Koesterich the ten trillion dollar gamble; the coming deficit debacle and how to invest now (2011)

THE TEN TRILLION DOLLAR GAMBLE This page intentionally left blank TEN THE TRILLION DOLLAR GAMBLE THE COMING DEFICIT DEBACLE AND HOW TO INVEST NOW RUSS KOESTERICH NEW YORK LISBON CHICAGO LONDON NEW DELHI MADRID S A N J UA N SYDNEY SAN FRANCISCO MEXICO CITY SEOUL TORONTO MILAN SINGAPORE Copyright © 2011 by Russ Koesterich All rights reserved Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher ISBN: 978-0-07-175404-0 MHID: 0-07-175404-0 The material in this eBook also appears in the print version of this title: ISBN: 978-0-07-175357-9, MHID: 0-07-175357-5 All trademarks are trademarks of their respective owners Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark Where such designations appear in this book, they have been printed with initial caps McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs To contact a representative please e-mail us at bulksales@mcgraw-hill.com This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, securities trading, or other professional services If legal advice or other expert assistance is required, the services of a competent professional person should be sought —From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc (“McGrawHill”) and its licensors reserve all rights in and to the work Use of this work is subject to these terms Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited Your right to use the work may be terminated if you fail to comply with these terms THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE McGraw-Hill and its licensors not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom McGraw-Hill has no responsibility for the content of any information accessed through the work Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise To my parents, who taught me the dignity in thrift This page intentionally left blank C ontents CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER Acknowledgments ix Introduction xi Why Worry about the Deficit? Why the Deficit Will Matter to You 23 What to Watch and When to Act 43 How to Manage Your Cash and Debts 61 Bonds: How to Make Money in a Rising Interest Rate Environment 77 Stocks: How to Make Money When Growth Is Slower and Rates Are Higher vii 115 viii CONTENTS CHAPTER CHAPTER CHAPTER CHAPTER 10 Commodities: The Benefits of Owning Real Assets 149 Real Estate and Deficits 173 Building Portfolios in an Era of Financial Turbulence 189 Is It Too Late? 213 Notes 239 Index 247 A cknowledgments I would like to thank a number of my colleagues at BlackRock whose guidance and assistance were instrumental in researching and writing this book: Blake Grossman, Naozer Dadachanji, Ken Kroner, Paul Harrison, Tom Parker, Fred Dopfel, Joanne Madera, Mike Rierson, Daniel Morillo, Gerry Garvey, and Dennis Stattman I also need to acknowledge Nancy Card who was instrumental in the editing of this book Thank you for your patience, wit, and tolerance of my creative uses of English grammar And finally, thank you to my wife Alice and son Palmer for their understanding, support, and encouragement ix 240 NOTES 10 Census Bureau, U.S Population Projections Accessed at www.census.gov /population/www/projections/summarytables.html on February 10, 2010 11 Ibid 12 Elmendorf, “CBO Testimony,” p 16 13 Ibid Chapter Peter R Orszag, The Budget Deficit: Does It Matter? paper presented at the City Club of Cleveland, July 16, 2004 Douglas Elmendorf, “CBO Testimony: The Long-Term Budget Outlook,” before the Senate Committee on the Budget, July 16, 2009, p 21 Orszag, The Budget Deficit Ari Aisen and David Hauner, Budget Deficits and Interest Rates: A Fresh Perspective, working paper, International Monetary Fund (IMF), February 2008 Bruce Bartlett, “How Excessive Government Killed Ancient Rome,” Cato Institute, Cato Journal, vol 14, no 2, fall 1994 Chapter www.federalreserve.gov/pubs/arms/arms_english.htm Accessed on May 4, 2010 Ibid Ibid Sewell Chan, “Fed Ends Its Purchasing of Mortgage Securities,” New York Times, March 31, 2010 Ibid www.federalreserve.gov/pubs/arms/arms_english.htm Accessed on May 4, 2010 Ibid www.fdic.gov/EDIE/fdic_info.html Accessed on May 3, 2010 Chapter Wikipedia Accessed on May 14, 2010 Ibid George Strickland, Josh Gonze, Christopher Ihlefeld, and Christopher Ryan, Strategies for Building Real Wealth, Thornburg Investment Management, June 2, 2010 Ibid NOTES Anna Prior, “Comparing ETFs and Index Funds,” Wall Street Journal, August 2, 2010, p R5 Ibid BlackRock Individual Investor, Point of View with Peter Hayes, “On New Playing Field, Munis Still Swinging Strong,” May 2010, p Ibid., p Ibid 10 Amaud Mares, Ask Not Whether Governments Will Default, but How? Morgan Stanley Research, August 25, 2010, p 11 Ibid 12 PIMCO, Global Bond Basics, www.pimco.com/Left/NAV/Bond+Basics /2007/Global+Bond+Basics12-07.htm Accessed on May 21, 2010 13 Emerging Market Debt: Becoming a Mainstream Asset Class, BlackRock, March 2008, p 14 Ibid., p 15 Alexander P Attie and Shaun K Roache, Inflation Hedging for Long-Term Investors, working paper, International Monetary Fund (IMF), June 2010 16 Inflation-Linked Bonds Primer, BlackRock, October 2009, p 17 Ibid 18 Fred Weinberger and Brian Weinstein, “TIPS to Hedge Inflation: Problems with TIPS,” Currents Quarterly News from BlackRock, May 2010, p 12 19 Ibid 20 Ibid 21 Bureau of Labor Statistics (BLS), “How the CPI Measures Price Change of Owner’s Equivalent Rent of Primary Residence and Rent of Primary Residence,” www.bls.gov/cpi/cpifacnewrent.pdf, p Accessed on May 21, 2010 Chapter Jan Hatzius, Ed McKelvey, Alec Philips, Sven Jari Stehn, and Andrew Tilton, No Rush for the Exit, Global Economics Paper No 200, Goldman Sachs, June 30, 2010, p Ben Broadbent and Kevin Daly, Limiting the Fall-Out from Fiscal Adjustment, Global Economics Paper No 195, Goldman Sachs, April 14, 2010, p Alexander P Attie and Shaun K Roache, Inflation Hedging for Long-Term Investors, working paper, International Monetary Fund (IMF), April 1, 2009, p Ibid., p 23 International Monetary Fund (IMF), World Economic and Financial Survey, “Navigating the Fiscal Challenges Ahead,” Fiscal Monitor, May 14, 2010, p 21 241 242 NOTES CIA World Factbook Country Comparison, Public Debt, www.cia.gov/ library/publications/the-world-factbook/rankorder/2186rank.html Accessed on July 19, 2010 Myths and Realities of Global Equities, Six Reasons to Rethink Your Approach to Global Investing, BlackRock, June 2010, p Russ Koesterich, The ETF Strategist: Balancing Risk and Reward for Superior Returns, Portfolio Books, 2008, p 65 Norbert Michel, Ph.D., and Ralph Rector, Ph.D., Dividend Policy and the 2003 Tax Cut: Preliminary Evidence, published on October 25, 2004 Accessed at www.heritage.org/Research/Reports/2004/10/Dividend-Policyand-the-2003-Tax-Cut-Preliminary-Evidence, on July 9, 2010 10 Minder Cheng and Ananth Madhaven, The Dynamics of Leveraged and Inverse Exchange-Traded Funds, Barclays Global Investors, April 8, 2009, p 11 BarclayHedge, Alternative Databases, Barclay Equity Market Neutral Index, www.barclayhedge.com/research/indices/ghs/Equity_Market_Neutral_ Index.html Accessed on July 19, 2010 12 Ibid 13 Koesterich, The ETF Strategist, p 192 Chapter Alexander P Attie and Shaun K Roache, Inflation Hedging for Long-Term Investors, working paper, International Monetary Fund (IMF), April 1, 2009, p Ibid., p 15 U.S Energy Information Administration, “Highlights,” International Energy Outlook 2010, release date May 25, 2010, www.eia.doe.gov/oiaf/ieo/high lights.html Accessed on August 6, 2010 Anna Stablum and Millie Munshi, “Copper Shortages Loom as Codelco Sees Limits on Mines,” Bloomberg, July 6, 2010 Rhodri Thomas, Energy Report, World Energy Book: Unconventional Hydrocarbons: A Hidden Opportunity, Petroleum Economist, January 15, 2010, www.petroleum-economist.com/default.asp?Page=14&PUB=279&SID=70 0775&ISS=24502 Accessed on August 2, 2010 Ibbotson Associates, Portfolio Diversification with Gold, Silver, and Platinum, study prepared for the Bullion Management Group, Inc., by Thomas M Idzorek, CFA, June 1, 2005, Executive Summary Ibid Scotiamocatta, Precious Metals Forecast 2010 Silver, October 2009 NOTES Chapter www.reit.com/AboutREITs/AllAboutREITs.aspx Accessed on August 28, 2010 Ibid Ibid Global Real Estate Trust Investment Report 2010, Against All Odds, Ernst & Young, p 11 Janet Morrissey, “REIT Returns Fell 37.3 Percent in 2008,” Investment News, January 7, 2009, www.investmentnews.com/article/20090107 /REG/901079980 Accessed on September 2, 2010 Bahram Adrangi, Arjun Chatrath, and Kambiz Raffiee, “REIT Investments and Hedging against Inflation,” Journal of Real Estate Portfolio Management, vol 10, no 2, 2004, p 7 John D Greenlee, Associate Director, Division of Banking Supervision and Regulation, “Residential and Commercial Real Estate,” before the House of Representatives Subcommittee on Domestic Policy, Committee on Oversight and Government Reform, Atlanta, Georgia, November 2009 Accessed at www.federalreserve.gov/newsevents/testimony/greenlee20091102a.htm Reprinted in Youguo Liang and James R Webb, Journal of Real Estate Research, p Youguo Liang and James R Webb, “Pricing Interest-Rate Risk for Mortgage REITS,” Journal of Real Estate Research, vol 10, no 4, 1995 Greenlee, “Residential and Commercial Real Estate.” 10 Adrangi, Chatrath, and Raffiee, “REIT Investments and Hedging against Inflation,” p 11 Ibid 12 Ibid 13 Ibid 14 Ibid, p 10 Chapter Gary Brinston, Brian D Singer, and Gilbert L Beebower, “Determinants of Portfolio Performance II, an Update,” Financial Analysts Journal, May–June 1991 Role of Asset Classes in Strategic Asset Allocation, Asset Allocation Staff, Calpers Investment Office, Appendix 1, March 15, 2010 Asset Returns under Economic Regions: January 1970 to December 2009, Calpers Investment Office, Appendix 1, March 2010 Ibid 243 244 NOTES 10 11 12 13 14 15 16 17 18 19 20 21 22 Ibid Ibid Ibid Alexander P Attie and Shaun K Roache, Inflation Hedging for Long-Term Investors, working paper, International Monetary Fund (IMF), April 1, 2009, p 23 Asset Returns under Economic Regions: January 1970 to December 2009 Ibid Grace Gu and Phil Green, Dynamic Asset Allocation under Different Phases in Business Cycles, BlackRock, July 29, 2009, p Attie and Roache, Inflation Hedging for Long-Term Investors Ibid Asset Returns under Economic Regions: January 1970 to December 2009 Attie and Roache, Inflation Hedging for Long-Term Investors, p 14 Ibid., p 23 Real Returns Risk and Correlations (1970 to 1998), Barclays Capital Equity Gilt Study, 2010 Ibbotson Associates, Portfolio Diversification with Gold, Silver, and Platinum, study prepared for the Bullion Management Group, Inc., by Thomas M Idzorek, CFA, June 1, 2005, p Ibid M Briere and O Signori, Inflation-Hedging Portfolios in Different Inflation Regimes, University Libre de Bruxelles Solvay Brussels School of Economics and Management, Credit Agricole Asset Management, August 24, 2009, p 18 Ibid., p 20 Ibbotson Associates, Portfolio Diversification with Gold, Silver, and Platinum Chapter 10 Ben Broadbent and Kevin Daly, Limiting the Fall-Out from Fiscal Adjustment, Global Economics Paper No 195, Goldman Sachs, April 14, 2010, p 16 Ibid Ibid., p 17 Ibid Ibid., p 18 Ibid., p 19 Ibid Ibid., p 20 NOTES 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 Ibid Ibid Ibid Jan Hatzius, Ed McKelvey, Alec Philips, Andrew Tilton, Sven Jari Stehn, David Kelley, and Maria Acosta-Cruz, “Assessing the Sustainability of Government Debt,” U.S Economic Analyst, issue no 10/15, April 16, 2010, Goldman Sachs Global ECS Research, p Ibid Congressional Budget Office (CBO), Economic and Budget Issue Brief: Federal Debt and the Risk of a Fiscal Crisis, Current Path, July 27, 2010, p Broadbent and Daly, Limiting the Fall-Out from Fiscal Adjustment, p Ibid Alan J Auerback and William G Gale, “The Economic Crisis and the Fiscal Crisis: 2009 and Beyond—an Update,” Brookings Institution, June 2009, p Christina Boccuti and Marilyn Moon, “Comparing Medicare and Private Insurers: Growth Rates in Spending over Three Decades,” www.content healthaffairs.org/content/22/2/230.full Accessed on August 15, 2010 Douglas Holtz-Eakin, “The Real Arithmetic of Healthcare Reform,” oped, New York Times, March 20, 2010, www.nytimes.com/2010/03/21 /opinion/21holtz-eakin.html Ibid Auerback and Gale, “The Economic Crisis and the Fiscal Crisis,” p 16 “The Unlikely Revolutionary,” Economist, August 14, 2010, p 19 Ibid., p 20 Broadbent and Daly, Limiting the Fall-Out from Fiscal Adjustment, p Brian Faler, Bloomberg News, June 25, 2010 Adam Fergusson, When Money Dies: The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany, Public Affairs, New York, 1975, p x Heidi Przybyla and Mike Dorning, “Americans in Poll Want Deficit Cut with Entitlements Secured,” Bloomberg News, December 9, 2010, p 245 This page intentionally left blank I ndex Active funds, 87–88, 131–132 Adjustable-rate mortgages (ARMs), 62, 63–65 adjustment period and, 64 hybrid (3/1 or 5/1), 71–72 LIBOR and, 70–71 projected rise in rates on, 68–70 2/28 and 3/27, 71–72 when to consider, 71–72 Agricultural commodities, 159, 160 Alternative minimum tax (AMT), 21–22 Asset allocation: deficit reduction and, 228–235 diversification and, 194–195 inflation and, 190–191 risk and, 191–198 time horizon and, 197–198 (See also specific types of assets) Australia: economic health of, 127–128 growth prospects of, 130 REIT market in, 177 Bids, noncompetitive, 49 Bid-to-cover ratio, 49–50 BlackRock, 96, 99, 170 Bonds, 77–113 BABs, 93 balanced portfolio of, 112–113 corporate, 96–99 coupon and, 81–82 determining allocation in portfolio, 77–79 Bonds (cont’d): duration of, 82–86, 98 emerging markets and, 101–104 fiscal reform and, 229–231 as fixed-income instruments, 79–80 government, international, 99–106 high-yield, 98, 199, 203, 230–231 inflation and, 106–108, 204–205 (See also Treasury inflation–protected securities [TIPS]) interest rates on, 81 investment-grade, 98 laddering, 84–86, 87 municipal, 90–96 par on, 81–82 prices of, 32, 79 returns on, 199 risk and, 78, 81–84, 98 sale of, 81–82 Treasury, 86–90, 106–112 yield of, 79 Brazil: demographics of, 103 inflation in, 103–104 Breakeven inflation, 108 Breakeven level, 108 Budget balance, primary, 220 Budget deficits: asset valuations of today versus longterm averages and, 201 economic growth and (see Economic growth) of emerging markets, 127, 129, 130 247 248 INDEX Budget deficits (cont’d): estimates of, 10–15 growth of, 1–2 impact over next decade, 39–41 inflation and (see Inflation) interest rates and (see Interest rates) past, lack of consequences of, 24–27 as percentage of GDP, 100 reasons for running, 6–8 reduction of (see Fiscal reform) response to, return assumptions and, 201–206 scenarios for future and, size of, 4–6 structural, 6–7, 226 Build America Bonds (BABs), 93 Canada: deficit reduction in, 217–218 economic health of, 127 growth prospects of, 130 REIT market in, 177 Capacity utilization, inflation and, 54–55 Cash: fiscal reform and, 229 inflation and, 205 Charles Schwab, 89 Chile, national debt of, 129 China: deficits of, 129 demographics of, 103 energy demand of, 154–155 investment in United States, 26, 33, 59 Commercial and industrial (C&I) loan demand, interest rates and, 45 Commodities, 149–172 buying, 165–170 choice of, 164–165 correlation with stocks, 157–158, 207– 208 differences among, 158–160 fiscal reform and, 233–235 inflation and, 150–153, 160–163, 204–205 precious metals as (see Precious metals) reasons to own, 150–158 returns on, 201 Constant-maturity Treasury (CMT) securities, 70 Consumer debt: interest rates and, 46–48 watching, 59 Consumer discretionary companies, 133, 135–136, 137 Consumer price index (CPI), TIPS and, 107, 110–111 Copper mining, 155 Core inflation, 151 Corporate bonds, 96–99 buying, 97–99 Corporate debt, watching, 59 Corporate earnings, stocks and, 120–122 Corporate stock (see Stock[s]) Correlation, 157–158, 207–208 Cost of Funds Index (COFI), 70 Coupons, 81–82 Credit risk, 83–84, 98 Crowding-out effect, 30–33 Currency, depreciation of, 37 Defaults, 36–38 Deficits (see Budget deficits) Demand: for energy, rising, 154–155 interest rates and, 48–50 Deposit insurance, 75, 199 Depreciation of currencies, 37 Derivatives, 144 Developing countries (see Emerging markets) Diversification: asset allocation and, 194–195 bonds for, 81, 104 commodities for, 156–158 volatility and, 206–208 Dow Jones-UBS Commodity Index, 167, 168 Economic activity, influence on budget, 11–12 Economic growth: debt stabilization and, 220–221 deficits and, 28–29 INDEX Economic growth (cont’d): fiscal reform and, 226–227 influence on budget, 12–13 real estate and, 178–180 returns and, 202–203 slowdown of, 29 stocks and, 119–122 watching pace of, 59 Elmendorf, Douglas, 19 Emerging markets: bonds of, 101–104 demographics of, 102–103 rising demand for commodities from, 153–155 stocks of, 128–130 Energy demand, rising, 154–155 Energy-related commodities, 159 Entitlement programs: Roman deficit spending for, (See also Medicare and Medicaid; Social Security) Equity REITs, 177 Europe: demographics of, 102 (See also specific countries) Excess reserves, 39 Exchange-traded funds (ETFs): bonds in, 87, 88–90, 95–96, 99, 105, 106, 112 commodities in, 165–166, 170 inverse, 139 shorting, 138–139 stocks in, 132–133, 137–139 Exchange-traded notes (ETNs), 145, 166 Fear index, 143 Fed funds rate, 70 Federal Deposit Insurance Corporation (FDIC), 199 Federal Reserve System (Fed): purchase of mortgage-backed securities by, 67–68 short-term interest rates and, 69–70 size of, inflation and, 57–58, 59 Fergusson, Adam, 236 Fidelity, 89, 98 Financial stocks, 136, 137 Fiscal reform, 215–238 asset allocation and, 228–235 in Canada, 217–218 critical elements of, 222–223 economic payoffs of, 226–228 goals of, 220 in Ireland, 215–217 leadership change and, 218 politics and, 235–236 spending cuts for, 219, 223–225 stabilizing national debt and, 220–221 in Sweden, 217 in United Kingdom, 225–226 5/1 ARMs, 71–72 Fixed-income instruments, 79–80 Fixed-rate mortgages, 62–63, 64–68 Foreign currency (f/x), international bond volatility and, 105 Foreign investment in United States, 26, 33, 59 France: inflation-linked bonds issued by, 107 REIT market in, 177 Futures contracts, 144 trading (rolling) out, 165 General obligation bonds, 91 Germany: benefits of investing in, 132–133 economic health of, 127 growth prospects of, 130 inflation-linked bonds issued by, 107 tax revenues in, 100 Getty, John Paul, 26 Gold (see Precious metals) Goldman Sachs Commodities Index (GSCI), 167–168 Government bonds, international, 99–106 Government spending: cuts in, 219, 223–225 economic activity and, 12 inflation and, 35–36 Greece: borrowing costs in, 13 national debt of, 100 249 250 INDEX Greenspan, Alan, 43 Gross public debt, 16–17 Health-care reform, 223–224 Hedge funds, 140–142 Hedging, 105 High-yield bonds, 98, 199, 203, 230–231 Holtz-Eakin, Douglas, 223–224 Home country bias, 126 Hong Kong: economic health of, 127 growth prospects of, 130 Housing prices: expectations for, 40 inflation and, 183–186 influences on, 34 owner’s equivalent rent and, 110–111 (See also Mortgage(s); Real estate; Real estate investment trusts [REITs]) Hybrid ARMs, 71–72 Hybrid REITs, 177 HYG fund, 99 Hyperinflation, 39 Imputed rent, 175 Income, from bonds, 79–80 Index funds, 88, 131–132 India, 102 deficits of, 129 demographics of, 103 Indirect bidder percentage, 50 Indonesia: deficits of, 129 demographics of, 103 Industrial metals, 159, 160 Inflation: amount to borrow and, 73 asset allocation and, 190–191 bonds and, 106–108, 204 (See also Treasury inflation-protected securities [TIPS]) breakeven, 108 cash and, 205 commodities and, 150–153, 160–163, 204–205 Inflation (cont’d): core, 151 deficits and, 34–35 in emerging markets, 103–104 fiscal reform and, 227 government spending and, 35–36 housing prices and, 183–186 hyperinflation and, 39 interest rates and, 58–59 labor markets and, 52–53 likelihood of rise in, 40–41, 75–76 manufacturing levels and, 53–55 money supply growth and, 55–57, 59 precious metals and, 160–163 real estate and, 181–186, 205 returns and, 203–206 sector performance and, 136–137 size of Fed and, 57–58, 59 stocks and, 122–124, 204 Inflation-linked bonds (ILBs), 107–108 Interest rates: adjustable-rate mortgages and, 68–70 on bonds, 32, 81 budget deficits and, 30–33 commodities and, 153 crowding-out effect and, 30–33 demand and, 48–50 determining timing of rise in, 44–48 estimates of, 13–14 fiscal reform and, 229–231 inflation and, 58–59 likelihood of rise in, 40, 75–76 on mortgages (see Adjustable-rate mortgages [ARMs]; Fixed-rate mortgages) past deficits and, 25–26 real estate and, 180–181 returns and, 201–202 rising, protecting assets with, 61–62 rising mortgage rates and, 33–34 savings on, 74–75 sector selection for stocks and, 133–136 short-term, Fed’s setting of, 50–52, 69–70, 75 stocks and, 122–124, 133–136 yield spread (yield curve) and, 51–52 INDEX International bonds, 99–106 buying, 104–106 of emerging markets, 101–104 International stocks, 126–133 buying, 130–133 of emerging markets, 128–130 Inverse EFTs, 139 Investment-grade bonds, 98 iPath S&P 500 VIX Mid-Term Futures ETN (VXZ), 145 iPath S&P 500 VIX Short-Term Futures ETN (VXX), 145 Ireland: deficit reduction in, 215–217 national debt of, 100 “Irrational exuberance,” 43 iShares COMEX Gold Trust (IAU), 170 Italy, inflation-linked bonds issued by, 107 Jackson, Andrew, 16 Japan: deficits of, 32, 127 demographics of, 102, 103 inflation-linked bonds issued by, 107 national debt of, 129 REIT market in, 177 Japanese Government Bonds (JGBs), 99 Job markets (see Labor markets) Keynes, John Maynard, 213–214 Labor markets: deficits and, 27–30 inflation and, 52–53 Laddering bonds, 84–86, 87 Large-capitalization companies (large caps), 117 Lehman Brothers, 86–87 London Interbank Offered Rate (LIBOR), adjustable-rate mortgages and, 70–71 Long-Term Capital Management (LTCM), 213–214 Lowenstein, Roger, 214 LQD function, 99 Manufacturing levels, inflation and, 53–55 Market neutral funds, 141–142 Medicare and Medicaid: increase in deficits due to, 5, 8–10 spending cuts for, 223, 225 spending on, 14–15, 18–22, 19, 20 Monetizing the debt, 37–38 Money supply, growth in, inflation and, 55–57, 59, 76 Mortgage(s): adjustable-rate (see Adjustable-rate mortgages [ARMs]) fixed-rate, 62–63, 64–68 rise in rates for, 33–34 size of, 72–73 Mortgage REITs, 177 Municipal bonds (munis), 90–96 buying, 94–96 features of, 90–94 Mutual funds: bonds in, 87, 95, 98, 105, 112 commodities in, 165, 166–167 stocks in, 131 National debt, 15–18 deficits and (see Budget deficits) of emerging markets, 129 growth of, 16 international comparison of, 100–101 measures of, 16–17 monetizing, 37–38 past, size of, 25 significance of, 17–18 stabilizing, 220–221 Net asset value (NAV), 88 Noncompetitive bids, 49 Off budget spending, 7–8 Oil production, 155–156, 159 OPEC, 159 Operating leverage, 120, 170 Options, 144 Owner’s equivalent rent (OER), 110–111 Par, on bonds, 81–82 Passive funds, 88, 131–132 Peru, deficits of, 129 Platinum (see Precious metals) 251 252 INDEX Policy assumptions, budget estimates and, 14–15 Politics, fiscal reform and, 235–236 Portfolio building, 189–212 asset assumptions for, 198–206 balancing risk and reward and, 192–198 for coming decade, 208–210 economic growth and, 202–203 inflation and, 190–191, 203–206 interest rates and, 201–202 risk and, 191–192, 210–212 rules of thumb for, 195–196 volatility and, 206–208 Precious metals, 159 buying, 168–170 in commodity allocation, 164–165 fiscal reform and, 233–235 inflation and, 43–44, 160–163 Price-to-earnings (P/E) ratio, 118 Primary budget balance, 220 Programmatic spending, Publicly traded debt, 17 foreign ownership of, 32–33 Quantitative easing, second round of (QE2), 38 Real estate, 173–188 as asset class, 175–177 growth of, 178–180 inflation and, 174–175, 181–186, 205 interest rates and, 180–181 returns on, 200 (See also Housing prices; Mortgage(s); Real estate investment trusts [REITs]) Real estate investment trusts (REITs), 175, 176–177 economic growth and, 179 inflation and, 184–186, 205 interest rates and, 181 types of, 177 Real income, slowing of economic activity and, 29–30 Rent: imputed, 175 owner’s equivalent, 110–111 Reserves, excess, 39 Returns: assumptions about, 198–201 balancing with risk, 192–199 on bonds, 199 on commodities, 201 economic growth and, 202–203 inflation and, 203–206 interest rates and, 201–202 on real estate, 200 on stocks, 199–200 Revenue bonds, 91 Risk: asset allocation and, 191–198 balancing with returns, 192–199 of bonds, 78, 81–84 bonds and, 98 credit, 83–84, 98 of municipal bonds, 91–92 Risk tolerance, 196–197, 210–212 Rolling out, 165 Roman Empire: default by, 37 deficit spending in, 7–8 Savings: deposit insurance and, 75 interest rates on, 74–75 private, 32 Secular bear markets, 117, 118–119, 231– 233 Shorting EFTs, 138–139 Silver (see Precious metals) Singapore: economic health of, 127 growth prospects of, 130 Social Security: increase in deficits due to, 5, 8–10 spending cuts for, 224–225 spending on, 19, 20 South Africa, national debt of, 129 South Korea: deficits of, 129 national debt of, 129 SPDR Barclays Capital High Yield Bond ETF (JNK), 99 INDEX SPDR DB International Government Inflation-Protected Bond ETF, 112 SPDR Gold Share (GLD), 170 Spending cuts, 219, 223–225 State Street, 99, 170 State Street Global Advisors (SSgA), 112 State Street SPDRs, 138 Stocks, 115–147 choosing, 124–126 of consumer discretionary companies, 133, 135–136, 137 correlation with commodities, 157–158, 207–208 economic growth and, 119–122 financial, 136, 137 fiscal reform and, 231–233 gold, 169–170 hedge funds and, 140–142 inflation and, 204 interest rates, inflation, and market multiples and, 122–124 international, 126–133 making money in, 145–147 returns on, 199–200 sector selection and, 133–139 shorting, 138–139 unexpected good news and, 117–119 U.S., history of, 116–117 utility, 134–135 volatility of, 142–145 Structural deficits, 6–7, 18, 226 Supply: interest rates and, 44–45 of money, growth in, inflation and, 55– 57, 59, 76 Sweden, deficit reduction in, 217 Taiwan, national debt of, 129 Tax(es): exchange-traded funds and, 89 municipal bonds and, 90–94 Tax equivalent yield, 90 Tax increases: AMT and, 21–22 to fund entitlement programs, 20–21 Tax increases (cont’d): likelihood of, 39–40 limits on, 21 3/1 ARMs, 71–72 3/27 ARMs, 71–72 Time horizon, asset allocation and, 197–198 Trading out, 165 Treasury bonds: buying, 86–90, 111–112 TIPS, 106–112 Treasury debt, interest rates and, 48–50 Treasury Direct Web site, 86–87, 111 Treasury inflation-protected securities (TIPS), 106–112 buying, 111–112 in weak economy, 203 Treasury notes, mortgage rates and, 66–67 2/28 ARMs, 71–72 Unconventional hydrocarbon, 156 United Kingdom: bonds of, 99 deficit reduction in, 225–226 deficits of, 127 inflation-linked bonds issued by, 107 REIT market in, 177 United States: China’s investment in, 26, 33, 59 deficits of (see Budget deficits) demographics of, 102 fiscal reform in (see Fiscal reform) inflation-linked bonds issued by, 107 Upward-sloping yield curve, 51 Utility stocks, 134–135 Vanguard, 89, 95, 98 VIX Index, 143, 144, 145 Volatility: of bonds, 80 diversification and, 206–208 of international bonds, 105 of stocks, 142–145 When Genius Failed (Lowenstein), 214 Yield spread (yield curve), 51–52 253 A bout the A uthor Russ Koesterich is iShares chief investment strategist and global head of investment strategy for BlackRock Scientific Active Equities He previously served as senior portfolio manager in the U.S Market Neutral Group for Barclays Global Investors Koesterich is the author of The ETF Strategist .. .THE TEN TRILLION DOLLAR GAMBLE This page intentionally left blank TEN THE TRILLION DOLLAR GAMBLE THE COMING DEFICIT DEBACLE AND HOW TO INVEST NOW RUSS KOESTERICH NEW YORK... After that, I am going to describe the warning signs to look for and how to read the economic tea leaves Then I am going to dig into what you need to THE TEN TRILLION DOLLAR GAMBLE While I recognize... about the Deficit? Why the Deficit Will Matter to You 23 What to Watch and When to Act 43 How to Manage Your Cash and Debts 61 Bonds: How to Make Money in a Rising Interest Rate Environment 77 Stocks: