Morningstar Economic Update March 2022
Outlook for Investment Markets
Markets have been roiled by a series of unpleasant shocks—most recently by the Russian invasion of Ukraine, on top of a pre-existing spike in inflation, the ongoing global evolution of the coronavirus, the outbreak of omicron in New Zealand and the subsequent consumer-inhibiting surge in cases, and the prospect of central banks unwinding the ultra-easy monetary policies that had helped sustain asset performance (other than the returns from cash) in previous years. Both bonds and equities are in the red for the year to date. The outlook remains subject to a high level of economic and geopolitical uncertainty: What happens next in Ukraine remains impossible to predict, and further deterioration in financial markets if (for example) there are expanded sanctions or a wider conflict cannot be ruled out. The scale and duration of the current inflationary surge, and the size and timing of central banks’ likely response, are also in play. As always, prudent portfolio diversification remains the first best defence against heightened risks, and some emphasis on the relatively defensive end of growth assets, and on assets which provide a degree of inflation hedging, look useful options in current circumstances.
New Zealand Cash and Fixed Interest — Review
Short-term interest rates have risen further as the Reserve Bank of New Zealand, or RBNZ, has continued to remove the previous degree of monetary stimulus, most recently on Feb. 23 by raising the Official Cash Rate, or OCR, by 0.25% to 1.0%. The 90-day bank bill yield is now just under 1.5%, up 0.5% since the start of the year. Long-term interest rates are also on the rise, and the 10-year government-bond yield is now close to 3.0%, and up 0.6% for the year to date. The kiwi dollar is up by a marginal 0.2% for the year to date in overall trade-weighted value. While it is down slightly in terms of its headline U.S. dollar rate—it has dropped by 0.4% to just over 68 U.S. cents—it has gained against European currencies, which have weakened since the Russian invasion of Ukraine.
New Zealand Cash and Fixed Interest — Outlook
It remains highly likely that short-term interest rates will continue to rise, as the RBNZ has little choice but to keep raising rates to deal with inflation that is well above its target range. The ANZ Bank, for example, thinks inflation, boosted further by recent rises in oil and other commodity prices, will hit a peak of 7.4% in the June quarter and will still be running at 5.7% at the end of this year; it has consequently raised its OCR forecast track and now thinks the OCR will reach 3.5% by the middle of 2023, 2.5% higher than today. The futures market is also pricing in hefty increases in the 90-day bank bill yield, which is expected to be almost 2% higher, at 3.35%, by mid-2023.
A highly inflationary environment and tightening monetary policy make for ongoing difficult market conditions for bonds: For the year to date, the S&P New Zealand Aggregate bond index has lost 2.8%. Some forecasters reckon that the rise in yields is largely complete: The ASB Bank, BNZ, and Westpac all expect yields to still be around 3%, or only a tad higher, by mid-2023. But with inflation continuing to surprise on the upside, the risk is that bond yields might yet have to rise further; ANZ, for example, expects the 10-year yield to hit 4.0% by June ’23.
The currency has held up better than might have been expected: Normally, events like the invasion of Ukraine and its associated financial market volatility tend to lead investors to retreat back home and not incur the foreign-exchange risk of holding currencies like the kiwi dollar. The ‘risk off’ retreat home, on this occasion, appears to have been counterweighed by the prospect of higher New Zealand interest rates, with the RBNZ poised to raise rates relatively energetically by world central bank standards; by New Zealand being a beneficiary of soaring commodity prices (the ANZ Bank’s commodity price index hit a new all-time high in February); and, possibly, by New Zealand being seen as a relatively safe harbour well away from the worst of the postinvasion impacts. Some forecasters even reckon that the kiwi could rise in value in this environment: The BNZ and Westpac, for example, both see the kiwi at 72 U.S. cents by mid-2023. That said, foreign-exchange forecasting is even more than usually problematic in the current geopolitical fog.
New Zealand Property — Review
Ex the utilities, which have held up better, most sectors of the New Zealand share market have sold off by similar amounts. The S&P / NZX All Real Estate index for the year to date has recorded a capital loss of 9.2% and returned a loss of 8.6% including dividends, much the same as the wider market’s 9.8% capital loss and 9.4% loss with dividends.
New Zealand Property — Outlook
The operating outlook continues to show strong subsectoral patterns. Industrial remains in by far the strongest position, with virtually no prime industrial vacancy in the Auckland market. Offices face the same immediate occupancy issues that Australia went through over the past three months, with the omicron case load running at high levels. On the other side of peak infections, there is likely to be a split between the ongoing demand for prime central business district assets and more difficult conditions for secondary offices, which are more at risk from trends like remote working. The going is toughest for retail: As Colliers said in their latest (March) research report, “Retail leasing conditions in major CBD markets remain challenging as a result of Covid-19 impacts on pedestrian counts, inflation, staffing and consumer spending activity”. Colliers also pointed to the increased headwinds from online shopping, citing NZ Post data for 2021, which showed that online shopping is now 52% higher than pre-COVID-19 levels and which has contributed to the strong demand for industrial logistics assets.
On the plus side, property has inflation-hedging value as rents are escalated, which is of particular value in New Zealand where inflation is running at 5.9% (December quarter) and is expected to go higher still in the coming months. On the down side, New Zealand bond yields are high by comparison with many other markets, with the 10-year government-bond yield around the 3% mark and potentially heading higher again, which threatens both the relative attraction of the yield on local listed property and the valuations of the underlying assets. So far, neither argument has dominated, and the most likely scenario may be ongoing performance in line with the equity market as a whole.
Australian & International Property — Review
The A-REITs had been one of the weaker-performing sectors even before the latest round of Ukraine-linked losses, and it has continued to underperform. For the year to date, the S&P / ASX200 A-REITs index has made a capital loss of 10.5% and an overall loss of 10.0% including dividends, compared with the wider share market’s 4.0% capital loss and 2.6% total return.
Overseas, REITs have also sold off, but although the absolute numbers have been weak, there is some comfort in the fact that the REITs fared less badly than global shares overall. The FTSE EPRA/NAREIT Global Index in U.S. dollars including dividends returned a loss of 8.4%, rather better than the 12.2% loss for the MSCI World index. All the major regions fared much the same, with returns ranging from a loss of 6.5% in the Asia-Pacific region through to a loss of 9.6% in the U.K., while the key U.S. market lost 9.3%.
Australian & International Property — Outlook
The operating outlook in Australia is similarly tiered by subsector. As NAB’s latest (December ’21 quarter) commercial property survey shows, industrial is strongest: Respondents expect capital values to grow by 3.4% this year and 3.1% in ’23, rents to grow by 3.3% in both years, and vacancy rates to stay low (below 4%). Offices are in the middle: Capital values are expected to increase a little (0.7% this year, 1.1% next year), but rents will show little net change (down 0.6% this year, expected to increase by 0.6% next year). Vacancy rates will be slow to come down from their current 9.9% (9.8% by end of year, 9.2% by end ‘23): Office occupancy data from the Property Council of Australia for late February show that the worst of omicron has passed, with occupancy levels improving all round, but they are still at low levels, especially in the two largest CBD office markets (Sydney occupancy is running at only 18% of pre-COVID-19 levels, and Melbourne at 15%). Retail remains weakest, with the NAB respondents expecting further modest falls in rents this year (down 1.6%) and next (down 0.4%).
For now, it appears that the new reality of the Reserve Bank of Australia tightening monetary policy earlier in the piece than previously expected is holding back A-REIT performance. Longer term, the outlook is stronger, particularly as Australia looks well placed on the radar of global and local institutional investors looking for real assets as inflation hedges. CBRE, for example, reckons that Australian super funds are currently underinvested in property (7.7% of their portfolios now, compared with a longer-term allocation of 8.2%). Restoring the status quo would see some AUD 68 billion of additional demand for property, and CBRE expects increased institutional demand to support capital values, the level of corporate activity, and the creation of new listed A-REITs.
Global REITs have provided some modest degree of downside defensive protection in the latest global equity market weakness: IHS Markit, which has been running a relatively new monthly survey of U.S. institutional investors (it has been going for 18 months), found in March that real estate was one of the relatively defensive sectors, with the likes of utilities and healthcare, that investors had been warming to in response to the heightened postinvasion uncertainties. And as with domestic property, the asset class has attractions as an inflation hedge. One significant challenge, however, will be the prospect of narrowing yield differentials: Global REITs (on S&P’s index) offer 3.4%, which will become progressively less attractive as bond yields continue their rise. A better approach to the sector might be to concentrate on opportunities at the subsector level, where the operating outlooks remain quite diverse. JLL’s latest (March quarter) Global Real Estate Perspective – Highlights noted, for example, the ongoing boom-time conditions in industrial logistics—“In both the U.S. and Europe, rents increased [in Q4 2021] at an annualized rate of around 10% amid record low levels of vacancy, with aggregate vacancy rates sub-4% in both regions” —and there are also opportunities in the premium CBD office space and in hotels and hospitality as COVID-19 runs its course and current travel restrictions are progressively relaxed.
Global Infrastructure — Review
Global listed infrastructure had been relatively resilient even before the Ukraine invasion and has continued to hold up well in the selloff since then. For the year to date, the S&P Global Infrastructure index in U.S. dollars has recorded a small capital loss of 1.0%, and a net return loss (including taxed dividends) of 0.6%. Hedged back into kiwi dollars, the asset class is slightly ahead for the year, with a 0.7% net return in kiwi dollar terms.
Global Infrastructure — Outlook
Infrastructure as an asset class has often been touted as a best-of-both-worlds option, with an element of downside protection from its less cyclical components (like utilities) mixed with some upside potential from more growth-exposed subsectors (like airports). For the year to date, it has done what it says on the tin, and the defensive option came into play, anchored by telcos and utilities in particular. Going by the total return from the FTSE global sector indexes in U.S. dollars, mobile telecommunications (down 0.6%), telecommunications (down 1.0%), and fixed line telecommunications (down 1.6%) took only marginal hits, while utilities, electricity, and gas/water/multiutilities proved relatively resilient (each down 4.0%), at a time when global shares on the FTSE reckoning dropped by 12.2%. Looking forward, the defensiveness of sectors such as telcos and utilities is likely to remain attractive, as is the degree of inflation-hedging provided by the periodic updating of regulated utility tariffs. Internet infrastructure is also a plausible theme: AMP Capital recently said that “Data and telecommunication is another area where a lot of smart money has been going. Working from home has driven dependence on fibre, telecommunication towers and data centres, but it’s still not a core asset class so that additional risk attracts a slightly higher return”. At some point in 2022, sentiment is also likely to turn more in favour of previously COVID-19-ravaged assets like airports. And although it has been on the outer so far—the FTSE index of Alternative Energy is down 7.4% year to date—renewable energy is likely to attract greater interest, given the recent surge in oil prices to around the USD 100/barrel mark.
Australasian Equities — Review
As in overseas equity markets, New Zealand shares had started the year with losses, even before the Ukraine invasion, and the post-invasion selloff has added to the pain. For the year to date, the S&P / NZX50 index is down 9.8% in capital value, for an overall loss including dividends of 9.4%. The weakness has been widely felt: The biggest caps are down 9.4%, the mid-caps are down 10.6%, and the small caps are down 10.4%. An exception, as in overseas markets, has been the utilities sector, where its appealing defensiveness in an environment of high uncertainty has seen it hold up much better than the wider market, with a small 1.4% loss.
Australian shares, while not immune to the global weak equity tone of the year to date, have fared relatively well by international standards. The S&P / ASX200 index is down by a relatively modest 4.0% (2.6% including the value of dividends). On the plus side, the miners have ridden the global commodity price surge and are up by 6.2%, and the utilities, a useful defensive option in the current uncertainties, are up by 6.1%. The large banking sector has also held up reasonably well, with only a small 1.0% loss. On the down side, IT has shared in the global tech selloff and is down 24.0%, and consumer discretionary (down 13.4%) and healthcare (down 12.4%) have also been notably weak.
Australasian Equities — Outlook
The immediate outlook in New Zealand is not encouraging. The February reading from the BNZ / BusinessNZ survey of services activity (some two thirds of the economy), the ‘PSI’, was its “seventh consecutive month below the breakeven 50 mark. Pain is accumulating”. Some areas are in very poor shape indeed: “Variation across industries was extreme in February. Omicron’s impact is there for all to see in the likes of accommodation, cafes, and restaurants with its lowest ever PSI recording of 11.2. Just dreadful. Cultural, recreational, and personal services was hardly any better with an unadjusted 20.8. Retail and wholesale trade were well below the 50 line—as spending plunged in the month as indicated by a large drop in electronic card transactions”. Statistics New Zealand had earlier reported that card transactions dropped by 7.6% between January and February and commented that “This drop across the board was the first of its kind since August 2021, when the country was in lockdown at alert level 4”. Part is down to ongoing COVID-19 restrictions, but the bigger moving part appears to be voluntary hunkering down as people have reacted to the surge in omicron cases.
Other surveys also show tough conditions. The ANZ Bank found that “The February ANZ Business Outlook results show widespread anxiety about the impact of Omicron. Activity indicators fell across the board”. Consumer confidence is also reeling: As ANZ reported, “The ANZ-Roy Morgan Consumer Confidence Index plummeted to a record low in February, as respondents nervously eyed up widespread COVID in the community for the first time … A net 2% expect to be worse off this time next year, down 12. That’s the first time that series has ever been in the red.” (The series goes back to 2004.)
As ANZ Bank said of their latest business survey results, “The survey makes grim reading, certainly. But this isn’t March 2020 and we do have an idea of the storm that we are heading into. Other countries have been through the Omicron wave already, and have seen a sharp bounce-back in spending on the other side. The disruption will be intense, but relatively short-lived”. Certainly Australia, which had a large outbreak some months earlier than New Zealand, now looks to be emerging from it. And there are some positives, notably record commodity prices and the prospect of some fiscal policy support in the May 19 budget. But even when demand picks up, however, profitability looks to remain under heavy pressure: Businesses are reporting record levels of input cost pressure and are deeply pessimistic about expected profits. At the moment, it is hard to see anything other than ongoing headwinds for local equities.
In Australia, the latest data suggest that the economy, at least pre-Ukraine invasion, was poised to recover from its omicron setback. The Ai Group’s suite of activity indicators for manufacturing, services, and construction all showed growth in February. Services, the largest sector of the economy, were particularly strong, with a reading of 60 when 50 is breakeven. Ai Group said that “All five of the services sectors available in the Australian PSI® showed robust expansion in February (seasonally adjusted). Activity was strongest in the consumer-oriented sectors; retail trade & hospitality recorded a large increase in activity, as did ‘personal, recreational & other services’ ”.
NAB’s latest business survey was also upbeat: “Business conditions and confidence strengthened in February as the Omicron virus wave eased and the late 2021 momentum was regained. After a fall in January, the conditions index rebounded to be above its long-run average”. The Roy Morgan survey of business confidence landed in the same place: It “jumped by 19pts (+18.7%) in February to 120.5, its highest mark since the beginning of the Delta wave of COVID-19 in June 2021 (128.3) … The quick recovery in the index came as the highly contagious, but relatively mild, Omicron variant dissipated during February which again highlights the underlying strength of the Australian economy”.
As Roy Morgan pointed out, however, the February results predate the Ukraine invasion and the latest leap in petrol prices, and the latest consumer confidence surveys for March clearly show a knockback to the expected economic outlook. Roy Morgan’s latest survey (second week of March) found that “Consumer Confidence dropped to its lowest since October 3/4, 2020 (95.7) this week as the Russian invasion of Ukraine led to sanctions on Russian energy exports and led to steep increases in the prices of petroleum products. The price of petrol in Australia has hit record highs above $2 per litre for the first time. Consumer Confidence is now below the neutral level of 100 in all States … Driving the weekly drop were declines in sentiment in regards to personal financial situations and also the performance of the economy over the next year and next five years”. The March Westpac / Melbourne Institute consumer survey found much the same: “This is the weakest print since September 2020 … Views on the economic outlook recorded the sharpest pullback”.
Clearly, the road ahead has become bumpier, but Australia drives it down from quite a good starting point. CommSec’s roundup of the corporate reporting season ended December said that “Earnings results are supporting Aussie shares with corporate profits on track to hit record highs. In fact, consensus earnings forecasts, using the S&P/ASX 200 index 12-month forward estimate earnings per share (EPS) have jumped 7.5 per cent in the past month to a near record $437, according to Bloomberg data. The increase reflects better-than-expected earnings results from an array of Aussie banks, miners, healthcare and energy companies, delivering above analyst expectations, as companies manage rising costs”. Some of the optimism will have been left behind by subsequent events, but it would not be surprising to see Australian equities continue to outperform in coming months.
International Fixed Interest — Review
The year 2022 has been a challenging one for fixed interest: For the year to date, the Bloomberg Global Aggregate in U.S. dollars has returned a loss of 6.0% (a 5.5% loss on global government bonds and an 8.7% loss on global corporate bonds). Investors looking to boost returns by opting for higher-yield options like junk bonds or emerging-markets debt have also been disappointed: Global ‘high yield’ (low credit quality) bonds have lost 7.8%, while emerging-markets debt has lost 10.8%. Making a duration bet—aiming at the higher yields at the longer end of the yield curve—has also misfired: In the U.S. market, for example, the Long Treasury index (maturities of over 20 years) is down by 10.5% as yields have risen, with the 30-year Treasury yield increasing from 1.9% at the start of the year to 2.5% now.
International Fixed Interest — Outlook
The poor performance of bonds reflects two linked factors. Yields are way below current rates of inflation, which means that bondholders will continue to suffer erosion of the purchasing power of their investments unless yields rise even further (or inflation unexpectedly drops back quickly, which currently looks unlikely). And central banks faced with these price pressures need to reverse their previously stimulatory monetary policies: With inflation running well above their mandated targets (typically around 2%), they are highly likely to raise interest rates and to wind back or reverse previous programmes that had kept bond yields unusually low.
The scale of the current inflationary surge has been a surprise. In the U.S., for example, the latest (February) inflation rate was a startling 7.9%, the highest in 40 years (since the 8.4% recorded in January 1982). In the U.K. in January, it was 5.5%, and in the eurozone, the early ‘flash’ estimate for February is 5.8%, up from January’s 5.1%. Japan, with a January inflation rate of 0.5%, is the only major developed economy not facing a spike in inflation. While some of the factors behind the surge may be short-term—temporarily strong post-lockdown demand meeting temporarily COVID-19-constrained supply—the risk is that there may be more permanent elements, notably fiscal and monetary policies that may be too loose for economies that no longer need that level of support. In the U.S., for example, the February unemployment rate was only 3.8%. People—whether producers, employees, or consumers—may also be tempted to change their behaviour on the assumption that inflation is higher than it used to be (for example, by asking for large pay rises), further cementing in higher inflation. In addition, there is the new risk that flow-on effects from the Russian invasion of Ukraine will exacerbate price pressures for food, energy, and industrial metals.
At time of writing, the Fed in the U.S. had just announced its policy response: On Feb. 16, it raised its target range for the fed-funds rate by 0.25%, to a range of 0.25% to 0.5%. Projections made by the officials at the policy meeting showed that the Fed expects to keep raising rates for the rest of the year, with the median forecast of the participants being an end-year target range of 1.75% to 2.0%. The immediate reaction of the U.S. futures market was that the Fed’s projected target looked either realistic (a 31% probability) or slightly on the low side (there is a 40% probability of a 2.0% to 2.25%% range). In the U.K, the Bank of England had already raised rates twice, and it did so again on March 18, citing the risk of 8% inflation in coming months, while in the eurozone, the European Central Bank, or ECB, is sidling up to the idea. This month, the ECB unexpectedly said that it would end its bond-buying programme earlier than previously announced (it will wind up by September at the latest), a preliminary step towards subsequent interest-rate increases.
It is possible, with the current geopolitical uncertainties around Ukraine in particular, that bonds might benefit from nervous ‘safe haven’ demand. There was, for example, a brief episode of buying of U.S. Treasuries immediately after the invasion, which saw the 10-year yield drop to 1.73% from just under 2%. And it is possible that the world economy could soften, easing inflationary pressures and reducing the need for interest-rate increases. But the more likely outcome is inflation continuing to run higher than central banks would prefer and investors needing to see higher yields to protect the real (after inflation) value of bonds. Conditions remain difficult.
International Equities — Review
World shares had been weakening in any event, even before the invasion of Ukraine on Feb. 24: Over that period, the MSCI World index had dropped by 7.8%. The invasion made things worse, with a further 5.2% fall since then, for a cumulative year-to-date loss of 12.5%. In the U.S., the S&P500 is down 12.4%; in Japan, the Nikkei is down 12.3%; and in Europe, the FTSE Eurofirst300 is down 9.8%.
Measuring the performance of the emerging markets postinvasion has become very difficult: Russian shares, while almost certainly worth substantially less than before, have not traded since Feb. 25. MSCI said that it “received feedback from a large number of global market participants, including asset owners, asset managers, broker dealers, and exchanges with an overwhelming majority confirming that the Russian equity market is currently uninvestable and that Russian securities should be removed from the MSCI Emerging Markets Indexes”. They subsequently have been. The ongoing Emerging Markets index is down 14.4% in U.S. dollars. The Brazilian market has done very well on the back of booming commodity prices (MSCI Brazil up 15.9%), but the overall result has been pegged back by weaker performance in China (MSCI China down 25.4%) and India (MSCI India down 6.7%).
International Equities — Outlook
Before the invasion of the Ukraine, the outlook for the world economy was looking positive. The most recent (February) J.P. Morgan Global Composite index of activity “saw the rate of global economic expansion revive from January's one-and-a-half year low, as growth of new orders and employment accelerated and business optimism strengthened to a near record high”. IHS Markit, who compile the national activity indexes that build up to the Global Composite index, run a three-times-a-year business outlook survey, and its February readings showed the same upbeat picture: “The story they tell is of a global business community relieved at the prospect of a lack of pandemic disruption for the first time in two years amid hopes that the Omicron variant spells the end of strict restrictions across much of the world. The expected return to normality fed record optimism around hiring and investment”.
But as IHS Markit cautioned, the data were gathered largely around the middle of February, before the invasion of Ukraine, and IHS Markit warned that “It remains to be seen how much of this positive outlook will be maintained following the invasion of Ukraine, the energy price spike and imposition of sanctions”. It has not helped that China has in recent days imposed a new series of strict COVID-19 lockdowns, raising further issues about interruptions to global trade.
The immediate impact has been to put a severe dent in investors’ expectations about the global outlook. The latest IHS Markit survey of U.S. institutional investors found that “The mood among US equity investors has turned much gloomier in March as the intensifying Ukraine crisis exacerbates existing headwinds and concerns. Geopolitics are exerting a greater drag on the market than at any time in the survey’s one-and-a-half-year history, as is the deteriorating global economic environment. The invasion has led to heightened worries over slowing growth, soaring inflation, a cost-of-living squeeze, and more protracted supply chain bottlenecks”. Investors also reported large changes in sectoral preferences: “Sector preferences have changed dramatically as the Ukraine crisis has flared up, most conspicuously with favour shifting sharply towards energy and utility stocks but away from financials”.
The long-running Bank of America Merrill Lynch, or BAML, survey of international fund managers also found a sharp deterioration in sentiment. Expectations for global economic growth have dropped to levels last seen in the depths of the global financial crisis in 2008, and expectations for global corporate profits, while not sinking to global financial crisis levels, have also turned deeply pessimistic and are not far short of the gloom that hit investors during the first outbreak of COVID-19 in early 2020. The three biggest risks seen on the horizon are Ukraine/Russia, a global recession, and ongoing high inflation, and fund managers have responded by raising the level of cash in their portfolios and (like the IHS panel) by shifting equity sectoral allocations, with commodities and energy heavily favoured.
Investors have not completely panicked. The BAML respondents are still slightly overweight to equities, although that may partly reflect the unattractiveness of alternatives: As noted earlier, bonds are in a hard place, and the BAML panel is unsurprisingly a net 56% underweight. It may be that the worst of the Ukraine impact is already in equity prices. On the other hand, geopolitical uncertainty remains very high, and the track record of analysts trying to understand President Putin's motivations and his likely next moves is not strong. There is clearly room for worse to befall, either on Putin’s side or on the West’s (for example, through intensification of sanctions). As always, diversification remains the key protection against setbacks and uncertainty, and within the equity sector, it might be no bad idea to follow the pros and either surf the inflationary pressures with exposures to subsectors like commodities and/or derisk by favouring relatively defensive subsectors like utilities.
Performance periods unless otherwise stated generally refer to periods ended Monday, March 14, 2022.
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