3-D-Hurricane..

The United States faces an endless sea of red ink...

Boosted by waves of deficit spending, the U.S. Government’s official debt now tops 100% of Gross Domestic Product(GDP). Including the debt of Government Sponsored Enterprises (GSEs) and unfunded entitlements, the total exceeds 600% of GDP.

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...As do other developed markets

Other developed markets also face staggering debt burdens. Japan’s debt-to-GDP ratio exceeds 230%. Among the GIIPS countries of Greece, Ireland, Italy, Portugal, and Spain, all but the last have ratios topping 100%. And the bigger European economic powers also are saddled with high debt levels: Germany, France, and the United Kingdom are approaching or are at 90%. If off-balance sheet entitlements were included, those figures would be substantially higher.

High debt burdens pose real and severe risks

Research by economists Carmen Reinhart and Kenneth Rogoff suggests that median growth rates drop by 1% for countries with a debt-to-GDP ratio exceeding 90%. Few countries recover after exceeding such a high debt-to-GDP ratio, often collapsing under the weight of their obligations.

Debt-laden markets face unattractive options

Debt-laden developed markets have three choices, none of which are attractive. First, they can choose austerity, which causes a reduction in GDP as well as debt--a painful outcome for a country’s citizens. Second, some countries are forced to choose default or restructuring. Third, countries with control of the currencies and interest rates often adopt policies that deliberately suppress real interest rates, known as Financial Repression. These policies often lead to steady inflation and negative real interest rates, which imply low returns on capital, weak economic growth, and high unemployment.

Emerging markets offer some hope

In contrast, emerging markets, with low debt and deficit levels and younger populations, appear far healthier economically and have strong growth prospects. They don’t encounter the headwinds facing developed markets.

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GDP measures spending, not prosperity

With the exception of exports, GDP measures spending—making no distinction between debt-financed spending and spending that we can cover with current income. It does not measure prosperity, and ignores the fact that we are mortgaging our future to feed current consumption.

Debt-financed consumption is misleading

If the government borrows an additional 5% of GDP and spends it immediately, GDP growth rises by 5%! This debt-financed consumption provides a misleading picture of the economy and a false sense of security. It is unreal GDP.

Structural GDP offers a better measure

Structural GDP—GDP net of new public borrowing—offers a far more accurate measure of prosperity. To net out the effects of population growth and inflation, real per capita Structural GDP tells the true story: Our prosperity is nearly unchanged since 1998.

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Developed countries are graying rapidly

Demographics only make the outlook worse, as populations in Japan, the United States, and Europe gray and the ratio of active workers to retirees shrinks. In the United States, there were five working adults for every retiree in 1970. Today, that ratio is 3.5 to 1 and, if the retirement age remains constant, that ratio is projected to drop below 2 to 1 by 2050, based on data from the U.S. Census and the United Nations.

Aging populations will slow growth

These demographic shifts will have substantial effects on the economy—a combination of increased inflation and interest rates, a rising trade deficit, slower GDP growth, delayed retirement, and increased immigration. The developed world may go from a period of high unemployment to a shortage of workers.

Emerging markets poised to benefit

Not only will aging populations cause GDP growth to slow, but retirees will sell off their assets—first stocks, then bonds—to finance their lifestyles. In contrast, much younger and relatively debt-free emerging markets stand to benefit from these changes.

 

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Dramatic implications for investments

The 3-D Hurricane of unending deficits, massive debt, and unfavorable demographics has dramatic implications for investments. Combined, they will create a headwind for growth in developed markets and a surge in inflation, which hurts valuations for bonds and, to a lesser extent, for stocks.

Alternative assets can protect against inflation

Investors need to create a third pillar in their portfolios that provides protection from inflation. This pillar should focus on asset classes that will over the long term generate superior real returns, such as emerging markets stocks and bonds, high-yield bonds, bank loans, TIPs, and REITs.

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Investors must focus on the real risk

Investors must ask themselves: What is risk? Short-term volatility or long-term impairment of purchasing power? Unless one plans to spend the bulk of one’s assets in the next year or two, inflation represents the far greater risk. Investors should consider adding a third pillar of inflation-hedging assets when prices for these securities are inexpensive.