2010 will be a year of transition from the Great Recession to hopefully, a period of sustainable economic growth. Despite the political wrangling, the economy’s vital signs are pointing in a positive direction. Economic growth as measured by the Gross Domestic Product was 5.7 percent for the fourth quarter. The unemployment rate improved from 10 percent to 9.7 percent in January. Reported corporate profits of the S&P 500 companies, excluding financials, improved by 16 percent.
On the other hand, there are some concerns that could send the economy back into cardiac arrest. The sale of new and existing homes, mortgage foreclosures and commercial real estate are still major problems. The sovereign debt crisis in countries such as Greece, Spain and Portugal is keeping the market jittery. Threatening geopolitical issues in Iraq, Afghanistan, North Korea or even a major terrorist attack on U.S. soil could send the economy into another tailspin.
The real problem
However, the real problem that threatens the country’s long-term prosperity is the rapidly growing federal debt. The budget recently presented by President Obama, projects a $1.7 trillion deficit for 2010, which will be added to the $12 trillion nation debt. The administration projects that the national debt could possibly double over the next decade. This projection caused Moody’s Investors Services to warn that the AAA credit rating of the U.S. “could come under downward pressure.”
The size of the deficit and national debt are almost beyond comprehension, but the possible future implications for U.S. citizens are real:
Higher taxes. The federal government cannot raise taxes during the current fragile recovery period. However, to reduce the deficit and national debt, taxes will have to be raised in the future. The Bush tax cuts expire Jan. 1, 2011 and President Obama has proposed raising the top marginal tax rates and increasing the capital gains tax rate.
Higher inflation. The Federal Reserve prints money to pay for government deficit spending, the various stimulus packages and to service the national debt. This will result in lower purchasing power per dollar and inflation.
Higher interest rates. The Federal Reserve borrows money to service the government debt. As the economy improves, the competition for money will increase and lenders will demand higher interest rates. Additionally, the Fed will raise interest rates to help combat inflation. The Fed is already talking about how they plan to raise rates in the future.
Lower standard of living. Higher taxes, lower purchasing power and higher interest rates can lead to a lower standard of living for the average American.
Go on offense
Taxes, interest rates and inflation are all still low during this transition period. However, we can anticipate that economic change is taking place, so let’s go on offense and look ahead. Below are some starting points to think about:
Taxes. Current conventional thinking is to defer income and the resulting tax into the future. However, if it is anticipated that income tax rates are going up, the opposite might be a better strategy. Examples might include: selling highly appreciated assets while capital gains rates are low; purchasing a Roth IRA versus a traditional IRA or considering converting an existing IRA to a Roth; and consideration of tax free income from municipal bonds.
Inflation. Typically in an inflationary environment, hard assets keep pace with inflation better than debt. Commodities, real estate, stocks and even collectibles may tend to outperform fixed dollar assets such as bonds, savings accounts and cash.
Interest rates. Current interest rates are near modern historical lows. Consider refinancing long- term debt at today’s low rates, if the numbers make sense. It is still smart to minimize credit card debt, because of the high rates and fees. Also, consider investing in Treasury Inflation Protected Securities (TIPS) which offer a guaranteed yield above the inflation rate.
Your standard of living
Just as your financial plan was tested during the Great Recession, it will again be tested in the economic expansion that will take place over the next few years. The growing federal debt is a structural change that will have significant impact on our economy. Anticipating the change will help you maintain and improve your family’s standard of living. Meet with your financial adviser to determine how you might adjust your plan.
(Michael G. Shinn, CFP, registered representative of securities and investment advisory services offered through Financial Network Investment Corp., member SIPC. Visit www.shinnfinancial.com for more information or to send your comments or questions to firstname.lastname@example.org.)