What to Do as Recession Fears Grip Investors

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. Shoppers’ changing habits are either helping or hurting retailers’ earnings. Morningstar analysts weigh in on what’s in store for three big-box retailers. Also, if you want to recession-proof your portfolio, you may want to include this asset. And HSA contribution limits are going up in 2024. I’ll talk with Morningstar contributor Mark Miller about that—and the healthcare debate focusing on HSAs. This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ivanna Hampton. Let’s get started with a look at the Morningstar headlines.

Home Depot Gets Hit

Customers are scaling back their renovation projects and that’s hit Home Depot. The home improvement giant’s sales fell about 4% in the first quarter to nearly $38 billion. It blames bad weather and falling lumber prices for half of that decline. Signs of lackluster demand included a drop in transactions. Customers shifted their spending from big-ticket projects to smaller ones because of issues like inflation. Home Depot revised its outlook of flat sales for 2023. Now, it’s forecasting comparable or same-store sales to fall between 2% and 5%. The indicator serves as a key gauge of a retailer’s health. The weakening demand for home improvement supplies is a natural slowdown from years of pandemic-fueled growth that benefited Home Depot. Short-term volatility hasn’t changed Morningstar’s long-term forecast for the retailer. It should maintain its leadership position with investments in supply chain, merchandising, and people. Morningstar has lowered its estimate of Home Depot’s stock from $267 to $259. It looks slightly overvalued.

Investors Should Wait on Target

Shoppers are filling their carts with necessities on their Target runs. Essentials and other products helped drive up its sales in the first quarter. But shoppers are also cutting their discretionary spending. Sales at stores open for at least a year or online barely rose, ending up a bit higher than Morningstar’s estimate. Sales mix hurt Target’s profitability, as essentials and day-to-day living items tend to carry lower margins. Organized retail crime and other theft also weighed on the big-box retailer’s performance. Morningstar believes both factors will become less of an issue as the year goes on. Target is expected to lap the second half of fiscal 2022. It has left its full-year earnings outlook intact. Competition remains fierce and should intensify when inflation cools. Shoppers have become more conservative because of economic uncertainty. Morningstar is holding its $171 estimate of Target’s stock. It’s trading near that mark. Investors should wait for a lower price.

Walmart Wows in Economic Environment

Walmart is thriving in this economic environment unlike other big-box retailers. America’s largest retailer by sales posted a solid start to fiscal 2024. Revenue rose almost 8% among its stores, while online sales jumped 26% worldwide. Cost-conscious customers snapped up groceries and other everyday essentials. They took advantage of ship-to-home, store pickup, and curbside services. That boosted domestic, non-U.S., and Sam’s Club stores. Management lifted its profit and sales outlook for the year based on the strong quarter. Morningstar believes the company is in a good spot with the current economic turbulence. People who don’t typically shop at Walmart are going there to cut costs as inflation remains hot. Walmart’s scale will likely allow it to continue to be aggressive with pricing. Morningstar still thinks Walmart’s stock is worth $148 and suggests investors wait for a bigger discount.

Shopping for a 529 Plan?

You can invest in a 529 education savings plan for your child’s future. But should you stay in-state or shop around? Income, contribution levels, and other factors vary among families. Morningstar recommends considering your unique tax profile before selecting an option. 529 tax benefits at the federal level are straightforward. The plans grow tax-free. Families don’t pay capital gains taxes if they spend that money on qualified education expenses. However, tax benefits at the state level are more complicated. A state may offer a tax deduction. People can deduct their 529 contributions from their taxable income calculations. Or a state may provide a tax credit to help offset state income taxes. These credits typically offer bigger tax savings to a broader range of families compared to deductions. Morningstar has outlined four scenarios when families might want to shop out-of-state for a 529 plan. And it’s not just if your state doesn’t have income tax. Check out the show notes for a link to the article—”529 Tax Benefits: How Does Your State Stack Up?” You can see the full list.

HSA Boost in 2024

A big boost is coming to health savings accounts contribution limits in 2024. But HSAs come with rules. Some lawmakers are considering changing those rules to expand healthcare coverage. Morningstar contributor and author of Retirement Reboot, Mark Miller, is joining Investing Insights to discuss the HSA debate.

All right, Mark, let’s begin with an explainer on what health savings accounts are and describe their triple tax benefit.

Miller: HSAs are used alongside what’s called a high-deductible health plan, and those are defined as health insurance plans that have a minimum deductible of $1,500 a year if you’re an individual or $3,000 for family coverage. And the tax benefits of the HSA are that the dollars that go in are not taxed on the front side. And then those dollars plus investment returns, if any, are not taxed when you withdraw them later to pay for healthcare. If you’re withdrawing them to pay for a health expense, then they’re not taxed at that point either. After age 65, if you withdraw from an HSA, you can use the dollars for nonhealth expenses, but then those dollars will be taxed as ordinary income.

New HSA Contributions

Hampton: And a big change is coming to the HSA contribution limit for 2024 because of inflation. What are the new contribution limits for 2024?

Miller: Next year, the individual contribution limit will be $4,150 or $8,300 for a family-level coverage.

HSAs May Work Best as Tax Shelters

Hampton: All right. And you’ve recently written an article for Morningstar.com titled “HSAs May Work Best as Tax Shelters.” Why do you think that?

Miller: I cover retirement, and so there’s a mantra in the retirement world from people who are fans of HSAs that argue that they can be a great way to save money to meet health expenses in retirement. And technically that is true, but what I’m doing in this article is just stepping back and looking at this from the standpoint of, really, tax policy. Tax subsidies of this type typically have some kind of public purpose. So, for example, the mortgage interest deduction is something that’s there to encourage us to purchase homes. The tax breaks on 401(k)s and IRAs, likewise, intended to encourage people to save for retirement. So, when we ask the question, “What is the public policy purpose of an HSA?” the answer often is it can be a great way to help people accumulate dollars to offset the rising costs of healthcare in retirement.

And technically that is true as we’ve just stated. But when you actually look at the patterns of what’s going on with HSA investment and saving is what you’re seeing here is that these tax benefits are accruing to about the top 20% of households and very little below that. And so that stands to reason, actually, if you think about it, because dollars that are going into the HSA on a current-year basis, most people are going to withdraw those dollars and use them in that current year to meet their deductible costs. In order to really generate meaningful accumulations, you need to be able to not only sock away those dollars that we discussed, but you’d also need to meet your deductible health expenses some other way, just out of pocket using post-tax dollars. So that’s going to be the most affluent households.

We look at these tax breaks, and I think oftentimes we think, “Well, it’s free,” but it’s not. There’s a cost to these things, to the federal government, they’re referred to as tax expenditures. They’re dollars that are forgone from the standpoint of the federal tax system. And so on a 10-year basis, it’s about $180 billion in forgone income tax revenue to the federal government. So the story is just saying, our HSA is living up to the promise of helping people, in a broad sense, save money for retirement that can be used to meet health expenses.

Using HSAs in New Ways

Hampton: All right. Now there’s legislation in Washington, D.C., talking about using HSAs beyond what they are now used for. Talk about the proposals.

Miller: The big one would be to allow them to be used alongside health insurance plans that are not high deductible. So you could expand that significantly. One would be Medicare. This is one of the interesting little complexities with HSA accounts. You can contribute to an HSA up to the point that you enroll in Medicare Part A, but once you’re in Part A, you need to stop contributing. Now, you can still have the account, and you can still draw dollars down to meet certain health expenses in the way that we already discussed. But the contributions need to stop because Medicare is not technically considered high-deductible health insurance. And so the same is true for employer-based plans that are not HDHPs, high-deductible plans. So, one proposal would be just to open the doors up and let people have HSAs and contribute to them no matter what. And then there have been various proposals to increase the contribution limits, which again, if you think about it, again would benefit the most affluent households who can afford to max out these accounts.

Paths to Healthcare Coverage

Hampton: All right. But then there are some who say that’s not the way to go, that actually to bring healthcare coverage to people who don’t have health insurance or struggle to afford it, there should be another path. What are those?

Miller: Well, just a couple of examples: If you think about that tax expenditure, again, the $180 billion that we’re spending on HSAs every decade, those dollars could be used to expand Medicaid in the dozen or so states that have refused to expand Medicaid under the Affordable Care Act. In other words, a federal benefit could be offered in those states. It’d be roughly the same costs.

Another example would be to take the current expansion of premium subsidies for Affordable Care Act policies that are in place through the end of 2025 and extend those permanently. It would have also about $180 billion a year of expense. So those are both examples of ways that you could make healthcare affordable right now for people with middle and lower incomes, and I think would be smart expenditures of federal resources.

So just to say, I’m not anti-HSA. I actually have one and use one myself, but I’m just raising the question here: “Is it really the case that these are great vehicles to help a wide array of people put aside money to meet healthcare expenses in retirement?” And you got to make a distinction between the accumulation of these resources and access to them? Actually, HSA account ownership is quite diverse. People working in all sorts of occupations with all kinds of income levels are offered them through the workplace, they have high deductible health insurance, and they’ve opened HSAs. It’s just that the accumulation patterns are raising these questions.

Hampton: All right. Mark, anything else to add?

Miller: No, I think it’s just something we should consider as we think about what are going to be smart policies with respect to health insurance and healthcare as we move forward.

Hampton: All right. Well, thank you, Mark, for your time today and providing insights into the HSA debate.

Miller: My pleasure. Anytime.

How to Recession-Proof Your Portfolio

Hampton: Recession expectations are peppering conversations from Main Street to Wall Street. What should investors include in their portfolios to guard against economic weakness? Morningstar Inc.’s investment specialist Susan Dziubinski and Morningstar Inc.’s director of personal finance Christine Benz talk about that.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Many economists think a recession is a real possibility over the next year. In fact, Morningstar’s Chief U.S. Economist Preston Caldwell suggests that there’s a 30% to 40% chance that we’ll experience a recession in the next 12 months. Joining me to discuss that prospect as well as how investors can recession-proof their portfolios is Christine Benz. Christine’s Director of Personal Finance and Retirement Planning for Morningstar.

Good to see you today, Christine.

Christine Benz: Hi Susan. It’s great to see you.

Dziubinski: So, macroeconomic events are nearly impossible to predict. So why does there seem to be this such a widespread concern about the U.S. slipping into a recession in the next year?

Benz: Right, the fundamental underpinning for those concerns is the fact that the Federal Reserve has been on this aggressive campaign of raising interest rates. The goal of doing so is to slow down the economy and in turn to slow down inflation. So the worry is that the Fed will push a little too hard and inadvertently slow down the economy a little bit more than it might have hoped. And another thing that we’re seeing is the bond market appears to be flashing some warning signals about a recession as well. So what’s called the yield curve which shows you that the yield that you can obtain for bonds of differing maturities, Treasury bonds typically of differing maturities is showing that you can get paid more today for short term investments than you can for long term investments. And so that’s signaling that bond market participants think well, those bond yields are going to go down at some point. And so that’s one of the considerations as well that historically this so-called yield curve inversion has been a signal that the economy is going to weaken. In fact, it’s been a close to foolproof signal.

Dziubinski: Now, as part of some broader work that you and your colleagues are doing terrific work on diversification and correlations. As part of that project and that white paper that you worked on, you’ve also been looking at how various asset classes have performed during economic downturn. So that’s what we’ll talk a little bit about today. And let’s start with equities how have they done in sort of previous recessionary environments?

Benz: Well, equities have not been great as you might expect, because stocks tend to respond to the economic environment, especially if the company is selling discretionary goods or services, people pull back in recessionary times. So when we examined previous recessionary periods we found that stocks in five of eight of the recessionary periods that we examined did have losses during those periods. Three of the eight periods they did not have losses, but nonetheless that’s kind of food for thought when we think about how our portfolios might behave, we probably wouldn’t want to over rely on the equities to be great performers, they will oftentimes experience some losses during a recessionary period.

Dziubinski: OK, and then how about bonds?

Benz: Bonds are the star of the show, in recessionary environments, especially high quality bonds I wouldn’t put too much faith in lower quality bonds, which will tend to be very much beholden to what’s going on in the economic environment. But when we looked at the category that had the best performance during recessionary periods, high quality bonds, especially Treasury bonds, really delivered. So in eight of those eight recessionary periods that we examined historically, bonds came through with flying colors and had positive returns and they also exhibited a negative correlation with equities. Which is one reason why we come back to this idea that a balanced portfolio is a good place to be for a variety of market environments.

Dziubinski: And then what about cash investments, what do you think investors should be expecting there during an economic downturn.

Benz: Right, everybody’s excited about cash today. The yields are the best of anything going right. The key consideration is yes, indeed cash will hold its ground in a recessionary environment because that’s part of the deal, right? But what I would not be surprised about is to see yields taper down. And of course, if you’re buying any short term security cash or short term bonds or anything like that. That’s the risk you face that you’re having to see your bonds mature or see your CD mature and you’re having to reinvest in a lower yield environment. So that’s a consideration, I think, for people who might say I love cash today, just be careful because you do face reinvestment risk. One countervailing point though is that inflation will tend to cool off in a recessionary environment. So that’s less of a headwind for you as a cash investor then when inflation is high, as it has been over the past year and a half or so.

Dziubinski: Yeah, that’s true. So then what implications are there for investors today putting together their portfolios, managing their portfolios, what should they be thinking about?

Benz: Well, I do think that if you’re looking at ballast for your equity portfolio, so say maybe you have 70% of your portfolio in stocks. The best ballast, the best category for a weakening economic environment, will be that high quality bond portfolio. Very plain-vanilla I wouldn’t necessarily dabble in lower quality bonds if I’m looking for ballast, that high quality fixed income portfolio with a heavy dose of government bonds is going to be your friend in a recessionary environment. You don’t need to get fancy, in fact, I would look for the cheapest product that you can find, a total bond market index for example, would have a healthy dose of Treasury bonds and other government related bonds, which would tend to perform pretty well in a recessionary environment.

Dziubinski: Well, Christine, thank you for your time today. We really appreciate it and we also appreciate your tips for how we should be thinking about our portfolios in case of a recession. Take care.

Benz: Thank you so much, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Hampton: Thanks Susan and Christine. Subscribe to Morningstar’s YouTube channel to see new videos about market news, personal finance, and investment picks. Thanks to lead technical producer Scott Halver, video producer Daryl Lanner, and senior video producer Jake VanKersen. And thank you for tuning in to Investing Insights. I’m Ivanna Hampton, a senior multimedia editor at Morningstar. Take care.

Read about topics from this episode.

Walmart Earnings: Solid Sales as Chain Benefits from Consumers’ Focus on Value

Target Earnings: Theft, Mix Weigh on Earnings, but Distribution Improvements Should Help in Long Term

Home Depot Earnings: Tough Macro Environment Weighs on Sales Momentum

529 Tax Benefits: How Does Your State Stack Up?

HSAs May Work Best as Tax Shelters

What’s the Best-Performing Asset Type During a Recession?