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Five Things for Americans to Know Before Moving to the United Kingdom

Five Things for Americans to Know Before Moving to the United Kingdom

With our historical links and common language, it is no surprise that hundreds of thousands (at least 200,000) American citizens reside in the United Kingdom. London has long been a truly international city and many Americans live and work in the greater metropolitan area. In my professional experience, more U.S. expats in the United Kingdom choose to remain in the UK than may be the case in any other foreign country. In fact, many clients come to identify as Brits and hold U.S./UK dual citizenship. 

However, whether you are considering a short, intermediate, or long-term move to the United Kingdom, there are a variety of planning topics that are best considered prior to making the move. In this blog, I discuss five key issues, but there are many, many more unique tax, estate planning, and investment issues that Americans in the United Kingdom may have to deal with once they become a resident in the United Kingdom. Each one of these issues below would merit a separate article, so consider this a cursory examination of these five topics that hopefully lead to further inquiry and discussion with your accountants, attorneys, and/or financial planners.

UNDERSTAND THE DIFFERENCE BETWEEN REMITTANCE BASIS AND ARISING BASIS TAXATION

Unlike the United States tax policy of taxing its citizens on their global income regardless of where they reside, most countries, including the UK, subject only those who are tax residents of that country to income taxes on both their country-sourced and non-country-sourced income (i.e., their worldwide income). To attract affluent foreigners and foreign companies to the UK, the UK has created a temporary tax status for non-UK nationals who chose to become residents of the UK called the “remittance-based” election. 

Accordingly, during the first seven years of UK tax residency, a non-UK national may elect the remittance basis on their UK income tax return, and thereby pay UK income tax only on two types of income: (1) UK-sourced income, and (2) non-UK-sourced income that is remitted to the United Kingdom. Remitting generally means that the funds are physically moved to the UK or used to pay UK obligations or purchase goods, services, or other assets in the United Kingdom. This election can be freely made for the first seven years; but, there are substantial fees/taxes paid to the HMRC (Her Majesty’s Revenue & Customs) to extend that privilege for a limited period (up to eight more years) thereafter. For those that do not elect the remittance basis, or for those whose remittance-basis term has expired, UK taxes income on the “arising basis,” meaning simply that all income from all sources (foreign and abroad) is taxed in the year in which it is received by the taxpayer.

At first blush, remittance basis sounds like a proverbial no-brainer for any expatriate that will derive any income from outside of the UK, whether that income is earned through business conducted outside of the UK, earned through passive investments in real estate, stocks, bonds, etc., or otherwise is characterized as non-UK-sourced income. However, the decision to elect the remittance basis in any of those initial seven years of UK tax residency is one that should be very carefully considered. Without going into considerable detail (and the rules surrounding remittance taxation contain meticulous details) the remittance basis can create accounting headaches, perhaps even nightmares, whenever funds are eventually remitted to the UK and the UK taxes come due on that part of the remitted funds that are attributable to income earned during the period in which remittance basis was claimed. The process of attribution involves what has come to be known as the “clean capital ordering rules,” and pitfalls abound when trying to track and trace the underlying UK tax characteristics of offshore funds (in particular investment accounts) when some of those resources are remitted to the UK. 

With our historical links and common language, it is no surprise that hundreds of thousands (at least 200,000) American citizens reside in the United Kingdom. London has long been a truly international city and many Americans live and work in the greater metropolitan area. In my professional experience, more U.S. expats in the United Kingdom choose to remain in the UK than may be the case in any other foreign country. In fact, many clients come to identify as Brits and hold U.S./UK dual citizenship. 

However, whether you are considering a short, intermediate, or long-term move to the United Kingdom, there are a variety of planning topics that are best considered prior to making the move. In this blog, I discuss five key issues, but there are many, many more unique tax, estate planning, and investment issues that Americans in the United Kingdom may have to deal with once they become a resident in the United Kingdom. Each one of these issues below would merit a separate article, so consider this a cursory examination of these five topics that hopefully lead to further inquiry and discussion with your accountants, attorneys, and/or financial planners.

UNDERSTAND THE DIFFERENCE BETWEEN REMITTANCE BASIS AND ARISING BASIS TAXATION

Unlike the United States tax policy of taxing its citizens on their global income regardless of where they reside, most countries, including the UK, subject only those who are tax residents of that country to income taxes on both their country-sourced and non-country-sourced income (i.e., their worldwide income). To attract affluent foreigners and foreign companies to the UK, the UK has created a temporary tax status for non-UK nationals who chose to become residents of the UK called the “remittance-based” election. 

Accordingly, during the first seven years of UK tax residency, a non-UK national may elect the remittance basis on their UK income tax return, and thereby pay UK income tax only on two types of income: (1) UK-sourced income, and (2) non-UK-sourced income that is remitted to the United Kingdom. Remitting generally means that the funds are physically moved to the UK or used to pay UK obligations or purchase goods, services, or other assets in the United Kingdom. This election can be freely made for the first seven years; but, there are substantial fees/taxes paid to the HMRC (Her Majesty’s Revenue & Customs) to extend that privilege for a limited period (up to eight more years) thereafter. For those that do not elect the remittance basis, or for those whose remittance-basis term has expired, UK taxes income on the “arising basis,” meaning simply that all income from all sources (foreign and abroad) is taxed in the year in which it is received by the taxpayer.

At first blush, remittance basis sounds like a proverbial no-brainer for any expatriate that will derive any income from outside of the UK, whether that income is earned through business conducted outside of the UK, earned through passive investments in real estate, stocks, bonds, etc., or otherwise is characterized as non-UK-sourced income. However, the decision to elect the remittance basis in any of those initial seven years of UK tax residency is one that should be very carefully considered. Without going into considerable detail (and the rules surrounding remittance taxation contain meticulous details) the remittance basis can create accounting headaches, perhaps even nightmares, whenever funds are eventually remitted to the UK and the UK taxes come due on that part of the remitted funds that are attributable to income earned during the period in which remittance basis was claimed. The process of attribution involves what has come to be known as the “clean capital ordering rules,” and pitfalls abound when trying to track and trace the underlying UK tax characteristics of offshore funds (in particular investment accounts) when some of those resources are remitted to the UK. 

Accordingly, there are circumstances where remittance basis makes perfect sense. To the extent that:

    • The U.S. expat is confident that the UK stay will not evolve into something longer-term or even permanent, and/or;
    • The U.S. expat has considerable non-UK-sourced income (e.g., from a very large investment within a U.S. taxable brokerage account, or perhaps through partnership income in a global concern where only a fraction of earned income is attributed to UK sources);

then remittance basis should be very seriously considered to lessen the UK income tax burden. Conversely, where the U.S. expat has modest income from non-UK sources or where the UK tax residency may become longer-term or even permanent, then the calculus may well favor UK income taxation on the arising basis from the onset of becoming a UK tax resident. In all cases, this is a decision facing all Americans moving to the UK and should be carefully contemplated with the advice of experienced professionals.

Short on time? Listen to our podcast for Stan’s overview on this topic:

PFIC AND UK TAX RULES FOR “OFFSHORE FUNDS”

It is fundamental that American expats, who obviously live and transact outside of the United States, understand the perils of “offshoring” their taxable investments. By offshoring, I mean owning foreign-registered pooled investments, such as ETFs that are not registered with the SEC and trade predominantly on foreign securities exchanges, mutual funds that are registered with foreign financial regulators and are not subject to U.S. laws and regulations, as well as foreign private equity funds and hedge funds (both of which are usually organized as limited partnerships). The IRS has created special regulations regarding the tax treatment of such foreign pooled investments, known as the “passive foreign investment company” (or “PFIC”) rules. 

A detailed discussion of how these offshore funds are taxed in the U.S. is beyond the scope of this article. For our purposes, it is simply important to understand that “offshore” funds lose their capital gains character because of the PFIC rules, and, therefore, all gains are taxed as ordinary income. That’s for starters – with income recharacterization to prior years in the holding period, interest, and penalties, the tax rate could be 50% and, in some cases, even higher! The bottom line: buying foreign mutual funds, ETFs and other pooled investments outside of a treaty-recognized foreign pension is usually tax toxic to U.S. tax residents.

So an American living in the UK would do well to avoid the temptation to “go native” and open brokerage accounts in the UK and invest in non-U.S.-registered funds. Can the American expat then avoid offshore tax rules by just keeping their investments in the U.S. and purchasing U.S. mutual funds or ETFs? For the American expat in the UK, the answer is usually “NO,” because the UK has similar tax rules with regards to offshore funds and, from a UK perspective, U.S. mutual funds and ETFs are offshore funds. The general HMRC tax rules in the UK therefore would deprive gains on the sale of these offshore funds of the lower and more favorable capital gains rates and instead levy taxes on realized gains at ordinary income tax rates, which tend to be higher than U.S. ordinary income tax rates. What a mess the U.S. expat investor might find themselves in trying to navigate the offshore funds rules of two different national tax authorities!

One way the U.S. expat might avoid these onerous tax rates would be to avoid “pooled” investments by just buying individual securities and building a fund-free portfolio of individual stocks and bonds. Naturally, this may be an imperfect solution at best for investors that don’t have the capital to adequately diversify such a portfolio. Moreover, even with ample capital to do so, most investors have their own careers, families, and social lives to manage and don’t want to be their own portfolio managers. 

Fortunately, the HMRC’s offshore funds tax rules do provide an important exception: where the foreign fund provides adequate accounting through reports sent annually to the HMRC, investors in these offshore “reporting funds” will be exempted from the special tax rules and will be entitled to capital gains treatment on gains generated from these reporting funds. Although the vast majority of U.S. mutual funds and U.S. ETFs do not qualify as reporting funds in the UK, there are enough decent U.S. funds that are in fact UK reporting funds that a fairly quality, low cost, and well-diversified portfolio can in fact be constructed. The main challenge is scouring the HMRC’s spreadsheet with thousands of reporting funds and identifying those that are indeed U.S.-registered. Beware the foreign “clones” of U.S.-registered funds that carry the same names of their U.S. counterparts but are, in fact, PFICs! 

UNDERSTAND THE INTERPLAY OF U.S. AND UK RULES REGARDING RETIREMENT ACCOUNTS, INCLUDING THE INCOME TAX TREATY

There are some advantageous and truly cooperative nuggets in the income tax treaty (and the technical explanation thereof) between the United States and the United Kingdom, particularly in the area of retirement accounts or “pensions.” For example, because of the treaty, distributions from a U.S. Roth IRA in retirement will enjoy the same tax-free qualities for a UK tax resident (expat or otherwise) as they do for domestic American taxpayers. Additionally, those horrid PFIC and Reporting Fund rules discussed in the previous section will be irrelevant to investments in retirement accounts in either country so long as the treaty benefit is claimed. There are other special rules regarding the special tax-free 25% lump-sum distribution from a UK pension that may benefit a former U.S. expat that participated in a UK pension scheme but thereafter returns to the U.S. before taking the lump-sum distribution. It is critical to work with advisors that can help the U.S. expat position their accounts to truly navigate the tax rules and take full advantage of these types of beneficial treaty provisions.

Unfortunately, for high-net-worth individuals, there have been severe limits put in place in the UK in recent years on how much can be contributed in tax-advantaged pension schemes. These newer rules tend to severely limit the contributions by and on behalf of higher earners in the UK to their company pension and even personal pension (SIPP) accounts. Interestingly, these rules will also dramatically affect the tax deductibility on UK tax returns of contributions to U.S. qualified retirement plans as well. Therefore, for Americans working and earning in the United Kingdom, it is particularly crucial to get the input of a UK tax accountant to assist in determining how much should or can be contributed to retirement plans and pensions regardless of where they are held for each and every UK tax year. Moreover, U.S. retirement contribution eligibility rules, rules on the deductibility of retirement plan contributions, and so forth require the U.S. expat to also discuss all (not just domestic) retirement plan contributions with their U.S. accountant to ensure that the investor’s strategy is tax optimal under U.S. tax rules, too. 

 

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“COMMON LAW?” – CAUTION WHEN BRINGING A U.S. TRUST WITH YOU TO THE UK

Trusts, like most estate planning issues and tools, are a creature of local law. It is a common folly of many expats, and even domestic U.S. attorneys, to believe that an estate plan carefully crafted under the laws of a particular state in the U.S. can be taken abroad and continue to operate as intended. It usually won’t, and, in some instances, a good domestic estate plan may well backfire spectacularly when the family, or one or more of its members, moves abroad. That’s a very broad and general statement, but consider it is based on my experiences as an expat advisor who has witnessed the unintended consequences materialize from a domestic estate plan when the legal and tax issues unfold in the cross-border/expat environment. To put it bluntly: when you move somewhere else, new rules apply, and it is highly unlikely that the original estate plan was crafted with any of the new rules in mind.

Another broad and general statement can be made about trusts: The more sophisticated an estate plan, the more likely that it will backfire in the cross-border environment and the more costly the unintended consequences that will materialize. However, we’re talking about moving to the United Kingdom – the birthplace of trust instruments– and one might think that a U.S. trust would always work just as well in the UK as it would in the domestic U.S. scenario, but one could pay a dear price for such an innocent assumption. 

For example, a U.S. expat family has utilized trusts that provide that one or more of the expat family members who serve as trustee. If the trustees of a U.S. trust become UK tax residents, the trust becomes a UK tax resident. From the UK perspective, the trust has been “on-shored” so to speak, and the trust is now a UK tax resident. Things can get even more complicated from there: what if the trustee(s) returns to the United States thereafter? From the UK legal and tax perspective, this could represent an “off-shoring” of the trust – the trust will no longer be characterized as a UK domestic trust, but as an offshore trust. The tax implications that flow from offshoring a trust are usually that an “exit tax” must be paid, which means that all unrealized gains from trust property are thereby realized and capital gains from the recognition of gain are now owed to the HMRC. 

Quite often, a few minor (or less minor, depending on the trust) changes to the trust could have been made before the trustee(s) moved to the UK, which may have prevented this issue from ever materializing. If minor changes do not suffice, the trust might need to be dissolved prior to the move. Accordingly, when family wealth is in any manner managed or protected by trusts, some legal advice (i.e., an estate plan review) from an estate planning expert in the future country of residency (in this case, the United Kingdom) can be critically important.

UNDERSTAND UK “DOMICILE” AND IT’S IMPLICATIONS

U.S. and UK income taxes differ in a variety of ways (e.g., the tax liability on the sale of a primary or secondary residence) and there may be a substantial income tax-rate divergence between the two countries for a given U.S. expat living in the United Kingdom, depending on the expat’s current income. However, the taxation of wealth transfers (gifts during your lifetime, or bequests/transfers upon death) should also be considered as the expat accumulates wealth. Like the U.S, the UK may tax gifts made during the life of the donor and will also tax the estate of a decedent before their wealth is transferred via their estate plan. Unlike the U.S., there may be income tax owed by the donor (known as a “deemed disposition”). Here, the opportunity for divergence between U.S. and UK tax exposure can be quite profound, due largely (but not exclusively) to the different exemption levels under the current tax laws of both countries. 

For example, in 2021, the United States provides a very generous lifetime personal exemption for gift and estate taxes of $11.7 million ($23.4 million for a U.S. married citizen couple). In stark contrast, the UK individual estate (IHT) exemption is only £325,000 (£650k for a UK domiciled couple), with possibly an additional allowance of £125,000 for the decedent’s primary residence. That differential puts a tremendous premium on estate tax planning and financial planning in general. 

A crucial part of determining the current and future UK IHT tax exposures for a U.S. expat family centers on whether the family, or individual members thereof, have voluntarily or involuntarily attained the status of a UK domicile. If a person is determined to be domiciled in the UK, then their worldwide estate would be subject to IHT. If tax residency and entrenchment have not yet crossed the threshold of domicile, then only the UK situs property will be subject to potential IHT tax liability. Domicile is a common law term that combines residency and long-term intention. Accordingly, there is a degree of subjectivity when determining whether an American expat has become entrenched in the UK to the point that this key threshold has been breached. 

It can be difficult to ascertain in close cases whether an expat’s behavior demonstrates enough intent to assure an HMRC finding that the expat is a UK domicile. On the one hand, if an expat moves to the UK on a work assignment (secondment) and spends five years living with family in a home that is rented by the company, it is certainly less likely that the status of domicile has been achieved. However, if that expat and family buy a home, apply for citizenship, sell their U.S. home, and effectively cut most ties with their old American community, the probabilities increase dramatically that the family would be considered UK domiciles. 

To combat the efforts for long-term UK tax residents to evade domicile status, the UK has created a “deemed-domicile” status or threshold based on the more objective criteria of how many years an individual has held UK tax resident status. Under the rules that went into effect in 2017, once the expat has held UK tax residency for 15 years of a 20-year period, that expat is thereafter deemed a domicile of the United Kingdom, regardless of any other circumstances. Beyond IHT exposure, this will also mean that the expat can no longer utilize the remittance basis of taxation (which requires substantial payments beyond year seven but is now unavailable at any cost after year 15).

Prior to obtaining domicile, steps can be taken to protect non-UK wealth from IHT exposure, but such planning is going to require retaining very specialized estate planning counsel. Given that the deemed domicile status is, in a temporal sense, the maximum but by no means a minimum time within which domicile can occur, an important first step for such planning would be to have counsel conduct what is sometimes referred to as a “domicile audit,” which may be a series of meetings and/or detailed questionnaires to first determine the current status of an expat, as well as determine what, if any, wealth might be strategically sheltered from the expat’s taxable (IHT) estate.

PLANNING AND INVESTMENT ISSUES ABOUND

Please consider this a very cursory examination of five key issues that should be considered and incorporated into your financial planning and your portfolios before completing the journey to live in the United Kingdom. This is by no means an exhaustive inventory, nor a complete examination of the financial, tax and legal issues within each area. It is our intention at Walkner Condon to enrich the expat communities around the world through sharing knowledge about such topics and to assist Americans who are or may be contemplating a move abroad in the near term or in the future. Through a little pre-move planning and strategic positioning, we believe that the transition to a new home can be less stressful and, ultimately, more rewarding. If you find these issues resonating with your personal situation, I, or one of my team members here at Walkner Condon, would be happy to schedule an introductory meeting with you.

Stan Farmer, J.D., CFP®️

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3 Reasons to Look at Investing Internationally in 2022

3 Reasons to Look at Investing Internationally in 2022

In 2021, the U.S. stock markets hit record highs almost 70 times, and the consensus is that the U.S. market is largely “expensive.” Such a snap view is confirmed by a variety of valuation metrics: price-to-earnings ratios (P/E) and forward P/E being chief among them. Moreover, the bond market is poised to face a rough 2022 because there is a growing consensus that the United States Federal Reserve Board (also known as the “Fed”) will also increase interest rates, which historically has caused bond prices to fall. Between this seeming domestic “rock and a hard place,” there are some areas that continue to look like good deals: one of which is international equities.

In this article, I will cite three key reasons why investing now in international markets might be a good long-term investment: or, in other words, explain why the U.S. is expensive and the rest of the world is not.

Currency and the Almighty Dollar

The U.S. dollar is relatively strong right now – and indeed might get stronger in the near future because the U.S. may raise interest rates as soon as March. Indeed, the dollar posted its best year since 2015 in 2021, and the U.S. dollar index (DXY) was up 6.5% in 2021

However, overall a stronger U.S. dollar will make international goods and services more competitive (or allow manufacturers to make more money) in the longer run. How does that work? In short, a stronger U.S. dollar means it is less expensive to buy foreign goods and services. If the dollar is weak versus the euro (let’s say $1 equals 0.8€), for example, a purchase of an automobile that costs 30,000€ would equal $36,000, and the automobile will be compared to those similarly costing $36,000. If, however, the dollar is strong (let’s say $1 equals 0.9€) a 30,000€ automobile would only cost $33,000. A manufacturer can deal with this in a variety of ways– it can aim to sell more cars at less price (instead of 10,000 cars at $36,000 try to sell 15,000 at $33,000) or the same number of cars at the original $36,000 price, booking the currency gain of $3,000. In either case, the firm will be helped by the stronger U.S. dollar.

The U.S. dollar being strong also has the effect of meaning that just as the foreign currency could theoretically buy more car for less– a stock originally priced in euro can also be bought for less. Indeed, foreign market returns for U.S. investors were hindered by approximately 5.2% by currency headwinds last year due to the strengthening U.S. dollar according to JP Morgan.

An additional tailwind of a strong dollar for international markets is that it frequently promotes international travel, improving many economies that depend on tourism for a large chunk of their GDP. However, the ongoing pandemic may lead to this effect being muted. Should COVID progress to an “endemic” rather than a pandemic, we’ll likely see an increase in travel to foreign countries buoyed by pent-up demand for travel and the ability to buy more with less.

(For those who prefer a video explainer from the perspective of U.S. companies, look here for an overview from the WSJ)

Rest of the world GDP growth 

One of the ongoing beliefs is that the U.S. economy (and accordingly its stock market) is doing better because the U.S. economy is doing better than the rest of the world. This is not necessarily the case.

In fact, between 2012 and 2019 the GDP growth rate of the rest of the world surpassed that of the United States by 0.5% per year – though this was admittedly a cooling down as the rest of the world grew at a rate exceeding the U.S. by 1.2% from 2001-2011 according to the JP Morgan Guide to the Markets. In fact, the last time the U.S. outpaced the rest of the world in GDP growth was from 1992 until 2000. Despite this growth advantage, U.S. large-cap stocks have outpaced the rest of the world (the MSCI EAFE index) by roughly 275% over the last 14 years. (JPM)

Valuations

This might be the most compelling case for looking at non-U.S. equities going forward – an international note we’ve hit on in our Gimme Some Truth podcast before in this episode. As I noted in the introduction, the U.S. (particularly U.S. large-cap stocks) is trading very high relative to its longer-term P/E measures. There are several reasons for this, but a key one is the low-interest rates in the United States and a very strong run for U.S. technology over the last 10 years. On the other hand, despite negative interest rates, valuations of non-U.S. stocks have not soared. 

Indeed, relatively speaking, valuations for non-U.S. stocks are deeply discounted compared to the U.S. Again, according to the JP Morgan Guide to the Markets, the rest of the world’s forward price-to-earnings ratio (FPE) was at 14.1 versus the S&P 500’s 21.2 FPE. This is compared to a 20-year average of 13.3 FPE versus 15.5 FPE for the U.S. In other words, the rest of the world is trading at a 32.7% discount versus U.S. FPE, which is significantly off of its 20-year discount of 13.2% discount. Moreover, the rest of the world is yielding higher than the U.S. right now. On average, the U.S. has dividend yields about 1.6% less than the rest of the world (compared with a 1.1% average difference over the past 20 years).

Such data also apply as we look from region to region. For instance, Japan, despite macroeconomic forecasts of 3.2% growth next year, is currently trading below its 25-year forward P/E ratio. 

In short, even if we take into account that the rest of the world tends to trade at lower valuations historically, the rest of the world is trading at a discount in terms of price to earnings. 

There is an old saying in investing that the market can stay wrong longer than you can stay solvent. While we don’t go that far in our risk-taking, the 14-year ongoing out-performance of U.S. large caps has exceeded the longest previous period of out-performance by approximately 6.5 years and growing (the rest of the world outperformed the U.S. for 7.3 years from approximately 2001-2008; the longest period of U.S. out-performance was a little over six years during the 1990’s dot com boom). It is impossible to predict when the shift will occur, but from a long-term perspective, the rest of the world is looking like a better and better deal.

Keith Poniewaz, Ph.D.

The Year of Impossible Choices: 2022 Market Outlook and 2021 Review

The Year of Impossible Choices: 2022 Market Outlook and 2021 Review

In last year’s market outlook, I described the current state of global monetary policy as a giant exercise in price control, specifically, control of the cost of capital. An environment in which perpetually falling rates and equity premiums favor longer duration growth stocks, but hardly resulted in what might be described as widespread prosperity. 

The (short-lived) revenge of the bottom half

During the grand re-opening of 2021, for a brief moment, dare I say it, things seemed to be going well. Bolstered by massive government stimulus and a strong job market, something remarkable happened to the average American household: they got richer.

While household wealth rising is not surprising given equity, real estate, and cryptocurrency gains, what was truly remarkable was the relative gain attributable to the bottom 50% of American households, whose share of total wealth rose above 2.5% in Q3. While the percentage remains low in absolute terms, we had not seen this metric rise above 2% since the 2008 crisis, and 2.5% was last witnessed in the early 2000s.

A tight labor market, marked by the “great resignation” (an unusual number of people quitting their jobs), has certainly contributed to the slight, but noticeable, narrowing of inequalities. For the first time in years, the labor market appears to have shifted in favor of workers, who may be in a much stronger position to secure higher wages, strengthening their ability to accumulate wealth. Direct COVID relief payments and expended child credits also contributed to this continued improvement in household wealth.

Unfortunately, before anyone could celebrate a resurgence of the American middle class, a much bigger story would steal the headline: the return of inflation. In the short term, moderate levels of inflation can have a beneficial effect on the job market, support asset prices, ease debt burden, and even reduce income inequality. In the long term, however, the upside risk to inflation makes me less than enthusiastic about the potential for a continued trend in narrowing wealth inequalities. 

While higher inflation means that everyone, in aggregate, gets poorer, some might get hurt more than others. Over time, cost pressures are likely to favor owners of productive assets at the expense of small savers and wage earners. A recent analysis by the Penn Wharton Budget Model already highlights the increasing burden on middle-income family budgets, who spent about 7% more in 2021 for the same products they bought in 2020 or in 2019. (3)

The era of low inflation never started, now it may be ending

The return of higher inflation, in the form of her CPI numbers, was heralded as a momentous shift in the economic environment in 2021. After all, inflation has not been a major concern in most of the developed world in the last decade, some have even suggested that we lived in the era of low inflation, and central bank action certainly focused on fighting the perceived threat of deflation first and foremost.

I was never a huge believer in the idea of a “low-inflation era.” To be sure, we may have had moderate levels of inflation on average, but more importantly, we’ve had an era of uneven, patchy inflation, where falling prices in some areas were offset but rapid increases in others. 

What charts like the one above highlight, is that the supposed low-inflation era has, in fact, been an era of selective inflation. An era in which, broadly speaking, the price of things we don’t really need, like toys and electronics, has collapsed, but the price of things we need (say, food, housing, and healthcare…) has continued to rise. 

In this environment, it is perhaps no surprise that middle-class households hardly seemed to reap the benefits of low prices. All else being equal, and despite the prevailing inflationist narrative: no inflation is good, deflation is even better (how often have you complained about prices at the store being too low?). For two decades deflation has been limited to a relatively small segment of largely discretionary expenses, while higher costs in other products may have actually reinforced inequalities. 

Regardless of how the Consumer Price Index is composed, it is also important to recognize the limitation of the CPI (our policy makers’ main tool in measuring inflation). CPI is a complex set of data maintained by the Bureau of Labor Statistics. Over the years, its methodology has been revised multiple times, and most recent adjustments have tended, in my opinion, to make monetary policy look better. Some of the most convenient CPI adjustments include: substitutions (the idea that if something is too expensive, we’ll just buy something else, say lemons instead of bananas…) or, even better: hedonics (an adjustment made when a price increase isn’t actually deemed to be a price increase, but just a reflection of improved product features). Not to mention the fact that shelter, one of the largest components of CPI, is for the most part not collected using a market-based mechanism. Instead, most of the CPI’s shelter data comes from something called Owner Equivalent Rent (OER). OER is basically a survey of homeowners, who get asked a simple question about how much they think their property could be rented for (imagine calling your parents who’ve lived in their house since 1976, and asking them what they think the rent is). 

Regardless of how much I doubt inflation numbers, what became obvious in 2021 is that no amount of adjustments could make inflation look benign. Since March 2021, CPI inflation started exceeding the Federal Reserve’s 2% target and has continued to rise ever since.

In August 2020, the Federal Reserve implemented a new flexible approach to inflation, effectively warning the market that it may allow inflation to “run hot” for a while if it deemed necessary. We are now in our ninth month of excess inflation, and just how much more of these inflation numbers will be tolerated is unclear. 

Over the last few years, central bank officials have often felt the subtle (or not so subtle) pressure to keep their policy stance accommodative (remember Donald Trump praising Janet Yellen for being a “low-interest person?). But politicians and the general public can be fickle, and the pressure to remain accommodative can just as easily morph into a pressure to tighten. If inflation continues to take hold, being a low-interest rate kind of person may not look so flattering anymore.

The trillion-dollar checking account

I have long been telling clients that the pandemic could, somewhat counterintuitively, be the catalyst for higher inflation. By pushing governments and central banks to implement a combination of both extremely loose monetary and fiscal policy, they may just have poured fuel on a fire that had been simmering for years underneath the low CPI numbers. While 2020 saw unprecedented levels of new debt issuance and stimulus, a lot of promises only reached full implementation in 2021, which may explain the sudden, but somewhat delayed, change in inflation dynamics. 

The U.S. Department of Treasury’s general account with the Federal Reserve (effectively, the government’s checking account) spent most of 2020 swelling up to unprecedented levels: normally fairly steady at a balance of around $300 billion, it reached a balance of $1.8 trillion in mid-2020 at the height of the pandemic.

In contrast, 2021 was truly the year of the great spending spree, when checks were finally cashed, even as treasury bill issuance slowed. $1.6 trillion was promptly spent in a matter of months between February and July 2021. As Citi’s market strategist Matt King highlighted back in February 2021: the flood of cash created by the drawdown in the treasury’s general account (TGA) risked tripling the amount of bank reserves, and pushing rates even further towards zero or negative territory: “surfeit of liquidity and a lack of places to put it – hence the rally in short-rates to almost zero, with the risk of their going negative.” As King further notes, “if relative ‘real’, inflation-adjusted Treasury yields fall, it could weaken the dollar sharply (…) at the global level the TGA effect will indeed prove highly significant.
As shown above, real yield would indeed fall throughout 2021, to levels unprecedented in modern history, and one of the side effects of negative real yield may have been to propel the now-familiar “risk on” investment theme to new heights. We all thought money was cheap at -1% real rates in February, how about -6.5% In November? 

The treasury department wasn’t the only one spending. As it turns out, American households too were fast and loose with their checkbooks. Individual savings rates had risen during the pandemic and remained relatively elevated well into the beginning of 2021. Since March 2021 however, saving rates have fallen back to their pre-COVID levels.

Against this backdrop, it is perhaps no surprise that the “buy everything” ethos, long limited only to financial assets, now seems to have spread into housing, commodities, energy, various consumption goods, and even used cars.
With gains of nearly 50% since December 2020, the Manheim Used Vehicle index outperformed both the S&P 500 and the Dow Jones in 2021.

Impossible choices

Over the last decade, central bankers have been almost entirely focused on supporting the economy. With the threat of inflation only a distant concern, there has been basically no downside to perpetually flooding markets with free money. To be sure, central bankers have been fairly successful in averting deflationary fears and consistently driving down real (inflation-adjusted) rates. With short-term rates at zero and longer-dated bonds at historic lows, many observers felt that yields had nowhere else to go. Real, inflation-adjusted rates have no such lower bound. And as much of what the recent spike in inflation will be heralded as a change of regime, in many ways, it can also be seen as the culmination of a broader trend in lower real rates that started many years ago – and arguably as far back as the mid-80s.

With real yield deeply negative, and central bank balance sheets at all-time highs, 2021 brought the scale of global monetary policy to yet another record-breaking year. However, for the first time in over a decade, inflation may truly force central banking officials to tighten policy this time. So far, policy response in the U.S. has been mainly limited to tougher talk and a planned reduction of the pace of asset purchases (the now-famous “tapering”). While FOMC guidance does indicate an expectation of multiple rate hikes in 2022, the Federal Reserve will be walking a very fine line as it looks to change course.

One of the paradoxes of the current environment is the continued flattening of the yield curve. A flood of bank liquidity may have contributed to the collapse in real short-term rates but has not resulted in any real upward shift in long-dated bond yields. This could be interpreted in numerous ways. Perhaps the bond market is simply not buying the idea of long-term inflation or may think it raises the probability of a policy mistake (excessive tightening leading to a deflationary crisis), or perhaps the Federal Reserve’s bond-buying program has simply distorted bond prices to such a degree that rates no longer reflect any realistic growth and inflation expectations. Whatever the case may be, hiking rates in this environment would mean running the risk of yield curve inversion: a situation where short-term rates would exceed long-term rates. While not always predictive of a crisis, an inverted yield curve generally sends a very negative signal and isn’t consistent with a healthy economy, in which opportunity cost should correlate positively with time.

Central banking officials are very aware of the risk, and the issue of curve flatness was explicitly brought up by members of the FOMC in their December meeting. There is a certain common-sense logic to the idea that, before resorting to traditional monetary tightening policies (raising short-term rates) the Federal Reserve should first get rid of the more exotic, experimental, crisis-time measures, such as quantitative easing. Doing so may allow long-term interest rates to rise, resulting in a more constructive environment in which to hike short-term rates. After all, if the economy is strong, to the point of raising rates, why have QE at all? That does not seem to be what committee members are thinking. In fact, according to their latest minutes, they seem intent on doing the exact opposite: begin to raise rates as early as March 2022, and then tackle balance sheet reduction. Even so, balance sheet reduction would not resemble a complete termination of their bond-buying program, but would probably involve a monthly cap on the amounts of “runoffs” (treasury bonds allowed to mature without being reinvested). Assuming that the monthly cap on runoffs does not exceed monthly maturities, the net effect of this policy may be that the Federal Reserve will be continuing to buy billions of dollars worth of bonds every month for the foreseeable future. Presumably with the hope that slowing the pace of balance sheet reduction will act as a buffer against the possible negative effects of rate hikes. 

In this balancing act between tapering and rate hikes, one might perhaps perceive a subtle acknowledgment that central bank officials have made themselves into de-facto custodians of stock prices. After all, their previous attempts at an interest rate hike cycle in 2018 ended in a 20% market sell-off and had to be promptly reversed. At today’s valuations, a similar sell-off would wipe out nearly 10 trillion dollars of value from the S&P 500 alone. Ultimately, the message buried in the complex mix of central banking rhetoric may simply be that the Federal Reserve intends to stay behind the curve in its attempts to tackle inflation. That it intends to tighten policy slowly, while remaining accommodative and relying on the magic of negative real rates to support asset prices and the economy, tightening without tightening. Exactly how long they can get away with this in the face of higher inflation is anyone’s guess. Given the huge political stakes around issues of wealth inequalities, and with midterm elections around the corner, I expect pressure on the Federal Reserve to ramp up over the coming months. Backed into a corner, central banking officials may just have to pick between continuing to support market valuations and curbing cost pressures. However things turn out, 2022 may very well be the year when investors and US households alike realize that free money does have a cost after all.

 

Syl Michelin, CFA

2022 Investment & Market Outlook Guide

Syl Michelin’s piece is part of Walkner Condon’s 2022 Investment & Market Outlook Guide, a comprehensive reflection of 2021 and glimpse at the factors impacting the year ahead in 2022.

2022 Investment and Market Outlook Guide

2022 Investment and Market Outlook Guide

Walkner Condon’s team of experienced financial advisors explores key topics that are top-of-mind as we transition out of 2021 and into a new calendar year, featuring the market outlook and review from Syl Michelin, a Chartered Financial Analyst™. Other topics include index funds, sector & factor performance, a pair of U.S. expat-focused pieces, and more.

Below you can find a breakdown of the individual pieces in this year’s outlook. 

1. The Year of Impossible Choices: 2021 Market Recap & 2022 Outlook
Syl Michelin, Chartered Financial Analyst™

Through a lens of current and historical data, Walkner Condon’s resident CFA® – and one of our U.S. expat advisors – explores the last year in the markets, with an eye on factors that may impact 2022. 

2. It Only Gets Harder from Here: Valuations, Bond Environment & Wage Growth
Clint Walkner

With a multitude of market highs throughout 2021 and a long stretch of gains post-2008 financial crisis, it would appear the “easy” money, if we can call it that, has been made. In this piece, Clint dives into the three main challenges as we move forward into 2022.

3. Reviewing 2021 Sector and Factor Performance and Positioning in 2022
Mitch DeWitt, CFP®, MBA

The markets were up routinely throughout 2021, but that doesn’t mean the gains were shared equally. Mitch discusses the sector winners (and losers) of the last year, along with what factors – things like high beta, value, and quality – had their day in the sun. He also goes into what might be on the horizon this year.  

4. Exploring Index Funds: History, Construction, Weightings & Factors
Nate Condon

The goal of this piece from Nate is to provide a general overview of indexes, the differences in how indexes are constructed, including equal-weighted indexes versus market capitalization-weighted indexes, and passive and factor indexing strategies.

5. Three Reasons to Look at Investing Internationally in 2022
Keith Poniewaz, Ph.D.

Though the U.S. dollar had its best year since 2015 in 2021, Keith – another of our expat advisors – explains several reasons to think about international investments in 2022, including the very strength of that U.S. dollar, valuations, and the rest of the world’s growth in GDP.  

6. Top Five International Destinations for U.S. Expats in 2022
Stan Farmer, CFP®, J.D.

One of our U.S. expat experts, Stan jumps headfirst into possible locations for Americans to consider in 2022 if they’re thinking about a move abroad – or even if they’re just wanting to dream a little bit. Stan covers ground in South America, Europe, and Asia in this thorough piece, perhaps his first crack at being a travel journalist in his spare time.

2021 Investment and Market Outlook Guide for U.S. Expats

2021 Investment and Market Outlook Guide for U.S. Expats

Our In-Depth Look at Markets & Investment Trends

Whether you’re craving analysis of the impact of quantitative easing on the markets in 2020 and how that may continue to unfold in 2021, or you’re curious about the trend that is Electric Vehicles, our experienced team of advisors has authored a breadth of content for U.S. Expats, which is curated in our first-ever comprehensive investment guide. Covering topics like sustainable investing and the trends in the S&P 500, this interactive PDF is meant to be a tool in your arsenal as you approach 2021.