The world is changing right before our eyes. Most of the time, one hardly notices the changes as we are conditioned to adjust to new quarterly data, the latest little white gadget from Apple or the next set of elections. But, sometimes, the change hits you right between the eyes.

Nobel Prize Winning Economist Paul Krugman wrote a blog outlining a strategy for how to compel the Chinese Government to revalue the RMB. His argument rested on the success of a short term tariff imposed on Germany and Japan back in 1971 of 10% which helped those two countries realize the errors of their ways. His conclusion? What worked then could work again now…only perhaps we should make the tariff 25% to show the Chinese that we are serious. Why should we consider doing this? Because the undervalued RMB is a drag on global economic recovery and it has negated the positive effects of the US stimulus program.

As a fan of the Austrian Economic School of thinking (Mises.org), I tend to find flaws in many of Mr. Krugman’s policy proposals. However, this one appears to cut across all schools of economic thought. The last time someone came up with a gem like this, we ended up with the Smoot-Hawley Tariff Act of 1930. The list of intended and unintended consequences has been well documented in the blogosphere. Stephen Roach may win the “most quotable” prize for suggesting that a baseball bat be employed to sort out Mr. Krugman’s advice.

However, sometimes one needs to take a step back and see the bigger picture. In this case, the big picture comes in the form of a cartoon from Jim Morin of The Miami Herald.

The level of indebtedness is the real issue. The US will soon have debt outstanding equivalent to 100% of GDP. As the IMF points out in a Bloomberg article, only Germany and Canada look likely to stay under the 100% mark by 2014. Mr. Krugman is correct that our stimulus policies are not delivering the promised goods (a “liquidity trap”). And he is probably correct that China’s trade surplus is not helping (an “anti-stimulant”). But the real problem with his Keynesian stimulus prescription is that we are at the end of the Debt Super Cycle. China’s currency manipulation is not the biggest problem the US or other G-7 nations will face in the coming 5 to 10 years. Growing out from under a mountain of government debt is the real challenge.

Why is the US Government loading up on debt? Because the usual sources of credit demand are sitting on the sidelines.

The US consumer is tapped out. Double digit underemployment and underwater mortgages have taken their toll on this once mighty sector which made up 72% of GDP at the peak.

Non-financial corporates are taking a pass on new loans as the sector chokes on idle excess capacity. Corporations are also facing an uncertain tax, pension and healthcare future.

The only private demand for credit is from financial firms which line up at the Fed to take Quantitative Easing (QE) money with which they purchase two year US Treasuries. The financial firms do this because:

  1. They have privileged access to the FED’s near zero cost funding and
  2. The interest rate differential is helping them to rebuild capital.

But, with the Fed’s US$1.25 trillion buy program of Mortgage Backed Securities due to expire at the end of the month, that last source of private demand for credit may dry up as well.

Perhaps this is a good time to look at and reweight your portfolio. What should you be looking for?

  1. Since governments (and the US in particular) are the only segment of the market still piling on debt, one should avoid their longer dated paper at these extremely high prices (low yields). The shape of the yield curve is not telling us that much about inflation at this point. Default is unlikely but a sharp rise in interest rates demanded may not be too far in the future. Keep your durations short.
  2. On the flip side, the US government will be increasing its already substantial spending on Pharmaceuticals (XPH) and Medical Equipment (IHI) over the next 10 years now that the Health Care Reform Bill has jumped another hurdle.
  3. Global Growth will continue to be concentrated in the Emerging Markets, especially those with raw materials and energy to sell. Russia and Brazil still look attractive. China will continue to be challenged to find sources of growth that do not ultimately depend on the US consumer.
  4. Corporate bonds, particularly high yield, still offer some upside potential.

For more specific ideas, go to the Portfolios Page.


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