Since it is highly unlikely that the US government will address the fiscal imbalance by reigning in entitlements, the pressure then builds for the financial market to rein in the government’s expansion of continuously growing deficits. Because of the built-in regulatory induced biases for institutions to hold Treasuries and because in an ultimate show down the Fed or money printing authority will be captured by the government and will monetize the debt, the mostly likely outcome is investors registering their concerns by exiting the US capital markets.
As an investor unconstrained by regulation one can do that. The obvious question is where will capital flow. To the extent we can learn from the past, the discussions relating to how the less developed countries set about attracting capital highlights the variables investor respond to. Since we are in a world of heightened sovereign risk sensitivity with implications for capital flight and inflation the question becomes how investors will choose another capital safe haven.
As Bill Gross of PIMCO points out the starting levels of country debt are most relevant to look at and hence I include his graphic display that indicates the extent to which over indebtedness and sovereign risk is common to the the developed world. In contrast those with a lower and declining sovereign risk problem are the countries that are considered developing or emerging. Further, with the emerging nations tending to have more competitive terms of trade based on labor cost and with emerging middle classes that will be spending larger proportions of their income these same low debt countries will likely be the high growth economies ahead. Hence this argues for a tilting of an investment portfolio in the direction of the developing nations and away from the developed. While this is a general proposition there are some among the developed that still merit conseration. They would be countries that have adequately funded its entitlements in advance and have other built in sources of economic stimulus such as being resource rich (Canada), or high productivity (Germany). Indeed those countries have been singled out by PIMCO for this purpose. Among the developing countries other issues such as rule of law, the liquidity of market and the likelyhood of future trade surpluses are important variables to consider. Germany’s special consideration especially its fixed income market is due to the likelyhood that it will suffer deflation rather than inflation as long as the Euro zone remains economically challenged with a central bank that is constrained from inflating its way out of trouble.