unexpected reduction in oil production by OPEC+, driving up oil prices sharply with an increase in gas prices to follow.
• Lingering concerns over an imminent recession.

And that was just one quarter. In most years, any one of these events would weigh heavily on the U.S. economy. The Fed must contend with all of them at once as they consider their next move.

How Did We Get Here? 

With interest rates already near zero at the beginning of the pandemic, the Federal Reserve put quantitative easing on steroids as the economy plunged into a recession, ballooning the federal balance sheet to nearly $9 trillion. This was done to increase the money supply and stimulate economic growth during the damaging COVID pandemic. As the growth of production of goods and services slowed, the raging money supply growth eventually overtook it, causing the price of goods and services to be bid up. When too many dollars are facing too few goods, you get inflation.

Then add in supply chain issues and increasing wages occurring at the time, causing employers to have to pay more to get people to come to work. That contributed heavily to inflationary pressures on the market. Despite the record low unemployment numbers at the time, there were still four to five million people not working, not contributing to production, which also contributed to the supply chain issues and rising prices.

Often ignored in the inflation equation is the velocity of money—the rate at which money is exchanged in the economy. Following the financial crisis in 2008 and the COVID pandemic in 2020, consumers were more inclined to save their additional dollars out of caution. During COVID, it was also because many services were no longer available for purchase, such as travel and restaurants.

Then, as COVID restrictions lifted, consumer activity reached pre-pandemic levels, increasing the velocity of money and setting the stage for more prolonged inflation.

As the inflation rate began to tick up in 2021, the Federal Reserve viewed it as transitory, caused by temporary supply and demand imbalances that would self-correct. That didn’t happen and inflation worsened, catching the Fed and everyone else off guard. That’s the reason the Fed took such drastic actions in 2022, increasing fears it could lead to a deeper recession.

Where We Go from Here

Consumers have been spoiled by low interest rates for a while. However, to put higher rates in perspective, mortgage rates, which are currently hovering around 6%, were as high as 18.5% in the 1980s. A normal business cycle lasts about six years, which usually encompasses an economic slump and an economic recovery.

Coming off a deep, albeit short-lived, recession in 2020, interest rates were kept low for an extended time and must now rise to combat inflation. The good news for consumers is an increase in rates is inevitably followed by a decrease in rates. The bad news is that it typically happens when the economy is slowing down.

At Platt Wealth Management, we remain committed to helping you navigate these challenging times. We also encourage you to stay informed and engaged with the economy and markets. As we’ve seen throughout history, the markets are resilient, and they recover to new highs over time.

Of course, we are always here to answer your most pressing questions and address your concerns. Simply reach out to the office to schedule a time to speak with your advisor.

Sincerely,

Your Platt Wealth Management Team

Resources:

FOMC meeting calendar and information: https://www.federalreserve.gov/monetarypolicy/fomccalendars.htm

Bureau of Labor Statistics on inflation: https://www.bls.gov/cpi/

The velocity of money and its impact on inflation: https://www.investopedia.com/terms/v/velocity.asp

Federal Reserve’s perspective on transitory inflation: https://www.federalreserve.gov/newsevents/speech/brainard20210601a.htm

Historical mortgage rates in the U.S.: https://fred.stlouisfed.org/series/MORTGAGE30US

Business cycle basics: https://www.investopedia.com/terms/b/businesscycle.asp

Platt Wealth Management offers financial plans to answer your important financial questions. Where are you? Where do you want to be? How can you get there? Our four-step financial planning process is designed to be a road map to get you where you want to go while providing flexibility to adapt to changes along the route. We offer stand alone plans or full wealth management plans that include our investment management services. Give us a call today to set up a complimentary review. 619-255-9554.

Markets go up. Markets go down. But no one can predict when, how, why, or for how long. Ups and downs are par for the investing course, but market cycles can have a greater impact on those nearing or in retirement than those in their accumulation years. That’s because in retirement you simply have less time and fewer opportunities to rebuild your savings should the market take a turn for the worst.

So, in order to understand how market cycles can impact your retirement (and what you can do about it) let’s look at some facts.

Understanding the Impact of Market Cycles

The most noticeable impact market cycles can have on your retirement is in regard to income distribution. When you rely on your investments to generate income, a less-than-favorable market cycle can dictate how long your money will last. That’s why it’s imperative to determine the optimal spend down of your assets, which can be complex and based on many factors (both known and unknown).

Over the years, many financial advisors have been applying the “4 percent rule,” developed several decades ago by financial planner William Bengen. Bengen modeled various asset allocations and spend-down rates over a 30-year period to see how each would have fared. He found that, between 1926 and 1976, an asset allocation mix of 50 percent stocks and 50 percent bonds enabled retirees to safely draw down four percent of their assets annually without running out of money. 

Following that rule in the 1980s and 1990s made sense because bonds and stocks experienced primarily positive returns. It didn’t work quite as well in the 2000s with a largely stagnated stock market, forcing retirees to deplete their assets more quickly.

What complicates this rule of thumb is market volatility, which introduces a greater risk to the portfolio. When retirees are drawing down assets during a declining market period, there is a higher probability their assets will not last as long as they’d hoped. The only remedy then seems to be to reduce the spend down rate, live a diminished lifestyle, or risk depleting their assets too soon. And of course, no one wants to run out of money.

There is an even greater risk when the market declines at the beginning of retirement. A steep market decline in the first few years before or after retirement, even if followed by a sustained market increase, can severely impact future income. This risk is referred to as a “sequence of returns” or sequence risk and is one that very few DIY investors are privy to. And if they are aware of the risk, they tend not to know how to account for it in their financial plans.

The Greatest Risk Retirees Face: Sequence of Returns Risk

When it comes to retirement drawdown and market cycles, timing is everything. That’s because a sequence of returns risk stems from the timing of market returns and their impact on your portfolio when you begin to draw down your assets.

While it is fair to assume that the market will generate an average rate of return over time, that doesn’t account for the timing of those returns. Your portfolio can average eight percent a year over twenty years, but if the first three to five years consist of negative returns, it could be too much to overcome even if the next fifteen years produced positive returns. 

Why? Because loss and gain are not inversely proportional. If stocks in your portfolio decline in value, you need to sell more shares to meet your income needs. That reduces the number of shares left to grow inside your portfolio. During a prolonged market decline, that accelerated depletion of shares could make it difficult for your portfolio value to recover as the market recovers. 

Imagine your portfolio like an apple tree. Each year you need to take 40 apples from the tree to survive. Based on the tree’s history, this is a safe rate at which the tree will at least replenish if not surpass restoring those 40 apples. But, if when you begin taking those 40 apples out each year, the tree starts to produce fewer apples—you run the risk of using up all your apples before the tree has a chance to grow more.

The Risk (or Reward) is Greatest at the Beginning of Retirement

Conversely, drawing down your assets during an advancing market could provide the boost needed to carry your portfolio through future market declines or allow you to live an enhanced lifestyle. That also means if your portfolio experiences negative returns in later years, it will probably have a minimal negative impact. 

Consider the following chart showing two portfolios starting with $500,000. Both are drawing down assets at a rate of $25,000 per year adjusted for 3% inflation. Portfolio 1 experiences negative returns in the first three years, followed by multiple cycles of positive and negative years. Portfolio 2 starts out with four years of double-digit returns followed by a typical market pattern of positive and negative returns with three years of negative returns at the end. 

For this analysis, the same rates of returns are used in both portfolios, except their sequence is reversed. So, both portfolios generated the same 6.5% average rate of return, yet the outcomes were vastly different due to the sequence of returns. 

Key Takeaway

While you can’t predict the stock market’s direction, much less the sequence of returns as you enter retirement, you can prepare a diversified portfolio that is designed to handle such possibilities. We help our clients mitigate this risk and provide them with peace of mind that the retirement income plan we have built for them will be able to mitigate the sequence of return risk and boost their overall lifetime income sufficiency.

Creating Your Financial Strategy

At Platt Wealth Management, we know that life is about so much more than accumulated wealth and that real, impactful financial planning starts with what you want most out of life. That’s why our mission is to provide the financial expertise our clients need to think through and achieve the dreams they never thought possible. If this sounds like the financial advisory relationship you’re looking for, we encourage you to reach out and schedule your complimentary appointment with our team today. Or you can call the office directly @ 619-255-9554. We look forward to meeting you.

Platt Wealth Management offers financial plans to answer your important financial questions. Where are you? Where do you want to be? How can you get there? Our four-step financial planning process is designed to be a road map to get you where you want to go while providing flexibility to adapt to changes along the route. We offer stand alone plans or full wealth management plans that include our investment management services. Give us a call today to set up a complimentary review. 619-255-9554.