McCarthy & Cox News and Articles
When Pristine Becomes Too Pristine
Written by Wesley W. Bean, CFA®
When I began thinking about this piece in late 2021, the word that kept coming to mind when thinking about the economic backdrop was “pristine”. However, there’s a point where “pristine” becomes too “pristine”, and market participants turn their attention to what needs to be done to slow it.
Fast forward a few weeks, and that’s where we are now. As I write this, the S&P 500 is off a little over 7% year-to-date. The Dow Jones Industrial Average is faring slightly better, off just 5%, while the tech-heavy Nasdaq is off by 11%. Look beneath the surface, however, and you’ll find more than 220 US large-cap names off over 20%, and nearly 40% of the names in the Nasdaq Composite have seen their share price cut in half.
So, with an economy that continues to grow, a central bank that has turned its attention to slowing it, and the continued backdrop of Covid-19, what’s an investor to do? Sit tight? Sell and go to cash? Buy more?
Our outlook for the remainder of the year centers around the transition to a period of slower growth, namely, how policymakers will navigate the waters, and how the markets may react.
We currently have several tailwinds, one of which is continued policy support. Quick, significant, and globally coordinated fiscal and monetary stimulus was delivered early in the pandemic and maintained throughout. This served as a powerful force in propping up economies and staving off a financial crisis.
Now, however, central banks are paring back these emergency measures. In the US, the Fed has slowed the rate it injects money into the economy (tapering) and started the rhetoric around interest rate hikes. Higher inflation seems to have forced the Fed to act sooner than initially planned, but we should keep in mind that any Fed rate hikes are coming from zero. This is still a supportive backdrop for stocks.
There is still an incredible amount of pent-up demand among consumers, another tailwind for both the economy and financial markets. Consumers built up savings during the lockdown, and the reopening spurred a robust activity restart and a vigorous spending cycle. Although we are past the initial swell, there is likely additional spending coming as we transition to an endemic state.
While some of this cash made its way to the financial markets, there are still near-record levels sitting on the sidelines, held by both businesses and individuals. Companies began to spend in 2021 in the form of dividends and share buybacks - nearly half of dividend payers in the Russell 1000 Index raised or initiated a dividend last year - and there are even better prospects for 2022. This leads us to look for quality companies with strong balance sheets and lots of free cash flow; those that are best positioned to return capital to shareholders and weather any storms.
Lastly, households are in good financial shape. Income statements and balance sheets are solid. Unemployment is down and wages are up. Even if rates rise, most of consumers' big payments are fixed in the form of mortgages or auto payments. Impacts to credit card payments would be minimal should we see only a handful of rate hikes.
On the flip side, we have several headwinds. The identification of the omicron variant in late November, and the market's strong immediate reaction to it, was a stark reminder that Covid-19 remains a risk. Although we now have multiple vaccinations, booster shots, and treatment options, when new variants emerge, cases and hospitalizations spike. Undoubtedly, this will continue to hang over consumer behavior and potential consumption patterns, but market reactions have and should continue to diminish over time. From an economic standpoint, any new variants of the Covid virus should be manageable and temporary. There will continue to be people that choose to not vaccinate, but the trend has been to ask them to wear masks, and the government has no intention of shutting down businesses again. However, for the near future, the markets will worry when, not if, new strains will appear and where.
According to data from the CDC, the flu shot many of us get annually reduces the risk of illness by between 40% and 60%. The specific strains of virus chosen for the seasonal flu vaccine are selected each year based on forecasts about which ones are the most likely to circulate during the coming season. Although the flu shot may not prevent all cases of influenza, it will help protect you from severe infection and death and can help reduce the spread of the virus in communities. Covid vaccines are no different in this respect, and vaccines can quickly be adapted as the virus evolves which bodes well going forward.
Geopolitical tensions between the U.S., China, and Russia are running high. It’s likely that none of the individual issues on a stand-alone basis would have a significant impact on the global economy, but the potential remains for an escalation of events that could. This would most certainly become a headwind if it were to have a disruptive effect on global growth.
I’m the first to admit when I’m wrong, and when it comes to inflation, I was wrong. I was in the “transitory” camp, even though we truly never knew what “transitory” meant. Fed Chair Powell recently stated the word “transitory” should be retired, and I agree. It’s time we admit some of the inflationary pressures have overstayed their welcome, and we can describe inflation as something other than “transitory”. This, along with the Fed’s planned policy normalization, will likely be the single biggest issue that shapes the markets in 2022.
During and after the housing crisis, there was too much to buy but not enough people that wanted to buy. In the early stages of the pandemic, this was also the case. As the economy shut down however, production stopped in the vast majority of goods and services, so things balanced out. As economies reopened, people wanted to buy again, but companies couldn’t produce enough fast enough.
A good example of this is rental cars. A majority of auto rentals occur at airports. When lockdowns first occurred, there were fewer people flying, which meant fewer people needed to rent cars. A car parked in an airport garage represents a cost to rental car companies, and with no demand, they sold off their cars to cut expenses. When travel resumed, rental companies were scrambling to replenish their supply. This led to a spike in demand at the same time the supply chain issues began occurring, which included chips and other automobile components. To see the result, all you need to do is try and rent a car this weekend. If you can find one, you’ll likely pay double what it would have cost pre-pandemic.
Demand surged in many areas after the vaccines were developed, and people wanted to go out to eat again, go to the theatre, go shopping, and get back to life as normal. But in many cases, supply chains couldn’t keep up. We’ve had all sorts of shipping and logistical delays across the globe. Many US ports are at a disadvantage compared to those globally because they have not yet embraced robotics and automation. As a result, it can take twice as long to unload a ship domestically as it does elsewhere. This, along with the increased demand, pushed prices higher.
And while much of the world has learned to live with Covid, China continues to shut down factories, or even cities, when the virus is detected. This will likely lead to ongoing supply chain issues with goods coming from China.
So, how long will inflation persist? It depends. If you’re doing anything other than going to Disney World, buying a used car, or filling your car with gas, it may already be over. If you’re renting a car at the airport, it may be a while. Either way, higher input costs will either be absorbed by business, passed along to customers, or a combination of the two. So far, businesses have been able to pass costs alone and consumer spending hasn’t slowed. Eventually they may, however, and companies will have to lower prices, squeezing profit margins. The only certainty around inflation is that it’s been more than transitory.
Speaking of transitory, Jerome Powell has been one of the most transparent Fed Chairs in history. And, given the market often reacts to unexpected Fed measures rather than the actions themselves, we appear to be in good hands. That said, just a week after he was nominated for a second term as Federal Reserve chairman, Jerome Powell sounded unfamiliar to some. He said it was time to retire the word “transitory” that he and many other officials have long used to describe building inflation, signaling in testimony before the Senate Banking Committee that the Fed is likely to accelerate the tapering of its emergency bond-buying program. That suggests rate increases might come sooner than planned.
Why the sudden change? It’s important to remember that the Federal Reserve has a dual mandate: to maintain price stability (inflation) and full employment. The price stability mandate likely doesn’t look so good to Powell right now, and he simply indicated this has become the bigger concern. Additionally, it’s becoming increasingly apparent the Fed has been behind the curve on inflation and wants to move to catch up before it’s too late. Powell has this flexibility now that he’s secured the second-term nomination.
The market, as represented by the Fed Funds rate, is pricing in three to four interest rate hikes in 2022. And although it seems too early to extrapolate rate hikes given the uncertainty around the evolution of the Covid virus, a year-end Fed Funds rate of around 1% doesn’t seem unreasonable. Should economic conditions deteriorate, we would expect the Fed to reevaluate.
While rising rates equate to falling bond prices, there are several factors that may serve as a cap on rates, and thus a floor on prices. With global populations aging and savings rates high, there is strong demand for long term bonds. Insurance companies and pension funds continue to purchase long-term US bonds to meet long-term liabilities because their yields are still higher than those in most other major countries. Additionally, the US is likely to issue less Treasury debt compared to last year, which should take some of the upward pressure off of yields.
On the equity side, historically, equity market returns have been robust in the 12 months prior to, and 36 months post, the first interest rate hike. So, even though we’re likely near the beginning of a tightening cycle, history tells us it’s not all doom and gloom. But anytime the Fed takes (or doesn’t take) action, there is a risk of a misstep. On one hand, tighten too slowly and inflation will likely grind higher. On the other hand, tighten too quickly and the economy could plummet into a recession.
Given this backdrop, the question becomes, how will 2022 play out?
2020 brought mainstream the use of the word “unprecedented” and 2021 gave us “transitory”. We need a word for 2022.
After the quickest bear market and subsequent recovery in history, we are now at a point where things are continuing to improve, but at a slower pace. A slowing recovery if you will, but I’m not particularly fond of using the word “slowing” at every investment committee meeting throughout 2022.
To convalesce means “to recover health and strength gradually after sickness or weakness”. This seems particularly relevant in describing the current state of our economy. So, let’s call this phase of the recovery convalescent.
Even though it’s slowing, we still expect growth in the coming quarters. For 2022, global GDP is likely to rise by 4-5%, which is less than 2021, but still nearly double the historical average. The economy is still expanding, unemployment is down, jobs are abundant, and consumers and businesses are confident about the future. Many economists agree the good times have some staying power.
So how do we take advantage of this? US equity market valuations are lofty, no doubt, particularly large cap growth stocks. Robert Shiller, a Nobel Laureate economist, cites a measure he created, the Cyclically Adjusted Price Earnings Ratio (CAPE). This ratio stands at a level that is only surpassed by the height of the measure reached in 2000, just before the stock market crash. This ratio can’t be used as a reliable predictor because it says nothing about the timing; it just tells us that valuations are rich. That is, although the CAPE is nearing an all-time high, stock prices may continue to climb throughout 2022.
Look a little closer, however, and you can quickly see valuations are most elevated within the US large cap growth space, particularly the largest 5-10 companies. For relative value, we’ll need to look to other areas of the market: value stocks versus their growth counterparts, smaller companies, and companies outside the US.
Many value stocks possess strong balance sheets, and these quality companies may better withstand any hiccups that should occur. International stocks’ fundamentals are improving, and the valuation gap between international and US equities continues to widen providing another source of relative value. Further, relative to the US, international stocks are overweight value names. Additionally, should interest rates rise as expected, value companies typically have cash flows that are received sooner than their growth counterparts, so they have a less violent selloff. Also, value stocks have performed particularly well in moderate-inflation environments, another factor that should favor the asset class.
Before we conclude, there’s one last thing we should be asking ourselves. While inflation is a concern, no one has been talking about the possibility of deflation, particularly as we look past 2022. Should we be paying more attention to this?
Covid wreaked havoc on supply chains, and we are currently seeing the resulting inflationary pressures. However, it also accelerated innovation. You have to go back to the times of the telephone, electricity, and the automobile to see as many major innovative themes evolving at the same time as we see today: DNA sequencing, robotics, energy storage, artificial intelligence and blockchain technology. These should lead to productivity gains of magnitudes not previously experienced. And since GDP is the product of hours worked times productivity, increases in productivity can boost GDP even if hours worked declines. In other words, innovation and technology that lead to productivity gains have the potential to boost GDP without the full complement of workers. Today, we have more jobs than workers – leading to higher wages - but as productivity increases, we will need fewer workers for the same amount of output, reducing costs.
The primary takeaways around inflation are this: Covid was initially deflationary as we shut the global economies down; it became inflationary as we reopened. Innovation is deflationary over the longer term, and it’s accelerating at rates not seen since the early 20th century. And regardless, inflation is a sign of a healthy economy, and stocks perform well during times of moderate inflation, particularly value stocks.
Wrapping this up, while we expect less impressive returns for risky assets in 2022, they should continue to climb. We have an ideal economic backdrop, accommodative policies, and near-record amounts of sidelined cash. And with bond yields that still hover near historic lows, we also have the TINA (There Is No Alternative) effect. We do have headwinds, primarily inflationary pressures, and the Fed’s response to it.
Trying to put a number on “less impressive returns”, strategists at Wall Street firms have a year-end target on the S&P 500 of 5,000-5,050, which implied returns in the neighborhood of 5%. Given the recent pullback and using the same year-end target, this number is now closer to 15%, but may be revised downward as analysts reassess.
Our tactical asset allocation views for 2022 are as follows:
- We maintain a preference for stocks over bonds, particularly quality companies with strong balance sheets.
- We favor value stocks over their growth counterparts.
- We will look to add to our international exposure, especially developed markets.
- We will seek to increase exposure to small cap stocks should the opportunity arise.
Predicting what financial markets will do in the coming year is tough at best. Whatever happens, there will always be bumps in the road over the shorter-term. However, longer-term, we have confidence in the trajectory of the global economies, which turn should push global financial markets higher. As a result, we must be prepared for these bumps in the short term in order to benefit from them in the long run.
Press Release | August 13, 2021
McCarthy & Cox Charity Outing a Success
The 9th annual McCarthy & Cox Charity Golf Outing was an enormous success, raising a record $24,930 for two charities! “We are very thankful for the outstanding turnout and support from our community and corporate sponsors,” commented Jim Cox, Managing Partner of McCarthy & Cox.
“Tom McCarthy and I started the McCarthy & Cox Cares Fund in 2013 to assist seniors, youth, and to fill emergency needs in Union County. To date, the Fund has donated more than $50,000 back into our community. The Cares Board manages the grants and consists of five current McCarthy & Cox clients who independently review requests from the community. For more information or to apply, we encourage people visit McCarthyandCoxCares.com,” Cox shared.
“The Elizavèta Fund also benefits from our annual golf outing, which Jim and Faye Cox founded in 2014 to assist families with the financial burden of adoption costs. Jim and Faye adopted their daughter, Caroline Elizavèta, from Russia in 2011. Throughout their adoption process, they came to realize the financial and time commitment that is required and decided to help others who wanted to grow their families in the same way. Over the years, the Elizavèta Fund has granted nearly $70,000 to assist 16 families, aiding in the adoption of 21 children. For more information, visit ElizavetaFund.org,” McCarthy noted.
Both funds are housed at the Union County Foundation and donations are tax deductible.
Mid-Year Update | Economic & Investment Management Perspectives
Written by Wesley W. Bean, CFA®
I went to Kroger a few weeks back and was able to pick out my own doughnuts rather than buy a box that the bakery had carefully pre-selected and packaged for me. When I left, I could leave through either door. Habits are hard to break so I still went out the one everyone was forced to use during the pandemic.
Recently, I traveled to San Juan. While there, I went to a breakfast buffet where I was able to get my own food rather than having to say my order out loud, piece by piece, to a waiter behind the buffet. I had to wear gloves, but I didn’t care because I could fill my plate obnoxiously full of bacon and scrambled eggs.
It feels like everything we’ve said over the last 15+ months has been about Covid-19, and rightfully so. It was unlike anything we’ve ever seen in terms of impact – both on a personal level and economic level. Globally, over four million people lost their lives, and we likely all know someone who either contracted the disease or lost their job. Entire industries were shut down. Unemployment skyrocketed. Restrictions kept people homebound. But finally, a return to some semblance of normal. And I finally get to write about the recovery.
Before we get started, we’d like to remind you of some of the things we always do at McCarthy & Cox to manage risk on an ongoing basis, not just when a crisis occurs.
On the equity side, we place an emphasis on high-quality companies, those with long track records of profitability, rising cash flows, good liquidity, and strong balance sheets. These are typically larger and more mature companies and have the flexibility to either return capital to shareholders or reinvest in their company leading to higher future growth. Companies that fit this bill have historically held up better during market turbulence than the broader market.
Turning to fixed income, we have continued to hold a series of high-quality, core fixed income positions. Traditionally, fixed income has two primary purposes in a portfolio: to generate income and to mitigate downside risks. With yields near all-time lows, it’s nearly impossible to generate meaningful income from fixed income. But the other purpose - mitigating risks - is still relevant, and this is where the high-quality, core fixed income positions come into play.
And finally, McCarthy & Cox has utilized Structured Products in many of our investment models for some time. Structured Products provide access to certain asset classes, but with the benefit of partial downside protection provided the product is held to maturity. This serves to lower the overall risk of an already diversified portfolio with the tradeoff of capping the upside potential.
Now for the rest of the year. As we wrote in our Annual Outlook, there were several themes we thought would shape the markets in 2021: expected volatile and choppy markets as we work through the recovery, continued challenges in the fixed income market, and finally, what would be the longer-term impacts from Covid-19?
A quick reminder about the business cycle: The economy ebbs and flows. There are good times and times when things aren’t so good. These “good” times and “bad” times fluctuate around some long-term average, much like the temperatures fluctuate between milder in the Summer and colder in the Winter each year.
When things are good, we spend more because we’re confident about the future. We purchase a new car, dine out more, or take an extra vacation. Companies may recruit new staff, build new buildings, invest in technology, etc. to create more products and services. Their expenses go up, and these expenses are passed on to consumers. At some point, we’ll slow our spending, and companies will cut prices to get rid of excess inventory. They may also lay off workers and sell some of these new buildings. When we hear about this, we aren’t so confident about the future anymore. This is known as the business cycle. And while it normally takes years for an economy to go through this cycle, we went through much of it in 2020 alone, and we now sit somewhere near early-to-mid cycle. As a reminder, the last time the economy was at this point was shortly after the 2008-09 housing crisis – which only recently ended with the pandemic.
What used to be called “cabin fever” is now “pent-up demand” as it relates to travel and other things we missed while quarantined, and “retail therapy” has turned into “revenge shopping”. There is still a lot of cash on the sidelines from both government stimulus and reduced spending over the last year-plus, considerably more than at the end of the housing crisis. Consumers have started to spend this cash which has increased the demand for goods and services beyond what our economy has been able to provide. This has spurred inflation, although it should be temporary. More on that later.
Coming into the year, we were expecting volatile markets and the emergence of new market leadership. Growth stocks had outperformed value stocks for four years, leading to one of the biggest disparities in history between the two styles. Many of the winning stocks in the early stages of the pandemic were those that provided technology to work from home, telemedicine, online learning, e-commerce, video streaming and social networking, and the gap between growth and value stock returns widened further. Because of this, relative to their growth counterparts, many value stocks became extraordinarily undervalued.
As the economy has reopened, however, a rotation back to value has occurred. These companies tend to do well early in an economic recovery. Although our models already held value-oriented positions, we added to strategy to gain more exposure to areas of the market expected to benefit from the reopening. Additionally, it slightly increased our exposure to financials, which should benefit if rates begin to normalize.
Small and mid-cap stocks are also favored by the early cycle environment. The recession is over, and we are early in a new business cycle. Like value stocks, small caps have historically performed well as the economy moves through this stage. We’ve adjusted our exposure there and should benefit from this as we work through the cycle.
And internationally, valuations continue to look relatively attractive. We’ll keep an eye on this throughout the remainder of the year and look to take advantage of any opportunities.
Moving on to our broken record portion, we thought the fixed income environment throughout 2021 would be challenging, at best. You’ve undoubtedly read articles recently about the death of the 60/40 portfolio. If not, google it and read any of the 192,000 results you’ll get. They’re based on this: with interest rates near historic lows, they must go up at some point. And since bond prices fall when rates rise, bond prices will therefore suffer.
But like many things in the investment world, interest rates are incredibly hard to predict. Economists are notoriously bad at predicting rates, including those at the Federal Reserve. Looking through the 192,000 search results, some of them date back to late-90s, and the message was the same: rates were near historic lows, everyone knew they were going up, and bond prices would suffer as a result.
Further, the Federal Reserve was in the middle of a hiking cycle. This should be bad for bonds, right? Death of the 60/40 portfolio. Sell your bonds and go all equities. Well, had you done that, you would have had more money in your pocket now. The all-equity portfolio would have returned 7.5% per year while the balanced portfolio would have returned just 7.0% per year. However, unless you had a stomach of steel, you probably would have sold out of the all-equity version during one of the three market corrections as it had twice the risk.
Incidentally, there was also an article that appeared in the search 1979 titled “The Death of Equities”. Hopefully no one read it…
The moral of this is to always maintain high-quality core fixed income in your portfolio to balance out equity risk - regardless of where the “experts” expect rates to go. No one truly knows. Not even the Fed.
Speaking of the Fed, it has promised to hold its policy rate close to 0% until inflation is on track to “moderately exceed” the central bank’s 2% target “for some time.” They’ve also continued to reinforce their bond-buying program and have asserted they’ll give plenty of notice before this changes. With all this liquidity, we should get used to a low-yielding environment for a prolonged period. And while they’ve had a horrible record of predicting interest rates, they directly control the policy rate and their bond-buying program, and this should indirectly carry over to longer-term rates.
And finally, what about any lingering impacts from Covid-19? How would this impact the markets and economy? Inflation has grabbed headlines recently, but much of the reason behind the spike will soon be over: the base rate effect. Inflation is measured as the price of a basket of goods from one year to the next; we weren’t spending as much last year on travel, clothes, entertainment, etc. – this is called the base rate effect. The base rate effect will largely have passed by the end of 2021.
Beyond the current spike, inflation is expected to cool over the intermediate term. Capacity constraints should ease as supply chains are repaired and supply/demand imbalances correct, pent-up demand will subside, and as workers rejoin the workforce later this year, companies should have additional capacity and wage pressures should subside. So, think of any increase in inflation as reflation back to normal long-term levels, rather than overheating to levels of concern. Look beyond the headlines – which are based on comparisons from 2021 to 2020 - and compare 2021 to 2019; this provides a much more accurate picture.
That said, there are some ingredients that could keep inflation slightly elevated in the short-to-intermediate term, but our base-case scenario is not for long-term runaway inflation. Keep in mind however, even if inflation were to fool us all and continue to climb, equity markets have historically performed well during such periods when coming from low levels.
The economy and markets have come a long way, but risks remain.
The United States has progressed quickly through a recovery and is now in an expansionary phase. Half of the population has been fully vaccinated, and most of the developed world is close behind. Economic growth is picking up steam and policy remains supportive.
Equity markets have continued their climb from the market lows of March 2020. Equities have the support of positive outlooks for economic and earnings growth in the coming years, along with strong consumer and business spending. With an extremely accommodative Fed, the backdrop is extremely favorable. However, market volatility reminds us that we’re not out of the woods just yet.
Inflationary concerns are grabbing the headlines, and we must focus on the Fed’s potential changes to monetary policy as we move through the remainder of 2021. In addition, though we have made lots of progress with the pandemic, the emergence of new variants - such as the Delta variant - could hurt the economy. Consumers have led the recovery, but a large surge in the virus would be reason for concern. We are certainly better prepared now than we were in February of 2020, so economic damage should be minimized.
The National Bureau of Economic Research recently declared that the recession ended in April 2020, just two months after it began, and confirming a new cycle began. If this cycle at all resembles past cycles, we’d expect this recovery/expansion cycle to be measured in years, not months or quarters. We therefore view any pullbacks as buying opportunities for long-term investors.
In summary, as the market continues to evolve in response to the virus, inflation, interest rates, and anything else that unfolds over the remainder of 2021, we remain keenly focused on monitoring the strategies held across the MC Select platform and identifying opportunities. As always, a diversified portfolio and long-term view still offer the best route to reach financial goals.
Certain sections of this commentary contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged, and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Bloomberg Barclays Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Bloomberg Barclays government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Bloomberg Barclays U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
Structured investments may not be suitable or appropriate for all investors. Your particular needs, investment objectives and financial situation were not taken into account in the preparation of this section of the website and the materials contained herein. You should consult your financial and tax advisor to determine whether a product is suitable for you and your investment needs and objectives. You must make your own independent decisions regarding any securities or financial instruments mentioned herein. You should consider whether an investment strategy or the purchase or sale of any product is appropriate for you in the light of your particular investment needs, objectives, and financial circumstances.
This communication is for McCarthy & Cox clients only and may not be distributed to the general public.
Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. Commonwealth Financial Network does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.
Understanding the American Rescue Plan Act of 2021
On March 11, 2021, President Biden signed the American Rescue Plan Act of 2021 (“the Act”) into law, with large portions of the bill acting as an economic stimulus for individuals and businesses affected by the COVID-19 pandemic. At $1.9 trillion in total expenditures, the bill contains provisions pertaining to a variety of areas. This summary is intended to address only the critical provisions for individuals and small businesses.
Direct Payments to Individuals
Much like the previous two coronavirus-related stimulus actions, individuals and families with incomes below certain thresholds can expect to receive a stimulus check (or direct deposit) from the government.
Adjusted Gross Income (AGI) Less Than . . .
Complete Phaseout at AGI of More Than . . .
Head of household
Married filing jointly
In addition, families will receive an extra $1,400 per dependent. The term “dependent” is an important change in this legislation, as previous stimulus funds were only applicable to taxpayers with children younger than 17. Accordingly, taxpayers with older dependent children, or other dependent family members living with them, will now see an enhanced payment amount.
Taxpayers with adjusted gross income (AGI) above established thresholds will see their eligibility for a payment phase out more quickly than under previous legislation. Regardless of the number of dependents, taxpayers with income that exceeds the upper phaseout threshold will not receive a payment at all. For those taxpayers within the phaseout range, their stimulus payment can be determined using the following formula:
(AGI – applicable threshold) / (upper phaseout threshold – applicable threshold)
For example, a married couple filing jointly with three dependents and an AGI of $155,000 would be eligible for a base stimulus of $7,000: $2800 + (3 * $1,400). They can calculate their reduction as follows: ($155,000 – $150,000) / ($160,000 – $150,000) = 50 percent of their base stimulus amount of $7,000, for a total stimulus of $3,500.
The determination of income will be based on taxpayers’ 2019 income tax return. If individuals would be entitled to a higher payment if 2020 AGI figures were used, they can file their return to claim eligibility to the higher payment. If a taxpayer receives a stimulus payment based on 2019 income and, thereafter, files a 2020 return with a lower AGI that entitles them to a higher payment, the government will use the 2020 AGI amount and supplement any payment already made based on 2019 income. To receive credit for a stimulus payment based on 2020 AGI, however, they must file their return by September 1, 2021, which is before the typical tax return filing deadline of October 15 for taxpayers who have requested an extension to the April 15 deadline.
A final opportunity for the maximum stimulus payment amount would come when taxpayers file their 2021 income tax return. If that return yields an AGI figure that entitles taxpayers to a higher amount than their 2019 or 2020 income did, they will receive a refundable tax credit equal to the increased stimulus payment amount eligibility.
The timing of the checks is not definitive, but government officials have expressed their intent to have payments sent as soon as administratively possible.
Expansion of Unemployment Benefits
Unemployed individuals, including those who typically aren’t otherwise entitled to unemployment compensation under state law (e.g., self-employed) and self-certify that they have been adversely affected by the COVID-19 pandemic, may receive unemployment compensation for an additional period of up until September 6, 2021.
In addition to any weekly unemployment compensation available under state law, unemployed individuals are entitled to an additional $300 per week for a period lasting until September 6, 2021, termed Federal Pandemic Unemployment Compensation.
The bill allows for up to $10,200 of unemployment income per individual to be tax free, subject to income limits. The stated income limit is an AGI of $150,000, which would include the sought-to-be-excluded unemployment income. The bill does not specify different income limits based on tax filing status (e.g., single, married filing jointly), and, therefore, it can be reasonably assumed that the AGI limit of $150,000 applies to all filing statuses. Additionally, the $150,000 AGI limit for unemployment income to be considered tax free is not a phaseout threshold; rather, it appears to be a “cliff,” meaning that if a taxpayer’s total AGI exceeds $150,000, they would not receive any tax-free treatment of benefits under the bill.
Loans to Distressed Small Businesses
The Paycheck Protection Program (PPP) will receive $7.25 billion in additional funding. Small businesses (defined as those employing 500 or fewer employees) will be eligible for forgivable, government-backed small business loans under the PPP. The same basic eligibility standards previously adopted for the PPP will remain applicable, and the window to request a loan will still close on March 31, 2021, unless otherwise extended.
The Act also provides funding to increase the accessibility of an Economic Injury Disaster Loan (EIDL) related to the COVID-19 crisis to the extent enough funding is available. Funds will be targeted from this program specifically to assist businesses with fewer than 10 employees and that suffered a substantial decrease in revenue.
A new Small Business Administration program designed to provide assistance to the disproportionately affected restaurant industry, called Restaurant Revitalization Grants, is funded in the Act. Similar to the PPP program, these tax-free Restaurant Revitalization Grants would be offered based on several conditions related to a loss of revenue due to the pandemic. Certain companies are excluded from eligibility for these loans, including restaurant chains with more than 20 locations and publicly traded companies. The first 21-day application period will be reserved for certain groups of owners (e.g., women-owned businesses, veterans).
Child Tax Credit
Many taxpayers will see an increase in their available child tax credit for the 2021 tax year from $2,000 per qualifying child to $3,000 per child age 6 and older and $3,600 per child younger than 6 as of December 31, 2021. Although the child tax credit is typically not subject to AGI limitations, the Act does put income limits in place for the enhanced credit amount over the typical $2,000.
Phase-Out Begins for AGI Less Than . . .
Head of household
Married filing jointly
If a taxpayer’s AGI exceeds the above-referenced threshold, the taxpayer’s eligible child tax credit over the typical amount of $2,000 would be reduced by $50 for every $1,000 of income over the threshold. For those taxpayers above the threshold, the amount of the credit can be calculated as follows:
Base amount – (the number of $1,000 increments the taxpayer is above the limit [e.g., 5 increments if they are $5,000 over the limit] * $50)
For example, a married couple filing jointly with a 4-year-old, a 7-year-old, and a 10-year-old and an AGI of $165,000 would be eligible for a base amount of $9,600 ($3,600 for the 4-year-old and $3,000 each for the 7-year-old and 10-year-old). Because they are $15,000 over the AGI limit, their credit can be calculated as follows: $9,600 – (15 * $50) = $8,850
Please note: The standard $2,000 credit is still subject to the typical phaseout of $50 for every $1,000 over the threshold of $400,000 for joint filers and $200,000 for single filers.
Taxpayers may receive an advance on their child tax credit in multiple installments beginning in July 2021. It is important to note that, unlike the direct stimulus payments, the advance of child tax credit amounts would need to be reconciled on the taxpayer’s 2021 tax return and could result in a liability for a return of any credit received that was in excess of their eligibility based on their 2021 tax return.
Additionally, the Child and Dependent Care tax credit, which provides tax credits for eligible childcare expenses incurred, will have expanded income eligibility and a higher potential credit amount during the 2021 tax year under the Act.
Another tax credit that has expanded eligibility under the Act is the Earned Income Credit (EIC). Individuals and couples without children, as well as younger individuals (as young as 19), could see access to a much higher EIC than was previously available.
Subsidized COBRA Benefits
Former employees who had their employment terminated and are eligible for an extension of their employee-sponsored health insurance under COBRA will not be responsible for health insurance premiums under COBRA from April until September 2021. Instead, those premiums will be paid by the former employer, and the employer will receive a refundable payroll tax credit. There will be a 60-day enrollment period for individuals to elect COBRA coverage, and eligibility for coverage would extend to individuals who lost their employment as far back as November 2019.
Student Loan Forgiveness
The Act also changes the treatment of student loan forgiveness to be nontaxable through 2025. In the past, President Biden has expressed a desire to forgive $10,000 in student loan indebtedness for each borrower, so experts theorize that this provision may be an anticipation of future executive and/or legislative action to forgive a portion of existing student loans.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.
McCarthy & Cox Retirement and Estate Specialists LLC is located at 127 W. 5th Street, Marysville, OH 43040 and can be reached at 937-644-0351. Securities and advisory services offered through Commonwealth Financial Network, member FINRA/SIPC, a Registered Investment Adviser. © 2021 Commonwealth Financial Network®