Economic Resilience in the Face of Rising Rates

The Federal Reserve’s (Fed’s) policy to increase the federal funds rate from zero to over 5% has worked to reduce inflation. Inflation peaked at 9.1% in June of 2022. Since then, the Consumer Price Index (CPI) has declined to 4.0% year over year according to the last reading as of May. While higher rates have slowed the economy, the broader economy has not entered a recession, nor does one appear imminent due to the strong job market. We do not know the mechanism for how the economy has remained stronger than expected, but it appears that “main street” is much less sensitive to interest rate changes than previously thought.

In an interview on CNBC in March, former Fed member Richard Clarida indicated that, “I think it’s fair to say that the Fed is not on a path to a soft landing. We’re going to have to raise rates enough to bring inflation down, and that’s going to mean some pain.” Fed Chairman, Jerome Powell, and other leading economists such as Larry Summers have echoed these thoughts since the Fed began raising interest rates. The economy has slowed significantly – the latest reading indicated that the economy was growing at a 2% rate in the first quarter of this year after declining from a rate of 5.7% in the fourth quarter of 2022. However, the rate is still positive, and the St. Louis Fed’s model expects continued growth – although slow – for the remainder of the year.

Certain strategists such as Mohamed El-Erian have opined that the US economy is experiencing rolling recessions in different economic sectors. According to this line of reasoning, certain sectors have been in recession while others have been growing so that the net effect is a growing economy. Currently, Healthcare and Retail services are strong while Financial Services and Manufacturing are declining. Each economic sector has been responding to the whipsaw in demand caused by Covid and subsequent stimulus measures.

Given the strong jobs numbers, the easiest explanation for the strength of the economy in the face of rising rates is the labor market. This year, the US economy has grown by an average of 357,000 jobs (non-farm) each month through May. This figure exceeds the growth of the labor market by a substantial margin as the country needs somewhere between 50-100,000 additional jobs per month to account for population growth. Job openings are off their peak from March of last year; however, the latest figures suggest there were still about 10 million job openings, which is an incredibly strong reading. Before the pandemic, the US economy only averaged 5-7 million job openings during the previous decade.

Our guess is that the strong jobs market is the result of demographic shifts in combination with the stimulus measures from the pandemic. 1957 was the peak year during the baby boom when 4.3 million children were born. Therefore, that peak baby boomer is turning 66 this year and has most likely retired recently or is planning to retire soon. For comparison, in the early 2000s the US only averaged about 4 million births each year. This math ignores immigration, participation rates and other factors, but the outflow from the labor force is substantial relative to the inflow of those in their early 20s starting their careers now.

Anecdotally, we still hear stories of labor shortages. Our technology service provider indicated that his company is having trouble staffing sufficiently to meet the growth in its customer base. A plumber from the oil company mentioned that he can earn $250 per hour moonlighting given the limited supply of tradesmen with his skills. These stories do not mean much, but it’s rare to hear about companies that are fully staffed.

This underlying economic strength has produced impressive equity returns. The S&P 500 increased 16.9% over the first half of the year as the technology sector rebounded strongly.

To end on a note of caution, the situation in Russia is very volatile. We have learned little in the aftermath of the Wagner Group’s coup attempt, but Putin is weak and the potential for regime change is high. Given Russia’s nuclear weapons cache and status as a top producer of energy and food, the potential for contagion to the rest of the world is significant if Russia implodes.

The Rise of Artificial Intelligence

Artificial intelligence (AI) has arguably been the biggest driver in the stock market over the first half of the year. Nvidia (NVDA), the graphics processing unit designer and developer, was the best performing stock in the S&P 500 due to expectations for increased AI driven demand for its chips. Other AI related stocks have done well, from other chip companies such as Advanced Micro Devices, software companies like Salesforce, and security companies like Fortinet. Even non-technology related companies are using AI phrases during presentations to generate investment excitement. Kroger, the supermarket company, referenced AI eight times at its most recent quarterly conference call, after zero mentions on previous calls. The comments centered around using AI to analyze data to improve marketing and the customer’s experience.

Governments have taken notice. The European Union (EU) drafted the first AI rules using a risk-based approach. The approach seeks to ensure AI systems are safe, transparent, traceable, non-discriminatory, and environmentally friendly. The rules look to ban dangerous AI practices such as biometric surveillance. In the United States, the Biden administration is considering new curbs on the exports of AI chips to China. Companies are aware of the potential government regulation and, most likely, trying to steer it in the friendliest manner possible. Google is working with governments in the EU and the United Kingdom to make sure regulation is adopted in, what Google considers, the right way.

Currently, AI centers around products like Microsoft’s Copilot, which helps users generate content from text, e.g., “make a presentation based on notes from yesterday’s meeting” and also helps coders by suggesting code for their program. AI chatbots are also increasingly being used. Snap Inc., the popular social media application, has a My AI chatbot allowing users to answer trivia questions or get suggestions for a birthday present. Most chatbot queries will be non-commercial in nature, but asking a chatbot for gift ideas will naturally lead to ads for the recommended gifts. Meta’s apps like Instagram and Facebook are looking to incorporate such AI chatbot technology.

AI will clearly become a bigger part of how technology is used by companies and in our everyday lives. It will make applications more valuable. For example, Microsoft’s Copilot will improve the functionality of its Office Suite and Adobe has introduced Generate Fill in Photoshop which allows users to generate artificial images. It may allow companies to cut costs, using AI to help write code or even fill out paperwork. However, there are concerns we are seeing the next bubble. NVDA is now trading at a 10-year high, with a forward price to earnings multiple over 200. It wasn’t long ago that the metaverse was the next frontier, and that investment has been scaled back significantly, even by Meta, the company that literally changed its name for the movement.

AI exposure is important in portfolios. We have several core positions with AI exposure, including the aforementioned Microsoft, Adobe, Alphabet (Google) and Meta. Broadcom is like NVDA in that its chips are used in the machines that power AI computers. For example, Broadcom designed an AI processor chip with Alphabet. An important aspect of these companies is that they were good investments before AI, and while they’ll benefit from AI, they are not dependent on its growth.

Converting your 529 into a Roth IRA

President Biden signed the SECURE Act 2.0 of 2022 into law late last year as part of the Consolidated Appropriations Act (CAA) of 2023. The legislation is designed to promote retirement savings and includes provisions for automatic 401(k) enrollment, increases the age for taking retirement plan minimum distributions, provides tax benefits for employers offering retirement plans, and much more. One provision, which garnered initial excitement from the investment community, allows for unused 529 Plan assets to rollover tax-free to a Roth IRA for the plan beneficiary. Recent IRS guidance on the operation of this new provision, that takes effect after 12/31/2023, has dampened some of that enthusiasm.

A 529 plan is an investment account that works much like a Roth 401(k) or Roth IRA by investing after-tax contributions in mutual funds, ETFs, and other similar investments. Investments grow on a tax-deferred basis and can be withdrawn tax-free if the money is used to pay for qualified higher education expenses. Some states offer additional state tax deductions for residents who utilize their in-state plan. Generally, qualified higher education expenses include costs required for the enrollment or attendance at a college, university, or other eligible post-secondary educational institution.

The benefits of 529s are evident, but for years investors have had the same apprehension to utilize them. What happens if my child/grandchild does not go to college or receives a scholarship or financial aid, and the funds go unused? The earnings portion of any plan distributions for non-qualified expenses will be subject to income taxes and a 10% penalty. 529 owners may change the plan beneficiary as many times as they like, so the commonly proposed solution to the ‘unused funds’ dilemma is to swap the beneficiaries and use any unused or leftover 529 savings for another person’s higher education. While this is a convenient answer for some, it does not work for everyone. Now that SECURE Act 2.0 is law, starting in 2024, 529 owners have an alternative method to solving that problem.
529 owners will be able to convert 529 funds tax- and penalty-free to a Roth IRA owned by the 529 beneficiary. However, there are several stipulations to make a qualifying conversion:

  • 529 must have been maintained with the same owner and the same designated beneficiary for 15 years or longer.
  • The amount converted each year cannot exceed the annual Roth IRA contribution limit. The contribution limit for 2023 is set at $6,500, with an extra $1,000 catch-up allowance for people over 50.
  • The annual conversion amount is aggregated with any annual IRA or Roth IRA cash contributions, so the 529 plan beneficiary may not “double dip” in terms of funding in any given tax year.
  • The Roth IRA owner (529 plan beneficiary) must have taxable income at least equal to the amount of the conversion in the year of the conversion.
  • The amount of 529 account funds converted to a Roth IRA may not exceed the aggregate amount contributed to the 529 plan account (including earnings on those contributions) in the 5 years prior to the Roth IRA conversion distribution date.
  • Finally, conversions are capped to a lifetime limit of $35,000 per beneficiary.

These stipulations ensure that 529 owners and beneficiaries will need to implement a coordinated conversion schedule over several years to take full advantage of the new rule. The $35,000 lifetime cap makes certain that wealthy parents and grandparents cannot shelter unlimited amounts from taxes while passing generational wealth to their families.

Roth IRAs are terrific retirement savings vehicles where earnings grow tax-free. Roth IRA distributions can be taken tax- and penalty free after the owner reaches age 59.5 and has met a minimum account holding period of 5 years. Roth IRAs have no mandatory withdrawals (required minimum distributions) like traditional IRAs and 401(k)s. Additionally, any Roth IRAs inherited by heirs receive tax-free growth (for 10 years) and income tax-free distributions.

The new rules that govern the conversion of 529 plan funds to Roth IRAs are complex. Eagle Ridge encourages our clients who own 529 plans or who are contemplating funding the college education of a family member to reach out to review the options at hand. While navigating the provisions of a 529 plan to Roth IRA conversion may be a complicated process, the benefits of a Roth IRA could make it a worthwhile endeavor.