EDITOR’S NOTE: Early this summer, Paul Merriman interviewed Knight Kiplinger, a highly respected financial journalist, for a Sound Investing podcast. This article contains excerpts from their discussion of the economy, inflation, interest rates, target-date retirement funds, investor psychology and prospects for dealing with government debt.

PAUL MERRIMAN: It gives me great pleasure today to welcome one of my favorite guests to Sound Investing. He is Knight Kiplinger, editor-in-chief of the weekly Kiplinger Letter, of Kiplinger’s Personal Finance monthly magazine, and of the online Kiplinger.com site, for which he writes a monthly feature on money and ethics.

Knight, thank you so much for joining me today.

KNIGHT KIPLINGER: Paul, it is always a pleasure.

PAUL MERRIMAN: I’ve got many things to ask you about. Let’s start with the economy. There seem to be lots of reasons to be afraid of the future of this economy. Is there any good news you can give us?

KNIGHT KIPLINGER: Well, Paul, in the Kiplinger Letter we recently stepped back from the daily headlines and did a very broad assessment of major sectors of the economy to identify. What’s going well, what’s not going well, which areas have recovered to a pre-slump level and which ones will probably take several more years to recover?

Our bottom-line judgment is that we’re not going to relapse into recession. We believe we are likely to continue seeing a modest level of broad economic growth, with GDP rising about 3.5% this year.

We understand that is an anemic level of growth after the severe recession we went through, but it is better than contraction. We know that the negative news is getting a disproportionate amount of attention these days. The problems of sovereign debt issues of Europe, Japan, and the United States are real. We know the Gulf oil spill is weighing on everybody’s mind. We know that housing will take awhile to recover.

Let's look at some positive things that are maybe not getting the attention they deserve. Exports are very strong. Whether we look at aerospace, aviation, chemicals, medical devices, or services, exports continue to recover nicely from the slump. It’s true that impaired demand in Europe might take a little bite out of that, but the Asian appetite for U.S. goods and services is still very strong.

Inventories are very, very lean. So, as consumer and business demand gradually recovers, and the shelves are bare; we will see manufacturers go back into production. This is why manufacturing in the United States is perking up very nicely right now.

People are being called back to work. Some employers who were reluctant to rehire laid off workers are adding overtime. When that no longer is enough, they are hiring and in some cases adding shifts.

Corporate earnings overall are rebounding very strongly, and that is perhaps not getting the attention it deserves right now in the minds of investors and in the financial press.

PAUL MERRIMAN: Those are very optimistic points. I also notice in the Kiplinger Letter you expect interest rates to remain relatively low with a little bump coming early next year. You don’t seem to see inflation as being much of a problem.

KNIGHT KIPLINGER: No, we don’t. A lot of people are throwing about the “D word” these days, and the bogeyman of broad systemic deflation is scary indeed. That’s a downward spiral in which people postpone purchases because they think they can buy things for less money in six months or a year. And, of course, that can become a self-fulfilling prophecy, with both prices and production falling.

However, I expect low inflation, near zero, rather than a long period of falling wages and prices.

PAUL MERRIMAN: Would any of these projections make you change your asset allocation between U.S. and international holdings?

KNIGHT KIPLINGER: That’s a great question, Paul. In general, I believe that the less developed nations of the world, the emerging economies, will enjoy faster rates of growth in the next 10 or 15 years than the well developed Western nations, including the United States.

I’ve always liked a fairly hefty allocation to international equities, on the order of 25% or 30%, but that’s not a knock on U.S. equities.  I think U.S. equities are in a correction right now. After getting ahead of themselves in the big bull market of last year, they were due to settle back a good 10% or so.
 
PAUL MERRIMAN: Knight, let’s talk a little about the psychological challenges facing investors these days. We know that the early part of 2009 forced a lot of investors out of the market and into bonds. Many of those people kept buying bonds and bond funds, and they ignored equities. While people were trying desperately to protect their assets, they missed out on the huge rally in stock prices last year.

There are now trillions of dollars sitting in money-market funds and bank accounts and CDs.  What will it take to trigger enough trust in the market to get that money back into stocks again?  

KNIGHT KIPLINGER: As you say, the investors who fled in terror from equities two years ago or 18 months ago did miss a great opportunity in 2009. Those who had the confidence to stay the course recovered a good bit of their eroded value. Yes, a lot of that money is now sitting in cash, earning close to zero or in short-term Treasuries earning close to zero.

There is not much upside price potential in bonds from any further drop in interest rates. The only direction that interest rates can go is up, and although I don’t believe they will do that this year, they will eventually. When that happens, bond prices will fall from today’s levels.

I’ve always liked bonds as a significant component of a portfolio, but you should buy bonds for the coupon interest. If you’re satisfied with today’s coupon on Treasuries of 1.5%, 2%, or 3% as a long-term investment return, then that’s fine. Stay in bonds.  

A lot of people will eventually get tired of earning so little on their money, and they will wade back into equities in a sensible way using index funds, ETFs, blue chip stocks that pay dividends. As you say, there are trillions of dollars on the sidelines. I think when some of the gloom of today’s headlines begins to dissipate, many investors will return to equities, because that is the only place to get bond-beating returns over a long period of time.

PAUL MERRIMAN: Yes, I think you’re right about that, but many people will have a very tough time knowing when to get back into the equities market. That is an extremely important decision. Many of them will stay on the sidelines until after there’s been a big rally that finally makes them feel comfortable. If they buy at or near the top of a bull market, they could suddenly run into a correction in which prices start falling.

This will leave those investors with three problems. First, they will have no way to know whether they should wait out the storm or run for the sidelines again. Second, they will lose some of the money they have been carefully guarding. Third, they may lose their trust in the stock market and never want to get back in again.

This reminds me of another topic I’d like to discuss and that is target-date retirement funds. A lot of investors thought they could invest in these funds, and the managers would preserve their capital by getting in and out of the market at the right times.

Yet, I don’t think this was ever the intention behind these funds. What’s your take on this?

KNIGHT KIPLINGER: I think the first thing that target-fund marketers have to do is define what the target means. When investors considered a 2012 target fund, some of them expected that when the year 2012 arrived, they could cash out and that the fund would have preserved their principal.

That was never the intention or expectation of the firms that originated and marketed and managed these funds. They designed a 2012 fund for somebody who would start retirement in 2012 and would take withdrawals over the next 20 years.

I don’t think this is a problem that Congress has to fix. I think the marketers at companies like Vanguard and T. Rowe Price want to fix it, and they are beginning to fix it. We need more education. In addition, some target funds now believe, with the benefit of hindsight, that they were much too heavy in equities and didn’t have enough bonds.

PAUL MERRIMAN: I think target-date retirement funds are one of the greatest inventions of the mutual fund industry for people who don’t understand how to invest. I think they are going to change the long-term investment habits and profits for many young investors. I’m hopeful, but I think you’re right, the fund companies need to get their stories right.

Speaking of getting a story right, I recently read your Money and Ethics column on the topic of the legacy we are leaving to our children and grandchildren, especially all the government debt. As a nation, how do you think we can dig ourselves out of this huge hole?

KNIGHT KIPLINGER: Generally over time, excessive debt is worked down in two ways. Since the beginning of time, governments have used inflation to pay back borrowed dollars in cheaper, devalued dollars. The second, and in my view, more responsible approach is to restrain and cut government spending, often increasing taxes at the same time.

Non-judgmentally, more as a forecaster than a prescriber of policy, I generally favor lower tax rates accompanied by spending restraint. I would expect that there are both higher taxes and spending restraints in the future of our fiscal policy.

PAUL MERRIMAN: Knight, I really appreciate the quality of your insight and information. I think your publications are among the very best. Thanks for taking the time to be with us here on Sound Investing.

KNIGHT KIPLINGER: You give very good advice to your listeners, Paul. So we’re simpatico.