Friday, January 06, 2006

How U.S. debt threatens the economy

More of what I've been saying all along... This Jan 5, 2006 MSN Money article written by Roger Ibbotson, discusses the US deficit, the potential for a falling dollar, rising inflation rates, bond prices, Asian competition for natural resources, increased oil prices, etc.

Mr. Ibbotson, who holds a Ph.D, and is a professor of finance at the Yale School of Management, is probably just a tad bit smarter than me. So, for those of you who think I'm off my rocker with all this stuff, read his article below.

In 2006, look for a falling dollar and dropping bond prices, along with rising inflation and interest rates, as growing economies in China and India assert themselves.

You don't have to invest in China or India to be affected by the dramatic growth of their economies. And you don't have to be a politician to worry about trade and budget deficits. They're all interconnected, and they will all affect your pocketbook in 2006 and beyond.

Yes, the growth of the global economy has created tremendous opportunities for trade and investment -- and helped keep our economy growing at a healthy rate. But certain long-term problems are becoming more apparent as a result of the way goods and dollars flow around the globe. A few: The U.S. dollar, long-term bonds and financial firms may be in for a rough ride.

But my forecast isn't all doom and gloom. The overall stock market looks like a value at current prices, and some sectors -- most notably energy stocks -- should benefit from Asia's continued rise.

A surplus of deficits
A trade deficit simply means that we import more than we export. The net result of this is that more money flows out of the country than flows in. Prior to 1980, the United States was a net exporter, selling more goods overseas than it imported. But over the last 25 years, the situation has reversed. The trade deficit today has grown to record levels (now almost 6% of gross domestic product), with the biggest import-export imbalances coming from China, Japan and Southeast Asian nations.

We're all familiar with a budget deficit. That's where we spend more than we earn and have to borrow to fill the gap. We rely on credit cards to get through a budget deficit; the federal government issues Treasury bonds to finance its shortfall.

The U.S. has run budget deficits over a great deal of its history. The budget deficit today isn't even the highest it's ever been -- we ran larger deficits (as a percentage of GDP) during World War II. But what has changed over the last 25 years is that foreign governments, rather than U.S. citizens, have been buying this U.S. debt (in the form of Treasurys). Now, approximately half of this country's debt is held outside the United States, primarily by China, Japan and Southeast Asian nations.

Until recently, none of this was a problem. These creditor nations, with whom the U.S. also had its largest trade imbalances, were happy to buy up our extra government debt. The system worked. Folks here bought their exports, and they bought our debt. American consumers benefited from the flow of inexpensive goods, and foreign creditors benefited both from their return on investment and the continued consumption of their goods. This global interdependency helped to kept interest rates low and the dollar relatively strong.

Through the 90s, as our trade deficit grew, our budget deficits made up only a small percentage of our GDP. We were easily able to service our debt. But war, tax cuts and Hurricane Katrina changed that. And the combination of a weighty budget deficit and a record trade deficit has made these creditor nations nervous about loading up on too much U.S. debt. It's reasonable to think that China, Japan and Southeast Asia may soon choose to diversify their investments and stop buying our debt.

Competition for oil
The U.S. is by far the largest consumer of oil, buying almost a quarter of the total supply. But as China and India emerge as world economic players, they are demanding significantly more oil for autos and industry. In fact, China has become the No. 2 world consumer of oil. And with a population almost four times ours (and yet, only slightly larger than India's), there's increasingly more demand for oil and natural resources.

At the same time, the potential to increase the global oil supply may be more limited than in the past. Saudi Arabia and other oil-exporting countries are already producing close to capacity. Static supply and increased demand will inevitably cause energy prices to rise. Like budget surpluses, cheap energy and natural resources are unlikely to return anytime soon.

What does this mean to me?
If foreign countries stop buying our debt, that will cause long-term bond prices to drop, interest rates to rise and the dollar to fall. Excess demand for energy and natural resources from China and India will likely spur a rise in U.S. inflation rates. Higher interest rates and inflation coupled with a weak dollar make long-term bonds a risky investment with very little upside. Investors looking to invest new money in fixed income will be better off investing in short-term bonds.

The impact on the overall stock market is less clear -- some sectors will benefit while others will struggle. The drop in long-term bond prices may be harmful to certain types of financial firms, for example. Rising oil prices may help energy companies but hurt manufacturing, while a falling dollar may make many of our products more competitive overseas.

Overall, the market is strong and more reasonably priced today than it was a few years ago. Price-to-earnings ratios have come down from highs in the 40s in 2000 to half that today. And that ratio hasnt come down because prices dropped, but rather because corporate earnings have increased -- a much healthier reason. Todays lower stock valuations make the market much more attractive and should attract more money to stocks, which should drive their prices higher.

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