Investment Management

U.S. federal deficits and the national debt are hot topics these days and for good reason. The federal deficit in 2010 was $1.3 trillion and the amount of gross federal debt outstanding (the national debt) is now $14 trillion. No one expects these to stop growing anytime soon.

Economists call the U.S. type of deficit a “structural deficit” because it isn’t temporary; the U.S.government habitually spends more than it takes in. Imagine if you ran your own personal finances this way. It would mean you spend more than you make each year and never pay your debt off—it just grows. Your creditors wouldn’t allow it and bankruptcy would surely be the outcome.

In The Ten Trillion Dollar Gamble: The Coming Deficit Debacle and How to Invest Now, Russ Koestrerich takes on this issue in straightforward prose that even a person unfamiliar with deficit economics can understand. In the first few chapters he explains the what, why and how of the U.S. deficit problem. He attributes the large and growing deficit to entitlement spending: revenue spent on Social Security, Medicare and Medicaid, compounded by our politician’s unwillingness to take action to reduce and control this spending. Koestrerich’s premise is that the largest pieces of the deficit pie, entitlement spending, along with the interest expense on existing bonds and defense spending, are politically untouchable. No politician wants to be voted out of a job.

Koestrerich concludes that the deficit isn’t going away and the result will be higher interest rates, slower economic growth and inflation.

In Chapter 2, Koestrerich explains why this matters to you—why slower growth, higher interest rates and inflation will dramatically affect the U.S. standard of living. As more government spending goes to paying interest on the debt, there will be less spending on more productive areas, such as job creation, education and infrastructure. Taxes will inevitably rise as a way to fund the deficit, hurting business and households alike. Higher deficits lead to higher interest rates on government debt which then extends to higher rates on consumer loans such as mortgages, auto and student loans. And in the worst outcome, inflation will start to rise, and each dollar will buy less goods and services, stretching already tight household budgets to a breaking point.

If you believe in Koestrerich’s worst case scenario, then Chapters 5 to 9 are for you.In them, he outlines investing strategies that can potentially protect your capital and make money in a deficit-run economy:

Bonds:

• Reduce bond holdings, particularly U.S. Treasuries.
• Focus your bond portfolio on shorter maturities.
• Build bond ladders.
• Raise allocation to municipal bonds.
• Favor corporate bonds over government bonds.
• Add international (including emerging market) bonds to your portfolio mix.
• Add TIPS (if held to maturity).
• If you need income, look to preferred and dividend paying stocks as bond substitutes.

Stocks:

• Increase your exposure to stocks outside of the U.S.
• Favor regions with better growth prospects and less debt, i.e. Canada, Australia, Germany, Hong Kong and Singapore.
• Own stocks in countries that produce commodities, particularly energy, i.e. Canada and Australia.
• Focus on U.S. companies that are large exporters of goods or services.
• Give more weight in your portfolio to emerging markets, i.e. Brazil.
• Overweight stocks that are more resilient to rising rates such as technology, energy and healthcare and own less in utilities, financial and consumer discretionary stocks.

Commodities

• Allocate a percentage of your portfolio to a broad commodity basket and gold.

Real Estate

• Buying a larger home, a second home or some commercial property is a good strategy in the event of higher inflation, but buying REITS is not.

Koesterich does an excellent job of describing the ways to invest in these different asset classes and the book is a useful investment primer. He explains his recommendations in just enough detail and again, in prose that most investors can understand. I would recommend this book to anyone who wants to get a deeper understanding of our current economy and ways to invest, whether you believe we are on the road to a deficit debacle or not.

Note:  This book was provided to me free of cost by McGraw-Hill. Any investment strategies discussed above are not recommendations. Consult your financial advisor or conduct your own due diligence to ensure investments are appropriate for your risk tolerance and investment timeframes.