Why 2013 Could Be a Year of Strong Economic Growth

2013 could bring strong economic growth to the U.S. because U.S. Banks and the Federal Reserve are now creating near-normal amounts of credit, which will stimulate domestic demand. This was the prediction made by Dr. Paul Kasriel, retired Chief Economist of The Northern Trust Co., at the January meeting of the San Francisco Financial Planning Association.

Dr. Kasriel believes there is a very strong correlation between Gross Domestic Product growth and bank credit growth. This is good news because the growth in credit for the U.S. has reached 5% annually, the same point it reached in 1994 and 1995, which preceded five more years of strong economic expansion.

The U.S. banking system operates with a fractional reserve monetary arrangement so that depository institutions (banks) can create an amount of credit that is some multiple of the amount of “seed” money (reserves) provided by the central bank. Dr. Kasriel asserts that banks use reserves to expand credit by a 10 to 1 ratio ($100 of reserves for every $1,000 loaned out). This credit, created by the depository institution, is essentially credit created figuratively— in other words, out of “thin-air.”

“Thin-air” credit is very powerful because the bank making the loan does not need to cut back on current spending, while the recipient uses the loan to increase spending. An increase in this type of credit will result in a net increase in nominal spending in the economy. A recovery in “thin-air” credit coincided with the vigorous economic recovery that brought the U.S. out of the Great Depression in the 1930’s.

With inflation abating in China, the Chinese central bank will reduce short-term interest rates, resulting in faster growth in Chinese “thin-air” credit and domestic demand. The acceleration in Chinese domestic demand will positively affect the international exports.

2013 could bring strong economic growth to the global stage as well.

New Year’s Financial Resolutions

Happy 2013!

As you are likely contemplating a host of New Year’s resolutions, we thought we might suggest a few to add to your plate. No not that plate. We know a diet is at the top of your list. Here are a few New Year’s resolutions to quickly get your financial house in order while you still have some positive momentum towards enacting change.

Build an emergency fund.

We council our clients to maintain a cash reserve of emergency funds. The amount varies based on the individual’s circumstances, but the reserve size typically ranges from six months of core living expenses for employed individuals with solid job security to two years for retired individuals living off of their investment portfolio. By “core living expenses”, we mean those bills that must be paid—the mortgage, the electricity, etc.—not those discretionary expenditures like new clothes or a summer vacation. Presumably, in lean times, you will cut back on those.

The reason for an emergency cash reserve is simple. Unexpected events are just that…unexpected. You don’t know when you might lose your job or when the transmission goes on your vehicle or if you are living off of your investment portfolio when the next bear market may strike. A cash reserve gives you flexibility and buys you time—covering costs and providing income in a time of need. And perhaps most importantly, it allows you to refrain from selling investments to generate cash in what may be an inopportune time.

Put that cash to work.

Once your emergency fund is set up, you need to put it to work for you. Traditional savings accounts, money markets, and CDs don’t cut it in this low interest rate environment as they all pay next to nothing. For your emergency funds—those six months to two years of core living expenses described above—consider an online savings account like those offered by ING or Ally Bank. These are safe, liquid, FDIC-insured, and pay closer to 1%.

For any cash you wish to hold above and beyond your emergency cash reserve, consider taking some risk with that money by investing it in short-to-intermediate-term bond funds, which yield a bit more than the online savings accounts.

Leaving your cash in a place where it earns nothing means you are losing purchasing power each day thanks to inflation. While inflation is low at about 2% currently, that still represents a loss on your money, and it certainly adds up the longer you take to act. If your bank were charging you 2% annually to hold your cash, you wouldn’t accept it, so take action and put that cash to work for you.

Consolidate those orphan 401(k)s.

In “Competing in the Retirement-Dominated Future,” a 2007 research paper produced jointly by BAI Research and Mercatus LLC, it was found via a survey of nearly 3,000 investors that a third had at least one orphaned 401(k) account with an average balance of $100,000. By “orphaned,” we mean a 401(k) account that is still in a former employer’s plan.

Because 401(k) plans typically limit your investment choices to a set and often small menu of mutual funds, we typically advise our clients to rollover orphaned 401(k)s into an IRA at a broker-dealer where they will have exponentially more investment choices.

In working with investors, we have anecdotally found that because these orphaned accounts are out of sight they are often out of mind too. That means that they are frequently allocated in a manner that is inconsistent with the client’s investment goals. And at worst, sometimes they are not invested at all, just sitting in cash or a low-yielding investment. By consolidating all of these rogue accounts in one IRA, you can more easily implement your investment plan over your entire portfolio.

Check your retirement account beneficiaries.

One of the services we provide to our clients is to occasionally check their IRA and retirement plan beneficiaries to make sure they’re still accurate. Family situations change, and you may not have thought about who the primary and contingent beneficiaries are on your IRA since you set it up 20 years ago. To check on the beneficiaries for your IRA, contact your custodian. For your 401(k), talk to your plan’s administrator.

What is the “Fiscal Cliff”?

If you have read or listened to the financial news at any point in the last few months, you have likely heard the term “fiscal cliff” thrown around as if it has long been part of the lexicon. It certainly doesn’t sound good, but what exactly does the term mean?

The fiscal cliff refers to a combination of automatic tax increases and spending cuts set to take hold in January 2013. If you recall, the Bush-era tax cuts were extended two years ago. That extension and those lower tax rates are set to expire on January 1, 2013. That means that if nothing is done by Congress the following tax rate changes will take effect:

– Top income tax rate: 35% → 39.6%

– Top tax rate on dividends: 15% → 39.6%

– Top tax rate on capital gains: 15% → 20%

– 3.8% tax on investment income for high income earners

– Social Security payroll tax rate: 4.2% → 6.2%

In addition to these tax increases, a host of automatic spending cuts over the next 10 years are set to commence in 2013. Approximately half would come from the budgets of domestic programs. The other half would come from military spending.

So what effect will this fiscal cliff have on the economy? According to the Congressional Budget Office, the spending cuts would reduce the budget deficit by $600 billion in 2013. That’s good. However, they also say that the spending cuts combined with higher taxes would likely push the U.S. economy into recession. That’s not good.

The positive take away in all of this is that President Obama wants to extend the tax cuts…for most folks. His plan is to extend it for all but “high income earners.” We have heard multiple definitions of “high income earners.” One would be households making over $250,000 in adjusted gross income per year. Another source has that dividing line at $1 million per year, which would be a bit more palatable to Republicans and more likely to gain bipartisan support.

So with the “fiscal cliff” looming just a few weeks away, what should you be doing prior to year-end? Our advice is to do nothing at this time. While we think that some extension of current tax rates is likely for most people, the extension may occur in 2013 and be applied retroactively to the start of the year. So there is no need to panic if an extension is not enacted prior to year’s end.

Because you’re flying blind on what future tax rates will be, we advise against making any changes in portfolio strategy or any other financial planning and tax-related moves until it is clear what the tax rates will be next year. In the past, we have suggested that it might make sense to realize long-term capital gains this year to get the lower rate, but that is not something we are recommending any longer because we don’t know for certain whether capital gains tax rates are going up or not. And we certainly don’t want you to realize a capital gain unnecessarily.

If it makes you uncomfortable to take risk in an uncertain environment, consider that history shows no correlation between rising tax rates and poor market performance. And as for the automatic spending cuts, they are less immediately-impactful than the tax increases and less likely to trigger a recession in 2013 on their own because they are spread out over 10 years and back-loaded, with the larger cuts coming in later years.