When I take a step back from what is happening in the economy and look at the major U.S. market averages, I see an incredible disconnect. And I’m not alone. U.S. Gross Domestic Product (GDP), which is the broadest measure of the value of goods and services in the economy, fell at the annualized rate of 32.9% in Q2 2020, the largest decline on record (U.S. BEA data – quarterly data began in 1947). The prior record, a 10.0% annualized decline, occurred in 1958 and coincided with the Asian flu pandemic. The contraction can be blamed on the unusually swift decline in economic activity that began in March and quickly accelerated in April.
Covid-19 lockdowns stifled economic activity in an attempt to reduce the momentum of its spread. As a result, we have experienced job loss at an unprecedented rate. In April alone, employment fell by a record 20.8 million (St. Louis Federal Reserve). For perspective, 152 million individuals were employed in February. While May and June saw a significant improvement from these very depressed levels, the improvement was unfortunately not sustained.
The economy generated a record number of jobs in May and June, erasing one-third of March and April’s job losses (U.S. BLS data). We also saw big gains in retail sales following a record decline in April (U.S. Census), as businesses began to reopen, furloughed employees returned to work, and stimulus money ($1,200 checks and generous jobless benefits) put directly into the hands of the public has worked itself into the economy. Nevertheless, the economy remains far below its pre-coronavirus state as people continue to be wary of being out in public.
As July came to a close, the broad-based S&P 500 Index turned positive for the year, while the tech-heavy NASDAQ Composite is having an impressive year (Table 1). Investors have taken notice that the larger tech stocks appear to be more insulated from the initial impact of economic pullback. The Federal Reserve’s massive response to the crisis, coupled with the response by the federal government, has encouraged buying. In addition, investors may be looking beyond a dismal Q2, both in terms of GDP and profits, and attempting to price in more favorable conditions later in the year and into 2021.
Very limited visibility
The recession that began in February (per the National Bureau of Economic Research) appears to have ended in April, which would make it the shortest on record. However, it may be months before the NBER, which is the official arbiter of recessions and expansions, decisively calls the bottom. As it is, we still see a good deal of uncertainty as states test different plans to reopen businesses and schools, which has resulted in a spike in Covid-19 cases. Some states have been forced to slow reopenings while others have had to implement new restrictions. Based on “high-frequency data,” such as daily air travel, restaurant bookings via OpenTable, and requests for directions via Apple Maps, economic progress slowed or stalled in July.
While those metrics do not directly correlate with the economy or the larger S&P 500 firms, they approximate broader economic activity. And, even if we had a moment of historic job growth, layoffs – as measured by weekly jobless claims – remain at historically high levels (Dept. of Labor).
The prescription
As Covid-19 continues to hamper economic recovery and creates new uncertainties, the path of the economy is linked to the virus. We continue to hope that we will soon be able to formulate a picture of where we will all be when the global health crisis is mitigated. With large efforts to develop a vaccine underway for months and occasionally encouraging news, Fed Chairman Jerome Powell said in late July, “The path forward for the economy is extraordinarily uncertain and will depend in large part on our success in keeping the virus in check.”
Social distancing, masks, and all CDC-recommended safety protocols are a step in the right direction. However, a vaccine and/or an effective treatment are probably the best way to enhance mobility and help us move past this difficult chapter in history. The economy may not be the same when the pandemic is eventually in the rearview mirror, and in the aftermath our path forward will be largely decided by how we adapt – as individuals, communities, counties, states, and nations.
Table 1: Key Index Returns
Source: Wall Street Journal, MSCI.com, Morningstar, MarketWatch
MTD return: Jun 30, 2020-Jul 31, 2020
YTD return: Dec 31, 2019-Jul 31, 2020
*in US dollars
Two more considerations for 2020
As we have mentioned in previous correspondence, distributions taken from your IRA since January 1, 2020 can be re-contributed until August 31, 2020. You may wish to do this to lower income taxes for the year and let the funds remain invested and tax-deferred. Please let us know if this is applicable to you as soon as possible.
Since required minimum distributions (RMDs) have been suspended for 2020, you can decline taking any distributions from your tax-deferred retirement savings until next year. However, if you find yourself in a lower tax bracket this year due to forgoing any distributions, consider a partial Roth conversion to take advantage of your temporary lower tax rates.
Why choose a Roth IRA?
A Roth IRA is an Individual Retirement Account that allows you to contribute after-tax dollars into a savings or investment account. The after-tax dollars won’t allow you to claim a tax deduction as you might on a traditional IRA, but withdrawals are not subjected to federal income taxes when withdrawn after 59 ½ years of age, as long as the account has been opened for at least five years. Like a traditional IRA, interest, dividends, and capital gains are sheltered from taxes inside the Roth.
Tax Time
IRA contributions are subject to income limits, up to $6,000 per year if you are under 50 and $7,000 per year if you are 50 or over. We are past the tax deadline for 2019, which means it is time to plan for the 2020 tax season. First, let’s be aware of the rules regarding income limits:
- For someone who is single (or head of household), you are eligible to make the full contribution to a Roth if your modified adjusted gross income (MAGI) is under $124,000 for the tax year 2020.
- The amount gradually declines between $124,000-$139,000.
- Above $139,000, Roth contributions are not allowed.
If you are married and filing separately, the rules become more complex so let’s talk if you are in this category. If you are married and file jointly (or a qualified widow/er), MAGI must be under $196,000 for the tax year 2020, while the contribution limit is gradually phased out between $196,000-$206,000 and are then phased out completely. You may contribute to a Roth and a traditional IRA, but you may not exceed the prescribed annual limits. In addition to tax-free withdrawals, Roth IRAs are not subjected to required minimum distributions.
Further, under the SECURE Act, an inherited Roth IRA (and a traditional IRA) must be distributed within 10 years if the beneficiary is not your spouse (in most cases). Unlike a traditional inherited IRA, the distributions are tax free. And beneficiaries may let the Roth account grow tax free until year 10, when the full distribution is required.
High-income taxpayers and the backdoor Roth
If you have a healthy six-figure income, hard limits prevent you from contributing directly to a Roth. But income limits don’t exist for converting a traditional IRA into a Roth, which leaves a loophole for high-income taxpayers. Long story short, you may contribute to a non-deductible traditional IRA, open a Roth IRA, convert the contribution into the Roth IRA, and pay the taxes on any appreciation.
Conceptually, the backdoor Roth strategy]is relatively straight-forward if you have no other IRAs. If there are other IRAs in your name, taxes are pro-rated. For brevity’s sake, we will avoid getting into the minutiae, but we’d be happy to work the numbers out for you. That is what we are here for.
In the meantime
I understand the uncertainty facing all of us. We are grappling with an economic and a health care crisis. It’s something none of us have ever faced. We will continue to apprise you of any recommended strategies of changes as things unfold and governments take action to deal with the fallout, and if this year has brought you any new financial issues with no clear solution, let us help you to understand and optimize your outcome. If you have questions or concerns, let’s have a conversation.
As always, I’m honored and humbled that you have given me the opportunity to serve as your financial advisor.
